Cross-country evidence highlights the importance of tax evasion and corruption in determining the size of fiscal multipliers. We introduce these two features in a New Keynesian model and revisit the effects of fiscal consolidations. VAR evidence for Italy suggests that spending cuts reduce tax evasion, while tax hikes increase it. In the model, spending cuts induce a reallocation of production towards the formal sector, thus reducing tax evasion. Tax hikes increase the incentives to produce in the less productive shadow sector, implying higher output and unemployment losses. Corruption further amplifies these losses by requiring larger hikes in taxes to reduce debt. We use the model to assess the recent fiscal consolidation plans in Greece, Italy, Portugal and Spain. Our results corroborate the evidence of increasing levels of tax evasion during these consolidations and point to significant output and welfare losses, which could be reduced substantially by combating tax evasion and corruption. •We show that tax evasion and corruption matter for the size of fiscal multipliers.•Evidence suggests that spending cuts reduce tax evasion, and tax hikes increase it.•We replicate these findings in a DSGE model with tax evasion and corruption.•We assess the recent fiscal consolidation plans in Southern European countries.•Our simulations show a rise in tax evasion, and large output and welfare losses.
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