This paper introduces underground activities and tax evasion into a one sector dynamic general equilibrium model with aggregate external e ects. The model presents a novel mechanism driving the self-fulfilling prophecies, which is characterized by well behaved (downward sloping) labor demand schedules. This mechanism di ers from the customary one, and it is complementary to it. Compared to traditional labor market income, the income derived from underground labor activity is subject to a lower

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... xpected tax rate when considering both the probability of detection and the evasion penalty. During a belief-driven expansion, the household allocates more time to both traditional and underground labor supply. In equilibrium, this action serves to lower the e ective labor tax rate faced by the household, thus providing stimulus to aggregate labor supply so as to make the initial expansion self-fulfilling. The mechanism here is akin to a "regressive tax"; the household's e ective tax rate depends negatively on the level of total labor income. We argue that an underground sector, and the associated tax evasion, o er a good economic rationale for a regressive tax rate. Journal of Economic Literature Classification Numbers: O40, E260