Might Fundamental Tax Reform Increase Criminal Activity?

Fundamental tax reform, replacing the income tax with a sales tax, is commonly thought to reduce levels of criminal and other ‘underground’ economic activity by implicitly taxing their returns. This paper finds instead that the impact of tax reform depends on the relative labour intensity of production in the legitimate and illegitimate sectors of the economy. In the likely event that illegitimate output is produced by using more labour‐intensive techniques than is legitimate output, then replacing an income tax with a sales tax reduces the cost of criminal and other underground activity, thereby stimulating its growth.