Research

Abstract:

In recent years, there have been calls for the introduction of a wealth tax. However the major concern is that a wealth tax induces tax evasion. There is empirical evidence that hidden wealth cannot easily be used as collateral as it must be brought into formal financial channels which raises detection risks. This paper theoretically characterises the optimal wealth tax in a general equilibrium model with tax evasion and financial frictions. The main theoretical insight is a new optimal tax formula consisting of three components. First, a redistribution term, reflecting the welfare gains from transferring resources toward agents with lower wealth and higher marginal utility. Second, a general equilibrium-effect term. And, third, a behavioural-effects term including the key elasticity of evasion with respect to taxes. This elasticity depends on the curvature of the evasion costs and on the extent to which hidden wealth can be used as collateral. When hidden wealth cannot be used as collateral by entrepreneurs, the evasion elasticity and behavioural responses are lower, and the optimal tax rate is higher. The numerical exercise quantifies two main results. First, all else equal, the higher the share of hidden wealth that cannot be collateralised, the lower the elasticity of evasion. Second, as the share of hidden wealth that cannot be collateralised increases, the planner chooses a higher tax rate. Despite evasion levels being higher as the tax rate increases, the redistribution motive of the planner outweighs these additional distortions.