Dynamic Tax Evasion with Habit Formation in Consumption*

• DOI: http://doi.org/10.1111/sjoe.12365
• Published date: 01 July 2020
• Date: 01 July 2020

Scand. J. of Economics 122(3), 966–992, 2020

DOI: 10.1111/sjoe.12365

Dynamic Tax Evasion with Habit Formation

in Consumption*

Michele Bernasconi

Universit`a Ca’ Foscari, 30121 Venice, Italy

bernasconi@unive.it

Rosella Levaggi

Universit`a di Brescia, 25122 Brescia, Italy

rosella.levaggi@unibs.it

Francesco Menoncin

Universit`a di Brescia, 25122 Brescia, Italy

francesco.menoncin@unibs.it

Abstract

We model the optimal intertemporal decision of an agent who chooses tax evasion and

consumption, over an infinite lifetime horizon, where consumption is driven byhabits. We find

the following: (i) tax evaders reduce consumption in the early stages of habit accumulation and

increase it over time; (ii) habit formation has a dampening effect on tax evasion;(iii) neglecting

tax evasion can lead to habit overestimation; (iv) the effect of the tax rate on tax evasion is

ambiguous; (v) heavy fines are more efficient than frequent controls in reducing tax evasion.

Keywords: Fiscal audit; lifetime decisions; simulations; tax compliance

JEL classification:G11; H26

I. Introduction

Tax evasion is a severe problem in many countries. Estimates show that

intentional under-reporting of income in the United States is about 18–

19 percent of reported income in the United States, leading to a tax gap

of about $500 billion per year (Feige and Cebula, 2012). In Europe, the

level of tax evasion is about 20 percent of GDP, which accounts for a

potential loss of about one trillion euros per year (Murphy, 2014; Buehn

and Schneider, 2016). The shadow economy, the size of which is closely

related to tax evasion, and tax evasion both reflect weak enforcement of

fiscal rules (Schneider, 2005; Alm and Embaye, 2013).

Several avenues have been explored to identify motivations for tax

evasion using the enrichment of traditional portfolio models with behavioral

*Wethank three anonymous referees for their helpful comments that have greatly improved the

quality of the paper.Any remaining er rors are our own.

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The editors of The Scandinavian Journal of Economics 2019.

M. Bernasconi, R. Levaggi, and F. Menoncin 967

Shadow Economy as % of GDP

Median Age

20 25 30 35 40 45

10 20 30 40 50

20 25 30 35 40 45

20 30 40 50 60 70 80

Household Consumption as % of GDP

Median Age

Fig. 1. Shadow economy and consumption versus population age for 49 high-income and

upper-middle-income countries

Source: The data are taken from Alm and Embaye (2013) for the shadow economy and from the United Nations

database (https://unstats.un.org/unsd/snaama/index) for household consumption and median age.

considerations and social norms – see Alm (2012) for an extensive review

– but little attention has been paid to the age-dependent structure of tax

evasion. To show this, in Figure 1 we plot the age-dependent paths of

both the shadow economy and the aggregate private consumption in several

high-income and upper-middle-income countries around the world (Alm and

Embaye, 2013).1

The size of the shadow economy decreases with the population’s median

age, more rapidly until the median age reaches about 35 and then slowing

as it approaches a steady state. Such a connection between the dynamic path

of household consumption and the relative weight of the shadow economy

cannot be explained by the recent literature on dynamic tax evasion

1We use the subset of high-income and upper-middle-income countries because data on

consumption for low income countries, also considered in Alm and Embaye (2013), are less

reliable; the overall dynamics of evasionis even more pronounced in the whole set of countries

compared with the subset we use.

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The editors of The Scandinavian Journal of Economics 2019.