A New Look at the Laffer Curve and the Displacement Loss from Tax Evasion

The two most prominent deadweight losses in public finance are the triangle loss from taxation and the rectangle loss from rent-seeking. This paper suggests that a third type of deadweight loss can rival these two in size and deserves detailed exploration. In the presence of the underground economy taxes give rise to a deadweight loss from displacement of efficient producers by inefficient producers. I consider an economy in which a producer faces two types of costs: the cost of production, and taxes. If good evaders are inefficient producers, tax evasion turns a flat tax into a tax based on ability to pay with the result that maximum government revenues possible under tax evasion may be larger than when no one evades taxes. Displacement deadweight loss is a subset of a larger class of losses that arise when productive and counterproductive features are bundled into the same economic agent and when that agent has no incentive or opportunity to specialize wholly in one or the other pursuit.