Suppose that the tax rate is 30%. Suppose also that the probability of getting caught evading taxes is 10% plus an additional 2.5% for every $1,000 in tax evasion. (Hence, P = 0.1 + 0.025X, where X is the number of dollars (in thousands) of evasion.) Individuals who are caught evading taxes will be forced to pay the taxes they owe in addition to a $10,000 penalty. How much evasion will a risk-neutral taxpayer engage in? How would your answer change for a risk-averse taxpayer?
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