Welfare-improving tax evasion

Abstract

We study optimal income taxation in a two-group framework where the private cost of misreporting income is positively correlated with productivity. We show that, if high-wage types always reveal their income truthfully, letting low-wage types cheat would lead to Pareto-superior outcomes regardless of the audit costs (as compared to deterring them). When there is no cheating, redistribution takes place on first- or second-best frontiers with the low-wage types always ending up worse off than the high-wage types. Letting low-wage types conceal their income reduces the need to recourse to second-best mechanisms for redistribution. Additionally, it increases the reach of first-best redistribution to outcomes at which low-wage types are better off than high-wage types.

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Reference

Chiara Canta, Helmuth Cremer, and Firouz Gahvari, “Welfare-improving tax evasion”, The Scandinavian Journal of Economics, vol. 126, n. 1, January 2024, pp. 98–126.