Discuss whether some positive amount of tax evasion could be optimal and why.

According to the
different theories, what characteristics are likely to be observed in an economy that has relatively
more tax evasion in equilibrium?

What is tax evasion?

Tax evasion occurs when individuals, corporations and others deliberately and illegally evade
tax.
It differs from tax avoidance, a legal activity, in which individuals simply use the tax system
to their advantage in order to minimize their tax burden.
Stylized facts and examples
Italy, UK vs Sweden etc.

Basic theory
Allingham and Sandmo (1972), Srinivasan (1973) and Yitzhaki (1974).
In Yitzhaki (1974) individual aims to maximize the following utility function

MaxU=(1-p)U(M-tX)+pU(M-tX-Ft(M-X))
Where: p = probability of being caught, Ft (M-X) = fine if caught, M = undeclared income, X
= declared income, t = tax rate
Main results:
Higher fine (F), lower tax evasion
Greater probability of detection (p), lower tax evasion
Higher income (M), higher tax evasion.
Anderson (1977), shows that as tax increases, evasion increases. However as penalties
increase, evasion falls.
Cowell (1981) and Isachen and Strom (1980) introduce a choice between employment in
the official, where tax evasion is difficult and the unofficial sector, where tax evasion is
comparatively easier.
They find that, as tax rate increases, the time spent in the official labour market falls and
accordingly tax evasion increases.

Is tax evasion optimal?

No (mainly because of social costs argument and opportunity costs for the government):
Wrede (1993 and 1995), Lin and Yang (2001), Richter and Boadway,
Yes
Peacock and Shaw (1982) because of the multiplier effects of unreported activities.
Boadway and Keen (1998) and Renstrom (1998) show that by tolerating some tax evasion
the government is able to partially alleviate some of the welfare loss from the time
inconsistency problem in capital income tax.
Davidson, Martin and Wilson (2005) present conditions when a black market will improve
welfare in an economy when otherwise goods would have been taxed at the same rate for
administrative simplicity but remember that uniform commodity taxation is not optimal
(Ramsey rule; Atkinson and Stiglitz; Ebrahimi and Heady; Deaton and Stern; McKinnon and
Harris; Heady and Mirta; Murty and Ray)
Other studies: Andreoni (1992); Fishlow (2002); Weiss (1976) and Stiglitz (1982); Wrede
(1995)

Empirics and measurement issues

Difficult for obvious reasons;
Most of studies focus on labour-income tax evasion (Bird, 1992).
One can start with the ratio between tax revenue and GDP (the richer the country, the higher
his tax revenue should be everything else the same);
Clotfelter (1973) uses: a. The number of those punished; b. Difference between reported
income and the amount of income that IRS investigators determine to be due.
Gutmann (1977) US, estimates the growth of currency in circulation relative to demand
deposits.
Feige (1979) US, measures tax evasion using a ratio of income to that of transactions,
assuming that total economic activity (measured and unmeasured) = transactions x price
level.
Rissarides and Weber (1989) observe the difference between expenditure and income
reported in the UK.
Cross and Shaw (1982) argue that the higher the level of tax avoidance the lower the level of
tax evasion.
Other studies: Niepelt (2005)

When is it most likely?

Refer to results from previous papers!