Evasive ability and the efficiency cost of the underground economy

In the presence of differing abilities to evade taxes, markets select produ cers for their evasive skills and their abilities to keep costs of producti on low. Inefficient firms crowd out efficient firms. If the least efficient firms are the best tax evaders, adverse selection is severe and output com es entirely from the high cost end of the supply curve. Tax revenue may be greater under tax evasion than without evasion if evasive ability allows go vernment to act as a price-discriminating monopolist. When evasive and prod uctive talents are unrelated this result disappears, but the deadweight los s due to adverse selection of firms persists and rivals the size of the tra ditional triangle deadweight loss. JEL Classification: H26, H43, K42, O17.