Tax Evasion and the Double Dividend

Abstract

This paper examines the implications of a “tax evasion effect” when revenues from an environmental tax are used to reduce other taxes. Tax evasion is modeled as a costly and unproductive firm activity. When the tax base is shifted in a revenue-neutral manner toward environmental taxes, the corresponding shifts in the costs of evasion are shown to sharply decrease the welfare cost reported in earlier work. Our key assumption is that the environmental tax, such as a tax on gasoline levied at the refinery, is less evadable than other taxes such as those on labor income. Since tax evasion is typically higher in developing countries, the tax evasion effect should be particularly relevant to policymakers in those countries. A simple computable general equilibrium model focused on carbon dioxide emissions is used to illustrate the potential magnitude of the effect. For a 10% reduction in carbon dioxide emissions, the welfare cost of using a price instrument such as a carbon tax is 28% lower in the United States taking into account the tax evasion effect, 87% lower in China, and 111% lower in India. The broad implication of this paper is that shifting to environmental taxes in the presence of substantial levels of pre-existing tax evasion may not be nearly so harmful to economic welfare as previously thought.