Brains or Muscles? A Political Economy of Tax Evasion

Abstract

An influential citizen wants to get away with tax evasion, a risky practice that can trigger audits resulting in sanctions. To reduce the chances of being audited, he can invest in the complexity of his evasion scheme —which we call "brains". The probability that an audit results in a sanction depends on the effort exerted by an investigator. To reduce the effort that she exerts, the citizen can commit to delivering punishments —which we call "muscles". We show that there exists a threshold in the quality of institutions below which muscles and brains are complements and above which they are substitutes. The citizen's equilibrium strategies yield a testable prediction: estimates of offshore tax evasion display an inverted U-shape along the quality of institutions. We provide evidence of this finding by building a panel dataset of estimated offshore wealth by individuals for 37 countries between 2002 to 2016.