Optimal tax enforcement with productive public inputs

We study optimal public expenditure and tax enforcement in a simple one-sector, dynamic endogenous growth model where agents optimize consumption and evasion; evasion is costly, while public expenditure increases private capital productivity. We show that tax evasion costs and the efficiency of endogenous audits play a crucial role in determining the relationship between tax evasion, tax rates, public expenditure, and growth. The key elements to improve tax enforcement are efficiency in the audit process and increased productivity in public expenditure. Increasing tax evasion costs could reduce tax evasion, but when tax enforcement is inefficient, this might trigger a perverse effect in which a tax rate increase reduces tax revenue. This finding implies that government spending depends on the efficiency of the audit process: expanding government expenditure optimally or increasing private productivity is impossible without improvements in tax compliance.