This study empirically examines the impact of federal income tax rates, IRS penalties on unpaid tax liabilities, and audit rates of the Internal Revenue Service on the size ofthe underground economy in the United States, Recent data generated by Edgar Feige ure u.sed to measure the size ofthe underground economy. Based on ordinary least squares estimates, it is found that the maximum marginal personal income tax rate raises the size of the underground economy. In addition, the size of the underground economy is found to be a decreasing function of both the percentage of tax returns audited and the penalties imposed by the IRS on unpaid taxes.• (Richard J, Cebula, PhD,, is professor of economics, Georgia Institute of Technology.! The author is indebted to two anonymous referees and the editor for helpful comments and suggestions.

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