1 The Evolution of Tax Evasion in the Czech Republic: A Markov Chain Analysis December, 2004 by Jan Hanousek, CERGE-EI, and Filip Palda, ENAP * Abstract This study departs from standard analyses of tax evasion, which ask why people evade. We seek instead to measure the average individual’s transitions in both directions between evading and not evading and use this to predict the evolution of tax evasion for the Czech Republic with the help of surveys taken in 2000, 2002, and 2004. We asked each respondent whether he evaded taxes in 1995, 1999, 2000, 2002 and 2004. Answers to the questions allowed us to calculate probabilities that the average individual will move between being a non-evader and being an evader. This "transition" probability leads us to predict a rising tide of tax evasion in the next decade. We estimate the structural and reduced form parameters, which determine evasion and suggest how government might influence these parameters to prevent the Czech Republic from bogging down in a permanent mire of tax evasion. (JEL Codes : H26, H43, K42, O17) 1. Motivation Most research into tax evasion has focused either on measuring the size of the sector that evades taxes, or in explaining why people evade taxes. Put differently, most studies of evasion are concerned with structural equations that predict the partial equilibrium response of an individual to a change in preferences or incentives. Few have sought to model how tax evasion evolves. The man who today does not evade taxes may next year decide to deduct from taxable income the car he uses to take his children to school. Emboldened by his first dodge he may in later years graduate to the corps of hardened evaders who do not declare their incomes and so do not need to fuss with receipts for false deductions. Another hardened * Jan Hanousek is Professor at CERGE-EI, a joint workplace of Charles University and the Academy of Sciences of the Czech Republic. Filip Palda is Professor at Ecole Nationale d'Administration Publique, Montreal, Canada and visiting professor at CERGE-EI. Address for correspondence: CERGE-EI, P.O.Box 882, Politickych veznu 7, 111 21, Prague, Czech Republic. Emails: Jan.Hanousek@cerge-ei.cz , Filip_Palda@enap.uquebec.ca . We thank Randy Filer and Stepan Jurajda for their comments on an earlier draft of this paper. This research was supported by by Grant Agency of the Czech Republic (402/04/0166), the Phare ACE Programme of the European Union (P97-8119-R) and the Volkswagen Foundation (II/75831).