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.