Fiscal and Regulatory Enforcement
Topic 10
An Example: Tax Collection
The basic problem :
Individuals know how much tax they owe.
The Inland revenue does not = Asymmetric Information.
The Policy Questions:
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Should the Inland Revenue audit every tax return?
If not how much effort should be put into enforcement?
What is the right mix of monitoring and penalties?
How do these policies affect the amount of tax evasion?
Outline
1. A model of polluter behaviour with random
enforcement.
2. The consequences for policy
• Balance between audit frequency and penalties.
• Effects on pollution abatement.
3. Enforcement and administration costs.
4. Enforcement and information gathering.
1. A Model of Polluter Behaviour
We will consider a polluter/criminal/tax evader to make
rational decisions in the light of the costs and benefits of
the actions they can take.
e.g. Becker and crime.
1. A Model of Polluter Behaviour
Some Modelling Issues:
Is violation
(a) a discrete choice? You either: pollute or comply.
(b) a continuous choice? Levels of violation can chosen.
This is a technological and a modelling issue.
Are Polluters:
(a) Risk neutral? I.e. large entities like firms who do not care
too much about risk.
(b) Risk averse? Individuals facing large punishment costs if
detected violating.
A Discrete Choice: Comply or Pollute
If you comply:
• there is no risk of a penalty = certainty.
• but there is also no gain.
If you pollute
• You save on abatement costs.
• Generate external damage.
• Risk detection (may not be immediate).
• If detected there is a penalty.
The Optimal Decision
Let
A = Abatement Costs.
p = Probability of detection.
F = Penalty/Fine if detected.
A risk neutral polluter would pollute iff
A > pF.
A risk averse polluter would require
(where c>0 is its risk premium.)
A+c > pF
Notice there is a trade off
To deter pollution need
A< pF
Need
(1) Low abatement costs (i.e. not onerous to comply).
Or
(2) pF large. Either: (a) very large fines with small
probability of detection or, (b) high probability of
detection with smaller fines.
For risk neutral polluters both (a) and (b) equivalent.
For a risk averse polluter (a) is much worse than (b).
For a risk loving (criminal) (b) is worse than (a).
Continuous Choice: How much pollution?
The quantity of pollution emitted depends on:
(1) The threshold that determines whether a violation has
been committed or not.
(2) How the probability of detection varies with the
amount of pollution.
(3) How the size of the fine varies with the amount of
pollution.
(4) How pollution affects costs and benefits.
Continuous Choice: How much pollution?
e = amount of emissions.
e*=threshold of violation.
Optimal level of emissions maximizes:
P(e) -A(e) - p(e-e*)F(e-e*)
Let us consider the case where p does not depend on e,
because a random audit will always detect it.
e*=0 and F(e) = F x e the fine is proportional to the size of
the violation (i.e. the fine is the price of a violation).
Then:
Risk Neutral Polluter
Marginal Abatement Costs = Slope of P(e)-A(e)=MAC
Emissions
Risk Neutral Polluter
Marginal cost of enforcement=pF
pF
Emissions
Risk Neutral Polluter: Optimal Choice
Marginal Abatement Costs = Slope of P(e)-A(e)
Marginal cost of enforcement
pF
Emissions
A Regulatory Standard that has an effect
MAC
Marginal cost of enforcement
pF
Regulatory Standard
Emissions
A Regulatory Standard that has no effect
MAC
Marginal cost of enforcement
pF
Regulatory Standard
Emissions
Some Comments
Enforcement operates exactly like a Pigouvian Tax (as in
the Stern Report) when firms are risk neutral.
The higher the MAC the higher the amount of emissions.
If firms have very different MAC’s, it will result in very
different compliance levels.
If firms are risk neutral this can result in an efficient
amount of emissions provided pF is chosen correctly.
The regulatory standard means that firms below it have no
incentive to make further reductions in emissions.
Audit frequency and Fine Size
From the perspective of the firm pF is the only thing that
matters. But,
- increasing p (likelihood of audit) can be very expensive
for the government.
- Increasing F is free!
Cheapest effective policy is: p -> 0 and F-> ∞
(Shoot any violator.)
Audit frequency and Fine Size
Cheapest effective policy is: p -> 0 and F-> ∞
(Shoot any violator.)
But:
(1) Bankruptcy makes imposing such penalties
practically impossible.
(2) Does not have a good marginal effect, if you are
going to be shot may as well be shot for a big gain not a
small one.
(3) This is very costly to those who are risk averse. A
small chance of being killed is very welfare reducing!
(4) Courts may not implement the policy.
Why do firms comply?
Actually the expected penalties for non-compliance with
pollution control are very low, still many firms comply.
Voluntary Compliance
=> Firms are not maximizing profits.
=> Firms may lose relative to their competitors.
Why do firms comply?
1) Market Penalties: Most of the penalty is in terms of lost
‘reputation’. (Estimated at 86% of costs of detection by
Badrinath & Bolster Journal or Regulation Economics
1996).
2) Misjudgement: firms don’t understand the risks or the
size of the penalties.
3) Type 1 errors: Polluters over comply to avoid the risks
of being wrongly identified as violators.
4) Penalty Leverage: There are long run costs from
violation: higher future audit frequency, heightened
regulatory attention.
5) Bargaining: This is a concession granted in exchange for
policy maker approval of other projects.
Different Kinds of Audit Errors
Firm Behaviour
Compliant Non-Compliant
Compliant
Audit Outcome
Non-compliant
OK
Type 2 Error
Type 1
Error
OK
Why these matter
These errors tend to occur if either:
the regulator has poor information or monitoring
ability.
the firm as poor control over its processes.
Type 2 Errors:
These tend to reduce the incentives to abate emissions as
they reduce the probability that the polluter is detected.
Type 1 Errors:
These tend to increase incentives to abate.
Enforcement Costs and Pollution Abatement
If the costs of enforcing a given level of abatement are
taken into account how does this affect the choice of
abatement level?
MAC = Marginal Abatement Costs
MDC = Marginal Deterrent Costs
Without Enforcement Costs
Marginal Abatement Costs =MAC
Marginal Deterrent Cost
Amount of Pollution
Enforcement Costs
We expect these to decrease as higher levels of pollution (or
lower levels of abatement) are tolerated.
Marginal enforcement cost = additional enforcement cost of
one more total unit of abatement.
This increases as pollution reduces.
Enforcement Costs
Marginal Abatement Costs =MAC
Marginal Deterrent Cost
Marginal Enforcement Cost
Amount of Pollution
Without Enforcement Costs
MAC + MEC
Marginal Deterrent Cost
Marginal Enforcement Cost
Amount of Pollution
Self Reporting
Self reporting has benefits:
- May eliminate asymmetric information problem.
- Gives policy makers more leverage in imposing
penalties (i.e. more severe penalties may be possible if
report lies).
- Can give individuals incentives to report truthfully.
- Societal benefits – better info about the scale of
problems and how to remedy spills etc.
Self Reporting
Self reporting Has Problems
- Incentives for truthful reporting will be costly in terms
of lost efficiency.
- Everyone has to report => reporting burden on
individuals.
- Investment in avoidance behaviour.
- Devising a good measure to report difficult.
Heyes “Cutting Pollution Penalties to protect the
environment” JPubEcon 1996
Here we consider a world where pollution is persistent but
can be cleaned up if it is detected.
Polluters have imperfect control over the amount of
pollution they produce.
Sometimes they pollute by accident.
Firms must choose:
(1) How little to pollute
And
(2) Whether to admit a spill.
Heyes 1996
Penalties do 2 things
(1) Makes a high planned level of pollution costly.
(2) Make polluters reluctant to admit a spill when it occurs
by mistake.
Policy is a compromise.
Penalty is too high – don’t want to admit accidents when
they happen but do not plan to pollute much.
Penalty is lower – firms prepared to admit accidents but do
not put in much effort at pollution abatement.
Other Conclusions
If pollution is not persistent => clean ups not so important
tend to want higher penalties.
If pollution is very persistent want to reduce penalties to
encourage firms to report and allow cleanups.
Kaplow and Shavell Optimal Law
Enforcement…. JPE 1994
Introduces the possibility that self reporting of violations
reduces the penalty that individuals face if the violation
were detected by audit.(Kind of like –turning yourself in
in the hope that you will be treated leniently.)
What happens if you raise the probability of audit?
- More people just turn themselves in => reduced
marginal deterrent cost.
- Number of non-violators increases => marginal
deterrent cost is higher (more people to audit).