Exploring tax evasion in the context of political uncertainty

•Agents facing political uncertainty insure against it by hiding funds from taxation.•By allowing this choice, the level of tax evasion in society emerges.•The level of tax evasion helps determine tax revenues that two different potential governments expect.•Consequently, it is an important factor in the optimum choices of the governments.•Our model suggests that ignoring tax evasion options may bias policy conclusions.

We present a model of agents facing the uncertainty of two future forms of government who are able to insure against this uncertainty by hiding funds from taxation. In order to choose whether or not to hide funds from taxation, agents need to know policy choices that each government would make should it come to power. But each government, before it could make its decision, would need to know the choices of the agents who would, for example, produce tax revenues. This informational tension is resolved endogenously. We derive the resulting level of tax evasion in society and the optimal choices made by the potential governments. We examine how changes in governmental structure would affect the level of tax evasion, and how that, in turn, would affect a particular form of capital flight.