A Theory of Inflation, Tax Evasion and the Demand for Redistribution

Abstract

We provide a theory which predicts that economies with greater inequality will tend to have greater tendency for tax evasion and more reliance on inflationary finance. Consistent with empirical evidence, the model features economies of scale in the credit transaction technology, and pervasive tax evasion in the extreme tails of the income distribution due to increasing returns in the tax evasion technology, and the existence of positive audit costs which makes auditing the poor unappealing. A rise in inequality in the sense of second order stochastic dominance spreads more mass to the tails, and raises the marginal cost of taxation thus making inflation more attractive from the public finance point of view. An important contribution of the paper is that when the level of redistribution is decided by majority voting, the median voter may prefer less redistribution, the greater the level of inequality, contrary to standard politico- economic theories, and consistent with some empirical evidence. We provide further empirical evidence in support of this view, according to which controlling for inflation and the size of the shadow economy dramatically changes the effect of inequality on redistribution.