Tax evasion and the cost of public sector activities

This paper examines the effects that tax evasion has on the cost to produce goods and service in an environment where input prices are homogenously taxes, but evasion is intersectorially differentiated. Tax evasion raises the relative cost of producing goods and services in the sectors where evasion is more difficult. Such effects adds a potentially important, but so far neglected, element to the relative cost of goods and services produced by the public sector. The general equilibrium analysis presented in this paper shows the perverse effects of tax evasion which reduces total production (hence total wealth) even in a model where, due to the absence of redistributive effects, tax evasion is simply fiscal illusion.