Chapter 16 Tax Evasion

1. Chapter 16 Tax Evasion

2. Reading • Essential reading • Hindriks, J and G.D. Myles Intermediate Public Economics. (Cambridge: MIT Press, 2005) Chapter 16. • Further reading • Allingham M. and A. Sandmo (1972) ‘Income tax evasion: a theoretical analysis’, Journal of Public Economics, 1, 323—338. • Baldry, J.C. (1986) ‘Tax evasion is not a gamble’, Economics Letters, 22, 333—335. • Becker, G. (1968) ‘Crime and punishment: an economic approach’, Journal of Political Economy, 76, 169—217. • Cowell, F.A. Cheating the Government (Cambridge: MIT Press, 1990) [ISBN 0262532484 pbk].

3. Reading • Glaeser, E.L., B. Sacerdote and J.A. Scheinkman (1996) ‘Crime and social interaction’, Quarterly Journal of Economics, 111, 506—548. • Schneider F. and D.H. Enste D.H. (2000) ‘Shadow economies: Size, causes, and consequences’, Journal of Economic Literature, 38, 77—114. • Mork, K.A. (1975) ‘Income tax evasion: some empirical evidence’, Public Finance, 30, 70—76. • Spicer, M.W. and S.B. Lundstedt (1976) ‘Understanding tax evasion’, Public Finance, 31, 295—305 • Challenging reading • Bordignon, M. (1993) ‘A fairness approach to income tax evasion’, Journal of Public Economics, 52, 345—362. • Cowell, F.A. and J.P.F. Gordon (1988) ‘Unwillingness to pay’, Journal of Public Economics, 36, 305—321.

4. Reading • Graetz, M., J. Reinganum and L. Wilde (1986) ‘The tax compliance game: towards an interactive theory of law enforcement’, Journal of Law, Economics and Organization, 2, 1—32. • Hindriks, J., M. Keen and A. Muthoo (1999) ‘Corruption, extortion and evasion’, Journal of Public Economics, 74, 395—430. • Myles, G.D. and R.A. Naylor (1996) ‘A model of tax evasion with group conformity and social customs’, European Journal of Political Economy, 12, 49—66. • Reinganum, J. and L. Wilde (1986) ‘Equilibrium verification and reporting policies in a model of tax compliance’, International Economics Review, 27, 739—760. • Scotchmer, S. (1987) Audit classes and tax enforcement policy, American Economic Review, 77, 229—233.

5. Introduction • Tax evasion is the illegal failure to pay tax • Tax avoidance is the reorganization of economic activity to lower tax payment • Tax avoidance is legal but tax evasion is not • The borderline between avoidance and evasion is unclear • Estimates show evasion to be a significant fraction of measured economic activity • It is an important consideration for tax policy

6. The Extent of Evasion • The names black, shadow or hidden economy are used to described economic activity for which payment is received but is not officially declared • Included in the hidden economy are: • Illegal activities • Unmeasured legal activity such as output of smallholders • Legal but undeclared activity • The unmeasured economy is the shadow economy plus activities which are economically valuable but do not involve any transaction

7. The Extent of Evasion • There are many methods for measuring the hidden economy • The difference between the income and expenditure measures of national income • Survey data directly or indirectly as an input into an estimation procedure • The demand for cash on the basis hidden activity is financed by cash (monetary approach) • The use of a basic input that is measured to estimate true output (input approach)

8. The Extent of Evasion • Table 16.1 presents estimates of the size of the hidden economy • These estimates are subject to error • There is a degree of consistency • Undeclared economic activity is substantial Table 16.1: Hidden Economy as % of GDP, Average Over 1990-93 Source: Schneider and Enste (2000)

9. The Evasion Decision • The simplest model of the evasion decision considers it to be a gamble • If a taxpayer declares less than their true income (or overstates deductions) • They may do so without being detected • There is also a chance that they may be caught • When they are a punishment is inflicted • Usually a fine but sometimes imprisonment • A taxpayer has to balance these gains and losses taking account of the chance of being caught and the level of the punishment

10. The Evasion Decision • The taxpayer has a fixed income level Y • This income level is known to the taxpayer • The level of income is not known to the tax collector • The taxpayer declares a level of income X where X ≤ Y • Income is taxed at a constant rate t • The amount of unreported income is Y – X ≥ 0 • The unpaid tax is t[Y - X]

11. The Evasion Decision • If the taxpayer evades without being caught their income is given by Ync = Y - tX • When the taxpayer is caught evading all income is taxed and a fine at rate F is levied on the tax that has been evaded. • The income level when caught is Yc = [1 - t]Y - Ft[Y - X] • If income is understated the probability of being caught is p

12. The Evasion Decision • Assume that the taxpayer derives utility U(Y) from an income Y • After making declaration X the taxpayer obtains • Income level Yc with probability p • Income level Ync with probability 1 – p • The taxpayer chooses X to maximize expected utility • The declaration X solves max{X} E[U(X)] = [1 – p]U(Ync) + pU(Yc)

13. The Evasion Decision • Observe that there are two states of the world. • In one state of the world the taxpayer is not caught evading and income is Ync • In the other state of the world they are caught and income is Yc • The expected utility function describes preferences over income levels in the two states • The choice of X determines income in each state • Varying X trades-off income between the states • High X provides relatively more income in the “caught evading” state • Low X provides relatively more in the “not caught”

14. The Evasion Decision • When X = Y the income after tax is [1 - t]Y in both states • When X = 0 income is [1 - t(1 + F)]Y if caught and Y if not caught • The options facing the taxpayer lie on the line joining the points for X = 0 and X = Y • This is the opportunity set of income allocations between the two states • The utility function provides a set of indifference curves • Along an indifference curve are income levels in the two states giving equal expected utility

15. The Evasion Decision • The choice problem is shown in Fig. 16.1 • The optimal declaration achieves the highest indifference curve • The taxpayer chooses to locate at the point with declaration X* • This is an interior point with 0 < X*< Y • Some tax is evaded but some income is declared Figure 16.1: Interior choice: 0 < X* < Y

16. The Evasion Decision Figure 16.2: Corner solutions • Corner solutions can also arise • In Fig. 16.2a X* =Y so all income is declared • In Fig. 16.2b X* = 0 so no income is declared

17. The Evasion Decision • Evasion occurs when indifference curves are steeper than the budget constraint on the 45o line • The indifference curves have slope dYc/dYnc = – [1 – p]U′(Ync)/pU′(Yc) • On the 45o line Yc = Yncso U′(Ync) = U′(Yc) implying dYc/dYnc = – [1 – p]/p • The slope of the budget constraint is – F • The indifference curve is steeper than the budget constraint on the 45o line p < 1/[1 + F]

18. The Evasion Decision • Evasion occurs if the p is small relative to F • The condition applies to all taxpayers • In practice F is between 0.5 and 1 so 1/(1 + F) ≥ 1/2 • Information on p hard to obtain • In the US • The proportion of individual tax returns audited was 1.7 per cent in 1997 • The Taxpayer Compliance Measurement Program revealed that 40 percent of US taxpayers underpaid their taxes • This is large but less than the model predicts

19. The Evasion Decision • An increase in detection probability is shown in Fig. 16.3 • An increase in p reduces the gradient of the indifference curves on the 45o line • The optimal choice moves closer to X = Y • The income declared rises so an increase in the detection probability reduces evasion Figure 16.3: Increase in detection probability

20. The Evasion Decision • A change in the fine rate affects income when caught evading • An increase in F pivots the budget constraint around the point where X = Y • The optimal choice moves closer to honest declaration • This is shown in Fig. 16.4 by the move from Xold to Xnew • An increase in F reduces evasion Figure 16.4: Increase in the fine rate

21. The Evasion Decision • An income increase moves the budget constraint outward • The optimal choice moves from Xold to Xnewin Fig. 16.5 • The effect depends on absolute risk aversion RA(Y) = - U′′(Y)/U′(Y) • If RA(Y)is constant the optimal choices lie on a locus parallel to the 45o line • If RA(Y)decreases with income the choice locus bends downward Figure 16.5: Income increase

22. The Evasion Decision • An increase in the tax rate moves the budget constraint inward as inFig. 16.6 • The outcome is not clear-cut • If RA(Y)is decreasing a tax increase reduces tax evasion • This is because the fine is Ft so an increase in the t raises the penalty • This reduces income in the state in which income is lowest Figure 16.6: Tax rate increase

23. Auditing and Punishment • The analysis of the evasion decision assumed that the p and F were fixed • This is satisfactory from the perspective of the individual taxpayer • From the government's perspective these are choice variables that can be chosen • The probability of detection can be raised by the employment of additional tax inspectors • The fine can be legislated or set by the courts • The issues involved in the government's decision can be analyzed

24. Auditing and Punishment • An increase in either p or F will reduce the amount of undeclared income • Assume the government wishes to maximize revenue • Revenue is defined as taxes paid plus the money received from fines • From a taxpayer with income Y the expected value of the revenue collected is R = tX + p(1 + F)t[Y – X]

25. Auditing and Punishment • Differentiating with respect to p • Differentiating with respect to F • If pF <1 – p an increase in p or F will increase the revenue the government receives • p is costly, F is free • Optimal policy is low p very high F

26. Auditing and Punishment • This policy maximizes revenue not welfare • The government may be constrained by political factors • The government may not be a single entity that chooses all policy instruments • A more convincing model would have: • The tax rate set by central government • The probability of detection controlled by a revenue service • The punishment set by the judiciary.

27. Auditing and Punishment • The economics of crime views tax evasion as just another crime • The punishment should fit with the general scheme of punishments • Levels of punishment should provide incentives that lessen the overall level of crime • Lower punishments for less harmful rather crimes • Tax evasion has a low punishment if viewed as having limited harm

28. Evidence on Evasion Table 16.2: Declaration and Income Source: Mork (1975) • Compares income level from interviews to income on tax return • Interviewees placed in income intervals based on interview • The percentage found by dividing the assessed income by the midpoint of the income interval • Declared income declines as a proportion of reported income occurs as income rises

29. Evidence on Evasion • The propensity to evade is reduced by an increase in the probability of detection, age, income but increased by an increase in perceived inequity and number of tax evaders known • Extent of tax evasion increased by inequity, number of evaders known and experience of previous tax audits. • Social variables are clearly important Table 16.3: Explanatory Factors Source: Spicer and Lundstedt (1976)

30. Evidence on Evasion • Data from the US Internal Revenue Services Taxpayer Compliance Measurement Program survey of 1969 • Evasion increases as the marginal tax rates increases but decreases when wages are a significant proportion of income • The difference between income and expenditure figures in National Accounts support this result • Belgian data found the converse: tax increases lead to lower evasion • There remains ambiguity about the tax effect

31. Evidence on Evasion • Tax evasion games can be used to test evasion behavior • These games have shown that evasion increases with the tax rate • Evasion falls as the fine is increased or the detection probability increases • Women evade more often than men but evade lower amounts • Purchasers of lottery tickets were • No more likely to evade than non-purchasers • Evaded greater amounts when they did evade

32. Evidence on Evasion • The nature of the tax evasion decision has been tested by running two parallel experiments • One framed as a tax evasion decision and • The other as a simple gamble • These experiments have the same risks and payoffs • For the tax evasion experiment some taxpayers chose not to evade even when they would under the same conditions with the gambling experiment • This suggests that tax evasion is more than just a gamble

33. Evidence on Evasion • There are several important lessons to be drawn from the evidence • The theoretical predictions are generally supported except for the effect of the tax rate • Tax evasion is more than the simple gamble portrayed in the basic model • There are attitudinal and social aspects to the evasion decision in addition to the basic element of risk

34. Effect of Honesty • The act of tax evasion can have psychological effects • Taxpayers submitting incorrect returns feel varying degrees of anxiety and regret • The innate honesty of some taxpayers is not captured by representing tax evasion as just a gamble • Non-monetary costs of detection and punishment are not captured by preferences defined on income alone

35. Effect of Honesty • Honesty can introduced by assuming the utility function has the form U = U(Y) - cE • The level of evasion is E = Y- X and c is a measure of honesty • The value of cEthe psychological cost of evasion • Assume taxpayers differ in their value of c but are identical in all other respects • Those with high c will have a greater utility reduction for any given level of evasion

36. Effect of Honesty • Evasion occurs only if the utility gain from evasion must exceed the utility reduction • Let E*be the optimal level of evasion • Evasion is chosen if EU( ) – cE* > U(Y) where is the random income after optimal evasion • The population is separated into taxpayers who do not evade (high values of c) and others who evade (low c) • Those who do not evade are “honest” but will evade if the benefit is sufficiently great

37. Effect of Honesty • Empirical evidence shows a positive connection between number of tax evaders known and the level evasion • The evasion decision is not made in isolation but with reference to the norms and behavior of society • Social norms can be incorporated as an additional utility cost of evasion. • This cost can be assumed an increasing function of the proportion of taxpayers who do not evade.

38. Effect of Honesty • This captures the fact that more utility will be lost the more out of step the taxpayer is with the remainder of society • If evasion is chosen expected utility is EU – m(n) • The function m(n) is increasing in the number of honest taxpayers, n • This modification reinforces the separation of the population into evaders and non-evaders

39. Tax Compliance Game • A revenue service chooses the probability of audit to maximize total revenue taking as given the tax rate and the punishment • The government is viewed as allocating choices to separate agencies • The choice of probability requires an analysis of the interaction between the revenue service and the taxpayers • The revenue service reacts to income declarations and taxpayers react to the expected detection probability

40. Tax Compliance Game • A strategy for the revenue service is the probability with which it chooses to audit any given value of declaration • A strategy for a taxpayers is a choice of declaration given the audit strategy of the revenue service • At a Nash equilibrium the strategy choices must be mutually optimal • In this game predictability in auditing cannot be an equilibrium strategy

41. Tax Compliance Game • Observe • No auditing at all cannot be optimal because it would mean maximal tax evasion • Auditing of all declarations cannot be a solution because this incurs excessive auditing costs • A pre-specified limit on the range of declarations that will be audited since those evading will remain outside this limit • To be unpredictable the audit strategy must be random

42. Tax Compliance Game • The probability of an audit should be high for an income report that is low compared to what one would expect from someone in that taxpayer's occupation • Or it should be high given the information on previous tax returns for that taxpayer • In either case a taxpayer should not be able to predict if they will be audited

43. Tax Compliance Game • A version of the strategic interaction is depicted in Fig. 16.7 • A taxpayer with income Y can either evade (reporting zero income) or not (truthful income report) • By reporting truthfully the taxpayer pays tax T to the revenue service (with T < Y) • The revenue service can either audit the income report or not audit • An audit costs C, C < T, for the revenue service to conduct and is accurate in detecting evasion • If the taxpayer is caught evading the tax T plus a fine F is paid (where F > C)

44. Tax Compliance Game Figure 16.7: Compliance game

45. Tax Compliance Game • There is no pure strategy equilibrium in this tax compliance game • If the revenue service does not audit the taxpayer strictly prefers evading and therefore the revenue service is better-off auditing as T + F > C • If the revenue service audits with certainty, the taxpayer prefers not to evade as T + F > T, which implies that the revenue service is better-off not auditing • The revenue must play a mixed strategy in equilibrium with the audit strategy being random • The taxpayer’s evasion strategy must also be random

46. Tax Compliance Game • Let e be the probability that the taxpayer evades, and pthe probability of audit • In equilibrium the players must be indifferent between their two pure strategies • For the revenue service to be indifferent between auditing and not auditing the cost of auditing C must equal the expected gain in tax and fine revenue e[T + F] • For the taxpayer to be indifferent between evading and not evading the expected gain from evading (1 – p)T must equal the expected penalty pF • The equilibrium is e* = C/(T + F), p* = T/(T + F)

47. Tax Compliance Game • The equilibrium payoffs are u* = Y – T, v* = T – (C/(T+F))T • The taxpayer is indifferent between evading or not evading so equilibrium payoff is equal to truthful payoff Y – T • This is because • Unpaid taxes and the fine cancel out in expected terms • Increasing the fine does not affect the taxpayer

48. Tax Compliance Game • A higher fine increases the payoff of the revenue service since it reduces the amount of evasion • increasing the penalty is Pareto-improving • The equilibrium payoffs also reflect a cost of evasion • for any tax T paid by the taxpayer the revenue service receives T –D • where D= (C/(T + F))T is the deadweight loss of evasion • Evasion involves a deadweight loss that is increasing with the tax rate

49. Compliance and Social Interaction • Evasion is more likely when others already evade • Payoff from non-compliance is increasing with the number of non-compliers • Aggregate compliance tendency is toward one of the extremes

50. Compliance and Social Interaction • This is shown in Fig. 16.8 • Always move away from the intersection Figure 16.8: Equilibrium compliance