The Legal and Illegal Markets for Taxed Goods: Pure Theory and an Application to State Government Taxation of Distilled Spirits

This paper, which is based upon the author's Ph.D dissertation for the Economics Dept., Univ. of Chicago, integrates the theory of illegal behavior into the economic analysis of regulation, developing implications for both the measurement of regulatory stringency and the determination of the economic effects of regulation. The discussion shows that measures of regulatory stringency must consider the level of law enforcement resources in addition to the statutory provisions in regulations. A more important conclusion is that an analysis of regulation that ignores the prospect of illegal behavior incorrectly analyzes the economic effects of changes in the statutory provisions of regulations. Empirical results from the study of state taxation of liquor suggest replacing the traditional analysis by the proposed alternative analysis that emphasizes the importance of tax evasion.