Optimal Tax Mix with Income Tax Non-compliance

Although developing countries face high levels of income inequality, they rely more on consumption taxes, which tend to be linear and are less effective for redistribution than a non-linear income tax. One explanation for this pattern is that the consumption taxes are generally more enforceable in these economies. This paper studies the optimal combination of a linear consumption tax, with a non-linear income tax, for redistributive purposes. In our model, households might not comply with the income tax code by reporting income levels that differ from their true income. However, the consumption tax is fully enforceable. We derive a formula for the optimal income tax schedule as a function of the consumption tax rate, the recoverable elasticities, and the moments of the taxable income distribution. Our equation differs from those of Mirrlees (1971) and Saez (2001) because households respond to income tax not only through labor supply but also through mis-reporting their incomes. We then characterize the optimal mix between a linear consumption tax rate and a non-linear income tax schedule. Finally, we find that the optimal consumption tax rate is non-increasing in the redistributive motives of the social planner.