The Marginal Cost of Public Funds in the Presence of Tax Evasion

This paper studies the Marginal Cost of Funds (MCF) in the existence of tax evasion. When tax evasion is incorporated as a behavioral response to tax rate change, the MCF can be different than the previously estimated ones in the literature. We develop a general equilibrium model of tax evasion, including the expected utility of taxpayers and three different revenue-raising policy instruments (i.e. tax, audit and penalty rate). In an environment where agents can evade tax with the risk of being caught and penalized, the government can use audit and penalty rate as revenue-raising policy instruments in addition to tax rate. In this rich model environment, we analytically derive the MCFs for the alternative policy instruments. We consider two main fiscal reforms: the revision in the nonlinear tax scheme and the changes in the enforcement mechanism (i.e. the audit and penalty rate). The derived MCF for tax rate is greater than the previous ones since it includes "risk-bearing cost" as well as tax distortion. In order to compare the magnitudes of three different MCFs, we present a numerical example. Our findings suggest that when audit and penalty have low costs and labor supply elasticities are positive, the audit and penalty rate as revenue-raising policy instruments are superior to the tax rate