unhidden revenues:
• When the ruler is unable to commit at all, greater taxability increases the ruler’s share
of production at the margin by increasing the proportion of revenues unhidden.
• When the ruler is able to commit to a lump-sum tax and state support augments
hidden production, greater taxability increases the ruler’s share of production at the
margin by reducing the amount that the firm must be guaranteed to avoid revenue
hiding.
• When the ruler is able to commit to a proportional tax and state support augments
hidden production, greater taxability increases the ruler’s share of production at the
margin by increasing the optimal tax on unhidden revenues.
Thus, while the ruler and firm fall farthest short of the Pareto frontier when the ruler is
unable to commit at all,
11
commitment power is not sufficient to achieve an efficient outcome
when state support makes hiding production more profitable. In essence, some portion of
the increase in production from state support must be spent to keep the firm from deviating
to the now-more-profitable informal sector. This effect is exacerbated when the ruler can
11
To see this, compare Propositions 1-4 and recall that there are two possible sources of inefficiency in
the model:
revenue hiding and underprovision of state support.
Revenue hiding is greatest in the no-
commitment case, as there is no hiding with a lump sum tax, while with the proportional tax g
H
= t ≤ 1
vs. g
H
= 1 when the ruler cannot commit.
Further, state support is the smallest in the no-commitment
case: c
e
= 1 − H
N C
vs. c
e
= 1 in the “de Soto” case and c
e
= 1 − H
N C
+ g
¡H
N C
¢inthe“taxevasion”
case. With respect to the proportional tax, recall from (3.9) that the ruler could always choose t = 1 as in
the no-commitment case; when she does not do so, it must be the case that the expected share of unhidden
revenues is greater than in the no-commitment case, implying greater support.
29
Convention