Inflation, tax evasion, and the distribution of consumption

We analyze the effects of inflation both on tax compliance and on the amount of government revenues in the framework of a monetary economy where households face a cash-in-advance constraint on consumption purchases. Since households are exposed to random audits from the tax enforcement agency, the stationary equilibrium exhibits a non-degenerate distribution of consumption. Our main results include a non-monotonic characterization of the relationship between the rate of monetary expansion and government revenue. This is in contrast to the standard cash-in-advance model with no evasion, where that relationship is monotonic. In our model, as government creates inflation, the penalty imposed on evaded taxes becomes smaller in real terms. This stimulates tax evasion and, hence, aggregate revenue turns out to be decreasing in the rate of monetary expansion when inflation is sufficiently high. Even if inflation raises the variance of the distribution of consumption, we show that high inflation rates end up being welfare enhancing. (C) 2004 Elsevier Inc. All rights reserved.