Tax evasion and choice of formal and informal sectors

The paper considers imposition of unit tax by the government on a firm selling product in a monopoly market. The firm has the option either to pay tax or to evade it. Tax evasion can be done either by selling the product in the formal sector or in the informal sector. The firm can evade the tax in the formal sector by under reporting its true quantity. On the other hand, it can evade by producing in the informal sector by adopting some illegal means of production. In this framework, it is observed that the firm pays tax only when the chance of getting detected is high. Interestingly, the paper highlights that imposition of a specific unit tax might not reduce tax evasion. If there is an increase in the efficiency of government monitoring and enforcement of penalties, tax evasion might be reduced significantly.