Is Tax Evasion Beneficial or Harmful to Growth?

[Abstract] Is tax evasion beneficial or harmful to growth? We approach this question by extending Persson and Tabellini’s (1994) growth model to a plausible world where individuals differ not only in terms of their skill in earning income but also in terms of their skill in concealing income from the tax authority. The Persson-Tabellini model identifies a fundamental tradeoff for redistribution: the higher the tax rate that is imposed, the greater will be the benefit from redistribution on the one hand, but the higher will be the cost of tax distortion on the other hand. Our central theoretical insight is that the presence of tax evasion will alter this fundamental tradeoff by both lowering the redistributive benefit of taxation and enhancing the distortionary cost of taxation at the margin. All else equal, this will lead to a lower equilibrium level of redistribution. A lower equilibrium level of redistribution must by implication result in a higher economic growth in the Persson and Tabellini model. However, as is consistent with the empirical evidence, this is not necessarily true in our model. We pinpoint a key comparative statics that determines the answer to our question.