Optimal Dynamic Tax Evasion: A Portfolio Approach

Abstract

Most tax evasion models are set in a timeless environment and assume that only income flow can be evaded. This framework is not suitable for financial market where an evasion decision is taken in an intertemporal framework and an asset itself can be evaded. We assume that a representative agent may invest on a risky asset (following a geometric Brownian motion) and on a riskless asset. The risky asset can be either declared for taxation or not. If it is not declared a fine must be paid with a given probability. In our framework the agent optimally chooses his intertemporal consumption and portfolio allocation where the "declared risky asset" and the "undeclared (evaded) risky asset" are treated as different assets. The main results are: (i) optimal consumption is higher with evasion, (ii) optimal evasion is affected neither by the return nor by the volatility of the risky asset, (iii) evasion reduces the investment in the risky asset and increases the investment in the riskless asset, (iv) evasion can be reduced more efficiently by increasing the amount of fine rather than increasing the frequency of controls, (v) for level of tax on the riskless asset sufficiently high tax evasion is not optimal.

Keywords: financial activities, dynamic tax evasion, asset allocation

JEL Classification: G11, H26, H42