Tax Evasion and the Marginal Cost of Public Funds
Tax evasion is analogous to deadweight loss in its effect upon the rules for cost-benefit analysis of public sector projects. Deadweight loss and tax evasion both cause the marginal cost of public funds to increase as tax payers attempt to reduce the tax base in response to increases in tax rates. In one case, the social cost is from the diversion of resources from highly taxed to less taxed activities. In the other, the social cost includes the expense of concealment of income from the tax collector, the cost to the public sector of detecting and punishing tax evasion, and the cost of punishment to the convicted tax evader. It follows that a complete theory of optimal taxation can be derived from the susceptibilities to evasion of the different means of taxation.
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