Working Papers

Job Market Paper
Digital Divergence: Optimal Taxation, Payment Choice, and Policy Uncertainty in the Shadow Economy

This paper develops a search-theoretic model of money to analyze optimal fiscal and monetary policy when tax evasion is linked to payment methods. In a decentralized market, a sales tax is automatically collected on monitored electronic money (e-money) but can be evaded using unmonitored cash, subject to a detection probability. Buyers endogenously choose payment methods, determining the effective tax base. A benevolent Ramsey planner optimizes the sales tax, cash audit intensity, and fiat money growth rate, balancing revenue needs against evasion incentives and distortions. We characterize the resulting equilibria. We then extend the model to include cryptocurrency as an untaxed alternative whose primary friction is volatility. Crucially, volatility depends on a perceived policy regime state Clear/Ambiguous x Friendly/Hostile, which evolves endogenously based on how policy actions deviate from expectations. We set up the dynamic Ramsey problem and show that the planner balances current welfare gains against the future cost of inducing ambiguity when setting policies. The desire to maintain policy credibility disciplines deviations from expectations. The framework highlights the interplay between taxation, evasion technology, payment choice, policy credibility, and endogenous market volatility.