Abstract
Workers appear to do less unreported work than what is most profitable for them according to their narrow self interest. We resolve this puzzle by using a model where individuals with different entrepreneurial talent choose between employment and ownership and between reported and unreported work. Since unreported work is easier to detect when it is organized, tax evasion reduces the opportunities to gain from efficient production and vice versa. This trade off between efficiency and evasion leads to a gap between the individually and the collectively optimal level of unreported work within firms. Employers therefore ration unreported work in their firms to ensure the collectively optimal level. We demonstrate that such rationing persist even when employees have opportunities for unreported work as self employed outside the firms. In equilibrium, employees are indifferent between jobs with high reported wages in firms with little unreported work and jobs with low reported wages in firms with more unreported work. Tax evasion induces an inefficient industry structure, where too much labor is allocated to small, low productive firms. Using Norwegian data we find that the gap between the willingness to receive unreported income and actual tax evasion is increasing in firm size --- in line with a key prediction of the model.