Tax Evasion as a Disciplinary Mechanism for Fiscal Policy

The paper provides a theory where the size of the inspection authority and the size of the fines evolve endogenously. We find that if a society cannot commit to future taxes it may gain form committing to a small Inland Revenue Service and small punishments for tax evasion. The possibility of the public evading taxes limits the effectiveness of capital taxation. By setting detection probabilities and punishment relatively low, the government indirectly commits itself not to tax capital income too heavily in the future.