Income tax evasion and third-party reported consumption and wealth: implications for the optimal tax structure

Abstract

Tax authorities increasingly make use of third-party reported consumption expenditures when appraising individual income reports. They may initiate an audit if consumption reports cannot be justified by self-reported income. This in turn incentivizes tax evaders to avoid third-party reported consumption goods. I determine the implications of this for the optimal tax structure. A tax on non-reported goods discourages tax evasion because these goods are disproportionately consumed by tax evaders. A tax on reported goods also discourages tax evasion because it further distorts the evader's consumption bundle. I show that it is desirable to tax third-party reported goods at a higher (lower) rate than non-reported goods if the elasticity of substitution between both goods is smaller (larger) than one. I then apply the same logic to third-party reported wealth – i.e., future consumption goods – which tax authorities also use in their audit policies. Existing evidence on the intertemporal elasticity of substitution suggests that it may be optimal to tax third-party reported wealth at a positive rate.