Tax Optimization under Tax Evasion

All opinions expressed here are those of the authors and not those of the Economics Education and Research Consortium Research dissemination by the EERC may include views on policy, but the EERC itself takes no institutional policy positions This paper considers the problem of determining the optimal taxation for a group of individuals with random, independent and identically distributed incomes. Because a taxpayer's income is private information, it can only be verified through a costly audit. The purpose of this paper is to characterize the optimal tax schedule and auditing strategy that maximizes the government's net tax revenue under certain participation constraints that are related to the interests of the taxpayers. The authors determine the optimal evasion-proof strategy, depending on the penalty constraint. They show that under certain conditions, tax evasion may increase net tax revenue, but typically the optimal government strategy is evasion-proof.