Indirect tax evasion, shadow economy, and the Laffer curve: A theoretical approach

This paper provides new theoretical insights into the causes and consequences of indirect tax evasion. I propose a decision-making framework that contemplates biased perceptions of apprehension probabilities, which are affected by the environment where the agents operate. This microfounded formulation allows for the analysis of how taxation affects tax evasion (and vice versa) in the aggregate, emphasizing the existing relationships between the relative size of the shadow economy, tax rates, and government revenue. It is shown that a traditional Laffer curve (inversely U-shaped and with a unique maximum) can only exist under certain conditions. The maximum government revenue attainable turns out to be, in any case, lower than in the absence of tax evasion. Nevertheless, evasion control policies are proven to be always effective in increasing government revenue.