The Bright Side of Tax Evasion

Abstract:This paper presents, to our knowledge, the first empirical investigation if tax evasion might be desirable for an optimal income tax schedule. More specifically: Does the opportunity to evade taxes eventually even increase tax revenues? Resuscitating the intriguing conclusions by the theoretical work on "randomized taxation", we test the hypothesis that incentives to evade partially offset the undesirable distortions of taxes on labor supply. Importantly, in exploiting behavioral responses, the proposed mechanism increases tax revenues beyond what an equivalent decrease in nominal rates would achieve. We implemented an original real effort experiment in a true (online) labor market with nearly 1,000 participants. Our findings show significant positive labor supply responses to the opportunity to evade (increased labor supply by 37%). More importantly, the expected tax revenue significantly and substantially increased by up to more than 50%. Strikingly, this effect persists when comparing effective tax rates: Lowering effective tax rates through the opportunity to evade is more efficient than simply lowering statutory tax rates. Since this effect is most pronounced for low wages, our work also contributes to the literature on optimal tax administration: Facing limited resources, tax enforcement should focus on high income individuals in non-rigid labor markets.