May Tax Evasion Help Control Public Debt?

Abstract

We show that tolerating tax evasion may increase debt less than an equivalent tax cut. In our model, utility-maximising entrepreneurs earn income from risky production technologies and risk-free bonds. The government uses income taxes and bonds to finance its expenses. Entrepreneurs can evade taxes at the risk of being audited and fined. Aggregate tax evasion and the debt-to-GDP ratio are positively related in equilibrium. Nevertheless, allowing tax evasion may increase debt-to-GDP ratios less (but reduce growth more) than equivalent tax cuts, as bond demand rises to hedge against auditing risks. These policies are equivalent with log utility

Keywords: Dynamic tax evasion, General Equilibrium, public debt.