Tax evasion and corruption: endogenous deterrence and the perverse effects of fines

Abstract

We consider a simple economy where self interested taxpayers have incentives to evade taxes and to escape sanctions by bribing public officials in charge of tax collection. However, tax collectors may be monitored by second-level inspectors whose incentives to exert detection activity are endogenously determined. In this framework, it is shown that the effects of classical deterrence instruments, such as fines, may be perverse; in particular, larger fines for corruption directly reduce corruption and indirectly reduce incentives to monitor it determining, as an overall effect, an increase in the underlying offence, that is tax evasion. Nevertheless, on the normative side, we show that, even if the Government cannot commit to a given level of deterrence, the maximal fine principle still holds.