Accepted Manuscript

Morality, tax evasion, and equity

Kangoh Lee

PII: S0165-4896(16)30036-1
DOI: http://dx.doi.org/10.1016/j.mathsocsci.2016.05.003
Reference: MATSOC 1866

To appear in: Mathematical Social Sciences

Received date: 9 August 2015

Revised date: 4 May 2016
Accepted date: 6 May 2016

Please cite this article as: Lee, K., Morality, tax evasion, and equity. Mathematical Social
Sciences (2016), http://dx.doi.org/10.1016/j.mathsocsci.2016.05.003

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*Highlights (for review)

Highlights

Morality, Tax Evasion, and Equity (MSS-15-215)

 Higher-income taxpayers may evade more or less than lower-income taxpayers.

 An increase in morality increases expected tax revenues.
 Evasion makes the tax system regressive at lower levels of morality.
 Evasion makes the tax system progressive at high levels of morality.
*Manuscript
Click here to view linked References

∗
Morality, Tax Evasion, and Equity

by

Kangoh Lee
Department of Economics
San Diego State University
5500 Campanile Drive
San Diego, CA 92182-4485
klee@mail.sdsu.edu

August 2015 (revised April 2016, May 2016)

∗
I am grateful to Firouz Gahvari for helpful discussion and to an anonymous referee for his/her comments
that improved the paper significantly.
 Abstract

This paper considers tax evasion with morality and its implication for equity of the tax sys-
tem. In the standard model of tax evasion without moral costs, higher-income taxpayers
evade more, relative to their incomes, than lower-income taxpayers, and evasion makes the
tax system regressive. With moral costs, equity of the tax system depends on the degree of
morality. As the level of morality in society increases, it increases moral costs of evasion and
evasion become inferior. Higher-income taxpayers evade less and pay more taxes, and evasion
makes the tax system progressive for a high level of morality. The opposite holds true and
evasion makes the tax system regressive for a low level of morality.

Keywords: morality; tax evasion; equity

JEL classification: D63, H26

 Morality, Tax Evasion, and Equity

1. Introduction
According to a set of recent tax gap estimates for tax year 2006 released by the Internal
Revenue Service (IRS, 2012), the gross tax gap in the U.S. is estimated to be 83.1%, meaning
that about 17% of tax revenues or $450 billion was not paid on a timely basis or never paid.
The loss of such tax revenues makes it difficult for the government to provide public goods
for citizens. In addition, due to tax evasion, the effective tax burden of a taxpayer differs
from the statutory burden determined by tax laws. For these reasons, tax evasion has been
extensively studied by scholars since the original tax-evasion model of Allingham and Sandmo
(1972), and has received much attention from policymakers.1
In the standard models of tax evasion (Allingham and Sandmo, 1972; Yitzhaki, 1974;
and almost all other models), moral costs of evasion are absent, and evasion is viewed as a
risky asset in the sense that a taxpayer has to pay the penalty when evasion is caught. The
standard portfolio model then directly applies to the tax evasion problem. That is, according
to the portfolio model, the fraction of one’s income held in the risky asset increases in income
with decreasing relative risk aversion (Cass and Stiglitz, 1972; Kihlstrom and Mirman, 1981),
implying that relative evasion, ratio of evasion to income, increases in one’s income with the
same assumption. As a result, the tax burden measured by the average tax rate decreases in
income, so evasion makes the tax system regressive. This regressivity has been a key argument
against tax evasion (Slemrod, 2007).
A literature has introduced morality to tax evasion (for example, Benjamini and Maital,
1985; Gordon, 1989), as will be discussed below. Morality makes evaders feel guilty about
evasion, discouraging evasion. With morality, some individuals thus never evade even if eva-
sion is financially profitable, explaining the over-compliance puzzle that most taxpayers do
not evade even if the probability of detection is very law and hence evasion is a profitable
gamble (Andreoni et al, 1998; Slemrod, 2007). However, other implications of morality have
not been explored, and this paper attempts to address the role of morality in determining
equity of the tax system.
Moral costs of evasion discourage evasion. When moral costs are small, the standard re-
1
For a survey of the literature, see Andreoni et al. (1998), Slemrod and Yitzhaki (2002), and Slemrod
(2007).

1
sult still holds, and relative evasion is a normal good with decreasing relative risk aversion. As
a result, higher-income taxpayers pay lower taxes relative to their incomes than lower-income
taxpayers. The average tax rate of those higher-income taxpayers is then lower than that
of lower-income taxpayers, and evasion makes the tax system regressive despite moral costs.
When moral costs are high, the opposite holds, and relative evasion decreases in income, and
evasion makes the tax system progressive. With constant relative risk aversion or increasing
relative risk aversion, higher-income taxpayers evade less and pay more taxes, relative to their
incomes, even without moral costs. As a result, tax evasion makes the system progressive,
irrespective of the magnitude of moral costs. Taken together, moral costs tend to promote
equity of the tax system despite tax evasion. An implication is that a society or policymakers
may want to increase the level of morality formally in school or informally at home, as schools
and parents may instill morality in their children (Bisin and Verdier, 2001; Lindbeck and
Nyberg, 2006; Tabellini, 2006).
The model also considers the case in which the probability of detection of evasion de-
pends on the extent of evasion. The endogenous probability creates two additional effects on
the tax burden. First, an increase in evasion results in an additional cost of increasing the
probability of detection and increasing the chance of enjoying the lower utility with evasion
caught rather than the higher utility without evasion caught. As income increases, it decreases
the difference between the higher utility and the lower utility due to the diminishing marginal
utility of income, decreasing the utility cost of increasing the probability of detection. This
reinforces the income effect on evasion, and higher-income taxpayers evade more and pay less
taxes than if the probability of detection is fixed. Second, more evasion increases the proba-
bility of detection, increasing the expected penalty. Higher-income taxpayers thus pay more
expected taxes gross of penalties than if the probability of detection is fixed. The two new
income effects move in opposite directions, but the first positive effect outweighs the second
negative effect. The reason is that the second high-penalty negative effect associated with
an increase in the probability of detection is a second-order effect while the first positive one
associated with more evasion is a first-order effect. As a result, evasion may make the tax
system progressive even with small moral costs.
A literature has introduced morality to tax evasion. Gordon (1989) relates morality to
the effect of an increase in the tax rate on evasion, and shows that an increase in the tax rate

2
can encourage evasion, rather than discourages, as in the standard model (Yitzhaki, 1974).
Alm and Torgler (2006) empirically investigate the effect of cultural differences on tax morale
in the U.S. and European countries. Traxler (2010) analyzes morality, and shows that the
decision to comply or evade depends on the behavior of other taxpayers, as tax morale is
considered a social norm. Myles and Naylor (1996) also study social equilibrium with no one
evading or all evading possibly, and show that an increase in the tax rate may increase evasion,
among other comparative statics results. However, those studies have not considered the role
of moral costs in determining equity of the tax system, the focus of this paper.
The next section considers a simple model of tax evasion with morality. Section 3 dis-
cusses the income effect on evasion with morality. Section 4 studies the effect of evasion on
equity of the tax system in the presence of morality. Section 5 extends the analysis to the
case with the probability of detection of evasion dependent on the extent of evasion. Section
6 discusses the limitations of the analysis and considers possible extensions. The last section
concludes.

2. The model
To highlight the role of morality in tax evasion and its implication for equity, mentioned
in the Introduction, the simplest possible model is considered (Yitzhaki, 1974; Benjamini and
Maital, 1985; Gordon, 1989). A taxpayer with income y attempts to evade taxes by reporting
y − e to the tax authority and paying taxes t(y − e), with t ∈ (0, 1) denoting the proportional
tax rate and e ∈ [0, y] representing the extent of underreporting or evasion. Tax returns are
audited with probability p ∈ (0, 1), and evasion is caught, and penalties are imposed on evaded
taxes, te, at a rate of m > 1. The taxpayer’s incomes when evasion is not caught and when
evasion is caught are, respectively,

yn ≡ y − ty + te,

yc ≡ y − ty + te − mte,

with subscripts n and c denoting the state of evasion being not caught and that being caught.
The taxpayer’s expected utility reads as

W (e, y, θ) ≡ (1 − p)U(yn ) + pU(yc ) − θe, (1)

with U ′ (.) > 0 and U ′′ (.) < 0. The difference from the standard model (Yitzhaki, 1974) is the

3
presence of moral cost, θe. This formulation of moral costs is simple but standard in the models
of tax evasion with moral costs (Benjamini and Maital, 1985; Gordon, 1989). In addition,
this formulation has been widely used in other fields of economics. When designing welfare
programs, policymakers are often concerned about welfare fraud, as ineligible individuals
may receive welfare benefits. In that literature, stigma costs play the same role as moral costs
here, and such costs are subtracted from the utility of financial gains (Moffit, 1983; Besley and
Coate, 1992). In the literature on the economics of crime, crimes are assumed to entail a moral
or psychic cost, and such costs are again deducted from the utility of financial gains resulting
from crimes (Rasmusen, 1996). In communication games such as a cheap talk sender-receiver
game, lying entails a psychic cost, reducing the utility of liars (Ellingsen and Johannesson,
2004; Chen et al., 2008).
θ ≥ 0 is the parameter that measures the extent of morality in a society. θ is assumed
to be influenced by a society or policymakers, and an increase in the magnitude of θ is said
to increase the level of morality in the sense that it increases the moral costs of evasion
for all individuals. A literature on cultural economics models how a society or policymakers
influence morality or other values such as trust and cooperation. For example, in Lindbeck and
Nyberg (2006), altruistic parents choose the degree of morality for their children by instilling
a norm in them. Parents also transmit a certain value to their children (Bisin and Verdier,
2001; Tabellini, 2006). Even if θ may not be directly targeted, policymakers or society can
certainly influence θ. For example, Frey (1997) and Feld and Tyran (2002) emphasize that
certain political institutions such as direct democracy enhance tax morale and induce greater
compliance. Society can then indirectly influence θ through a change in political institutions.2
The taxpayer chooses e to maximize her expected utility, and the first-order condition
for an interior maximum of the expected utility reads as
∂W (e, y, θ)
= (1 − p)tUn′ − p(m − 1)tUc′ − θ = 0, (2)
∂e
where Un′ = U ′ (yn ) and Uc′ = U ′ (yc ). Let e∗ (y, θ) satisfy (2). A corner solution may occur
because (2) decreases in θ and becomes negative and e∗ (y, θ) = 0 for a large θ. To find such
2
For an alternative interpretation, reformulate moral costs as αv. v is the degree of individual morality
and differs across individuals, but α is the level of morality in a society and not individual-specific. Since
the analysis concerns if the tax system is progressive or regressive among the individuals of a given v with
different incomes, moral costs of evasion depend on α, given v. As a result, letting αv ≡ θ, the reformulation
is equivalent to the model above.

4
values, evaluate (2) at e = 0, giving

∂W (e, y, θ)
|(e=0) = (1 − p)tUn′ − p(m − 1)tUc′ − θ = (1 − pm)tU ′ (y − ty) − θ, (3)
∂e
where yn = yc = y − ty and Un′ = Uc′ = U ′ (y − ty) with e = 0. Thus, there is a value of θ,
denoted θ(y), such that

e∗ (y, θ) > (=) 0 f or θ < (≥) θ(y) ≡ (1 − pm)tU ′ (y − ty). (4)

For a meaningful analysis, assume that pm < 1 and evasion is profitable in the absence of
moral cost θe, as in the standard model, so that evasion occurs and e∗ (y, θ) > 0 at least for
some θ. That is, without this assumption, evasion never occurs, es evident in (3) and (4). The
subsequent analysis concerns mainly interior cases with e∗ (y, θ) > 0 to analyze a number of
comparative statics results, and attention is restricted to θ < θ(y).
For later use, the first-order condition (2) is differentiated to obtain

∂e∗ (y, θ) 1
= < 0, (5)
∂θ D
with D ≡ (1 − p)t2 Un′′ + p(m − 1)2 t2 Uc′′ < 0 denoting the second-order condition for the maxi-
mization problem. Intuitively, an increase in θ increases the moral cost of evasion, decreasing
evasion. The income effect on evasion is the focus of the analysis and will be considered in
the next section.

3. Income effects on evasion

Differentiation of (2) leads to

∂e∗ (y, θ) 1
= − (1 − t)[(1 − p)tUn′′ − p(m − 1)tUc′′ ]. (6)
∂y D

The sign of (6) in general cannot be determined, but it is positive and evasion is a normal
good with DARA (decreasing absolute risk aversion) and without moral costs, as known in
the standard models of tax evasion. With moral costs, evasion is not necessarily a normal
good even with DARA. The main result on the tax burden below will use only the expression
for ∂e∗ (y, θ)/∂y in (6), but does not depend on the sign of (6). It is thus not necessary to
explore the income effect on evasion e∗ (y, θ) in (6). However, Section 5 with the probability of
detection of evasion dependent on the extent of evasion explores the income effect on evasion

5
in detail.
The key question concerns the effects of evasion on the tax burden, measured by the
average tax rate. As the average tax rate depends on relative evasion, e∗ (y, θ)/y, it is necessary
to consider the effect of an increase in income on relative evasion. Using (6), the effect is

d e∗ (y, θ) 1 ∂e∗ (y, θ)

( ) = 2 [y − e∗ (y, θ)]
dy y y ∂y
1
=− [(1 − p)t(1 − t)Un′′ y − p(m − 1)t(1 − t)Uc′′ y + (1 − p)tUn′′ te∗ (.) + p(m − 1)tUc′′ te∗ (.)]
Dy 2
1
= − 2 [(1 − p)tUn′′ yn − p(m − 1)tUc′′ yc ]. (7)
Dy
The second equality comes from (6) and the definition of D in (5). The next one uses the
definitions of yn and yc .
The sign of (7) coincides with that of the expression inside the pair of square brackets,
denoted
Ω(θ) ≡ (1 − p)tUn′′ yn − p(m − 1)tUc′′ yc . (8)

To see the role of moral costs in determining the income effects, rewrite Ω(θ) as

Ω(θ) = −(1 − p)tRn Un′ + p(m − 1)tRc Uc′

= −(1 − p)tRn Un′ + Rc [(1 − p)tUn′ − θ]

= (1 − p)tUn′ [Rc − Rn ] − Rc θ, (9)

where Ri ≡ −Ui′′ yi /Ui′ denotes the coefficient of relative risk aversion, i = n, c. The first
equality of (9) uses the definition of Ri , and the second one is obtained by substituting
p(m − 1)tUc′ = (1 − p)tUn′ − θ from the first-order condition (2). The sign of (9) depends
in part on the relationship between Rc and Rn . As is well known in the literature on risk
and uncertainty (for example, Guiso et al., 1996; Ogaki and Zhang, 2001, Gollier, ch. 17,
2001), DRRA (decreasing relative risk aversion) is considered a reasonable assumption. With
DRRA, Rc > Rn and the first term involving the pair of square brackets is positive. This,
along with the remaining negative term associated with moral costs, makes the overall sign
of Ω(θ) ambiguous. As a result, a higher-income taxpayer may evade more or less, relative
to her income, than a lower-income one. This ambiguous result stands in contrast with the

6
standard result in the literature without moral costs that relative evasion is a normal good.
That is, without moral costs, θ = 0 and

Ω(0) = (1 − p)tUn′ [Rc − Rn ] > 0 (10)

with DRRA.
To determine the sign of Ω(θ) in (8) with moral costs, observe first that e∗ (y, θ) = 0 for
θ ≥ θ(y) and
Ω(θ(y)) = (1 − pm)tU ′′ (y − ty) < 0, (11)

where yn = yc = y − ty with e∗ (y, θ) = 0. In addition, differentiation of Ω(θ) gives

∂e∗ (y, θ)
Ω′ (θ) = [(1 − p)(Un′′ + Un′′′ yn ) + p(m − 1)2 (Uc′′ + Uc′′′ yc )]t2 <0 (12)
∂θ
with DRRA. The inequality follows because DRRA implies Ui′′ + Ui′′′ yi > (Ui′′ )2 yi /Ui > 0 and
∂e∗ (y, θ)/∂θ < 0 from (5). These results may be summarized as:

Lemma 1. Assume DRRA. There is a critical value of moral cost, denoted θ∗ (y),
such that Ω(θ) ≥ (≤) 0 and hence d(e∗ (y, θ)/y)/dy ≥ (≤) 0 for θ ≤ (≥) θ∗ (y).

The lemma has a simple intuition. As noted earlier, in the standard model of portfolio
with a risky asset (Cass and Stiglitz, 1972; Kihlstrom and Mirman, 1981), DRRA implies
that as a person’s income increases, the person increases the fraction of the portfolio held in
the risky asset. As evasion is viewed as a risky asset in the sense that a taxpayer has to pay
the penalty beyond the tax when evasion is caught, the portfolio model directly applies to
the tax-evasion problem, and the fraction of evaded income or relative evasion increases in
the taxpayer’s income. With moral costs, the cost of increasing the fraction of the risky asset
or relative evasion increases additionally by the amount of moral costs of evasion, reducing
the incentives to increase relative evasion. When moral costs are small with θ ≤ θ∗ (y), the
standard result still holds and relative evasion increases in income. When moral costs are large
with θ ≥ θ∗ (y), moral costs weigh and the opposite holds, so that relative evasion decreases
in income.
DRRA has been assumed. Alternatively, assume CRRA (constant relative risk aversion)
or IRRA (increasing relative risk aversion). Then, Rc ≤ Rn and Ω(θ) ≤ 0 for all θ with the
equality holding only when θ = 0 and CRRA is assumed. Thus, relative evasion becomes

7
inferior for all θ, not just for large θ with θ ≥ θ∗ (y).

4. Tax burden
A taxpayer with income y pays her taxes ty − te∗ (y, θ), regardless of whether her evasion
is caught or not. In addition, she pays the penalty mte∗ (y, θ) when her evasion is caught. Since
the probability of evasion being caught is p, the taxpayer pays the expected taxes, denoted
T (y),
T (y) = ty − (1 − pm)te∗ (y, θ). (13)

As usual, the tax burden of an individual is measured by the average tax rate of the individual,
and the analysis concerns the effect of an increase in morality θ on the average tax rate. Given
(13), the average tax rate of the individual with y, denoted τ (y) = T (y)/y, is
e∗ (y, θ)
τ (y) = t − (1 − pm)t .
y
The question concerns if the tax burden increases or decreases with income in the pres-
ence of evasion. Since
′ d e∗ (y, θ)
τ (y) = −(1 − pm)t ( ), (14)
dy y
the sign of τ ′ (y) is the opposite of the sign of Ω(θ) in Lemma 1. These results may be sum-
marized as:

Proposition 1. Assume DRRA. τ ′ (y) ≤ (≥) 0 f or θ ≤ (≥) θ∗ (y)

For small moral costs with θ ≤ θ∗ (y), relative evasion, e∗ (y, θ)/y, is a normal good,
as in the standard model of evasion without moral costs as long as relative risk aversion is
decreasing. As a result, higher-income individuals evade more and pay lower taxes, relative to
their income, decreasing their average tax rate and hence their tax burden. Tax evasion thus
makes the tax system regressive, and this regressivity has been one of the arguments against
tax evasion. For large moral costs, with θ ≥ θ∗ (y), the opposite holds and tax evasion makes
the tax system progressive.
With CRRA or IRRA, Ω(θ) ≤ 0 for all θ, as noted in the discussion of Lemma 1 in the
previous section. Thus, τ ′ (y) ≥ 0 for all θ, reinforcing the result that evasion makes the tax
system progressive.
As noted earlier, the analysis has focused on interior cases where evasion occurs. How-
ever, if θ ≥ θ∗ (y), e∗ (y, θ) = 0 from (4) and T (y) = ty. Thus, τ (y) = t and τ ′ (y) = 0. It is

8
obvious that when no evasion occurs, tax evasion has no effect on the tax system in terms of
equity. Taken together, for large moral costs with θ ≥ θ∗ (y), τ ′ (y) ≥ 0, so that tax evasion
makes the tax system progressive or neutral.
To focus on interior cases, the analysis has ignored the effect of a change in income on
θ(y). To see the effect, consider a taxpayer with income y and another with y ′ > y. Since
θ(y) is decreasing in y from (4), θ(y ′) < θ(y). Thus, when θ < θ(y ′ ), evasion occurs for a
taxpayer with y and another taxpayer with y ′ , so that e∗ (y, θ) > 0 and e∗ (y ′, θ) > 0. Lemma 1
then implies that there is θ∗ (y, y ′) such that e∗ (y ′, θ)/y ′ ≥ (≤) e∗ (y, θ)/y for θ ≤ (≥) θ∗ (y, y ′).
Since e∗ (y ′ , θ) = 0 and e∗ (y, θ) > 0 for θ ∈ [θ(y ′ ), θ(y)), and since e∗ (y ′ , θ) = e∗ (y, θ) = 0 for
θ ≥ θ(y), the tax burden of each taxpayer equals
e∗ (y ′ , θ) e∗ (y, θ)
τ (y ′ ) = t − (1 − pm)t < τ (y) = t − (1 − pm)t f or θ < θ∗ (y, y ′),
y′ y
e∗ (y ′, θ) e∗ (y, θ)
τ (y ′ ) = t − (1 − pm)t ′
≥ τ (y) = t − (1 − pm)t f or θ ∈ [θ∗ (y, y ′), θ(y ′ )),
y y
e∗ (y, θ)
τ (y ′ ) = t > τ (y) = t − (1 − pm)t f or θ ∈ [θ(y ′), θ(y)),
y
τ (y ′ ) = t = τ (y) f or θ ≥ θ(y). (15)

Thus, as long as moral costs are not too small (θ ≥ θ∗ (y, y ′)), τ (y ′ ) ≥ τ (y) and tax evasion
makes the tax system progressive or neutral. As a result, the consideration of the income
effect on θ(y) does not alter the result in Proposition 1.
The proposition shows the role of moral costs that has been ignored in the literature.
Moral costs have been mainly used to explain why most taxpayers comply even if tax evasion
is profitable financially, explaining the over-compliance puzzle (Andreoni et al, 1998; Slem-
rod, 2007). The proposition demonstrates that moral costs also make the tax system more
equitable if the level of morality is not too low. To the extent that promotion of equity is a
policy goal and moral costs can be influenced, a society would want to increase the level of
morality through formal education in school or informal education at home, as noted above.

5. Evasion and probability of detection

This section extends the analysis to the case with the probability of detection of evasion
dependent on the extent of evasion. The motivation of this section is that if the probability of
detection increases in evasion, as in the standard model of evasion, higher-income individuals

9
pay more penalties. This counteracts the argument that evasion makes the tax system regres-
sive in the standard model without moral costs. Thus, evasion could make the tax system
progressive even without moral costs, and it is worthwhile to consider the role of moral costs
in determining the effects of evasion on equity.
Let the probability be p(e). As in all tax evasion models, it is assumed that p′ (e) > 0.
The sign of p′′ (e) cannot be a priori assumed. However, the satisfaction of the sufficient
second-order condition for the maximization problems below requires p′′ (x) ≥ 0, which will
be assumed throughout, as in the literature (for instance, Kleven et al., 2011). The first-order
condition (2) is modified as
∂W (e, y, θ)
= (1 − p)tUn′ − p(m − 1)tUc′ + p′ [Uc − Un ] − θ = 0, (16)
∂e
where p′ = p′ (e). The second-order condition becomes
∂W 2 (e, y, θ)
D≡ = (1−p)t2 Un′′ +p(m−1)2 t2 Uc′′ −2p′ [(m−1)tUc′ +tUn′ ]+p′′ [Uc −Un ] < 0, (17)
∂e2
with p′′ > 0, as assumed. The condition for an interior solution in (3) and (4) remain the
same, as Uc = Un with e = 0 and hence the term, p′ [Uc − Un ] in (16) vanishes. The effect of
an increase in moral costs on evasion is still the same as that in (5).
To see the income effect on evasion, the first-order condition (16) is differentiated to
obtain
∂e∗ (y, θ) 1
= − (1 − t)[(1 − p)tUn′′ − p(m − 1)tUc′′ + p′ (Uc′ − Un′ )]. (18)
∂y D
Unlike in (6) of Section 3, it turns out to be necessary to explore the income effect on evasion
in (18). The sign of ∂e∗ (y, θ)/∂y coincides with

φ(θ) ≡ (1 − p)tUn′′ − p(m − 1)tUc′′ + p′ (Uc′ − Un′ ). (19)

Even without moral costs, the sign of (19) cannot be determined. That is, φ(0) can be positive
or negative. However, at θ = θ(y),

φ(θ(y)) = (1 − pm)tU ′′ (y − ty) < 0, (20)

because e∗ (y, θ) = 0 and hence yn = yc at θ = θ(y). In addition, with prudence

∂e∗ (y, θ)
φ′ (θ) = [(1−p)tUn′′′ +p(m−1)2 tUc′′′ −2p′ (Uc′′ (m−1)t+Un′′ t)+p′′ (Uc′ −Un′ )]t < 0. (21)
∂θ

10
With prudence or U ′′′ (.) > 0, φ′ (θ) < 0 due to ∂e∗ (y, θ)/∂θ < 0 from (5). Prudence is
considered a reasonable assumption (Kimball, 1990; Guiso et al., 1996; Gollier, ch. 16, 2001),
as it implies that an increase in future income risk increases precautionary savings. In addition,
prudence is a weaker condition than DARA, the standard assumption in the literature. (20)
and (21), along with the ambiguous sign of φ(0), imply the following result:

Lemma 2. Assume prudence. (i) φ(θ) < 0 for all θ < θ(y), or (ii) there is a critical
value of moral cost, denoted θ̂(y), such that φ(θ) ≥ (≤) 0 for θ ≤ (≥) θ̂(y).

As noted in the discussion of (6), ∂e∗ (y, θ)/∂y > 0 and evasion was a normal good with
DARA in the absence of moral costs. In this section, even without moral costs (θ = 0) and
with DARA, the sign of ∂e∗ (y, θ)/∂y in (19) cannot be unambiguously determined. However,
evasion becomes inferior for large moral costs. As a result, evasion may be inferior for all θ
or for large θ.
To see the difference between (6) and (19), observe first that the first-order condition
(16) includes the additional term, p′ (Uc − Un ) < 0. That is, an increase in evasion resulted in
two types of costs in the first-order condition (2) of Section 2, more penalties in case of evasion
being caught −p(m − 1)tUc′ and more moral costs −θ. In (16), an increase in evasion results
in an additional cost of increasing the probability of detection and increasing the chance of
enjoying the lower utility U(yc ). This additional cost reduces the expected utility of evasion,
as reflected in p′ (Uc − Un ) < 0, reducing evasion. Less evasion affects the income effect on
evasion in two ways. First, it decreases yn and increases yc , decreasing the first two terms of
(19), (1 − p)tUn′′ − p(m − 1)tUc′′ , due to prudence. Second, less evasion lowers the probability
of detection, increasing the expected utility. The expected utility increases more for a higher-
income taxpayer, as p′ [Uc′ − Un′ ] > 0, the last term of (19). Thus, the endogenous probability
of detection may reinforce or weaken the income effect on evasion, leading to the ambiguous
income effect. However, for large moral costs, the second positive effect, p′ [Uc′ − Un′ ] > 0,
tends to diminish, as evasion becomes smaller and [Uc′ − Un′ ] becomes smaller, making the
income effect negative.
The taxpayer’s expected tax equals

T (y) = ty − (1 − p(e∗ (y, θ)m)te∗ (y, θ),

11
and the average tax rate is
e∗ (y, θ)
τ (y) = t − (1 − p(e∗ (y, θ))m)t . (22)
y
Differentiation gives
1 ∂e∗ (y, θ) e∗ (y, θ) ∂e∗ (y, θ)
τ ′ (y) = −(1 − pm)t [y − e∗
(y, θ)] + p ′
mt
y2 ∂y y ∂y
1 ∂e∗ (y, θ) ′ e∗ (y, θ) ∂e∗ (y, θ)
> −(1 − pm)t 2 y + p mt
y ∂y y ∂y
1 ∂e∗ (y, θ) ′ ∗
=t [p me (y, θ) − (1 − pm)], (23)
y ∂y
where p = p(e∗ (y, θ)) and p′ = p′ (e∗ (y, θ)). The inequality is obvious due to e∗ (y, θ) > 0, and
the equality comes from the rearrangement of the terms. Substituting p′ = [(1 −p)tu′n −p(m−
1)tUc′ − θ]/[Un − Uc ] from the first-order condition (16) into the expression inside the pair of
square brackets, the expression becomes

p′ me∗ (y, θ) − (1 − pm)

1
= {[(1 − p)tUn′ − p(m − 1)tUc′ − θ]me∗ (y, θ) − (1 − pm)(Un − Uc )}
(Un − Uc )
1
< {[(1 − p)tUn′ − p(m − 1)tUc′ − θ]me∗ (y, θ) − (1 − pm)Un′ mte∗ (y, θ)}
(Un − Uc )
1
= me∗ (y, θ) {p(m − 1)tUn′ − p(m − 1)tUc′ − θ} < 0. (24)
(Un − Uc )
The first inequality uses the concavity of the utility function U(.), along with yn − yc =
mte∗ (y, θ). The second one again comes from the concavity of the utility function (Un′ < Uc′ ).
The last inequality of (24) implies that the sign of the last expression in (23) is the opposite
of the sign of ∂e∗ (y, θ)/∂y. Lemma 2 then implies the following result:

Proposition 2. Assume prudence. With the probability of detection dependent on

evasion, (i) τ ′ (y) > 0 for all θ < θ(y), or (ii) τ ′ (y) > 0 for θ ≥ θ̂(y).

Even if moral costs are small with θ < θ̂(y) and hence ∂e∗ (y, θ)/∂y > 0, it does not make
τ ′ (y) < 0, because the inequalities in (23). The proposition extends the result in Proposition
1 in the sense that tax evasion makes the tax system progressive for large moral costs. How-
ever, unlike in Proposition 1, tax evasion may make the tax system regressive or progressive

12
even with small moral costs. The inequalities in (23) contrast with the equalities in (14).
This contrast stems from the fact that (23) is based on the income effect on evasion, e∗ (y, θ),
and (14) was based on the income effect on relative evasion, e∗ (y, θ)/y. The income effect on
relative evasion is not considered in this section, as it becomes regrettably complicated and
it involves p′′′ (e), whose sign cannot be determined or a priori assumed. However, as noted
above, the main result that evasion makes the tax system progressive with large moral costs
continues to hold even if the probability of detection depends on the extent of evasion.

6. Extensions
The analysis has considered a simple model of tax evasion with morality in order to focus
on the role of morality in determining tax burdens. This section discusses the limitations of
the model and considers possible extensions. However, the results in this section are still based
on models of partial equilibrium in the sense that they are obtained from individual compar-
ative static analyses and do not consider the system of social relationships and economy-wide
constraints.

6.1. Notions of equity

Equity has been couched in terms of the average tax rate, and this section attempts
to extend the analysis in two ways. First, rather than considering an individual taxpayer in
isolation from other taxpayers in society, the analysis incorporates a public good and a gov-
ernment budget constraint, enabling the study of the welfare effect of an increase in morality θ
on different taxpayers. Second, the analysis considers other types of equity such as horizontal
equity among the taxpayers with the same income (Hashimzade et. al (2013)).
Suppose that there are two types of taxpayers, high-income y H and low income y L . The
number of each type does not matter, and assume that the economy consists of one high-
income individual and one low-income one. The utility of the type-i taxpayer is modified to
include the public good, G, so

W i (e, y i , θ) ≡ (1 − p)U(yni ) + pU(yci ) + v(G) − θe, i = L, H, (25)

where yni = y i − ty i + te, yci = y i − ty i + te − mte, and v ′ (G) > 0. The public good G is financed
by the tax revenues, and G = T H + T L with T i ≡ T (y i ) in (13). Letting ei∗ maximize W i (.),
and ei∗ is understood to be a function of y i .3
3
When choosing ei , each individual takes G as given.

13
 The effect of an increase in θ on the utility of the type-i taxpayer is then

dW i (.) ∂W i (.) ∂ei∗ ′ ∂G ∂W i (.)

= + v (G) +
dθ ∂ei∗ ∂θ ∂θ ∂θ
∂G ∂W i (.)
= v ′ (G) +
∂θ ∂θ
L∗
′ ∂e ∂eH∗
= −v (G) (1 − pm)t [ + ] − ei∗ , i = L, H. (26)
∂θ ∂θ
The first equality comes from the fact that ei∗ is chosen to maximize W i (.) and ∂W i (.)/∂ei∗ =
0, envelop result. The next equality uses the expression of T i ≡ T (y i) in (13). The first
term of (26) is positive because v ′ (g) > 0 and ∂ei∗ /∂θ < 0 from (5). Thus, an increase in
θ results in the trade-off between a higher level of the public good and a higher moral cost
of evasion, making the welfare effect of an increase in θ ambiguous. More importantly, the
first term of (26) is common to both types, and the welfare effects differ between the two
types in the last term, −ei∗ . The sign of ∂e∗ /∂y is ambiguous, as in (6). If ∂e∗ /∂y ≥ (≤) 0,
dW L (.)/dθ ≥ (≤) dW H (.)/dθ and an increase in morality θ is more likely to make the low-
income type better (worse) off than the high-income type. As a result, if ∂e∗ /∂y ≥ (≤) 0, an
increase in morality makes the tax system more (less) equitable.
The analysis turns to horizontal equity among the taxpayers with the same income.
Consider two taxpayers with the same income y but different moral costs, so that the utility
function is written as

W i (e, y, θ) ≡ (1 − p)U(yn ) + pU(yc ) + v(G) − β i θe, i = L, H, (27)

where yn and yc are defined in Section 2, and β H > β L , so that the type-H taxpayer suffers a
larger moral cost, given the level of morality θ and evasion e. The utility-maximizing evasion
ei∗ is a function of β i θ. As in (5), evasion decreases in β i or θ, and

∂ei∗ θ
i
= i < 0, (28)
∂β D

where D i ≡ ∂W i (.)2 /∂e2 < 0 is the second-order condition. The average tax rate τ (y) is
proportional to −e∗ from Section 4. Since eL∗ > eH∗ from (28), −eL∗ < −eH∗ and hence
τ L (y) < τ H (y). Thus, even if both taxpayers have the same income, the average tax rate for
the type-H taxpayer is higher, creating a horizontal inequity.

14
 Another type of equity concerns the balance between the taxes and the benefits from
the government (Hashimzade et. al (2013)). If taxpayers feel that they receive the benefits
from the government less than the taxes they pay, they feel that the system is not equitable.
In addition, due to fairness concern, the moral cost of evasion decreases in the number of
evaders. The utility of a taxpayer is then written as

W ≡ (1 − p)U(yn ) + pU(yc ) + v(G) − γθ(G, µ)e. (29)

As noted above, the moral cost θ(.) decreases in µ, the number of evaders. The moral cost
θ(.) also increases in G, as a higher level of the public good justifies taxes better and hence
increases the moral cost of evasion. γ is a shift parameter, similar to β i in (27), except that
γ is assumed to be affected by policies or parents or education and not specific to individuals
while β i was individual specific. In this setup, an increase in morality γ increases the moral
cost of evasion, given G and µ, decreasing evasion and increasing the tax revenues and hence
the public good level G. The increase in the moral cost also decreases the number of evaders.
Thus, an increase in morality γ makes taxpayers feel that the tax system is more equitable,
promoting equity.

6.2. Progressive statutory taxes

This section considers a progressive tax rather than a proportional tax. Let z(x) denote
the tax, when reported income is x, with z(0) = 0, z(x) < x, z ′ (x) ∈ (0, 1] and z ′′ (x) ≥ 0. The
incomes when evasion is not caught and when it is caught become, respectively,

yn = y − z(y − e) and yc = y − z(y − e) − m(z(y) − z(y − e)).

As before, e∗ (y, θ) maximize W (e, y, θ) ≡ (1 − p)U(yn ) + pU(yc ) − θe, and the first-order
condition becomes
∂W (e, y, θ)
= [(1 − p)Un′ − p(m − 1)Uc′ ]z ′ − θ = 0, (30)
∂e
where the argument of z(y − e) is and will be omitted to avoid cluttering up notations, but
the argument of z(y) will not be omitted to avoid possible confusion. The critical value of
θ, θ(y), in (4) becomes
θ(y) = (1 − pm)z ′ (y)U ′ (y − z(y)).

15
For the subsequent analysis, it proves useful to first consider the income effect on evasion, and
total differentiation of the first-order condition gives
∂e∗ (y, θ) 1
= − {[(1 − p)Un′′ − p(m − 1)Uc′′ ](1 − z ′ )z ′
∂y D
+p(m − 1)Uc′′ m(z ′ (y) − z ′ )z ′

+[(1 − p)Un′ − p(m − 1)Uc′ ]z ′′ }, (31)

where D ≡ [(1 − p)Un′′ + p(m − 1)2 Uc′′ ](z ′ )2 − [(1 − p)Un′ − p(m − 1)Uc′ ]z ′′ < 0. The expression
inside the first pair of square brackets of (31) is the main income effect and identical to that
in (6), except z ′ replacing t. The remaining terms were not present in (6), as z ′ (y) − z ′ =
z ′ (y) − z ′ (y − e) = t − t = 0 and z ′′ = z ′′ (y − e) = ∂t/∂y = 0 with the proportional tax. The
remaining terms are thus due to the progressive tax. The second term is negative, because
z ′ (y) − z ′ = z ′ (y) − z ′ (y − e) ≥ 0, given z ′′ ≥ 0. The first-order condition (30) implies
[(1 − p)Un′ − p(m − 1)Uc′ ] > 0, and the last term is positive. The progressive tax then makes
the income effect on evasion smaller or larger than the proportional tax. This difficulty of
comparing the progressive tax and the proportional tax in terms of the income effect turns
out to make ambiguous the effect of an increase in morality on equity under the progressive
tax.
The tax burden equals

T (y) = z(y − e∗ (y, θ)) + mp[z(y) − z(y − e∗ (y, θ))]

= mpz(y) + (1 − mp)z(y − e∗ (y, θ)),

and the average tax rate is

z(y) z(y − e∗ (y, θ))
τ (y) = mp + (1 − mp) .
y y
Differentiation gives
d z(y) d z(y − e∗ (y, θ))
τ ′ (y) = mp ( ) + (1 − pm) ( ). (32)
dy y dy y
The first term is positive, because yz ′ (y) − z(y) ≥ 0. This first term, however, has nothing to
do with evasion or morality, as it simply reflects the fact that the statutory tax is progressive.
In other words, the first term is positive even without evasion or morality while it would be

16
zero with the proportional tax, meaning that the first term overestimates the effects of evasion
on the progressivity of the tax system. For this reason, the subsequent analysis focuses on the
second term. The sign of the second term is identical to that of

′ ∂e∗ (y, θ)
yz (1 − ) − z. (33)
∂y
Using the expression of ∂e∗ (y, θ)/∂y in (31), simple calculation can show that the sign of (33)
is in turn identical to that of

Q(θ) ≡ [(1 − p)Un′ Rn − p(m − 1)Uc′ Rc ](z ′ )2

−(m − 1)pUc′′ m[yz ′ (y) − z(y)](z ′ )2

−[(1 − p)Un′ − p(m − 1)Uc′ ]zz ′′ . (34)

The expression inside the first pair of square brackets coincides with −Ω(θ) in (8) with the
proportional tax, and the remaining terms are new and reflect the additional income effects
on evasion in (31).
At θ = 0, (1 − p)Un′ − p(m − 1)Uc′ = 0 from the first-order condition (30), and

Q(0) = (1 − p)Un′ [Rn − Rc ](z ′ )2

−(m − 1)pUc′′ m[yz ′ (y) − z(y)](z ′ )2 .

At θ = θ, yn = yc = y − z(y) and

Q(θ) = (1 − pm)U ′ (y − z(y))R(z ′ )2

−(m − 1)pU ′′ (y − z(y))m[yz ′ (y) − z(y)](z ′ )2

−(1 − pm)U ′ (y − z(y))zz ′′ .

The sign of Q(0) or Q(θ) cannot be determined in general. In addition, Q(θ) is not monotonic.
Thus, tax evasion may make the effective tax progressive or regressive under the progressive
statutory tax. However, if the statutory tax is not too progressive (yz ′ (y) − z(y) and z ′′ are
small), Q(0) < 0 and Q(θ) > 0, as in the proportional tax case.4 In this case, evasion makes
4
For instance, let z(y) = αy k with α > 0 and k ≥ 1. As k approaches one, yz ′ (y) − z(y) = α(k − 1)y k
approaches zero and Q(0) approaches (1 − p)Un′ [Rn − Rc ](z ′ )2 < 0. Analogously, as k approaches one, z ′′ (y) =
αk(k − 1)y k−2 approaches zero and Q(θ) approaches (1 − pm)U ′ (y − z(y))R(z ′ )2 > 0.

17
the effective tax regressive at low θs and makes it progressive at high θs.

6.3. Alternative formulations of moral costs

This section considers a number of alternative formulations of moral costs. First, suppose
that a taxpayer feels guilty when evasion is not caught while feels ashamed when evasion is
caught, as in Erard and Feinstein (1994). The taxpayer’s expected utility is then modified as

W (.) = (1 − p)[U(yn ) − g e] + p[U(yc ) − s e],

where g and s denote guilt and shame, respectively. This formulation of moral costs does not
affect the results qualitatively, as the moral costs can be redefined as [(1 − p)g + ps] = θ.
Second, moral costs may be measured in monetary units, so that yn and yc include −θe.
The expected utility is then W ≡ (1 − p)U(yn ) + pU(yc ). The first-order condition for an
interior maximum of W becomes
∂W
= (1 − p)Un′ (t − θ) − pUc′ (mt + θ − t) = 0.
∂e
Total differentiation gives
∂e∗ 1
= − [(1 − p)Un′′ (t − θ) − pUc′′ (mt + θ − t)](1 − t),
∂y D
where D ≡ (1 − p)Un′′ (t − θ)2 + pUc′′ (mt + θ − t)2 < 0. Using the expression of ∂e∗ /∂y, it can be
easily shown that the sign of τ ′ (y) in (14) is the same as that of (1 − p)Un′ (t − θ)[Rn − Rc ] < 0,
as t−θ > 0 at an interior solution. Thus, evasion makes the tax system regressive, irrespective
of the magnitude of θ. The intuition of this result is that the model of monetary moral costs
essentially reduces to the standard model of evasion without moral costs. Although it will
not be analyzed to conserve space, the same result holds and evasion makes the tax system
regressive if the monetary moral cost −θe is included only in yn or in yc .
Third, moral costs of evasion may depend on the evaded fraction out of income y, rather
than the absolute level of evasion. The expected utility is then W ≡ (1 − p)U(yn ) + pU(yc ) −
θ(e/y). The first-order condition for an interior maximum of W becomes
∂W
= (1 − p)Un′ t − pUc′ (m − 1)t − θ/y = 0,
∂e
and the critical θ becomes θ = y(1 − pm)tU ′ (y − ty). Total differentiation of the first-order
condition gives
∂e∗ 1 θ
= − {[(1 − p)Un′′ t − pUc′′ (m − 1)t)](1 − t) + 2 },
∂y D y

18
where D ≡ (1 − p)Un′′ t2 + pUc′′ (m − 1)2 t2 < 0. The expression of ∂e∗ /∂y includes the new
term, θ/y 2 > 0, so the income effect on evasion is larger than before. Intuitively, an increase
in income y reduces the moral cost of evasion θe/y, encouraging more evasion. This larger
income effect makes the tax system less progressive or more regressive than if the moral cost
were simply θe. In fact, the sign of τ ′ (y) in (14) is the same as that of
θ
S(θ) ≡ (1 − p)Un′ tRn − p(m − 1)Uc′ tRc − , (35)
y
and the last negative term reduces τ ′ (y). At θ = 0, S(0) = (1 − p)Un′ tRn − p(m − 1)Uc′ tRc =
(1 − p)Un′ t[Rn − Rc ] < 0, as before. At θ = θ, S(θ) = (1 − pm)U ′ (y − ty)tR − θ/y =
(1 − pm)U ′ (y − ty)t[R − 1] ≥ (≤) 0 as R ≥ (≤) 1, where θ = y(1 − pm)tU ′ (y − ty), as defined
above. In addition, it can be shown that S ′ (θ) > 0 if R ≥ 1, and S ′ (θ) cannot be signed
otherwise. Thus, if R > 1, the same result holds and an increase in morality makes the tax
system progressive at high θs while it makes the system regressive at low θs.
Fourth, moral costs of evasion may be independent of the level of evasion, as in Ben-
jamini and Maital (1985). The expected utility is then W ≡ (1 − p)U(yn ) + pU(yc ) − θ. The
first-order condition becomes ∂W/∂e = (1 − p)Un′ t − p(m − 1)Uc′ t = 0 and does not involve θ.
The evasion decision then becomes identical to that in the standard model of evasion without
moral costs as long as θ ≤ θ ≡ (1−p)U(yn )+pU(yc )−U(y −ty), where e is chosen to maximize
(1 − p)U(yn ) + pU(yc ). Thus, as in the standard model, evasion makes the tax system regres-
sive, and θ plays no role in determining progressivity or regressivity, as evasion decision does
not depend on θ. Morality, however, can still affect the progressivity or regressivity of the tax
system at a margin, as the critical moral cost θ depends on y. If ∂θ/∂y > 0, then an increase
in morality θ discourages lower-income taxpayers with lower θ from evading, making the tax
system regressive. If ∂θ/∂y < 0, then the opposite holds true, and an increase in morality θ
makes the tax system progressive. Unfortunately, there appears to be no simple and intuitive
condition to determine the relationship between y and θ, and no definite statement can be
made regarding the effect of morality on the progressivity of the tax system.

7. Conclusion
The paper has considered the role of tax evasion in determining equity of the tax system
in the presence of moral costs. The analysis has shown that tax evasion makes the tax system
regressive with low moral costs but progressive with high moral costs. When the probability of

19
detection depends on the degree of evasion, the same conclusion holds with high moral costs,
but evasion may make the tax system progressive even with small moral costs. In general,
evasion tends to make the tax system more equitable in a society with a high level of morality,
and it is desirable to increase the level of morality to the extent that society or policymakers
care about equity. To illustrate the role of morality in models of tax evasion, the paper has
focused on the relationship between morality and equity of the tax system, but morality may
affect other known results in an important way and appears to deserve more research.

20
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