Taxation and Evasion in the Presence of Extortion by Organized Crime

Abstract

We model the taxation behavior of a revenue maximizing government in the presence of tax evasion by firms and the existence of a competing tax collector in the form of organized crime (the "mafia"). In order to evade taxes, the firm must shift some of its sales underground, possibly incurring costs. We show that the government's optimal tax rate and revenue in equilibrium crucially depend on the importance of public goods or, equivalently, the efficiency of their production. When public goods can be produced cheaply, both the state's tax rate and tax revenues are lower in the presence of the mafia than without it. However, when public goods are difficult to provide, the government benefits from the fact that the mafia's taxation imposes costs on the underground activities of the firms. The firms, on the other hand, are typically hurt by the mafia's presence when public goods are not important and benefit from it otherwise. The joint payoffs of all players are higher with the mafia than without it if public goods are difficult to produce, but may become lower at the other extreme.

Keywords: Optimal taxation, tax evasion, organized crime

JEL Classification: H26, H21, P5