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MSc Public Economics 2008/9

http://darp.lse.ac.uk/ec426

Fiscal AdministrationFiscal Administration

9 March 2009

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Overview...Background

Objectives and constraints

Optimal policy C&B

Tax design

Policy Design

Locating the subject within public economics

Optimal policy Cat-&-Mouse

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Issues in enforcement policy design

Identify main policy rulesIdentify main policy rules based on utilitarian ethicsbased on utilitarian ethics using the principal model typesusing the principal model types

ObjectivesObjectives reconcile with utilitarian goals?reconcile with utilitarian goals? what guidance for tax agencies? what guidance for tax agencies?

Implications for tax policyImplications for tax policy what guidance for tax agencies? what guidance for tax agencies? impact of level and structure of income tax on tax evasion? impact of level and structure of income tax on tax evasion? and vice versa?and vice versa?

Feedback to tax designFeedback to tax design For overviews: Cowell (2004), For overviews: Cowell (2004), Slemrod and Yitzhaki (2002)Slemrod and Yitzhaki (2002)

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GovernmentGovernment

TaxpayersTaxpayers

The principal economic actors

Tax AuthorityTax Authority

The key players

Delegation Tax farming

Corruption model

Control & reporting, simple constitution

Further delegation

InspectorInspector InspectorInspectorInspectorInspector

Control & reporting, full delegation

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Government Control? Government is denied direct information about citizensGovernment is denied direct information about citizens

Is therefore denied some measure of controlIs therefore denied some measure of control Multi-layered structure Multi-layered structure

Different types of concealed information and control failure?Different types of concealed information and control failure? Leads to different types of economic modelLeads to different types of economic model

Fundamental difference between types of “control failure”Fundamental difference between types of “control failure” 1 Tax-evasion:1 Tax-evasion: Assumes effectively a two-level model Assumes effectively a two-level model

Version 1Version 1 ( (Government, taxpayerGovernment, taxpayer). Assumes complete internal ). Assumes complete internal compliance; external non-compliance.compliance; external non-compliance.

Version 2 Version 2 ((Tax authority, taxpayerTax authority, taxpayer). A simplified model of delegation). A simplified model of delegation..

2 Corruption:2 Corruption: focus on incentives facing the focus on incentives facing the inspectorinspector level level TaxpayerTaxpayer offers payment to offers payment to inspectorinspector to reduce prob of punishment to reduce prob of punishment InspectorInspector is monitored by is monitored by authorityauthority..

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Questions in enforcement policy

Policy questions from previous lecturePolicy questions from previous lecture What is the optimum degree of enforcement? What is the optimum degree of enforcement? Can smart auditing improve efficiency?Can smart auditing improve efficiency? Move beyond this to broader questionsMove beyond this to broader questions

Should we try to eliminate evasion?Should we try to eliminate evasion? Often an implicit objectiveOften an implicit objective But on what grounds?But on what grounds?

Implications of devolution of function Implications of devolution of function Not just lack of control Not just lack of control Also the type of objective functionAlso the type of objective function

Implications for tax design?Implications for tax design?

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Connection with previous topic

Related to compliance lectureRelated to compliance lecture Examine general issues of “breakdown” in fiscal Examine general issues of “breakdown” in fiscal

relationshipsrelationships tax under-reporting is one exampletax under-reporting is one example also black/shadow economyalso black/shadow economy

And the mechanisms that may act as insulationAnd the mechanisms that may act as insulation institutionsinstitutions social factorssocial factors

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Overview...Background

Objectives and constraints

Optimal policy C&B

Tax design

Policy Design

Limitations of standard utilitarian model

Optimal policy Cat-&-Mouse

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Modelling issues

What is the appropriate objective?What is the appropriate objective? Law enforcement? Eliminate evasion?Law enforcement? Eliminate evasion? Welfare of law-abiding citizens?Welfare of law-abiding citizens? Utilitarianism?Utilitarianism?

What institutional structure?What institutional structure? Direct government-taxpayer relation?Direct government-taxpayer relation? Tax collection/enforcement agencies?Tax collection/enforcement agencies?

What components of the enforcement problem?What components of the enforcement problem? requires a multi-stage approachrequires a multi-stage approach see see Cowell (1989)Cowell (1989)

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Utilitarian enforcement problem

Basic behavioural modelBasic behavioural model taxpayer maximises expected utility taxpayer maximises expected utility EEuu((cc) = ) = EEuu([1 –([1 – t t] ] yy + + rr te te) ) yy: taxable income: taxable income tt: proportionate tax rate: proportionate tax rate ee: concealed income: concealed income rr : rate of return to evasion (= – : rate of return to evasion (= – ss with prob with prob p, p, 1 with prob 1 –1 with prob 1 – p p))

Outcome of basic modelOutcome of basic model determines optimal evasion response determines optimal evasion response ee** = = ee((p, s, tp, s, t; ; yy, , aa)) in general depends on both tax and enforcement parameters in general depends on both tax and enforcement parameters ((p, s, tp, s, t)) and and

on personal characteristics on personal characteristics ((yy, , aa))

Welfare model Welfare model Take expected utility of representative taxpayer as welfare criterionTake expected utility of representative taxpayer as welfare criterion W W = [1 –= [1 – p p] ] uu([1 –([1 – t t] ] yy + + tete) + ) + pp uu([1 –([1 – t t] ] yy – – ste ste) ) where where y y = = y , y , a a = = a a (representative taxpayer)(representative taxpayer) (so we can drop (so we can drop yy, , aa from optimal evasion response) from optimal evasion response)

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Fundamental constraints Realities for the government / tax agencyRealities for the government / tax agency

a fixed revenue requirement a fixed revenue requirement RR cost of enforcement cost of enforcement ((pp) where ) where is an increasing functionis an increasing function in utilitarian modelin utilitarian modelmay include private compliance costsmay include private compliance costs

Government budget constraintGovernment budget constraint R R RR which implieswhich implies ty ty ––rrtete –– ((pp) ) RR where where rr is the expected rate of return to evasion, is the expected rate of return to evasion, 1–1– p p – – ps ps zero evasion if zero evasion if pp pp00 where where ((pp00) =) = ty ty ––RR

Welfare contour for utilitarianismWelfare contour for utilitarianism [1 –[1 – p p] ] uu([1 –([1 – t t] ] yy + + tete) + ) + pp uu([1 –([1 – t t] ] yy – – ste ste) = const) = const where where ee = = ee((p, s, tp, s, t))

Evasion eliminated where rate of return is zero:Evasion eliminated where rate of return is zero: s s = [1= [1−−pp]/]/pp gives zero-evasion contour where welfare is gives zero-evasion contour where welfare is uu([1 –([1 – t t] ] yy) = ) = WW0 0

so determines boundary of “honesty set”so determines boundary of “honesty set”

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Model types

Problem essentially has three control variables, Problem essentially has three control variables, p, s, tp, s, t Three stages in the approach to the solutionThree stages in the approach to the solution Keep Keep tt fixed fixed

enforcement authority has considerable, but not total, discretionenforcement authority has considerable, but not total, discretion can trade off severity of penalty against probability of detectioncan trade off severity of penalty against probability of detection

Keep Keep ss or or pp fixed fixed unmovable penal systemunmovable penal system inflexible police systeminflexible police system trade off tax against an enforcement parametertrade off tax against an enforcement parameter

Vary Vary p, s, tp, s, t together together Total flexibilityTotal flexibility

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The problem if t is fixed

0 1

s

p

R R

zero

-eva

sion

line

W

W0

s [1−p]/p

p0

A

B

The feasible set

A: The zero-evasion point

W0 welfare contour through A

Welfare contours

B: the optimum

The “enforced honesty set”

(pp00) = ty ty ––R

WW00 satisfies satisfies s = [1−p]/p

Welfare increases Welfare increases “South-West”“South-West”

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Assessment of the fixed-t model

Corresponds to the case where:Corresponds to the case where: enforcement decisions are separated from tax-enforcement decisions are separated from tax-

schedule decisionsschedule decisions government tries to maximise welfaregovernment tries to maximise welfare welfare respects individuals’ utilitywelfare respects individuals’ utility

Features of the model:Features of the model: there is a determinate welfare-maximising solutionthere is a determinate welfare-maximising solution does not imply elimination of evasiondoes not imply elimination of evasion

Could appeal to non-EU model to justify thisCould appeal to non-EU model to justify this

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The problem if p is fixed

0 1

s

t

R R

W

1−p——

pA

Draw feasible set The “enforced honesty” set A welfare contour Welfare contours Optimum

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Assessment of the fixed-p model

Case of an inflexible enforcement infrastructureCase of an inflexible enforcement infrastructure Again there is a determinate welfare-maximising solutionAgain there is a determinate welfare-maximising solution But in this case utilitarianism But in this case utilitarianism doesdoes imply elimination of evasion imply elimination of evasion Reason: Reason:

Resource costs are fixedResource costs are fixed You can raise the surcharge and compensate with lower You can raise the surcharge and compensate with lower tt For risk-averse people this increases welfareFor risk-averse people this increases welfare

Danger is the problem of penalty structureDanger is the problem of penalty structure ““Might as well be hung for a sheep as for a lamb”Might as well be hung for a sheep as for a lamb” Iyengar (2008)Iyengar (2008)

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Tax farming

Farming involves delegating some action to an agencyFarming involves delegating some action to an agency ((Stella 1993Stella 1993))

Suppose the agency’s remit is Suppose the agency’s remit is to use to use ss and and pp to maximise revenue to maximise revenue to ensure complianceto ensure compliance

Government may use revenue raised through reductions Government may use revenue raised through reductions in in pp to reduce to reduce tt

To analyse this, transform the problem…To analyse this, transform the problem…

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Transform optimisation problem from this…

01

s

pA

objective

constraint

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.…to this

0 1

s

p

constraint

Aobjective

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Tax farming: optimality?s

pR = constant

“Enforced honesty” set

reve

nue

01

Draw “enforced honesty” setA revenue contourRevenue increases to North-East

Tax farmer moves this way?

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“Tax farming” has no solution!

Consider an arbitrary status quo where evasion is just Consider an arbitrary status quo where evasion is just deterreddeterred

Consider the following processConsider the following process1.1. Increase the surcharge Increase the surcharge ss2.2. Decrease the probability of detection Decrease the probability of detection pp. . 3.3. Cost of enforcing honesty fallsCost of enforcing honesty falls4.4. So revenue increases and tax can be cutSo revenue increases and tax can be cut5.5. Therefore welfare increasesTherefore welfare increases

Steps 1-5 can be repeated indefinitely…Steps 1-5 can be repeated indefinitely… ……as long as as long as p p > 0 !> 0 !

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Should evasion be eliminated?

The answer depends on the appropriate institutional The answer depends on the appropriate institutional background:background:

Keep Keep tt fixed fixed don’t eliminate evasiondon’t eliminate evasion

Keep Keep pp fixed: fixed: eliminate evasioneliminate evasion

Vary Vary p, s, tp, s, t together: together: no solutionno solution

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Overview...Background

Objectives and constraints

Optimal policy C&B

Tax design

Policy Design

A utilitarian approach

Optimal policy Cat-&-Mouse

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Optimal degree of enforcement?

Take a standard welfare-economics approachTake a standard welfare-economics approach fixed fixed tt fixed fixed ss

Basic utilitarian modelBasic utilitarian model homogeneous populationhomogeneous population simple revenue targetsimple revenue target uses a paradigm adopted elsewhere in public economicsuses a paradigm adopted elsewhere in public economics a type of cost-benefit approach to enforcementa type of cost-benefit approach to enforcement

Extended utilitarian modelExtended utilitarian model Heterogeneous populationHeterogeneous population Public goodsPublic goods

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Optimisation problem

IndividualIndividual income: income: y =y = whwh consumption: consumption: cc = [1 = [1 tt]]yy + + rrtete leisure: leisure: ℓ = 1ℓ = 1 hh utility: utility: uu((cc, , ℓℓ) )

Government/tax authorityGovernment/tax authority enforcement cost per taxpayer: enforcement cost per taxpayer: ((pp)) revenue requirement: revenue requirement: RR expected revenue leakage per tax dollar: expected revenue leakage per tax dollar: r =r =11 p p ps ps bbudget constraint:udget constraint: twh twh [1[1 p p ps ps]]t t ee((, , ww)) ((pp)) ≥≥R / nR / n

Utilitarian model, homogenous populationUtilitarian model, homogenous population objective function: objective function: vv((, , ww) = max ) = max EEuu((cc, , ℓℓ)) Lagrangean: Lagrangean: vv((, , ww) + ) + [ [twh twh [1[1 p p ps ps]]t t ee((, , ww)) ((pp)) R / nR / n ] ]

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Choosing p for given (s,t)

0 1

p

p

Bp

p*

Probabilities, costs and benefitsMarginal cost of audit

Marginal benefit of audit

Optimum investigation effort

MC of auditMC of audit

direct yielddirect yield

indirect yield from extra honesty

indirect yield from extra honesty

supply side effectsupply side effect

effect of risk on utilityeffect of risk on utility

MC is monotonic increasingMC is monotonic increasingMB MB may not be monotonicmay not be monotonicMB may go to zeroMB may go to zero

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A cost-benefit approach: to policy?

Model of enforcement assumes:Model of enforcement assumes: fixed fixed ss, , tt uniform uniform pp

Can be extended to Can be extended to heterogeneous populationheterogeneous population case where revenue is spent on public goodscase where revenue is spent on public goods other interesting cases (non-utilitarian welfare)other interesting cases (non-utilitarian welfare)

Can also be simplified down to a “tax-agency” ruleCan also be simplified down to a “tax-agency” rule ignore risk-aversion component in marginal ruleignore risk-aversion component in marginal rule

But it relies on a “lucky dip” approachBut it relies on a “lucky dip” approach Where taxpayers and the authority are in a reporting Where taxpayers and the authority are in a reporting

relationship one may be able to do better than thisrelationship one may be able to do better than this

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Overview...Background

Objectives and constraints

Optimal policy C&B

Tax design

Policy Design

Strategic approach to audit policy

Optimal policy Cat-&-Mouse

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Policy: strategic interaction model

Results of cat-and-mouse model:Results of cat-and-mouse model: simultaneous move: no equilibrium in pure strategiessimultaneous move: no equilibrium in pure strategies leader-follower, get a simple outcomeleader-follower, get a simple outcome

Build this into a richer policy modelBuild this into a richer policy model focus on tax-collector/tax-payer interactionfocus on tax-collector/tax-payer interaction what role is there for beliefs about others’ goals and actions?what role is there for beliefs about others’ goals and actions? can tax authority precommit to an audit strategy?can tax authority precommit to an audit strategy?

Model ingredientsModel ingredients tax rates and penalties are exogenously determinedtax rates and penalties are exogenously determined tax enforcement powers are delegated, like contract farmingtax enforcement powers are delegated, like contract farming there is a constant, universally known, cost of audit there is a constant, universally known, cost of audit there is a known distribution of attributes and incomes...there is a known distribution of attributes and incomes...

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Tax-payer v. Tax-collector game (2)

Similar to earlier version of model, but now includes Similar to earlier version of model, but now includes yy the difference between high and low income the difference between high and low income

Remember, there is no NE in pure strategies. Remember, there is no NE in pure strategies. To find a solution we need to look more closely at:To find a solution we need to look more closely at:

the structure of taxpayer population the structure of taxpayer population control that can be exercised by tax authoritycontrol that can be exercised by tax authority

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Types of taxpayer

Essence of model is taxpayer heterogeneityEssence of model is taxpayer heterogeneity differ by income and by attitude to tax-payingdiffer by income and by attitude to tax-paying authority does not know individual taxpayer attributesauthority does not know individual taxpayer attributes but does know distribution in the populationbut does know distribution in the population

Take a simple 2x2 version:Take a simple 2x2 version:

typetype income income attitudeattitude pop pop proportionproportion

poorpoor yy00 ?????? 00

honest richhonest rich yy0 0 + + yy always pay always pay 11

chancerschancers yy0 0 + + yy cheat if can cheat if can 22

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A mixed-strategy approach

Each knows that there is no equilibrium in pure strategiesEach knows that there is no equilibrium in pure strategies Each expects the other to play probabilisticallyEach expects the other to play probabilistically::

tax authority investigates low incomes with probability tax authority investigates low incomes with probability pp taxpayer cheats with probability taxpayer cheats with probability

Expected net tax receiptsExpected net tax receiptsTT = = 1122 – – tty + y + 22pp[[1 + [[1 + ss]]tt y – y – ]] – – 00pp

Marginal impact on receipts from increasing Marginal impact on receipts from increasing pp is: is:22[[1 + [[1 + ss]]tt y – y – ] ] – – 00

This is positive if This is positive if is greater than a threshold value: is greater than a threshold value:00

22[[1+[[1+ss]]tt y – y – ] ]

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Equilibrium concepts

Taxpayers and tax agency each form beliefs about the Taxpayers and tax agency each form beliefs about the other’s actionsother’s actions

Equilibrium where each adopts a consistent set of Equilibrium where each adopts a consistent set of beliefsbeliefs

What is the optimal “tailored” audit strategy?What is the optimal “tailored” audit strategy? Two types of relationship between taxpayer and tax Two types of relationship between taxpayer and tax

authority:authority: tax authority precommits to a strategytax authority precommits to a strategy tax authority does not precommittax authority does not precommit see Reinganum and Wilde (1985, 1986)see Reinganum and Wilde (1985, 1986)

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Precommitment: policy

If the tax authority were permissive, net receipts would be low:If the tax authority were permissive, net receipts would be low: TT||=1,=1,pp=0=0 = = 11ttyy

If authority can commit it ought to audit all low-income reports:If authority can commit it ought to audit all low-income reports: p p = 0 if report is = 0 if report is yy00 + + yy p p = 1 if report is = 1 if report is yy00

Tax receipts net of audit costs areTax receipts net of audit costs are TT||=0,=0,pp=1=1 = = 1122tty – y – 00

This amounts to a “Punish the poor” policy This amounts to a “Punish the poor” policy Is this in fact optimal?Is this in fact optimal?

viabilityviability credibilitycredibility

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Precommitment: optimality?

Condition 1 for financial viability is:Condition 1 for financial viability is: TT||=0,=0,pp=1=1 ≥ ≥ TT||=1,=1,pp=0=0 1122tty – y – 00pp ≥ ≥ 11ttyy 22tty y ≥≥ 00

Condition 2 for financial viability is:Condition 2 for financial viability is: net return from investigating a false report must be non-negativenet return from investigating a false report must be non-negative sstty – y – ≥ 0≥ 0

Combining the two conditionsCombining the two conditions sstty – y – ≥ ≥ s s – – 22//00ttyy satisfied if satisfied if

if audit cost is not too highif audit cost is not too high if there are not too many honest peopleif there are not too many honest people

Credibility:Credibility: everyone sees that only the genuinely poor people are auditedeveryone sees that only the genuinely poor people are audited no revenue is ever raised in equilibriumno revenue is ever raised in equilibrium policy may not be credible in a repeated settingpolicy may not be credible in a repeated setting

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No commitment: outline

Tax authority:Tax authority: believes probability that a chancer will cheat is believes probability that a chancer will cheat is perceived probability of catching an evader is perceived probability of catching an evader is 22/[/[0022]] expected net tax receipts can be written asexpected net tax receipts can be written as::

00const + const + 00++22

is pivotal value of beliefis pivotal value of belief Chancers:Chancers:

believe that probability of audit is believe that probability of audit is pp expected utility if cheat is: expected utility if cheat is: pupu((ttyy00tt– –

ststyy))ppuu((ttyy00yy)) expected utility if don’t cheat is: expected utility if don’t cheat is: uu((ttyy00yy)) there is a pivotal probability satisfied there is a pivotal probability satisfied pp which equates these two utilities which equates these two utilities if if uu is risk neutral then is risk neutral then pp = 1 / = 1 / [1+[1+ss]]

Solution:Solution: tax authority’s best response given belief tax authority’s best response given belief defines reaction function defines reaction function pp(()) chancers’ best response given belief chancers’ best response given belief pp defines reaction function defines reaction function ((pp)) equilibrium where beliefs consistent – where reaction functions intersectequilibrium where beliefs consistent – where reaction functions intersect

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No commitment: Solution

1

0 1

p*

taxpayerreaction

tax authorityreaction

p

p()

(p)

(p*,*)

always audit if proportion always audit if proportion of cheats is believed highof cheats is believed high

always cheat if probability always cheat if probability of detection is believed lowof detection is believed low

The strategy space Tax authority’s strategy Chancer’s strategy Equilibrium

00

22[[1+[[1+ss]]tt y – y – ]]

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What happens as tax-enforcement parameters change

increasing the cost of audit increases increasing the cost of audit increases equilibrium evasionequilibrium evasion

increasing the tax rate decreases increasing the tax rate decreases equilibrium evasionequilibrium evasion

increasing the surcharge decreases increasing the surcharge decreases equilibrium evasionequilibrium evasion

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What happens as the population proportions change Increasing the proportion of the poor Increasing the proportion of the poor

increases equilibrium evasionincreases equilibrium evasion

increasing the proportion of chancers increasing the proportion of chancers decreases equilibrium evasiondecreases equilibrium evasion

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Overview...Background

Objectives and constraints

Optimal policy C&B

Tax design

Policy Design

Another look at optimal taxation

Optimal policy Cat-&-Mouse

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Implications for tax design

How should presence of evasion affect tax progression?How should presence of evasion affect tax progression? two approachestwo approaches

1 Build evasion into optimal income tax model1 Build evasion into optimal income tax model Will presence of tax evasion lower optimal marginal tax rate?Will presence of tax evasion lower optimal marginal tax rate? Cremer and Cremer and GahvariGahvari (1994) (1994)

2 Fiscal administration model that involves multiple failures2 Fiscal administration model that involves multiple failures Tax evasion:Tax evasion:

false reports to governmentfalse reports to government may involve more than one economic actormay involve more than one economic actor

Corruption:Corruption: corruptibility involves self-interested public agentscorruptibility involves self-interested public agents usually involves briberyusually involves bribery

Extortion: Extortion: threaten the taxpayer with an excessively high assessmentthreaten the taxpayer with an excessively high assessment

Hindriks et al (1999) based on Mookherjee and Png (1995)Hindriks et al (1999) based on Mookherjee and Png (1995)

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Model 1: Assumption and results

Standard utilitarian optimal linear income tax Standard utilitarian optimal linear income tax disposable income function disposable income function c = c = [[11tt]]y y ++BB where where y=why=wh welfare welfare W = W = ∫ u∫ u((((ww) d) dww individual can conceal income individual can conceal income ee spend spend on concealment to reduce prob of audit on concealment to reduce prob of audit pp ∂∂pp((ee,,yy,,))//∂∂ < 0, ∂< 0, ∂22pp((ee,,yy,,))//∂∂22 < 0< 0 ∂∂pp((ee,,yy,,))//∂∂e e ≥ 0, ∂≥ 0, ∂pp((ee,,yy,,))//∂(∂(ee//yy) ≥ 0) ≥ 0

Theorem 1. Theorem 1. The optimal tax must satisfy:The optimal tax must satisfy: cov (cov (uu', [1 ', [1 rr] ) / ] ) / EEuu'' = = EE([([w w + + pp] d] dhh/d/dtt)) EE(d(d/d/dtt))

Theorem 2. Theorem 2. Given ∂Given ∂p/p/∂(∂(ee//yy)) = 0 = 0 and and uu'''''' < 0 then the < 0 then the optimal mtr is lower with evasion that without evasionoptimal mtr is lower with evasion that without evasion

Two problems:Two problems: Theorem 1 does not give explicit formula for the mtrTheorem 1 does not give explicit formula for the mtr Theorem 2 applies to very few useful functional formsTheorem 2 applies to very few useful functional forms

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Model 2: Objectives, Agents, Information Government objectives:

raising revenue concerns with tax evasion and corruption distribution of tax payments

Tax inspector government agent takes incentive schemes as given is risk-neutral and corruptible

Taxpayer (citizen): risk-neutral and willing to pay bribes

Information At time of inspection: taxable income is private information After tax inspection inspector also knows taxable income and

taxpayer knows whether inspector has behaved corruptly Government does’nt know if inspector has truthfully

reported

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Model 2: Timing

Inspector selects taxpayer: made in ignorance of true income only the distribution known no additional signals available

Inspector meets taxpayer: true income becomes known assessment is made bribe may be paid

Inspector reports to government misreporting in two directions: under-reporting (collusion in tax evasion ) over-reporting (extortion)

Taxpayer may appeal decided by an honest judge random non-appeal cases investigated by an honest auditor

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Model 2: Rewards and incentives Tax inspectors can be rewarded several ways:Tax inspectors can be rewarded several ways:

straight fee, related to tax revenue, related to nature of reportsstraight fee, related to tax revenue, related to nature of reports payment scheme create incentive for zeal?payment scheme create incentive for zeal? also create conflicting incentive effects?also create conflicting incentive effects?

Effect 1Effect 1: Collusion:: Collusion: defeats effectiveness of tax instruments, undermines deterrent effect of defeats effectiveness of tax instruments, undermines deterrent effect of

penaltiespenalties provide high-powered incentives to the inspectorprovide high-powered incentives to the inspector commission payment to resist the temptation to collusion commission payment to resist the temptation to collusion

Effect 2Effect 2: Extortion:: Extortion: discretion of inspector gives power: threat of extortiondiscretion of inspector gives power: threat of extortion to deter inspectors from abusing power need low-powered incentivesto deter inspectors from abusing power need low-powered incentives

In Hindriks et al model:In Hindriks et al model: extortion effect dominatesextortion effect dominates never any strict gain from paying positive commissions. never any strict gain from paying positive commissions. threat of extortion leads to low-powered incentives.threat of extortion leads to low-powered incentives.

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Model 2: Tax and penalty structure

Pay tax inspectors commission on low income reports? can be counterproductive a risk of inducing corruption

Heavy penalties on corrupt inspectors ineffective if on collusion… … raises equilibrium bribe effective on extortion

A wage for inspectors? if government just maximises revenue… …and is averse to evasion and corruption pay inspectors a fixed wage… …with penalties proportional to misreporting

Argument for a flat tax? if government just maximises revenue… …and is averse to evasion and corruption set a proportional tax schedule

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Model 2: Distributional outcomes

Evasion is regressive poor have less to gain from evading taxes rich have more to gain from evading taxes

Extortion is regressive poor are vulnerable to over-reporting of their incomes rich are less vulnerable to over-reporting of their incomes

Collection of progressive taxes can be costly conflicting temptations: understate income to evade progressive taxes, overstate income to raise the commission payments inducing honesty requires additional resources

An additional aspect of the equity-efficiency tradeoff

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Assessment

Compliance is a central component of public economicsCompliance is a central component of public economics Arises naturally from the issues concerning the provision of public Arises naturally from the issues concerning the provision of public

goodsgoods Analysed using standard microeconomic techniquesAnalysed using standard microeconomic techniques

Incentives issues similar to those of labour supplyIncentives issues similar to those of labour supply Important to model the interactions involved in evasionImportant to model the interactions involved in evasion

Perceptions of others’ behaviour may be important.Perceptions of others’ behaviour may be important. Also interaction between tax-payers and enforcement agenciesAlso interaction between tax-payers and enforcement agencies

Crucial issues on policy concern the institutional background Crucial issues on policy concern the institutional background What is the nature of the optimisation problem?What is the nature of the optimisation problem?

Is a standard reporting model appropriate? Is a standard reporting model appropriate? What information should each party be assumed to have?What information should each party be assumed to have?

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References Cowell, F. A. (1989)Cowell, F. A. (1989) “Honesty is sometimes the best policy,” “Honesty is sometimes the best policy,” European Economic ReviewEuropean Economic Review, ,

3333,605-617 ,605-617 Cowell, F. A. (2004)Cowell, F. A. (2004) “Carrots and Sticks in Enforcement” in Aaron, H. J. and Slemrod, J. “Carrots and Sticks in Enforcement” in Aaron, H. J. and Slemrod, J.

(ed.) (ed.) The Crisis in Tax AdministrationThe Crisis in Tax Administration, The Brookings Institution, Washington DC, 230-275 , The Brookings Institution, Washington DC, 230-275 Cremer, H. and Cremer, H. and GahvariGahvari, F. (1994), F. (1994) “Tax evasion, concealment and the optimal linear “Tax evasion, concealment and the optimal linear

income tax,” income tax,” The Scandinavian Journal of EconomicsThe Scandinavian Journal of Economics, , 9696, 219-239, 219-239 HindriksHindriks, J., Keen, M. and , J., Keen, M. and MuthooMuthoo A. (1999) A. (1999) “Corruption, Extortion and Evasion”, “Corruption, Extortion and Evasion”, Journal Journal

of Public Economicsof Public Economics, , 7474, 395-430, 395-430 IyengarIyengar, R. (2008), R. (2008) “I'd rather be Hanged for a Sheep than a Lamb:  The Unintended “I'd rather be Hanged for a Sheep than a Lamb:  The Unintended

Consequences of 'Three-Strikes' Laws,” NBER Working Paper, 13784Consequences of 'Three-Strikes' Laws,” NBER Working Paper, 13784 Mookherjee, D. and Png, I. (1995) “Corruptible law enforcers: how should they be Mookherjee, D. and Png, I. (1995) “Corruptible law enforcers: how should they be

compensated?” compensated?” Economic JournalEconomic Journal,, 105105, 145–159, 145–159 Reinganum, J. F. and L. L. Wilde (1985) “Income tax compliance in a principal-agent Reinganum, J. F. and L. L. Wilde (1985) “Income tax compliance in a principal-agent

framework framework ,,” ” Journal of Public EconomicsJournal of Public Economics, , 2626, 1-18., 1-18. Reinganum, J. F. and L. L. Wilde (1986) “Equilibrium verification and reporting policies in Reinganum, J. F. and L. L. Wilde (1986) “Equilibrium verification and reporting policies in

a model of tax compliance,” a model of tax compliance,” International Economic Review,International Economic Review, 2727, 739-760. , 739-760. Slemrod, J. and Yitzhaki, S. (2002) “Tax avoidance, evasion and administration,” Slemrod, J. and Yitzhaki, S. (2002) “Tax avoidance, evasion and administration,”

Handbook of Public EconomicsHandbook of Public Economics, Volume 3, pp 1423-1470, North-Holland, Elsevier, Volume 3, pp 1423-1470, North-Holland, Elsevier Stella, P. (1993) “Tax Farming: A Radical Solution for Developing Country Tax Stella, P. (1993) “Tax Farming: A Radical Solution for Developing Country Tax

Problems?” Problems?” IMF Staff PapersIMF Staff Papers 4040, 217-225 , 217-225