An Empirical Model of Labor Supply in the Underground Economy

This paper uses micro data from a random survey carried out in the region of Quebec City, Canada, to estimate a model of labor supply in the underground economy. The model assumes that the individual's gross wage rate in the regular sector is parametric while his gross labor earnings in the underground sector are a concave function of hours of work. This distinction between the two sectors is used to generate a simple separation result between preferences and the magnitude of underground labor market activities. This result implies that the individual's labor supply in the underground economy is generally a negative function of his net wage rate in the regular sector. The separation result also implies a set of restrictions on the parameters of the reduced form of the model, which are imposed using minimum distance methods of estimation. Various generalized method of moments specification tests allow us to verify the validity of these restrictions. According to our results, the marginal tax rates embodied in the Quebec tax-transfer system are an important determinant of the decision to participate in the underground sector.