Tax Evasion and Public Expenditures on Tax Collection Services in an Endogenous Growth Model

Tax Evasion and Public Expenditures on Tax Collection Services in an Endogenous Growth Model

This paper analyzes the relationship between tax evasion and the two main policy instruments affecting evasion rates, namely, the announced tax rate and the share of tax revenues allocated to tax monitoring mechanisms.

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Published in: European Economic Review

Income or corporate profit taxation matters for economic growth since taxes distort the accumu- lation of capital. Standard economic growth models with infinite horizon suggest that the rate at which physical capital is accumulated increases with their private return and, hence, high tax rates on income or corporate profits are typically associated with low growth rates (Lucas, 1988; Rebelo, 1991). Moreover, in endogenous growth models with overlapping generations, private capital ac- cumulation is obtained through savings of individuals who rent their labor to the firms earning a wage in exchange of that. Hence, an increase in the income tax rates reduces the disposable income of individuals resulting to even slower private capital accumulation.

However, on the other hand, taxation generates resources to finance the supply of the produc- tive inputs provided by the government including public goods and infrastructure (Barro, 1990; Turnovsky, 1997). Since individuals are not charged by the use of these public goods, government spending plays the role of an externality for the private sector. Such an externality ends up being an engine of endogenous growth since the resulting aggregate production function could display an uniformly high marginal productivity from private capital, and this makes perpetual capital accumulation possible (see Jones and Manuelli (1990)). Therefore, as pointed out by Barro (1990), there is a tension between the role of taxation in disincentiving the accumulation of capital and the role of the public spending financed by these taxes in raising the return from private capital and, hence, the speed of accumulation.

An effective tax system though must be efficient, that is, it must provide incentives to the tax payers (individuals or corporate firms) for tax compliance. Without these incentives nobody would pay taxes voluntarily in a competitive economy. Indeed empirical evidence suggests that tax evasion and fiscal corruption has been a general and persistent problem in virtually every country with serious negative consequences not only in transition and developing countries, but also in countries with developed tax systems. Tax evasion, which constitute a sizable share of the shadow economy, is prevailing even in advanced industrialized countries around the globe. Slemrod and Yitzaki (2000) estimated that about the 17 percent of income taxes are unpaid in the US, while the Tax Justice Network (2011) estimated that on average tax evasion rates in 119 developed and developing countries around the world was more than the 50 percent of their healthcare spendings. Furthermore, Schneider (2000) reports that the shadow output equals 39 percent of the actual magnitude of reported GDP in developing countries, 23 percent in transition countries and 14 percent in OECD countries.

Starting from the seminal papers by Mirrlees (1971) and Allingham and Sandmo (1972), a large amount of literature relating to corruption and tax evasion has emerged aimed to analyze its determinants, magnitude, and effects on economic growth and welfare in both developed and developing economies (see Feige (1992) and Jung et al., (1994) as well as the papers reviewed therein for a discussion on tax evasion and underground economies). More importantly though Schneider and Enste (2000) and Bajada (2003) suggest that the underground economy and the associated tax evasion deepens recessions and increases the volatility of business cycles that makes the study and modeling of tax evasion of great interest particularly in nowadays.

Along these lines, we adopt a standard one-sector endogenous growth model in order to analyze how the statutory tax rates and tax compliance policy affects the rate of economic growth. The novel feature of our model is the inclusion of the tax evasion rate as a positive function of the announced tax rate and as a negative function of tax revenues allocated for tax monitoring purposes. This feature introduces a trade off between these two policy instruments into our model, which is analyzed by calculating both their growth-maximizing as well as their optimal values. Our analysis supports Barro’s (1990) finding that the growth-maximizing tax rate is equal to the output elasticity of public capital, while, at the same time, it provides an explanation for some deviations from this finding in the relevant literature. Further, using a general objective function for central government we do not find evidence of Barro’s (1990) result that the growth-maximizing tax rate also maximizes government’s welfare. Finally, we calibrate our theoretical model to gain a better understanding of the relationship between the optimal values of our policy variables and the corresponding tax evasion rate and growth rate of the economy 

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