Optimal fiscal policy in the presence of VAT evasion: the case of Bulgaria

This paper explores the effects of fiscal policy in an economy based on indirect taxes, and in the presence of VAT evasion channel. In addition, the government is taxing all income at the same rate. The focus of the paper to compare and contrast two regimes - the exogenous (observed) vs. optimal (Ramsey) policy case. The results are evaluated in light of consumption vs. income taxation debate, the issue of optimal provision of valuable public services, and the effect of fiscal policy on the size of VAT evasion. To this end, a Real-Business-Cycle model, calibrated to Bulgarian data (1999-2014), is augmented with a government sector. Bulgarian economy was chosen as a case study due to its dependence on consumption taxation as a source of tax revenue, and the prevalence of VAT evasion. The main findings from the computational experiments performed in the paper are: (i) The optimal steady-state income tax rate is zero; (ii) The benevolent Ramsey planner provides the optimal amount of the utility- enhanc- ing public services, which are now three times lower; (iii) The optimal steady-state consumption tax needed to finance the optimal level of government spending is twice lower, as compared to the exogenous policy case.