Dynamic Tax Evasion and Capital Misallocation in General Equilibrium
We study tax evasion in a dynamic model where utility-maximizing entrepreneurs finance firms, facing heterogeneous productivity shocks and subject to financial constraints that limit their leverage to a multiple of their net worth. Entrepreneurs can evade income taxes at the risk of being audited and fined. The government provides productivity-enhancing public goods by raising income taxes and debt. Individually optimal tax evasion decreases with firms' productivity. This strategy exacerbates capital misallocation due to financial constraints, fostering tax evasion and reducing productivity in the aggregate. However, consistent with the data, the productivity-tax evasion relation is heterogeneous in sign and magnitude across firms' productivities. Increasing public good provision can reduce tax evasion by curbing capital misallocation but is less effective when financial constraints loosen.
Area: CS21 - Stochastic Modeling in Finance and Insurance II (Gabriele Stabile and Alessandro Milazzo)
Keywords: Dynamic tax evasion; financial constraints; general equilibrium; misallocation; productive public expenditure
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