A Growth Model with Income Tax Evasion: Some Implications for Australia*

Abstract

We develop an endogenous growth model à la Barro (1990), augmented with income tax evasion. Unlike many traditional rational choice models of tax evasion, the numerical simulations of our model do not produce counter‐intuitive results. Further, we show that: (i) accounting for evasion costs (while capturing the full risk associated with the tax evasion process) is important for obtaining realistic relationships between key model variables; (ii) productive government expenditures explicitly affect the economy’s tax evasion rate; (iii) Barro’s natural efficiency condition for setting the optimal statutory tax rate holds even in the presence of tax evasion; (iv) given realistic estimates of the public expenditure externality, the average marginal income tax rate in Australia is not too far away from the optimal one; and (v) differences in tax evasion opportunities aggravate inequality over time.