Economic Growth and the Household Optimal Income Tax Evasion

This paper presents an analysis of the relationship between economic growth and income tax evasion. For this purpose we constructed a dynamic model with human capital in which income tax evasion is endogenous. The model captures the effects of income tax evasion on economic growth through three channels: 1) Income tax evasion alters the optimal path of consumption and savings 2) income tax evasion generates labor market distortions; 3) returns on assets are affected when tax evasion occurs. The concept of optimal policy against evasion is introduced. Based on the Ramsey policy approach, the income tax evasion is reformulated as particular case of endogenous incompleteness tax code. In this case, we found that the optimal income tax rate in the steady-state is different to zero. The model was calibrated for the 2000 Colombian economy. Counterfactual experiments show that different enforcement policies based on an increased probability of detection and punishment have a positive impact on welfare and growth. On the other hand, as income tax evasion increases so the capital cost goes up, the labor supply is reduced and economic growth and welfare decreases.