Re-Examining the Neutrality of Profit Taxation and the Separability between Evasion and the Production Decisions of Firms

Abstract

It is a very robust conventional view that profit taxation has no impact on the output level even in the presence of evasion with a random audit scheme. In addition, the firms’ evasion and production decisions are separable as well. In this note we show that if the firm evades tax via underreporting quantities sold and the output level is essential to the audited profit of the tax authority, the profit tax is non-neutral and the separability between production and evasion decisions no longer holds. Otherwise, the traditional view is still robust.