Informality, Tax Evasion via Strategic False Litigation and Tax Rate

ABSTRACT We use an empirically based model and theoretically analyze a global problem—that of tax evasion, a problem faced by countries across the world. Credit market imperfection coupled with an active informal sector promising a greater than the formal sector return coupled with the loopholes in the judiciary processes attract the formal sector firms to strategically false litigate against the government's tax claims and attempt tax evasion by tax deferment and invest in the informal sector for the said higher return. Our main results are counterintuitive and contrast the standard results in the literature: (i) in the absence of an informal sector the earnings reporting decision of the firms is not affected by the tax rate, and (ii) in the presence of an informal sector and the informal‐formal rate of return differential, earnings reporting (evasion) is a positive (negative) function of the tax rate. Thus, the tax rate acts as an effective policy tool to counter evasion, that is, a higher tax rate leads to greater compliance—higher (lower) compliance by larger (smaller) firms.