Herding, taxpayer's rent seeking and endemic corruption

In an environment with extensive corruption where much of the population evades paying their full taxes due, we tackle the question of optimal taxation when constituencies with conflicting objectives (the poor and the rich) push tax policy in different directions. We think in terms of a government policy maker here called the tax administrator (TA) and rent-seeking lobbying efforts by poor and rich constituencies. We recognize the taxpayers’ inter-dependency as reflected in increased evasion likelihood when others are thought to be evading. Thus our modeling incorporates elements from the theory of information cascades (herding) into a standard model of tax evasion. The poor and rich undergo a rent-seeking contest seeking to influence the TA in setting policy so that their constituency is favored. The TA maximizes an objective function that is a weighted average of expected social welfare, their own interests, and investment in better tax administration. With these building blocks we examine the functioning of the economy. Our results include those that are expected, counterintuitive and surprising. For example, we learn that lower taxes on the rich does not mean the TA cares more about the public interest. Instead, it may result from the TA caring less about the public welfare of others in society, i.e., less about both the poor and the rich. Furthermore, with an increase in perceived inequality society's optimal tax rate rises. On the other hand, high tax levels lead to high herding and greater herding decreases investment by the poor and the rich attempting to affect the tax level set by the TA. Thus, a TA who only cares about their own self will enact lower tax levels than if they cared about others in the society.