Optimal Tax Policy with Misreporting: Theory, and Evidence from Real Estate

Abstract

Taxable transactions may be misreported to evade taxes and hide illicit wealth. Tax authorities must therefore set policy governing both tax rates and enforcement. We develop a model of optimal taxation and enforcement in which policymakers seek both welfare maximization and "tax accuracy," wherein taxpayers remit the amount that they statutorally owe under truthful reporting; we characterize the optimal combination of tax rate and enforcement stringency in this setting. We apply this framework to the Mumbai real-estate market, a setting with widespread misreporting and a transparent enforcement instrument: government-specified guidance values act as a minimum required tax base. Bunching in reported transaction values around the guidance value identifies the degree of under-reporting. We estimate the elasticities governing the optimal degree of enforcement, and we recover the revealed-preference inaccuracy penalty that rationalizes observed policy. We show that mortgage-facilitated purchases-which are subject to additional reporting requirements-exhibit less evidence of misreporting, suggesting that financial markets can play a complementary role in tax enforcement.

Keywords: real estate, tax evasion, mortgages, bunching, optimal tax policy, misreporting

JEL Classification: G21, G50, H26, H71, R30, R38, H21