Tax Evasion and the Cost of Public Sector Activities

Abstract

This article examines the effects of tax evasion on the cost of goods and services in an environment where input prices are homogenously taxed but evasion is intersectorially differentiated. Tax evasion raises the relative cost of producing goods and services in the sectors where evasion is more difficult. Such an effect adds a potentially important but so far neglected element to the relative cost of goods and services produced by the public sector. The general equilibrium analysis presented in this article shows the perverse effects of tax evasion, which reduces total production (and hence total wealth) even in a model where because of the absence of redistributive effects, tax evasion is simply fiscal illusion.