Welfare improving tax evasion

Abstract

We study optimal income taxation in a framework where one's willingness to report his income truthfully is positively correlated with his type. We show that allowing low-productivity types to cheat leads to Pareto-superior outcomes as compared to deterring them, even if audits can be performed costlessly. When there is no cheating, redistribution takes place on first- and second-best frontiers and can never make low-ability types more well-off than high-ability types. Letting low-ability types cheat allows first-best redistribution up to a limit at which low-ability types are better off than high-ability types.

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Reference

Chiara Canta, Helmuth Cremer, and Firouz Gahvari, “Welfare improving tax evasion”, TSE Working Paper, n. 20-1121, July 2020.