Income tax evasion: tax elasticity, welfare, and revenue
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Income tax evasion: tax elasticity, welfare, and revenue Max Gillman1,2,3,4 Accepted: 19 September 2020 © Springer Science+Business Media, LLC, part of Springer Nature 2020
Abstract This paper provides a general equilibrium model of income tax evasion. As functions of the share of income reported, the paper contributes an analytic derivation of the tax elasticity of taxable income, the welfare cost of the tax, and government revenue as a percent of output. It shows how an increase in the tax rate causes the tax elasticity and welfare cost to increase in magnitude by more than with zero evasion. Keeping constant the ratio of income tax revenue to output, as shown to be consistent with certain US evidence, a rising productivity of the goods sector induces less evasion and thereby allows tax rate reduction. The paper derives conditions for a stable share of income tax revenue in output with dependence upon the tax elasticity of reporting income. Examples are provided with less and more productive economies in terms of the tax elasticity of reported income, the welfare cost of taxation and the tax revenue as a percent of output, with sensitivity analysis with respect to leisure preference and goods productivity. Discussion focuses on how the tax evasion analysis may help explain such fiscal tax policy as the postwar US income tax rate reductions along with discussion of government fiscal multipliers. Fiscal policy with tax evasion included shows how tax rate reduction induces less tax evasion, a lower welfare cost of taxation, and makes for a stable income tax share of output. Keywords Optimal evasion · Tax law · Welfare · Tax elasticity · Revenue · Productivity · Development JEL Classification E13 · H21 · H26 · H30 · H68 · K34 · K42 · O11
* Max Gillman [email protected] 1
Department of Economics, University of Missouri - St. Louis, 1 University Boulevard; SSB 408, St. Louis, MO 63121, USA
2
CERS-IE, Budapest, Hungary
3
CERGE-EI, Prague, Czech Republic
4
Loughborough University, Loughborough, UK
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Vol.:(0123456789)
M. Gillman
1 Introduction The paper models tax evasion in a general equilibrium, representative agent, optimizing framework. Using closed form solutions, it derives the elasticity of labor income to a flat tax, the welfare cost of the labor income tax, and the effect of productivity and tax rate changes on tax revenue. The paper uses a certainty-equivalence model of tax evasion as an optimal choice of the share of earned income to report for tax purposes.1 It contributes how the tax elasticity and welfare measures are based on structural utility, technology, and policy parameters rather than being behavioral, immutable, parameters. It is shown how rising goods sector productivity causes less tax elasticity, tax evasion, and welfare loss, and how falling income tax rates act similarly.2 The paper contributes analytic conditions for how income tax rate reductions can keep income tax revenue as a share of output constant over time. Given a trend up in goods sector productivity, the tax rate
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