Pareto efficient income taxation under costly monitoring

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This paper studies the problem of Pareto efficient fiscal policies when labour supply is elastic and the government has no a priori information on income earned. The model is a two-class economy with an official and an unofficial labour market. Official income is taxed non-linearly, while unofficial income is only observable after a costly audit upon which it is taxed at an exogenous penalty rate. After characterisation of the Pareto efficient audit and tax policies, it is verified how these policies react to a higher government revenue requirement, an increase in the penalty rate, a stronger ambition to redistribute. In the two last scenarios, the effect on the marginal tax and the audit rate is shown to decompose into a government revenue effect and a substitution effect. A numerical example shows that the substitution effects are of minor importance, suggesting that first intuition about the best way for a government to cope with increased evasion opportunities— substituting auditing effort for high marginal tax rates—sketches only part of the picture.