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Presumptive Income Taxation and Costly Tax Compliance 1

This paper uses a Stackelberg game to analyze the problem of taxation by a benevolent social planner in the face of costly tax compliance. The social planner minimizes deadweight loss subject to a marginal benefit of tax revenues. I ask whether it is optimal in this case to introduce an alternative presumptive income tax, and I find conditions for its optimal tax rates. I model the production and tax return filing decisions of risk-neutral firms facing a hybrid tax system that allows them to choose between a self-assessed tax on profits and a presumptive income tax. Anybody can choose to file under the presumptive regime, but in order to file under the self-assessed regime, a taxpayer must keep costly accounting books. The cost of bookkeeping differs across firms. The model implies that, in the presence of costly tax compliance, a benevolent social planner with a given marginal value of tax revenue can always enhance social welfare if she allows taxpayers the alternative of filing a presumptive income tax return. In addition, the optimal marginal tax rate on profits may fall below one, even if the individual labor decision is binary.