Taxation by State and Organized Crime: Harmony or Conflict? 1

Abstract

Organized crime has played an important role in several economies in transition, where the state has been either unwilling or unable to fulfill some of its important functions. in particular, the mafia has taxed the producers and provided such services as protection and contract enforcement. Typically, the analytical literature has assumed that the mafia operates only in the unofficial economy. We drop this assumption and examine the previously unexplored implications of the mafia's taxation of legal economic activity and particularly the effect this has on the revenue-maximizing government's tax policy and its incentive to combat the mafia. Our main result is that as long as the demand for the firms’ output is inelastic and if the mafia is not too strong, as measured by how costly it is for the mafia to tax official sales, its taxation of legitimate economic activities does not affect the revenue-raising capacity of the state. However, if the demand is elastic, an increase in the mafia's strength always hurts the state. in addition, we investigate the official tax policy consequences of the change in the firms’ costs of operating underground, the government auditing of firms, and the implications of welfare optimization by the state.