Optimal tax policy under tax evasion

We study the properties of the optimal tax mix in the presence of tax evasion. The setup is a version of the neoclassical growth model in which households can choose to under-report their labour and capital income, firms can choose to under-report their sales, and a Ramsey government, taking all this into account, chooses the time-paths of tax rates on labour, capital and consumption to maximize households’ lifetime utility. We show that tax evasion, and its type, are crucial to the properties of optimal tax policy.