Tax morale, tax compliance and the optimal tax policy

This paper incorporates the positive relationship between tax compliance and tax morale into the social welfare function and derives the optimal tax policy in the presence of honest taxpayers and tax evaders. The right mix of policy instruments of deterrence for clamping down on tax evasion depends on taxpayers' morality. Monitoring turns out to be an effective tool for controlling illegal activities, thus a tighter audit is recommended in any case. For honest taxpayers, this increase in monitoring should be offset by tax reductions. In contrast, in the case of tax evaders, the increase in monitoring should be accompanied by higher penalties.