Income Tax Evasion: A Theoretical Analysis

This chapter considers a tax-payer who values honesty as well as net income. It presents a simple introduction to the theoretical literature on the economics of income tax evasion, which explains the work of M. G. Allingham and A. Sandmo and S. Yitzhaki and provides the background to the theoretical modelling. A most unusual paradox exists in the literature on income tax evasion. This is the theoretical result that, assuming non-increasing absolute risk aversion, an increase in the income tax rate will lead to an increase in the amount of income declared to the tax authority. The first rigorous economic analysis of an individual&s;s decision to evade payment of income tax was due to Allingham and Sandmo. Yaniv models advanced tax payments systems and shows that, in a prospect theoretic framework, as long as the declaration is sufficiently large, an increase in the tax rate would decrease the tax declaration.