Tax Evasion and Trust

Tax evasion is typically analyzed in a principal/agent framework,the government (principal) trying to provide agents with the incentives to pay their taxes. However, evading sales, excise or trade taxes requires the cooperation of at least two taxpayers. When individuals evade taxes, they face two potential costs. One is that tax evasion may be detected and sanctioned; the other is that their partner in crime might cheat. An increase in the sanction for tax evasion leads to a direct increase in the expected cost of a transaction in the illegal sector. However, it may also reduce the incentive to cheat. It may then be that a small increase in the sanction reduces the total cost of transacting in the illegal sector. Tax evasion may increase as a result.