Tax Administration and Tax Systems

1. Tax Administration and Tax Systems Joel Slemrod University of Michigan Tax Administration Research Centre University of Exeter March 10, 2014

2. The Modern Theory of Taxation • The modern theory of taxation, beginning circa 1970, represented a major breakthrough in how economics addressed the evaluation of taxes. • It provided a rigorous basis for analysis, which enables intellectual progress. • Like all models, the modern—now standard—model of taxation is stylized, making simplifying assumptions and emphasizing certain aspects of taxation at the expense of others. • But it hampers addressing many key issues.

3. 6 Limitations of the Standard Toolkit • Little attention paid to the administrative and compliance costs of taxation. 2. A focus on tax rates and, to a lesser extent, tax bases, to the relative exclusion of all other tax system instruments, such as enforcement tools (audits, evasion penalties, public disclosure) and administrative choices.

4. 6 Limitations of the Standard Toolkit 3. A focus on what might be called real behavioral responses to taxation, to the relative exclusion of avoidance and evasion responses (e.g., Mirrlees considers only labor supply choices; Allingham & Sandmo introduce evasion). 4. A recognition of the central role of asymmetric information between the government and private citizens, but extreme assumptions regarding what is measurable without cost and what is not measurable at any cost. (e.g., in Mirrlees the tax authority can measure income, but cannot measure ability or effort.)

5. 6 Limitations of the Standard Toolkit 5. No meaningful role for firms. With the standard assumption of constant returns to scale, firm size is indeterminate and irrelevant. The implications of firm heterogeneity cannot be pursued. 6. No concern with the details of tax remittance. In spite of folk theorems about its irrelevance, it does not hold in the real world.

6. A Tax-Systems Approach I will argue two points today: • A tax-systems perspective can provide insight into many important issues relevant for taxation that the standard model misses. • Tax administration, broadly defined, is central to a tax-systems perspective. Tax Systems, co-authored with Christian Gillitzer, explores these issues in depth.

7. Some PR Tips • To economists, “administration” is not sexy. • I suggest using “implementation” when possible. • I also recommend playing up the “economics of information” aspects of the field of inquiry. • If it’s not too late, re-title the new journal the Journal of Tax Systems (just kidding).

8. What Is a Tax System? A set of rules, regulations, and procedures that: 1. Defines what events or states of the world trigger tax liability (tax bases and rates). 2. Specifies who or what entity must remit that tax and when (remittance rules). 3. Details procedures for ensuring compliance, including information-reporting requirements and the consequences (including penalties) of not remitting the legal liability (enforcement rules). Standard analysis presumes that tax liability can be ascertained and collected costlessly, in which case statement 2 is irrelevant and statement 3—and any tax administration—is unnecessary.

9. Outline of Today’s Talk • Building Blocks of Tax Systems • Multiple sources of cost—not just distortion of choices • Multiple behavioral responses—not just “real” • Multiple tax instruments—not just rates and bases • Optimal Tax Systems • New analysis of standard tax instruments • Analysis of new tax instruments • Implications of the information revolution

10. Administrative Costs • Collecting taxes, especially non-capriciously, requires a costly bureaucracy. • One reason is the need for a payment and collection system. • For any given objective, there are more and less effective ways for a tax administration to operate. • For example, should a tax administration be organized by tax levy (e.g., corporate tax versus value-added tax), or by taxpayer segment (e.g., corporations versus high-income individuals)?

11. Administrative Costs There are important procedural differences across tax systems, including: • the degree of self-assessment • the extent to which income withholding at source is used • the amount of arms-length information reporting to the tax authority.

12. Administrative Costs • Market (non-cash) transactions facilitate administration. • AC is a function of the physical size, tangibility, visibility and mobility of the tax base (e.g., it is harder to tax diamonds than windows), whether there is a registration of the tax base (e.g., owners of cars), and the number of taxpayer units. • AC is an increasing function of the complexity and lack of clarity of the tax law. • AC tends to be discontinuous and to have decreasing average costs with respect to the tax rate.

13. Compliance Costs • Compliance costs, borne in the first instance by taxpayers, tend to dwarf AC. For the U.S. income tax, CC =~10% of revenues, versus 0.6% for AC. • Burden may be shifted, as for tax liability. • Both AC and CC ultimately burden citizens, although only AC shows up as government expenditures. • CCs have been generally measured using surveys. Biases going both ways: a survey is like a tax form, and some may want to express frustration.

14. Compliance Costs • How to value time spent? • Voluntary versus involuntary CCs—does it matter in measuring social cost? • Which costs are truly marginal is tricky, especially for businesses. What value, if any, does addressing one’s financial affairs provide? • Trade-offs in administrative versus compliance costs: existing expertise, transparency, differing shadow cost (i.e., AC must be funded).

15. Multiple Behavioral Responses: Evasion • Positive theoretical analysis has taken off since the deterrence model of Allingham and Sandmo (1972). • Non-deterrence theories (e.g., duty, altruism, process) have proliferated, but with mixed empirical support to date, while there is overwhelming support for deterrencethat I’ll discuss later.

16. Evasion • Empirical analysis is challenging, due to the nature of evasion. (“You can’t measure the right-hand-side variables, and you can’t measure the left-hand-side variable!”) • A similar, but not identical, problem is faced by tax administrations. • Let’s work together!

17. Evasion There are several promising developments: • Traces-of-income approach • Pissarides-Weber, Feldman-Slemrod, etc. 2. Analysis of administrative data (in the past mostly in Scandinavia, but now in Canada, the UK, and the US)

18. Evasion 3. We may never be able to do randomized field experiments on tax rates or bases, leaving us out of the “credibility revolution” in empirical economics. But we can do them for other tax-system instruments. Examples include: • Slemrod et al. on income tax in Minnesota (USA) • Kleven et al. on income tax in Denmark • Pomeranz on VAT in Chile • Fellneret al. on TV fees in Austria

19. Multiple Behavioral Responses: Avoidance • What is it? “Taxpayer efforts to reduce their tax liability that do not alter their consumption basket other than due to income effects.” • Examples: paying a tax professional to search for deductions, tax arbitrage, slightly re-timing a transaction, slightly re-engineering a vehicle.

20. Avoidance • Much income tax avoidance arises because what triggers tax liability is income per se, but rather surrogate tax bases that may be justified on administrative or compliance cost grounds. • Examples: taxes on realized capital gains; income shifting; arbitrary, incoherent treatment of financial transactions such as debt versus equity.

21. Interactions among Responses • Example: Income from real U.S. investment in Puerto Rico was subject to a low rate, and was not subject to any U.S. residual tax, thus making income shifting very attractive. • Result: Much U.S. investment in high-margin activities in P.R. (electronics, pharma, high-fashion) • The income-shifting was facilitated by real investment, thus providing an avoidance-facilitation implicit subsidy to real investment there. • Lesson: Tax-systems issues matter for real behavior.

22. Interactions among Responses • The notion of avoidance facilitation suggests that the response to a pre-tax price and the tax rate may not be identical; rethink Rosen (1976), who interpreted the differential response of labor supply to the pre-tax wage rate and the tax rate as tax illusion (“lack of salience” in modern terminology). • But, the effective price of a real decision depends on the avoidance and evasion technology: the tax can be “finessed,” but the pre-tax price cannot be.

23. Multiple Tax Instruments • The vast majority of tax analysis addresses tax rates and bases. • Thus it ignores critical aspects of tax systems such as audits, evasion penalties, information reporting, withholding regimes, taxpayer education, self-assessment regimes, public disclosure. • The good news is that modern analytical tools, econometric and theoretical, can be applied to these policies.

24. Withholding and Information Reporting In the United States, the income tax noncompliance rate is: • 56% when “little or no” information reporting • 11% when “some” information reporting • 8% when “substantial” information reporting • 1% when both withholding and substantial information reporting This suggests a central role of firms, which I’ll discuss later, and provides support for the deterrence theory.

25. Market Transactions • Basing tax liability on market transactions provides a natural check on accuracy, relies on better-documented data, and establishes arm’s-length prices. • But cash transactions are much more problematic. Compare Gordon-Li argument for subsidizing relationships with financial institutions and the recent IRS 1099-K initiative. • Issues also arise with family firms, as examined by Kopczuk and Slemrod (2011).

26. Public Disclosure • Policy in the United States during the Civil War, and again in the 1920s and 1930s. • Current policy in Norway, Sweden, and Finland; it was policy in Japan from 1949-2004. • A serious proposal in Australia recently. • Supporters say it reduces tax evasion/avoidance and improves policy transparency, opponents decry the loss of privacy and the negative attention brought to the affluent. • What do we know about its consequences? • New evidence from Japan in Hasegawa et al. (2012) and from Norway in Slemrod et al. (2013).

27. Optimal Tax Systems • Changes answers to classic OT questions, such as optimal income tax progressivity and optimal commodity taxation. • Raises new questions, such as: • How many resources to devote to enforcement? • What is an optimal auditing structure? • How to collect information (e.g., through third-party information reports)? • What is the proper role of firms in remittance? • If higher top tax rates would induce taxable income flight offshore, should we abandon the attempt, or crack down on the flight itself?

28. Bringing Firms into Tax Theory: Remittance • Public finance textbooks assert a remittance irrelevance proposition: it doesn’t matter which side of a taxed transaction must remit. • This is wrong, though, notwithstanding the cup-at-the-counter metaphor. • Examples: predominance of firm remittance, VAT vs. RST, employer withholding, small business exemptions. • Evidence: see Kopczuk et al. (2013), where the amount of diesel tax pass-through is shown to depend on the point of collection.

29. Why Exempt Small Businesses? • Exemption violates the standard (Diamond-Mirrlees) injunction against violating production inefficiency. • But it economizes on collection costs. • This trade-off has not been closely addressed by the optimal tax literature, although see Dharmapala et al. (2011) on optimal taxation with per-firm administrative costs. • One reason is that heterogeneous firms are absent from the theory of taxation, although they are ubiquitous in other fields of economics.

30. Taxes and the Missing Middle • Dharmapala, Slemrod, and Wilson (2011) identify conditions under which it is optimal to exempt small firms from taxation, and consider per-firm administrative costs. • These inefficiencies occur in part because some firms obtain the tax exemption by reducing their outputs to inefficiently low levels—below the tax net cutoff—creating a “missing middle” of intermediate-sized firms. • This production inefficiency is balanced against the cost savings from collecting revenue from, on average, larger firms.

31. Line Drawing Much real-world scuffling about taxation involves drawing and interpreting lines, yet analysis of this topic is almost completely absent from economic analysis. Why? • One reason is that optimal commodity tax theory allows an unlimited number of tax rates, but this is infeasible. • Differentiating tax classes is often done by referring to characteristics of goods, types of income, or transactions.

32. Tax-Driven Product Innovation • Drawing lines (e.g., in characteristics space) creates notches in choice sets—a small change in some aspects of the taxed good creates a large change in tax liability. • This causes tax-driven product innovation, goods just slightly on the low-tax side of the line. • Examples: car-like motorcycles in Indonesia and car-like panel trucks in Chile; 17.9” arrows in the United States, outrageous costumes worn by ABBA. • A very important example: equity-like finance that qualifies for (debt-like) interest deductibility.

33. Future Directions: Information Revolution • Computerization of the tax collection process is the most visible example of the effects. • Can base tax liability on a wider range of information. • Finnish income-based speeding fines • Use of tags (even genome?) • Smart (tax) cards • But it works both ways. Note the existence of automatic sales suppression devices, known as “zappers,” that skim cash sales by excluding random transactions from the apparent electronic record.

34. Insights • The British economist Frank Hahn once wrote that “optimal tax formulas are either guides to action or nothing at all.” • As of now, these formulas mostly refer to a stylized world far from the reality of withholding, information reports, audits, tax havens and evasion, and where line drawing and notches lurk everywhere. • Tax-systems analysis applies rigorous economic analysis of taxation to issues that are prominent in the formulation and administration (sayimplementation!) of real-world tax policy.

35. Policy Contributions • Policymakers should recognize the interrelationship among tax rates, tax bases, enforcement, and administration. • There are many alternative ways to raise revenue, and many types of costs, some that show up in government budgets but most of which do not. • The costs of using one tax instrument often depends on the setting of the others. • Recognizing that tax policy is really tax-system policy can ward off substantial policy errors, such as foregoing tax increases because the existing base is too narrow or too poorly enforced.

36. Thank you!