This paper estimates the extent of income underreporting by households with business income relative to households of wage earners in Estonia. The paper uses a modified version of the methodology pioneered by Pissarides and Weber (1989). The extent of income underreporting is estimated by comparing food Engel curves for households with and without business income. The baseline result is that the reported income of households with business income above 20% of total income must be multiplied by 2.6 in order to attain the same propensity of food consumption as households of wage earners. Households with business income above 0 but below 20% also underreport income, but to a lesser extent. The estimates are higher than those found for developed countries, but consistent with other studies of the shadow economy in transition countries. The analysis also shows that the presence of business income is a better indicator of income underreporting than a reported status of self-employment.
JEL code: H26, E21, E26, H24
Keywords: tax evasion, business income, income underreporting, Engel curve, transition country