Tax evasion and the underground economy*

The problem of tax evasion arises in an economy in which every taxpayer regards the output of the public sector as independent of her actions and the taxpayer can be audited by the public authority and fined, if found guilty. Earlier contributions to the study of tax evasion in a game-theoretical framework include Sandmo (1981), Reinganum and Wilde (1985, 1986), Graetz et al. (1986), Greenberg (1985), Benjamini and Maital (1985), Schlicht (1985), Mookherjee and P'ng (1986), Scotchmer (1987), Border and Sobel (1987), and Ortuño-Ortín (1991). Each of these papers focuses on the problem from a different angle, and obtains sorne conclusions on the welfare effects of tax evasion [a review of this literature can be found in Cowell (1985, 1990) and Mookherjee (1989)]. In all these papers, evasion is modeled as a continuous variable, i.e. the range of evasion goes from zero to the value of due taxes. A prominent example of this kind of situation is income tax evasion. No matter how important these situations are, there are examples in which it is more natural to model evasion as a discrete choice model, reflecting an