The term “underground economy” is defined as a production of those goods and services that are not seen in official statistics. The term can also be referred to as “shadow economy,” “hidden economy,” “unregistered economy,” “illegal economy,” or “black economy.” Underground economy stems from heavy tax burdens and social security contributions, the expenses of registered economy, the quality of institutions, tax moral and tax audits. Underground economy exists in both developed and developing countries. It reduces tax revenues and motivates illegal activities. This study examines the impact of underground economy on the sustainability of tax policies in Turkey.

Because of easy implementation, growth-friendly structure and multiple-stage structure of value added tax (VAT), consumption taxes are better than income taxes when we analyze underground economies. However, the rise in tax burdens increases unregistered employment, and therefore it also reduces tax revenues. To compensate for the loss of tax receipts, governments raise tax rates. By doing so, governments reveal the feedback effect of underground economy. In this context, picking true tax policy tools reduce the feedback effect of underground economy. 

Tax systems are affected by culture, technology, globalization, and the intensity of production factors. Those which are charged from income and wealth are direct taxes whereas those which are charged form expenditures are indirect taxes. Taxation in Turkey is made up of indirect taxes and labor-based income taxes. The Turkish tax system has an upper limit in indirect taxes, and does not apply direct taxes due to undercapitalization. This position of tax system is called a tax trap. The tax trap, in turn, reduces the elasticity of the Turkish tax system.

This paper investigates the impact of underground economy on the sustainability of Turkish tax policies by using data from the Organization for Economic Co-operation and Development (OECD), Eurostat, and Turkish tax revenue service. Underground economic activities in the European Union (EU) countries and Turkey have been significantly reduced since 2003. In 2016, an estimation on the underground economy in Turkey is 27.8 percent which is larger than the EU’s average. According to the results of tax audits in 2016, tax base and tax revenue differences in Turkey were 60.1 percent and 32.8 percent respectively. As a conclusion, average tax rates in Turkey, when comparing tax revenue difference to tax base differences, is 54.6 percent. The result questions the overall credibility of tax audits.

Contrary to traditional belief, there exists no connection between tax systems and underground economy. It is not true that indirect taxes reduce the size of underground economy. It is claimed here that the link between population and underground economy is limited. In Turkey, the development of tax audits and technology provides more accurate data, and therefore, this position makes the underground economy smaller in size. Tax audits, which regain crucial amounts of tax revenue, mean that underground economies erode away from tax revenues. 

Turkish tax system manages to levy a tax on consumption. Yet, this is not valid for income. Therefore, the situation creates tax traps which make tax designs even more complex. Technology, underground economy and public expenditures affect the sustainability of tax policies. Tax policies are expected to provide both regular and adequate tax revenues at the lowest cost, without breaking social justice and other balances of macroeconomic variables, such as employment, inflation, and growth. In this context, coping with underground economy is crucial in sustaining tax policies and to increase the efficiency of public expenditures.