reported by China with the Hong Kong data on its exports to China at the product level for 1998 they demonstrated that a one-percentage-point increase in the tariff rate was on average associated with a three percent increase in underreporting.<sup>5</sup> Our study also contributes to the emerging literature on differentiated products. In his seminal work, Rauch (1999) classified goods into three categories. He defined homogeneous goods as products whose price is set on organized exchanges. Goods which are not traded on organized exchanges, but possess a benchmark price, were defined as reference priced. Finally, products whose price is not set on organized exchanges and which lack a reference price because of their intrinsic features were labeled as differentiated. Rauch argued that search costs tend to be higher for differentiated products relative to homogeneous goods and showed that colonial ties and common language are more relevant for trade in differentiated products than trade in homogeneous goods. In subsequent work, Rauch and Trinidade (2002) found that the positive impact of ethnic Chinese networks on bilateral trade is greater for differentiated products relative to homogeneous ones. In line with this result, Rauch and Casella (2003) showed that the higher the degree of product differentiation the larger the impact of international ties between wholesalers on bilateral trade. Fink, Mattoo and Neaugu (2002) provided evidence that the effect of communication costs on trade is larger for differentiated products. Feenstra, Markusen and Rose (2001) showed that home market effects are more pronounced for differentiated than for homogeneous products, while Evans (2003) found that the higher the degree of product differentiation, the smaller the border effects. In a recent paper, Besedes and Prusa (2006) showed that transactions in differentiated goods tend to start involving smaller values than transactions of homogeneous goods and that trade relationships tend to be longer for differentiated products than for homogeneous ones.

While our study does not explicitly analyze the effects of customs reform, its results suggest that a system which gives customs officials discretion and does not involve effective audits or secondary inspections is likely to lead to tariff evasion. Corrupt behavior aside, the ability of the customs official to evaluate invoice prices may be greatly enhanced by computerization and international agreements that allow them to obtain verification from foreign institutions about the validity of documents presented by

> 5 Our work is also related to a more general literature on tax evasion. While many theoretical models have analyzed the impact of tax rates on evasion, Slemrod and Yitzhaki (2000) concluded in their survey paper that theoretical findings are not clear-cut, as they strongly depend on modeling assumptions. Contrasting results are provided by empirical studies as well. Clotfelter (1983) and Feinstein (1991), who study the impact of tax rates on tax evasion by using the U.S. Taxpayers Compliance Measurement Program data, ended up drawing opposite conclusions. Cloetfleter found a positive relationship, while Feinstein, who employed a subset of the dataset, provided evidence of a negative relationship.

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