Tax evasion and the optimum general income tax

This paper incorporates tax evasion into an optimum general income tax problem with endogenous labor supply. It posits a two-group model with high- and low-wage individuals to investigate the properties of optimal audit and tax structures. The following main results are obtained. First, high-wage persons are never audited while low-wage persons are audited with a probability strictly less than one. Secondly, high-wage persons should face a zero marginal tax rate. Thirdly, low-wage individuals who have been audited and found innocent should pay a lower tax than those who are not audited. Fourthly, there are two possible tax regimes: low-wage persons face a positive marginal tax rate under one regime and a zero rate under the other. Fifthly, even if honesty cannot be rewarded, the other results of the paper continue to hold.