Dynamic Tax Evasion with Habit Formation

Although tax evasion and auditing are dynamic processes, they have been approached in a dynamic framework only recently. In this paper we argue that the decision to evade taxes is dynamically embedded with consumption decisions, which in turn are driven by consumption habits. The model is cast in a dynamic context with an infinite horizon. Consumer's utility is a strictly increasing and concave in the (positive) difference between current consumption and a habit level given by a weighted mean of past consumptions. Our paper makes several contributions to the existing literature on tax evasion: 1) habit formation has a dampening effect on tax evasion; 2) as the representative consumer grows older, the gap between habit and consumption decreases and his/her tax evasion decreases. This has important implications for fiscal policies aimed at reducing tax evasion. 3) The effect of an increase in tax evasion depends on the ratio of habit to capital, i.e. the presence of the Yitzhaki (1974) paradox depends on such ratio; 4) we show that in the long run the ratio increases, i.e. over time this effect from positive becomes negative.