Public Provision of Private Goods, Self‐Selection, and Income Tax Avoidance

• Author: Sören Blomquist,Vidar Christiansen,Luca Micheletto
• Date: 01 October 2016
• DOI: http://doi.org/10.1111/sjoe.12151
• Published date: 01 October 2016

Scand. J. of Economics 118(4), 666–692, 2016

DOI: 10.1111/sjoe.12151

Public Provision of Private Goods,

Self-Selection, and Income Tax Avoidance∗

S¨

oren Blomquist

Uppsala Center for Fiscal Studies at Uppsala University, SE-751 20, Uppsala, Sweden

soren.blomquist@nek.uu.se

Vidar Christiansen

University of Oslo, Blindern, NO-0317 Oslo, Norway

vidar.christiansen@econ.uio.no

Luca Micheletto

University of Milan, 20122 Milan, Italy

luca.micheletto@unimi.it

Abstract

Redistributive taxation should benefit those with low earnings capacity rather than those

who choose a lower income to obtain tax savings. Several contributions have highlighted

how public provision of work complements can discourage people from lowering labor supply

to diminish taxable income. We show how tax avoidance, previously neglected, can alter the

conclusions regarding public provision. Tax avoidance breaks the link between labor supply

and reported income. An agent reducing his reported income to escape taxes might no

longer forego a publicly provided labor complement, because he can now lower his income

by avoiding more rather than working less.

Keywords: Income misreporting; optimal nonlinear income tax; tax avoidance

JEL classification:H21; H26; H42

I. Introduction

A key issue in public economics is how to combine taxes and public

expenditures in order to achieve the desired redistribution and revenue-

raising at low efficiency costs. Within the optimal tax body of literature,

several contributions have highlighted the welfare-enhancing role of using

public provision of certain private goods as an instrument to alleviate labor-

supply discouragement and other tax-induced distortions, for instance by

∗We are grateful to two anonymous reviewers for their constructive comments. V. Chris-

tiansen’s contribution to the paper is part of the research at Oslo Fiscal Studies at the

Department of Economics, University of Oslo, supported by the Research Council of

Norway.

CThe editors of The Scandinavian Journal of Economics 2015.

S. Blomquist, V. Christiansen, and L. Micheletto 667

lowering the cost of working.1So far, however, the literature on this topic

has largely abstracted from any tax evasion or avoidance. In this paper,

we integrate the research on taxes and public provision with the research

on how people evade taxes by under-reporting true income, or by finding

more sophisticated and elaborate ways to shelter income from taxation –

known as tax avoidance. We find that tax avoidance affects how we would

like to use public provision as part of redistributive policy.

A basic insight from the conventional literature is that public provision of

a good should favor those who actually have a low earnings capacity rather

than those who choose a low income through low labor supply despite

having a higher earnings capacity. For this reason, there is a case for

supplying goods that are complements with labor supply. However, when

avoidance is possible, agents with higher earnings capacity can choose

lower reported income by under-reporting income without lowering labor

supply, or even in combination with increased labor supply. They could

work more to earn what is now tax-free income at the margin. Working

more, agents with high earnings ability but low observable income will

benefit more from the publicly provided commodity. Also, without working

more, these agents might value the good more as they have more (evaded)

income to spend. In either case, a good that is appropriate for public

provision with full income reporting might no longer be suitable when

there is tax avoidance.

Even when those able agents who choose a low income would like

to consume more than those with lower earnings ability, public provision

might be socially efficient in certain circumstances. Suppose that an agent

has to choose either to accept an amount that is publicly provided free

of charge or to fully acquire the commodity in the market (i.e., choosing

public or private health care). Then, the agent with the lower valuation of

the commodity can be the beneficiary if a small amount (or a low quality)

is provided. The reason for this is that the agent with the higher valuation

might find the public provision inadequate and might opt for the market

alternative, foregoing the benefits of public provision. However, whether

an agent has a low valuation or not might depend on the extent to which

he can engage in tax avoidance activities. Suppose that high-wage non-

avoiders who choose a low income have a low valuation, while avoiders

who report a low income have a high willingness to pay because of a large

1The literature on the welfare-enhancing role of public provision of private goods as a policy

instrument in Mirrleesian optimal tax models has been developed in a series of papers since

the mid-1990s. The main contributions include Blomquist and Christiansen (1995), Boadway

and Marchand (1995), Cremer and Gahvari (1997), Balestrino (2000), Pirttil¨

a and Tuomala

(2002), and Blomquist et al. (2010).

CThe editors of The Scandinavian Journal of Economics 2015.