May Tax Evasion Help Control Public Debt?

Abstract

We study the relationship between tax evasion and public debt in a dynamic macroeconomic framework with incomplete financial markets. In the model, utility-maximising entrepreneurs invest their endowments in risk-free government debt and risky capital production. The government finances unproductive spending using income taxes and debt. Entrepreneurs can evade taxes at the risk of audits and fines. We show that tax evasion opportunities increase entrepreneurs' consumption by reducing their precautionary motive and, consequently, their capital investments. As a result, tax evasion leads to slower economic growth and higher debt financing costs, increasing the debt-to-GDP ratio in equilibrium. Nevertheless, reducing effective tax rates through tax evasion results in a smaller increase in the debt-to-GDP ratio--but also slower growth--than an equivalent nominal tax cut under perfect tax enforcement. This difference arises because, unlike tax evasion, nominal tax cuts directly raise the marginal productivity of capital (and thus the risk-free rate) in equilibrium.

Keywords: General equilibrium, incomplete markets, publicdebt, tax evasion.