A theory of tax evasion in developing countries

Abstract

The literature on tax evasion assumes that taxpayers wish to evade their taxes entirely and the only reason they do not do so is that there is some non-zero probability of being caught by the government. Also, it is assumed that government uses the taxes and fines from caught evaders on goods that it consumes which produce no utility to taxpayer-citizens. In a developing country, however, we argue that taxpayers use tax evasion to compensate for imperfect financial markets as well as government expenditure patterns that do not benefit them. We demonstrate that imperfect financial markets result in situations where when individuals find the chance of earning high returns from investments, it causes them to overcome their aversion to risk and participate in actuarially unfair tax evasion gambles. Also, tax evasion increases when either public goods are underprovided, or the government is sufficiently predatory , or the government directs policies at groups that the taxpayer is not a member of. In such a situation tax evasion is viewed by the taxpayer as a means of shifting the allocation of his income in favor of investments and away from government expenditure policies that give little benefit to him.