Dynamic Tax Evasion with Habit Formation

Although tax evasion and auditing are dynamic processes, they have been approached in a dynamic framework only recently. We argue that the decision to avoid taxes is dynamically embedded with consumption decisions, which in turn are driven by consumption habits. The model is cast in a dynamic context with an infinite horizon. Our paper makes several contributions to the existing literature on tax evasion: 1) habit formation has a dampening effect on tax evasion; 2) as the representative consumer grows older, the gap between habit and consumption decreases and his tax evasion decreases; 3) the effect of an increase in tax evasion depends on the ration of habit to capital, i.e. the presence of the Yitzhaki (1974) paradox depends on such a ratio; 4) we show that in the long run the ratio increases while the relationship between evasion and the tax rate changes from being positive to being negative; 5) the model has policy implications: other things being equal, it is better to induce people to reduce their level of tax evasion with controls rather than fines.