Entrepreneurship and tax evasion

Business income is systematically underreported and accounts for a sizable share of the US tax gap. This paper examines the importance of tax evasion in the entrepreneurial sector for the effects of tax reforms. I analyze the long-run effects of switching from a progressive income tax to a proportional one in a model with heterogeneous agents and incomplete markets, including an entrepreneurial choice and a tax evasion decision. Explicitly considering tax evasion in this reform implies (i) significantly lower increases in capital accumulation and output and (ii) a less negative impact on wealth concentration. This finding contrasts with the results obtained when abstracting from tax evasion, which implies much higher output and capital responses and a more adverse impact on wealth inequality; thus, accounting for entrepreneurs' evasion behavior is vital for the quantitative analysis of tax reforms.