Optimal Nonlinear Income Taxation with Costly Tax Avoidance

In this article, we study the problem of optimal income taxation in an economy in which income can be falsified. Agents are assumed to have access to a technology that allows them to hide income from public view. As hidden income cannot be taxed, the possibility of income falsification puts a limit on the amount of redistribution that can be implemented in this economy. Given that the process of income concealment is costly, however, limited social insurance can be provided through partial redistribution of revealed income. In this economy, under various specifications of the income concealment cost, we derive Pareto-optimal income redistribution schedules and show how the resulting allocations of consumption can be implemented with a system of nonlinear income taxes. In particular, we demonstrate that, for a large class of income concealment cost specifications, (1) no actual concealment of income takes place at the optimum, and (2) income taxes that implement the optimum are progressive with positive marginal tax rates everywhere, even at the top of the income distribution