Tax audits, fines and optimal tax evasion in a dynamic context

What is it about?

We study the relationship between evasion and tax rate in a dynamic setting. We generalise the approach proposed by the literature by focusing on the effects that tax audits and fines have on tax evasion. We show that the optimal evasion can be either a positive or a negative function of the tax rate according to the form chosen for the fine that must be paid when evasion is discovered.

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Why is it important?

Since the seminal papers by Allingham and Sandmo (1972) and Yitzhaki (1974) literature on tax evasion has been producing controversial and sometimes counter-intuitive results on the relationship between evasion and tax rate. This is particularly important for the relationship between tax evasion and the tax rate. The innovative element of our approach is that we develop a full dynamic model to study tax evasion. By assuming a general form for the fine, we show that the optimal evasion may be either a positive or a negative function of the tax rate. The sign of the derivative depends on the particular functional form taken by the fine