Tax Policy Design in a Hierarchical Model with Occupational Decisions

This study incorporates occupational decisions in a hierarchical model to investigate distortions in the tax policy design. The economy has two sectors, wage-earners and self-employment, where evasion is only possible in the latter. The optimal audit split self-employed between audited and non-audited distorted the occupational decision in the last group. The marginal tax rate is smaller than the case without occupational choices, showing that not considering it produces an upward tax bias. The optimal IRS budget does not allow for auditing the entire self-employment sector but is larger than the case without occupational choices. Production efficiency is not attained at the optimum because occupational decisions are distorted. This result contradicts the Diamond-Mirrlees theorem. Finally, differential taxation is a Pareto improvement but implies higher taxes for self-employment. This result increases distortions in the optimal allocation of agents compared to the former setting.