Chapter 16: Tax evasion
An implicit assumption that supported the analysis of taxation in the previous chapters was that firms and consumers honestly report their taxable activities. Although acceptable for providing simplified insights into the underlying issues, this assumption is patently unacceptable when confronted with reality. The purpose of this chapter can therefore be seen as the introduction of practical constraints upon the free choice of tax policy. Tax evasion, the intentional failure to declare taxable economic activity, is pervasive in many economies as the evidence given in the following section makes clear and is therefore a subject of practical as well as theoretical interest. After reviewing evidence on the extent of tax evasion, the chapter considers the tax evasion decision of a consumer. This decision is represented as a choice under uncertainty. Within this framework, the optimal degree of auditing and of punishment is considered. The analysis predicts the relationship between the level of evasion, tax rates and punishments. Evidence that can be used to assess the model’s predictions is then reviewed. In light of this, some extensions of the basic model are then considered.
16.1 The extent of evasion
Tax evasion is illegal so those engaging in it have every reason to seek to conceal what they are doing. Tax evasion should be distinguished from tax avoidance, which is the reorganisation of economic activity, possibly at some cost, to lower tax payment. Tax avoidance is legal, tax evasion is not. Secondly, the terms black, shadow or hidden economy refer to all economic activities for which payment is received but is not officially declared. The unmeasured economy would be
the shadow economy plus activities such as do-it-yourself which are economically valuable but do not involve any transaction.
There are many methods for measuring the hidden economy including:
• Using the difference between the income and expenditure measures of national income.
• The use of survey evidence, either directly or indirectly as an input into an estimation procedure.
• The analysis of the demand for cash, on the basis that transactions in the hidden economy are financed by cash rather than cheques or credit.This general method can be called the monetary approach to measurement.
• The use of the quantity of a basic input that is measured (such as electricity) to estimate the output that should be produced. This requires knowledge of the input/output relationship.
• Distinction between evasion and avoidance
• Alternative methods of measurement
• Extent of the hidden economy
16.2 The evasion decision
The decision to evade tax can be modelled as a choice with risk. There is a chance that they may be caught. When they are, a punishment is inflicted (usually a fine, but sometimes imprisonment) and they are worse-off than if they had been honest. In deciding how much to evade, the taxpayer has to weigh up these gains and losses, taking account of the chance of being caught and the level of the punishment.
The solution to this choice problem can be derived graphically by identifying the outcomes that arise for various values of X (declared income). The interesting question is what condition guarantees that evasion will occur rather than the corner solution with X = Y. Comparing the figures it can be
seen that evasion will occur if the gradient of the indifference curve is steeper than that of the budget constraint on the 45° line.
The final variable to consider is the tax rate. The effect of an increase in this is not clear-cut. However, when absolute risk aversion is decreasing the effect of the tax increase is to reduce tax evasion. This final result has received much discussion since it is counter to what seems reasonable. A high tax rate is normally seen as providing a motive for tax evasion whereas the model predicts precisely the converse. Why the result emerges is because the fine paid by the consumer is determined by t times F. An increase in the tax rate thus has the effect of raising the penalty. This takes income away from the taxpayer when they are caught – the state in which they have least income. It
is through this mechanism that a higher tax rate can reduce evasion.
• Evasion as a choice under uncertainty
• The sufficient condition for evasion
• The effects of changing the model’s parameters
16.3 Auditing and punishment
From the government’s perspective, the probability of detection and the fine levied on someone caught evading are variables that can be chosen. The first step is to consider how p and F affect the level of revenue raised by the government where revenue is defined as taxes paid plus the money received from fines.
The choice problem of the government can now be addressed. Assume an increase in p can only be achieved by the employment of additional tax inspectors so that an increase in p is costly. In contrast, there is no cost involved in raising or lowering the fine so increases in F are costless to produce. Since p is costly and F is free, government revenue is maximised by reducing p close to zero while raising F towards infinity. Kolm has described this as the policy of ‘hanging taxpayers with probability zero’. Expressed in words, the government should therefore put virtually no effort into attempting to catch tax evaders but should severely punish those it apprehends. This is an extreme form of policy and nothing like it is observed in practice.
With the tax rate set as a tool of economic policy and the fine set by the judiciary, the only instrument under the control of the revenue service is the probability of detection. As has already been seen, an increase in this raises revenue but only does so at a cost. The optimal probability is found when the marginal gain in revenue just equals the marginal increase in cost.
• The fine should be increased without limit
• Economics of crime apply to punishment
• A revenue service aims to reduce audit costs
16.4 Evidence on evasion
The model of tax evasion has predicted the effect that changes in various parameters will have upon the level of tax evasion.
When income levels ascertained from interviews have been contrasted to that given on the tax returns of the same individuals, a steady decline of declared income as a proportion of reported income occurs as income rises. This finding is in agreement with the comparative statics analysis. Econometrics and survey methods have been used to investigate the importance of attitudes and social norms in the evasion decision. These have shown that the propensity to evade taxation was reduced by an increased probability of detection and an increase in age. An increase in income reduced the propensity to evade.
Turning now to experimental studies, tax evasion games have shown that evasion increased with the tax rate and that evasion fell as the fine was increased and the detection probability reduced.
There are two important lessons to be drawn from this brief review of the empirical and experimental results. Firstly, the theoretical predictions are generally supported except for the effect of the tax rate. The latter remains uncertain with conflicting conclusions from the evidence. Secondly, it appears that tax evasion is more than a simple gamble as portrayed in the basic model. In addition to the basic element of risk, there are attitudinal and social aspects to the evasion decision.
• Empirical evidence highlights social factors
• Experiments suggest evasion is not just a gamble
• Evidence questions theoretical prediction on the tax rate effect
16.5 Extended models
The evidence discussed in the previous section has turned up a number of factors that are not explained by the basic model of tax evasion. Foremost among these are the fact that some taxpayers choose not to evade even when they would accept an identical gamble and the social aspects of
the evasion decision.
This formulation is intended to capture the fact that more utility will be lost, in terms of reputation, the more out of step the taxpayer is with the remainder of society. An alternative approach is to explicitly impose a social norm upon behaviour. One such social norm can be based on the concept of Kantian morality and, effectively, has each individual assessing their fair contribution in tax payments towards the provision of public goods.
• Psychic costs can modify evasion decision
• A tax change affects two margins
• Social customs link taxpayers
READING: Hindriks and Myles, Intermediate Public Economics, MIT, 2004
Chapter 18: Tax Evasion
.. tax evasion is the failure to declare taxable activity. Tax evasion should be distinguished from tax avoidance, which is the reorganization of economic activity, possibly at some cost, to lower tax payment. Tax avoidance is legal, tax evasion is not. In practice, the distinction is not this clear cut since tax avoidance schemes frequently need to be tested in court to clarify their legality. Secondly, the terms black, shadow or hidden economy refer to all economic activities for which payment is made but are not officially declared. Under these headings would be included illegal activities, such as the drug trade, and unmeasured activity such as agricultural output by smallholders. They would also incorporate the legal, but undeclared, income which constitutes tax evasion. Finally, the unmeasured economy would be the shadow economy plus activities such as do-it-yourself
which are economically valuable but do not involve any transaction. p428
The simplest measure of tax evasion is to use the difference between the income and expenditure measures of national income. The standard analysis of
the circular flow of income suggests that these two should be equal: what is spent must be earned. However, the existence of tax evasion can destroy this identity... This method is a useful first step but suffers from the problem that both incomes and expenditures may be undeclared, so it can only place a lower limit on the extent of evasion. p428-29
The second general method [apart from survey] is to infer the extent of tax evasion, or the hidden economy generally, from the observation of another economic variable. This is done by determining total economic activity then subtracting measured activity to gives the hidden economy. The direct input approach observes the use of an input to production and from this predicts what output must be. An input which is often used for this purpose is electricity since this universally employed and accurate statistics are kept on energy consumption. The monetary approach employs the demand for cash to infer the size of the hidden economy on the basis that transactions in the hidden economy are financed by cash rather than cheques or credit. Given a relationship between the quantity of cash and the level of economic activity. This allows estimation of the hidden economy. p429
Tax inspectors require payment so, as a consequence, an increase in p is costly to achieve. In contrast, there is no cost involved in raising or lowering the fine. Effectively, increases in F are costless to produce. From these observations, the optimal policy can be determined.
Since p is costly and F is free, the interests of the government are best served by reducing p close to zero whilst raising F towards infinity. This has been termed the policy of “hanging taxpayers with probability zero”. Expressed in words, the government should put virtually no effort into attempting to catch tax evaders but should severely punish those it apprehends. This is an extreme form of policy and nothing like it is observed in practice. p438
Revenue Service Audit No Audit Evasion Y − T − F , T + F − C Y , 0 Taxpayer No Evasion Y − T , T − C Y − T , T
There is no pure strategy equilibrium in this tax compliance game. If the revenue servicet does not audit, the agent strictly prefers evading, and therefore the revenue is better off auditing as T +F > C. On the other hand, 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. Therefore the revenue must play a mixed strategy in equilibrium, with the audit strategy being random. Similarly, for the taxpayer, the evasion strategy must also be random. p444