Frank Cowell: HMRC-HMT Economics of Taxation
14 December 2011
HMRC-HMT Economics of
Taxation 2011
http://darp.lse.ac.uk/HMRC-HMT
10.1 Tax Evasion and Compliance
Frank Cowell: HMRC-HMT Economics of Taxation
Overview...
Tax Evasion and
Compliance
Background
How compliance
fits into public
economics
TAG model
Interaction
models
Evidence
2
Frank Cowell: HMRC-HMT Economics of Taxation
Tax compliance: Questions

Fundamental questions about non-compliance
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The how much? question:
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tax evasion important special case
to be distinguished from tax avoidance?
several ways of drawing the line between the two
The what drives it? question:
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
simple quantification
does it matter?
The what is it? question:

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How much?
What is it?
What drives it?
how to represent non-compliance in an economic model
how does tax evasion fit into the economics of taxation?
complex relation between the individual taxpayer and society as a whole
Begin with numbers…
3
Frank Cowell: HMRC-HMT Economics of Taxation
2001 US Federal Tax Gap
($billion)
Underreported nonbusiness income
56
Underreported business income
109
Overreported Offsets to Income & Credits
32
Individual Income Tax
197
Employment Tax
54
Corporation Income Tax
30
Estate and Excise Taxes
5
Total underreporting
285
Nonfiling
27
Total underpayment
34
Gross tax gap
345
Enforced and other late payments
-55
Net tax gap (tax not collected)
290
Source: US Department of the Treasury, Internal Revenue Service (2006)
4
Frank Cowell: HMRC-HMT Economics of Taxation
UK Tax Gap Estimates
2004-05
2005-06
2006-07
per cent
2007-08
2008-09 2009-10
Value Added Tax (VAT)
Excise duties and other
indirect taxes
11.7
8.6
15.2
7.8
13.5
8.6
12.4
7.7
15.5
7.7
13.8
6.5
Income Tax, National
Insurance Contributions,
Capital Gains Tax
Corporation Tax
Other direct taxes
Total tax gap
6.2
5.4
5.4
5.2
5.2
5.8
14.7
8.4
8.5
11.1
7.2
8.3
9.3
7.5
7.4
10.3
6.5
8.1
11.7
4.9
7.9
Total tax gap
35
36
10.6
7.5
8
£bn
37
36
39
35
Source, HMRC (2011) Tables 1.2, 1.3
5
Frank Cowell: HMRC-HMT Economics of Taxation
Tax compliance: broader issues

Tax gap

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Lack of information? (McManus and Warren 2006)
US, UK evidence is not bad
but elsewhere can be scanty
Shadow economy



broader than tax evasion / avoidance
includes other illegal, unobserved actrivities
estimates from Schneider and Enste (2000) based on currency demand
Sweden
Denmark
Norway
Germany
United States
Austria
Switzerland

1960
2%
4.5%
1.5%
2%
3.5%
0.5%
1%
1995
16%
17.5%
18%
13.2%
9.5%
7%
6.7%
Should we find this alarming?

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definition of shadow economy is not always consistent
shadow economy estimates vary enormously according to method
difficult to test proposition that change in relationship due to non-compliance
6
 Case 1 – a large economy?
Roman
Greek
[+]
[−]
[ + ] (b, B)
(d, A)
[ − ] (a, D)
(g, C)
Roman
Greek
Frank Cowell: HMRC-HMT Economics of Taxation
Public sector and the Public (1)
[+]
[−]
[ + ] (b, B)
(g, A)
[ − ] (a, C)
(d, D)
 Case 1 equilibrium
 Case 2 – a small economy?
 Case 2 equilibria
Case 1
•A large tax-financed public sector may be
perceived as desirable (b, B)
•People will still try to default on taxes
•Need a “policeman”
Case 2
•“policeman” may still be needed…
•…to avoid disaster (d, D)
•…to avoid inequity (a, C) or (g, A)
7
Frank Cowell: HMRC-HMT Economics of Taxation
Agenda

Outline main approaches to tax compliance
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Consider some important variants
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1 TAG
2 Strategic interaction
3 Social interaction
public goods and the public sector
the role of firms
Will lay basis for policy lecture
Literature overviews:

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

Andreoni et al (1998)
Cowell (1990, 2004)
Slemrod (2007)
Slemrod and Yitzhaki (2002)
8
Frank Cowell: HMRC-HMT Economics of Taxation
Overview...
Tax Evasion and
Compliance
Background
Risk-taking
behaviour and
compliance
TAG model
Strategic
interaction
Social
interaction
Evidence
9
Frank Cowell: HMRC-HMT Economics of Taxation
TAG model

Standard model is essentially one of Taxpayer As
Gambler


The gamble involves a bet with the tax authority




based on Allingham and Sandmo (1972)
Individuals make bets on whether they will be caught
concealing income
…or not reporting at all
…or working in underground economy
Appropriateness relies on a special set of assumptions


about motivation of individuals
about the way that the government is perceived
10
Frank Cowell: HMRC-HMT Economics of Taxation
TAG: taxes, penalties, returns

Tax payer/evader has true income y
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Tax authority audits:

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
if evader is caught, pays a surcharge s on the evaded tax te
perceived probability of this happening is p
Parameters determine returns to evasion:

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is supposed to pay tax on all of this at rate t
chooses to conceal an amount e, pays tax on the remainder
consider rate of return to $1 of evasion activity...
r = – s with probability p
r = 1 with probability 1 – p
expected rate of return is 1 – p – ps
Consumption (disposable income) is a function of:

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income y and tax rate t
random rate of return r
evasion choice e
c = [1 – t] y + rte (a random variable)
11
Frank Cowell: HMRC-HMT Economics of Taxation
TAG: budget constraint
c': consumption if not caught
c'': consumption if caught
A: Payoffs if absolutely honest
B: Payoff if blatantly dishonest
Consumption possibilities for all e
1 A cut in the surcharge rate s
2 A cut in the tax rate t
3 Increase in income y
c"
 c' = [1 – t] y + te if not
audited / convicted
c'' = [1 – t] y – ste if audited
and convicted
A
[1t]y
[1tst]y
B
c'
[1t]y
y
12
Frank Cowell: HMRC-HMT Economics of Taxation
TAG: Preferences and beliefs
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Tax payer has von-Neumann Morgenstern preferences
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Consumer’s welfare is expected utility of consumption:
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Eu(c) = [1 – p] u(c' ) + p u(c'' )
Eu(c) = [1 – p] u([1 – t] y + te) + p u([1 – t] y – ste)
Cardinal utility function u has the “usual properties”:
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gets no intrinsic pleasure from evasion and feels no shame
correctly perceives probability of detection p
assumes that it is exogenously given
uc(•) > 0 (first derivative)
ucc(•)  0 (second derivative)
Both u and p determine shape of ICs in (c', c'' )-space


curvature of ICs depends on risk aversion – ucc(•)/uc(•)
slope of ICs where crosses 45º line is [1 – p]/p
13
Frank Cowell: HMRC-HMT Economics of Taxation
Equilibria of the tax-evader
 Feasible set
A: corner solution (honesty)
c"
B: corner solution (dishonesty)
C: Interior (partial honesty)
E: Expected payoff
solution depends on
•tax parameters t:= (p, s, t)
•income y
•personal attributes a
e* = e(t, y, a)
•E
•A
•C
 E(ruc(c)) ≤ 0 if e* = 0
•B
0
 E(ruc(c)) ≥ 0 if e* = y
 E(ruc(c)) = 0 if 0 < e* < y
c'
14
Frank Cowell: HMRC-HMT Economics of Taxation
Comparative statics

Focus on the interior solution
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Effect of increased p:
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Indifference map “rotates”
For given budget constraint, tangency moves closer to A
Effect of increased s:

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what happens to this when tax and enforcement
parameters change?
do this graphically or analytically
differentiate the first-order condition E(ruc(c)) = 0
Point B moves down
For given utility function, tangency moves closer to A
Effect of increased t:
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assume decreasing absolute risk aversion (DARA)
amount “invested” in a risky asset increases with resources
so in this model, given DARA, evasion rises with y
but this will also imply that evasion falls with t
15
Frank Cowell: HMRC-HMT Economics of Taxation
Extending the model

Government budget constraint:
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Define economy-wide aggregates
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R = tY  t ∫ re(t, y, a)  F(p)
So budget constraint becomes

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aggregate income: Y := ∫ y dF(y, a)
aggregate nominal tax receipts: tY
aggregate “leakage” from evasion: ∫ re(t, y, a) dF(y, a)
cost of enforcing probability p across economy F(p)
Composition of revenue


R ≥` R
revenue actually raised ≥ required target revenue
tY  t ∫ re(t, y, a)  F(p) ≥`R
But this ignores how the government revenue may be used…
16
Frank Cowell: HMRC-HMT Economics of Taxation
TAG model: Public Sector

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Taxes are used to pay for a public good z
Government budget constraint in this extended model is:
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Individuals benefit from provision of the good

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E(ruc(c,z)) = 0
essentially as before
Response of e in this model is much the same for some cases:

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…but they prefer that someone else pay for it
so there is still a motive for tax evasion
and expected utility is now Eu(c,z), where uz(c,z) > 0
FOC for an interior maximum is:


R ≥ yz
where y is the (constant) marginal rate of transformation
Surcharge
Probability of detection
But for the tax rate t we have new insights…
17
Frank Cowell: HMRC-HMT Economics of Taxation
The effect of a rise in the tax rate

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There are still the conventional “income”
and “substitution” effects
But t also affects amount of public good
available
Increasing t will:



Eua
Desirable to increase t?


reduce private consumption c
increase availability of public good z
depends on amount of public good already
available
Expect a “hump” shape:


for t close to 0 we have z close to 0: raising t
is desirable
for t close to 1 we may have satiation in z:
lowering t is desirable
“underprovision”
z < z*a
“overprovision”
z > z*a
18
t
Frank Cowell: HMRC-HMT Economics of Taxation
Preferences for public and
private goods

How is z* determined?

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Optimal provision uses standard SMRS = MRT
rule
Because of the risk component general formula
is unwieldy
c
So take a simplified set of preferences
ua(c, z) = c + va(z)
 ma := uza(c, z)/uca(c, z) = vza(z)
 m := Sma = MRT
Evasion erodes effectiveness of tax in providing z...
 feeds back into effect of tax on evasion



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change in (et) has sign of m – y / zt
a simple criterion for determining under / over
provision
slope = m
z
19
Frank Cowell: HMRC-HMT Economics of Taxation
Effect of a rise in the tax rate

If the public goods are…

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But individuals differ in:

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ty
risk aversion
taste for public goods
income
So, different responses:

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under-provided: a rise in t increases the amount of evasion
over-provided: a rise in t decreases the amount of evasion
Cowell and Gordon (1988)
te
constrained by e ≤ y
high marginal evaluation
low marginal evaluation
t
Get a more complex relationship between t and evasion overall
20
Frank Cowell: HMRC-HMT Economics of Taxation
Overview...
Tax Evasion and
Compliance
Background
Reporting
models. Climate
of evasion and
social sanction
TAG model
Interaction
models
Evidence
21
Frank Cowell: HMRC-HMT Economics of Taxation
Strategic interaction

Based on a application of game theory
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Intuition of simple strategic model: simultaneous move

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if tax authority plays “audit” best response of taxpayer is “report”
if taxpayer plays “report” best response of tax authority is “not audit”
etc, etc.
no equilibrium in pure strategies
Intuition of simple strategic model: leader-follower

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Two players: tax authority and taxpayer
Tax authority chooses whether or not to investigate
Taxpayer chooses whether or not to cheat
if tax authority moves first, perhaps get a simple outcome
Develop this into a richer policy model?

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focus on tax-collector/tax-payer interaction
what role is there for beliefs about others’ goals and actions?
can tax authority precommit to an audit strategy?
22
Frank Cowell: HMRC-HMT Economics of Taxation
Social interaction

Different countries, different types of compliance behaviour?
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1 Symmetric consumption externality
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the more others evade…
…the easier to find a corrupt accountant
leads to reduction in “noncompliance costs”
3 May also be induced by tax authority

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if you evade maybe I feel less pain if caught behaving antisocially
social stigma (Benjamini and Maital 1985, Kim 2003)
2 Technological (production) externality


develop a model of a compliance climate? (Cummings, et al. 2009)
others’ evasion choices affect my evasion decision (Fortin et al. 2007)
several possible foundations…
auditing rules may induce a perceived interdependence
creates a “co-ordination game” – Alm and Mckee (2004)
Develop the first of these variants.
23
Frank Cowell: HMRC-HMT Economics of Taxation
Climate: model

Evasion decisions affect outcomes in two ways

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Nature of the consumption externality

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e: Own evasion activity
E: aggregate evasion
In principle there are two subcases:

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aggregate evasion affects utility
moral climate?
Utility of an a-type is Va(e,E) where

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each person’s outcome affected by own choices (as before)
also affected by evasion of others (independently of public goods)
1 where aggregate E increases utility
2 where aggregate E reduces utility
Focus on case 2
24
 The Evasion-Utility Space
 Payoffs if act honestly
utility
Frank Cowell: HMRC-HMT Economics of Taxation
Interaction: model behaviour
•
 Payoffs if act dishonestly
 Check incentive to switch
 Dominant behaviour
Va(0,E)
 Find equilibrium…
 Check stability…
min E = 0, max E = Y
low E : individual switches to 0
high E: individual switches to y
◦•
E < E*: switching decreases E
E > E*: switching increases E
Va(y,E) •
Y
0
E*
aggregate evasion
Three equilibria:
•E = 0 (stable)
E
•E = E* (unstable)
•E = Y (stable)
25
Frank Cowell: HMRC-HMT Economics of Taxation
Overview...
Tax Evasion and
Compliance
Background
What do we
know? What can
we know?
TAG model
Interaction
models
Evidence
26
Frank Cowell: HMRC-HMT Economics of Taxation
Empirical evidence

Few governments/agencies publish data

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Best data (TCMP) enable one to address only a restricted set of questions

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Survey data obviously problematic
Experimental data sometimes useful (Alm et al. 1990 )
Indirect methods are often seriously flawed

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Focus is on false reports. Limited info on non-filers.
Last full TCMP in 1988
recently (2005/6) updated in National Research Program
Private data must be treated with caution


For survey see Andreoni et al (1998)
Focus on aggregate expenditure/income gaps or the demand for currency
neglect measurement error and other sources of discrepancy
Some micro-data studies are useful


focus on relationship between expenditure and income for self-employed on
regularly employed (Pissarides and Weber 1989)
focus on charity giving and different types income (Feldman and Slemrod 2007)
27
Frank Cowell: HMRC-HMT Economics of Taxation
Personal compliance

Behaviour varies by income type and population group (TCMP)
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Effect of tax rates:

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weak relationship with probability of audit
weak relationship with severity of penalties
Detection is imperfect (TCMP):

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
Less compliance in audit classes with higher marginal tax rates?
Corroborated by evidence on the reporting of capital gains
Corroborated also by time series?
Enforcement parameters work in expected direction (TCMP):


Personal taxpayers income-elasticity of underreporting: 0.3
Farm business income income-elasticity of underreporting: 0.65
Source of income rather than level which is a significant determinant of evasion.
Married people evade more than single persons
variation in detection rates at least as important as…
variations in personal characteristics
Slemrod et al (2001) controlled experiment results:



as expected for modest incomes
and for those with high opportunity to evade
But high-income people reported less than those in control group
28
Frank Cowell: HMRC-HMT Economics of Taxation
Compliance by firms



Surveys: Nur-tegin (2008), Slemrod (2004)
Evidence: Rice (1994) based on TCMP
Highlights lack of ...




theoretical models
corporate income tax compliance microdata;
confidence in microdata on tax compliance
Two key results:


compliance positively associated with being publicly traded
and belonging to a highly regulated industry
having low profits relative to the industry median is
correlated with higher corporate tax evasion
29
Frank Cowell: HMRC-HMT Economics of Taxation
Evidence: summary



TCMP evidence is broadly in line with evidence of
responses from TAG model
Confirmation as to evasion patterns by different groups
according to income and personal characteristics
However implied detection probability suggests that
there is far too little tax evasion going on…!



may neglect heterogeneity of effective detection probability
also taxpayer ignorance
Responses are also borne out by experimental evidence
(Alm et al.1990 )
30
Frank Cowell: HMRC-HMT Economics of Taxation
References (1)
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Allingham, M. and A. Sandmo (1972) “Income tax evasion: a theoretical analysis,” Journal of
Public Economics, 1, 323-338
Alm, J. and Mckee, M. (2004) “Tax compliance as a coordination game,” Journal of Economic
Behavior & Organization 54, 297-312
Alm, J., Bahl, R. and Murray, M. N. (1990) “Understanding Taxpaying Behavior: A Conceptual
Framework with Implications for Research,” The Review of Economics and Statistics, 72,603-613
* Andreoni, J. Erard, B. and Feinstein, J. (1998) “Tax Compliance”, Journal of Economic
Literature, 36, 818-860
Benjamini, Y. and Maital, S. (1985) “Optimal tax evasion and optimal tax evasion policy:
behavioral aspects,” in Gaertner, W. and Wenig, A. (eds) The Economics of the Shadow Economy,
Springer Verlag, Berlin
Cowell, F. A. (1990) Cheating the Government, MIT Press, Cambridge MA
Cowell, F. A. (2004) “Carrots and Sticks in Enforcement” in Aaron, H. J. and Slemrod, J. (ed.) The
Crisis in Tax Administration, The Brookings Institution, Washington DC, 230-275
Cowell, F. A. and Gordon, J. P. F. (1988) “Unwillingness to pay: tax evasion and public good
provision,” Journal of Public Economics, 36, 305-321
Cummings, R. G., Martinez-Vazquez, J., McKee, M. and Torgler, B. (2009) Tax morale affects tax
compliance: Evidence from surveys and an artefactual field experiment, Journal of Economic
Behavior and Organization, 70, 447-457
Feldman, N. E. and Slemrod, J. (2007) “Estimating tax noncompliance with evidence from
unaudited tax returns,” The Economic Journal, 117, 327–352
Fortin, B., Lacroix, G. and Villeval, M.-C. (2007) “Tax evasion and social interactions,” Journal
of Public Economics, 91, 2089–2112
HM Revenue and Customs (2011) Measuring Tax Gaps 2011
Kim, Y. (2003) “Income distribution and equilibrium multiplicity in a stigma-based model of tax
31
evasion”, Journal of Public Economics, 87 1591–1616
Frank Cowell: HMRC-HMT Economics of Taxation
References (2)
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McManus, J. and Warren, N. (2006) “The Case for Measuring Tax Gap,” eJournal of
Tax Research, 4, 61-79
Nur-tegin, K. D. (2008) “Determinants of Business Tax Compliance,” The B.E. Journal
of Economic Analysis & Policy, 8, Article 18
Pissarides, C. and Weber, G. (1989) “An Expenditure-Based Estimate of Britain's Black
Economy,” Journal of Public Economics, 39, 17-32
Rice, E. M. (1994), “The corporate tax gap: evidence on tax compliance by small
corporations”, in Slemrod, J. (ed.) “Why people pay taxes”, University of Michigan
Press, p. 125-161
Slemrod, J. (2004) “The Economics of Corporate Tax Selfishness,” National Tax
Journal, 57, 877-899
Slemrod, J. (2007) “Cheating Ourselves: The Economics of Tax Evasion,” Journal of
Economic Perspectives, 21, 25-48
Slemrod, J., Blumenthal, M. and Christian, C. (2001) “Taxpayer Response to an
Increased Probability of Audit: Evidence from a Controlled Experiment in Minnesota,”
Journal of Public Economics, 79, 455-483
Slemrod, J. and Yitzhaki, S. (2002) “Tax avoidance, evasion and administration,”
Handbook of Public Economics, Volume 3, pp 1423-1470, North-Holland, Elsevier
* Schneider, F. and Enste, D.H. (2000) “Shadow economies: size, causes and
consequences” Journal of Economic Literature, 38, 77-114
US Department of the Treasury, Internal Revenue Service (2006) Updated Estimates of
the TY 2001 Individual Income Tax Underreporting Gap. Overview. February 22.
32
Washington, D.C.: Office of Research, Analysis, and Statistics.