Contributive Pensions and Imperfect Tax Compliance: A Political Economy Model

Abstract

This paper sheds light on the role of public institutions as a way to reduce tax evasion through a close link between payroll taxation and pension benefits. We use a political economy model in which agents have the possibility to hide part of their earnings in order to avoid taxation. Taxation is exclusively used to finance a pension benefit which is partly redistributive. We show that in the absence of evasion costs, agents are indifferent to the tax rate level as they can always perfectly adapt compliance so as to face their preferred effective tax rate. There is unanimity in favour of the maximum tax rate and, the public pension system is found to be contributory in order to increase compliance and thus the resources collected, which in turn enable higher redistribution toward the worst-off agents. When evasion costs are introduced, perfect substitutability between compliance and taxation breaks down. The majority voting equilibrium is such that individuals at the bottom of the income distribution who are in favour of more redistribution, and those at the top who want to transfer more resources to the old age, form a coalition against middle-income agents, in favour of high tax rates. In addition to the tax base argument, the optimal level of the Bismarkian pillar will now be chosen so as to account for increased political support.