Journal of Public Economics 3 (1974) 201-202.

0 North-Holland Publishing Company

A note on
INCOME TAX EVASION: A THEORETICAL ANALYSIS*

Shlomo YITZHAKI+
The Maurice Falk Institute for Economic Research in Israel, Jerusalem, Israel

Received January 1974

In the Allingham-Sandmo model the taxpayer should pay a penalty rate 7c on

the undeclared income. This assumption leads to the conclusion that when the
tax rate increases there will be two opposing effects, an income and a substitution
effect.
In this note I want to show that if the fine is imposed on the evaded tax, as it is
under the American or Israeli tax laws, there are no contradictory effects.
Assuming that the taxpayer has an absolute risk aversion which decreases with
income, we can conclude that as the tax rate increases the income evaded
decreases. In this case there is no substitution effect.
To show this result, I use the same notation and equation numbers as Alling-
ham and Sandmo (1972).
The taxpayer will choose X so as to maximise
E[U] = (1 -p)v(W-ex)+pU[W-8x-Fe(W-x)J, (l)*
where F is the fine (F > 1),
Y= W-ex,
and
2 = w-ex-Fe(w-X). m*
The first-order condition is

e[-(1 -p)U( Y)+p(F- l)U(Z)] = 0. (3)*

The conditions for interior solution are

w w> P@-1)
U[ W( 1 - Fe)] <I-p

pF< 1. (6)*
These conditions are the same as in the Allingham-Sandmo model if F = x/e.
*M.G. Allingham and A. Sandmo, 1972, Income tax evasion: A theoretical analysis,
Journal of Public Economics 1,323-338.
tl would like to thank Michael Bruno and Agnar Sandmo for their helpful comments.
202 S. Yitzhaki, Note on Income tax evasion

If we assume U(0) + co, FO > 1 will always lead to a positive income

declaration.
If we differentiate (3)* according to 8, we get

ax
-= -~(~-P)U(Y)~~[R,(Z)-~,(Y)I+W-W?A(Z)~, (14)*
ae

where D s @[(l -p)U( Y)+P(F- l)!U(Z)] and RA( Y) < RA(Z) leads to
8X/% > 0. In this case both the ordinary tax rate and the penalty rate increase
proportionally with 0. Therefore there is no substitution effect and we are left
with a pure income effect.
Differentiating (3)* with respect to W, we get

ax Fe&m - [R4W- R4(VI

-= (la*
aw Fezt,(z)- ep,(z) - R~( r)] *
From this equation we can see that RA(Z) > RA( Y) leads to 8X/a W < 1, so
that declared income changes more slowly than true income.