Tax evasion in a heterogeneous-agent incomplete-markets economy

This paper revisits the relationship between tax evasion and tax rates in a heterogeneous-agent, incomplete-markets model. Extending the foundational works of Allingham and Sandmo (1972) and Yitzhaki (1974), we explore how financially constrained households use tax evasion to mitigate the adverse effects of market imperfections. We show that deterrence policies, such as audit probabilities and penalties, exacerbate the effects of borrowing constraints. Importantly, increasing income tax rates can sometimes alleviate these negative impacts when individuals evade taxes. We identify three mechanisms shaping underreporting: the direct effect, the threshold effect, and the income effect. These help explain when and why the Yitzhaki puzzle arises. Numerical results reveal a non-monotonic relationship between tax rates and underreporting, underscoring the relative strength of these effects and offering fresh insights into the Yitzhaki puzzle.