Income Taxation and Tax Evasion in a Finite Economy

This paper introduces tax evasion in an optimal income taxation problem. It deals with finite economies. Two different problems are addressed. First, allowing the government to use generalized tax schedules (GTS, income distribution-contingent set of lump sum transfers), we show that any first best Pareto optimum can be implemented, by proposing beside the GTS well defined audit strategy and fine function. Second, restricting the government to use classical tax schedules, we show that with the same type of audit strategy and fine function, (only) a subset of the first best Pareto allocations is implementable; moreover, all the agents except the more able evade some income and are not audited.