The aggregate consequences of tax evasion

Abstract

This paper studies how tax evasion in the self-employment sector affects aggregate outcomes and welfare. We develop a dynamic general equilibrium model with incomplete markets in which heterogeneous agents choose between being a worker or self-employed. Self-employed agents may misreport their business income but face the risk of being detected by the tax authorities. Our model replicates important quantitative features of the U.S. economy in terms of income, wealth, self-employment, and misreporting. Tax evasion alleviates credit constraints and leads to a larger self-employment sector but reduces the average size and productivity of self-employed businesses. Tax evasion generates positive welfare effects for the self-employed at the expense of the workers.