Black Markets and Optimal Evadable Taxation

In a simple model of evadable indirect taxation, some surprises emerge. Because of a ‘market‐thinning’ effect of high prices, high taxes induce multiple equilibria (low‐price black markets and high‐price legal markets). Further, evadability introduces a bifurcation to optimal taxation: For less effective tax administrations, the optimal tax system follows a ‘cash cow’ pattern, with one sector bearing all of the tax; but for relatively effective administrations, the optimum follows a slightly modified Ramsey rule. This discontinuity results from the mathematics of evasion incentives, and may help explain tax reforms commonly seen over the course of economic development