Public Sector Cost Inflation through Tax Evasion

Abstract

In his seminal paper, Baumol (1967) argued that public sector activities, like other labour-intensive productions, are destined to grow as a ratio of total GDP because of the comparatively lower productivity growth experienced by labour inputs in these sectors relatively to capital-intensive sectors. In this paper it is shown that tax evasion can have the same effect through a mechanism that is self-reinforcing: the reduction in tax revenues associated with tax evasion raises the cost of producing public goods and services, and creates the conditions for an increase in fiscal pressure, which in turn can boost tax evasion. This cost-inflation effect of tax evasion adds a potentially important, but so far neglected, element to the cost of tax-financed public good provision. In particular, the general equilibrium analysis presented in this paper shows that tax evasion can reduce production (hence total wealth) even in a model where, due to the absence of redistributive effects, tax evasion is simply fiscal illusion.