Welfare‐improving tax evasion

• Published date: 01 January 2024
• Author: Chiara Canta,Helmuth Cremer,Firouz Gahvari
• Date: 01 January 2024
• DOI: http://doi.org/10.1111/sjoe.12539

Scand. J. of Economics 126(1), 98–126, 2024

DOI: 10.1111/sjoe.12539

Welfare-improving tax evasion

Chiara Canta

TBS Business School, FR-31068 Toulouse, France

c.canta@tbs-education.fr

Helmuth Cremer†

Toulouse School of Economics, FR-31080 Toulouse, France

helmuth.cremer@tse-fr.eu

Firouz Gahvari

University of Illinois at Urbana-Champaign, Urbana, IL 61801, USA

fgahvari@illinois.edu

Abstract

We study optimal income taxation in a two-group framework where the private cost of

misreporting income is positively correlated with productivity. If high-wage types always reveal

their income truthfully, then letting low-wage types cheat leads to Pareto-superior outcomes

regardless of the audit costs (as compared to deterrence). With no cheating, redistribution takes

place on first- or second-best frontiers and low-wage types always end up worse off than

high-wage types. Letting low-wage types misreport reduces the need to recourse to second-best

mechanisms. Additionally, it increases the reach of first-best redistribution to outcomes at which

low-wage types are better off than high-wage types.

Keywords: Optimal taxation; audits; redistribution

JEL classification:H20; H21; H26

1. Introduction

It is nearly five decades since Mirrlees (1971) and Allingham and

Sandmo (1972) launched the literatures on the optimal general income tax

and on tax evasion, which have now grown into two of the most fertile

subdisciplines in the area of economics of taxation. They are both concerned

with efficient and fair ways to raise tax revenues for the government, yet,

rather curiously, they have gone their own separate ways. The focus of the

optimal tax literature has been on the formulation of income tax schedules,

and that of the tax evasion literature on the design of enforcement policies

taking the tax schedule as given. One fundamental reason for this parting

of ways is no doubt their diametrically different foundational assumptions.

Whereas the Mirrleesian optimal taxation literature assumes incomes are

†Also affiliated with University of Toulouse Capitole.

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C. Canta, H. Cremer, and F. Gahvari 99

publicly observable, the tax evasion literature has unobservability of incomes

as its raison d’ˆ

etre.

Over this period of time, the attempts to bring these two literatures together

have been few and far between. One, published some 25 years ago, is Cremer

and Gahvari (1995) who, using the Stiglitz (1982) two-group reformulation

of Mirrlees (1971), allow for incomes to be misreported and observed only

through costly audits. They investigate the properties of the resulting optimal

policy with a general income tax schedule, an audit policy conditioned on

reported incomes, and punishment for misreporters as its instruments. Chander

and Wilde (1998) consider nonlinear taxation with a continuum of individuals,

and establish some properties of the optimal tax schedule for the case where

individuals are risk neutral. Schroyen (1997) also allows for nonlinear taxation

but restricts the penalty to be proportional to the tax evaded.1

The aim of this paper is to cast doubt on a widely accepted view about tax

evasion in the literature and by the public. This is the view that tax evasion is

a “bad thing”; that is, it lowers social welfare and must be deterred when not

too costly. We ask if this is always the case: are there indeed no circumstances

under which tax evasion can be a “good thing” which should be glossed over

even if it can be deterred at a low cost (indeed costlessly)? The answer lies in

a hitherto ignored role that tax evasion might play in the design of an optimal

general income tax schedule. This role is a result of the existence of private

evasion costs, and it comes into play when high-wage individuals find it more

costly to engage in evasion activities than do low-wage individuals. Allowing

for this, as we show below, opens up an avenue for tax evasion to become a

determining factor for designing optimal tax/deterrence policies. Tolerating

some tax evasion can, at times, be socially optimal.

The key insight comes from the realization that optimal tax systems are

inherently distortive as they have to ensure that certain incentive compatibility

constraints are satisfied (unless, of course, the constraints do not bite). Tax

evasion can ease these constraints and alleviate the distortions. In this way, tax

evasion can improve social welfare. Needless to say, tax evasion is also, by

nature, a costly activity that reduces social welfare. In designing an optimal tax

system, when incomes are publicly unobservable, these positive and negative

effects both need to be taken into account. An important point to consider

though is that it is not just the magnitude of misreporting costs per se that

matters in the trade-off between the gains and losses. How the misreporting

costs affect individuals of different types also plays a crucial role in this

calculus. It is this aspect that helps determine which incentive compatibility

1Casamatta (2021) considers costly but legal avoidance so that the issue of auditing does not

arise. In his setting, concealment costs are the same for everyone. Gahvari and Micheletto (2020)

rule out audits by following a riskless approach to evasion and assume identical concealment

technologies.

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