Discussion Paper

No. 2010-27 | November 10, 2010
Optimal Capital Income Taxation with Tax Evasion

Abstract

The paper discusses the applicability of optimal taxation theory to source-based capital incomes when significant tax evasion is observed. Without tax evasion a modified Ramsey Rule may reduce distortions brought by international capital mobility, leading to levying differentiated tax rates in domestic sectors inversely proportioned to observed elasticities in terms of capital mobility. The introduction of tax evasion brings additional complexity. The viability of optimal tax rates à la Ramsey is explored, and additional requirement (namely that tax evasion is either very low or very homogeneous) are shown to be necessary in order to allow policy-makers to obtain the tax rates minimizing total excess burden. Results are also provided to solve the optimal taxation objective when tax evasion is a relevant phenomenon and is not homogeneous throughout domestic sectors.

JEL Classification

H21 H26

Cite As

Diego D'Andria (2010). Optimal Capital Income Taxation with Tax Evasion. Economics Discussion Papers, No 2010-27, Kiel Institute for the World Economy. http://www.economics-ejournal.org/economics/discussionpapers/2010-27

Assessment



Comments and Questions


Anonymous - Comment
November 11, 2010 - 12:31

I read the whole paper but I cannot find any net contribution to the literature. From my point of view, it is not a kind of paper that can find a room in a good scientific publication. It is a literature review. Moreover, in the introduction the author states that ...[more]

... "This paper contribution is to test...", I did not find any statistical test implemeted by the author but only citations.

If the author thinks I make a mistake in judgeing the paper, I would like to ask the author to indicate to the readers where exactly is the new things that the paper can add to the economic knowledge.


Diego d'Andria - Reply to previous comment
November 13, 2010 - 11:30

Dear Anonymous,

thank you for taking the time to leave a comment. It also gives me a chance to better illustrate the scope of the paper.

The theory of constrained optimal capital income taxation which leads to define differentiated tax rates based on an inverse elasticity rule has ...[more]

... been, to my knowledge, formally discussed only recently in Sorensen (2007). This result is in no way trivial, since it directly clashes with policy prescriptions from some pillars of optimal taxation theory, namely Diamond and Mirrlees (1971) who argue in favor of a neutral tax on capital income. Neutrality is also assumed in dynamic analysis (see Judd, 1985 and 1999; Chamley, 1986 and 2001), and in the literature on capital income taxation with evasion.

My aim is to bridge the gap between this recent research and practical policy advice. The point is if policy-makers were to adopt differentiated tax rates following Sorensen's resoning and heterogeneous tax evasion happens among sectors, the outcome of such policy would be unpredictable. Equivalently that means informational requirements of differentiated taxation may be too much to handle for a high-evasion country.
To inquire this intuition I review the existing literature I believe it is applicable to the specific scenario of a constrained policy-maker dealing with a not-null capital tax under international capital mobility. Some original results (under paragraph 4.1 and Section 5, with mathematical derivations under the Appendix) specifically address the question of what informations are needed to levy tax rates following an inverse elasticity rule. No empirical test was run: the "test" is purely theoretical and is aimed at checking the concrete applicability of the inverse elasticity rule in presence of tax evasion.

Of course I believe deeper research is needed to address the topic. Partly this is done in a subsequent paper I am working on, where I look specifically at the coordination between tax auditing and tax rate policy.
In my view, this paper may contribute to the existing economic literature in two ways:
1) by providing a basic analytical framework for differentiated capital taxation with heterogeneous tax evasion;
2) by making it explicit the information requirements of such policy.

Both points 1 and 2 are, to my knowledge, absent from current literature. Since the core policy prescription of differentiated capital tax rates is not developed in literature, I believe this paper could provide a basic starting point to include evasion. In particular, the paper points to the need for sectoral estimates of tax evasion elasticities in order to assess whether observed capital elasticity is a good proxy to compute tax rates. This is something future research should try to discover.


References:

Chamley, C. (2001), “Capital income taxation, wealth distribution and borrowing constraints”, Journal of Public Economics, 79, pp. 55-69.
- (1986), “Optimal Taxation of Capital Income in General Equilibrium with Infinite Lives”, Econometrica, 54, pp.607–622.

Diamond, P.A. - Mirrlees, J.A. (1971), “Optimal taxation and public production (I)”, American Economic Review, 61, pp. 8-27.

Judd, K.L. (1999), "Optimal taxation and spending in general competitive growth models", Journal of Public Economics, 71, pp.1-26.
- (1985), “Redistributive Taxation in a Simple Perfect Foresight Model”, Journal of Public Economics, 28, pp. 59–83.

SØrensen, P.B. (2007), “The theory of optimal taxation: what is the policy relevance?” International Tax and Public Finance, 14, pp. 383-406.


Anonymous - Referee Report 1
January 04, 2011 - 09:00

see attached file


Diego d'Andria - Reply to Referee Report 1
January 04, 2011 - 20:15

Please find my comments in the attached file.


Anonymous - Referee Report 2
February 01, 2011 - 10:04

see attached file


Diego d'Andria - Reply to Referee Report 2
February 21, 2011 - 12:12

Please find my comments in the attached file.