Catch Laffer If You Can: Tax Take in an Evasion‐Detection Game

In a simple taxation framework, we analyze a taxpayer's decision of whether to report income truthfully or engage in an evasion game with the tax agency. Specifically, taxpayer and tax agency can expend efforts, respectively, to conceal income and detect evasion. These activities are costly, and the final outcome—whether evasion is detected or not—is stochastic, and depends endogenously on the relative abilities of the contestants and on the policy parameters set by the authority. We present two main results: (i) evasion always occurs at relatively low tax rates, and then it may exhibit a U‐shaped relationship with the tax rate; (ii) at the revenue‐maximizing tax, the government's revenue is invariant to both detection efficiency and penalty rate.