The present paper considers a problem of optimal taxation for a group of individuals
with random, independent and identically distributed incomes. An agent’s income
is her private information and can only be verified through a costly audit. The purpose
is to characterize the optimal tax schedule and auditing strategy that maximize net
tax revenue under participation constraints related to the interests of the taxpayers.
The authors determine the optimal evasion proof strategy, depending on the penalty
constraint. They show that under certain conditions tax evasion may increase net
tax revenue, but typically the optimal government strategy is evasion proof.