Optimal Income Taxation with Mobility between the Legal and Black Labour Markets

Abstract

The standard model on optimal income taxation in the presence of tax evasion is extended to allow for mobility between the legal and hidden sectors. The conclusions from the traditional analysis of tax evasion strongly contrast with those that result when extensive margin responses are taken into account. We find that individuals indifferent between working in either of the two sectors play a crucial role in determining both the marginal tax rate and the optimal policy against tax evasion. Likewise, technological changes affecting relative wages are influential in the choice for each sector, by either boosting or lowering the benefits from tax evasion. Interestingly, it may be welfare improving to permit the existence of a hidden sector where evasion is possible.