Welfare improving tax evasion

Abstract

We study optimal income taxation in a framework where the cost misreporting income is positively correlated with productivity. We show that allowing low-wage 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 rst- and second-best frontiers and can never make low-ability types better o than high-ability types. Letting low- ability types cheat allows rst-best redistribution up to a limit at which low-ability types are better off than high-ability types.