1 OPTIMAL INCOME TAXATION WITH MOBILITY BETWEEN THE LEGAL AND BLACK LABOUR MARKETS X. Ruiz del Portal * Abstract This paper contributes to the literature on optimal income taxation with tax evasion by incorporating labour mobility between the legal sector and the black economy. The conclusions from the traditional analysis strongly contrast with those that result when extensive margin responses are taken into account. We find that individuals indifferent between working in either of the two sectors play a crucial role in determining both the marginal tax rate and the optimal policy against tax evasion. Likewise, technological changes affecting relative wages are influential in the choice for each labour market, by either boosting or lowering the benefits from tax evasion. Interestingly, it may be welfare improving under risk neutral preferences to permit the existence of a hidden sector where evasion is possible and marginal tax rates are higher. Keywords: optimal income taxation; tax evasion; extensive margin responses. JEL classification: C6-D6-D8-H2 1. Introduction Tax evasion represents a major problem in most developed countries, as it imposes limits on the attainment of public policy goals such as income redistribution and economic stability. Strangely enough, while the issue of income redistribution constitutes one of the main focuses of optimal tax theory, most research in this area has been developed under the assumption that evasion decisions are inexistent. An early exception was however the paper of Sandmo (1981), who formulated a model that captures the implications of income underreporting for redistribution through linear taxation. This enabled him to derive a formula for the marginal tax rate and a complete characterization of the instruments for the control of tax evasion, namely, the probability of detection, the penalty rate and the fine. Nevertheless, Sandmo (1981) simplified the analysis to two ability levels, one for non-evaders and another for evaders. On the other hand, in his setting non-evaders cannot elude tax, unlike evaders, who may or may not do it according to the magnitude of the policy parameters. Of these simplifications Sandmo (1981, 2005) commented: “A more careful analysis would take the aggregation problem more seriously and base predictions on a model of many taxpayers, differing both with respect to their income and evasion opportunities.” And similarly: “The assumption that the relative size of the two groups is fixed is of course a simplification. In the long run one would like to assume that occupational choice would be influenced by the opportunities for tax evasion, so that the size and * Department of Applied Economics/ University of Lleida (Spain). E-mail: rportal@econap.udl.cat