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Tax evasion in a heterogeneous-agent incomplete-markets economy

Published online by Cambridge University Press:  11 July 2025

Yunmin Chen  and
Tsaur-Chin Wu
Yunmin Chen*
Affiliation:
Department of Economics, National Central University, Taoyuan City, Taiwan
Tsaur-Chin Wu
Affiliation:
Department of Public Finance, Feng Chia University, Taichung City, Taiwan
*
Corresponding author: Yunmin Chen; Email: cyunmin1@gmail.com
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Abstract

This paper revisits the relationship between tax evasion and tax rates in a heterogeneous-agent, incomplete-markets model. Extending the foundational works of Allingham and Sandmo (1972) and Yitzhaki (1974), we explore how financially constrained households use tax evasion to mitigate the adverse effects of market imperfections. We show that deterrence policies, such as audit probabilities and penalties, exacerbate the effects of borrowing constraints. Importantly, increasing income tax rates can sometimes alleviate these negative impacts when individuals evade taxes. We identify three mechanisms shaping underreporting: the direct effect, the threshold effect, and the income effect. These help explain when and why the Yitzhaki puzzle arises. Numerical results reveal a non-monotonic relationship between tax rates and underreporting, underscoring the relative strength of these effects and offering fresh insights into the Yitzhaki puzzle.

Keywords

Tax evasionincomplete marketsYitzhaki puzzle

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Type
Articles
Information
Macroeconomic Dynamics , Volume 29 , 2025 , e118
Copyright
© The Author(s), 2025. Published by Cambridge University Press

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