Abstract
This paper is an attempt to incorporate tax evasion into the analysis of optimum income taxation. A model of variable labour supply with tax evasion is used to derive supply functions for labour in ‘regular’ and ‘irregular’ markets. Given taxpayer behaviour, the government chooses tax rates, penalties and the probability of detection to maximize a utilitarian social welfare function. The results consist in the derivation of a formula for the optimum marginal tax rate and a characterization of the factors determining the choice between the penalty rate and the probability of detection as instruments for the control of tax evasion.
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