The evasion of fiscal and labor regulations: Firm behavior and optimal tax policy

Abstract Firms face many fiscal and labor regulations, but they may evade these legal requirements in several different ways. We develop a model that captures these two types of evasion decisions and unlike existing literature assume firms can evade labor regulations independently from income tax responsibilities. We characterize firms’ entry and evasion behavior and find that the design of the tax system can generate both positive and negative correlations between evasion decisions consistent with what is observed empirically. We then characterize optimal government policies given the firms’ decisions. We obtain intuitive optimal tax rules that highlight the trade‐offs the government faces when firms have multiple margins on which to evade.