Tax Evasion and the Minimum Wage

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Can tax evasion justify high but taxed minimum wages? Exploiting a change in reporting defaults and the implied audit threat in Hungary, we demonstrate that a substantial portion of those who declare the minimum wage have much higher earnings in reality. This can be seen from their sharp but temporary jump to the new reporting default, a twofold increase in reported earnings. Consistent with misreporting, the response is concentrated both spatially and by employer, and the distribution of covariates around the threshold exhibits anomalies. Requiring minimum wage earners to pay higher taxes or ask for explicit exceptions increases reported earnings for some and decreases formal employment for others, suggesting a trade-off for taxation. In a model of labor demand and evasion with a linear tax and differential enforcement, raising the minimum wage generates a fiscal externality and can substitute for stricter enforcement by requiring tax evaders to report higher earnings. This goes towards rationalizing a prevalent international practice.