Tax Evasion, Endogenous Spending and the Design of Optimal Tax Codes

In this paper I show that, in economies characterized by tax evasion and endogeneity of government spending, the qualitative characterization of the optimal factor income taxes depends on both these factors. In particular, the well known Chamley Judd result that, in the long run, tax rates on capital income should be zero is, in many cases, overturned. It is shown that the nature of tax evasion matters: if a reproducible factor --a capital stock-or a whole sector evades taxes, then the long run tax code still displays no taxation of capital, but increased taxation of labor. If, on the other hand, it is a non-reproducible factor --e.g. labor-that is evading tax payments, then the optimal tax code requires that capital be either taxed or subsidized depending on the elasticity of substitution between capital and the evading factor. Next, I discuss the role of endogenous spending. I consider two types of public goods: utility enhancing --e.g. parks, arts-and productivity enhancing --e.g. infrastructure, education. I show that suboptimal settings for the spending variables can affect the long run taxation of capital. For example, in the case of productive public goods, I show that excessive --relative to the first best-levels of spending require taxes on capital income, while low levels of spending result in subsidies to capital. Overall, our results point to an interaction between tax evasion, spending and the design of the optimal tax code. Policy makers engaged in tax reforms need to take into account tax evasion not only for its revenue effects, which are secondary in our story, but also for efficiency considerations associated with the relative returns to all factors. Similarly, policy makers need to make assumptions about the structure of spending. Suboptimality of spending plays no role in the Ramsey result. However, when the suboptimal level is endogenous --a more realistic setting-the optimal tax code needs to "correct" for the inefficiencies in the level and composition of publicly provided goods. Tax Evasion, Endogenous Spending and the Design of Optimal Tax Codes