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MSc Public Economics 2010/11

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

Tax ComplianceTax Compliance

14 February 2010

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Overview...Introduction

Basic model

Extensions

Policy

Tax Compliance

How compliance fits into public economics

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Tax compliance and PE

In tax problems usually focus on margin of individual choice…In tax problems usually focus on margin of individual choice… labour supplylabour supply the demand for particular consumption goodsthe demand for particular consumption goods

Could consider tax-compliance analysis as just another marginCould consider tax-compliance analysis as just another margin ……compliance/noncompliance in reportingcompliance/noncompliance in reporting ……work above/below groundwork above/below ground

But: it’s related to a core problem of public economicsBut: it’s related to a core problem of public economics public goods will not be provided efficiently by private initiativepublic goods will not be provided efficiently by private initiative usual response is to say “let government do it”usual response is to say “let government do it”

Useful to reinterpret the basics of this type of problemUseful to reinterpret the basics of this type of problem provision of collective goodsprovision of collective goods pure public goods and others involving externalitiespure public goods and others involving externalities focus on relations between citizens and statefocus on relations between citizens and state

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Agenda

Outline main approaches to tax complianceOutline main approaches to tax compliance 1 TAG1 TAG 2 Strategic models2 Strategic models 3 Social interaction3 Social interaction

Consider some important variantsConsider some important variants public goods and the public sectorpublic goods and the public sector the role of firmsthe role of firms

Analyse implications for policyAnalyse implications for policy Literature overviews: Literature overviews:

Andreoni et al (1998) Cowell (1990, Cowell (1990, 2004) ) Slemrod (2007) Slemrod and Yitzhaki (2002)

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Overview...Introduction

Basic model

Extensions

Policy

Tax Compliance

Individual behaviour and the public sector

•Individual taxpayer•Multiple taxpayers

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TAG model

Standard model is essentially one of Standard model is essentially one of TTaxpayer axpayer AAs s GGamblerambler based on based on Allingham and Sandmo (1972)

The gamble involves a bet with the tax authorityThe gamble involves a bet with the tax authority Individuals make bets on whether they will be caught Individuals make bets on whether they will be caught

concealing incomeconcealing income ……or not reporting at allor not reporting at all ……or working in underground economyor working in underground economy

Appropriateness relies on a special set of assumptions Appropriateness relies on a special set of assumptions about motivation of individualsabout motivation of individuals about the way that the government is perceivedabout the way that the government is perceived

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TAG: taxes, penalties, returns Tax payer/evader has true income Tax payer/evader has true income yy

is supposed to pay tax on all of this at rate is supposed to pay tax on all of this at rate tt chooses to conceal an amount chooses to conceal an amount e, e, pays tax on the remainderpays tax on the remainder

Tax authority audits:Tax authority audits: if evader is caught, pays a surcharge if evader is caught, pays a surcharge ss on the evaded tax on the evaded tax tete perceived probability of this happening is perceived probability of this happening is pp

Parameters determine returns to evasion:Parameters determine returns to evasion: consider rate of return to $1 of evasion activity...consider rate of return to $1 of evasion activity... rr = – = – ss with probability with probability pp rr = 1 with probability 1 – = 1 with probability 1 – pp expected rate of return is expected rate of return is 1 – 1 – p p – – psps

Consumption (disposable income) is a function of:Consumption (disposable income) is a function of: income income y y andand tax rate tax rate tt random rate of return random rate of return rr evasion choice evasion choice ee cc = [1 – = [1 – t t] ] yy ++ rrte te ((a random variable)a random variable)

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TAG: budget constraint

A

B

c"

c'

[1t]y

[1tst]y

y

[1t]y

line o

f perf

ect

certa

inty

c': consumption if not caught

B: Payoff if blatantly dishonest

c'': consumption if caughtA: Payoffs if absolutely honest

Consumption possibilities for all e

c'c' = [1 – = [1 – t t] ] yy + + te te if not if not audited / convicted audited / convicted c''c'' = [1 – = [1 – t t] ] yy – – ste ste if audited if audited and convictedand convicted

1 A cut in the surcharge rate s2 A cut in the tax rate t3 Increase in income y

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TAG: Preferences and beliefs

Tax payer has von-Neumann Morgenstern preferencesTax payer has von-Neumann Morgenstern preferences gets no intrinsic pleasure from evasion and feels no shame gets no intrinsic pleasure from evasion and feels no shame correctly perceives probability of detection correctly perceives probability of detection pp assumes that it is exogenously givenassumes that it is exogenously given

Consumer’s welfare is expected utility of consumption:Consumer’s welfare is expected utility of consumption: EEuu((cc) = [1 –) = [1 – p p] ] uu((c'c' ) + ) + pp uu((c''c'' ) ) EEuu((cc) = [1 –) = [1 – p p] ] uu([1 –([1 – t t] ] yy + + tete) + ) + pp uu([1 –([1 – t t] ] yy – – ste ste) )

Cardinal utility function Cardinal utility function uu has the “usual properties”: has the “usual properties”: uucc(•) > 0 (first derivative)(•) > 0 (first derivative) uucccc(•) (•) 0 (second derivative) 0 (second derivative)

Both Both uu and and pp determine shape of ICs in ( determine shape of ICs in (c'c', , c''c'' )-space)-space curvature of ICs depends on risk aversion – curvature of ICs depends on risk aversion – uucccc(•)/(•)/uucc(•) (•) slope of ICs where crosses 45slope of ICs where crosses 45ºº line is [1 – line is [1 – p p]/]/pp

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c"

c'0

Equilibria of the tax-evader Feasible setA: corner solution (honesty)B: corner solution (dishonesty)C: Interior (partial honesty)E: Expected payoff

• B

•A

• E

EE((rruucc((cc)) )) ≤≤ 0 if 0 if e*e* = 0 = 0

EE((rruucc((cc)) )) ≥≥ 0 if 0 if e*e* = = yy EE((rruucc((cc)) )) == 0 if 0 < 0 if 0 < e*e* < < yy

• C

solution depends onsolution depends on•tax parameters tax parameters := (:= (p, s, tp, s, t))•income income yy•personal attributes personal attributes aa

e*e* = = ee((, , yy, , aa))

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Comparative statics

Focus on the interior solutionFocus on the interior solution what happens when tax / enforcement parameters change?what happens when tax / enforcement parameters change? do this graphically or analyticallydo this graphically or analytically differentiate the first-order condition differentiate the first-order condition EE((rruucc((cc)) )) == 0 0

Effect of increased Effect of increased pp:: indifference map “rotates”indifference map “rotates” for given budget constraint, tangency moves closer to Afor given budget constraint, tangency moves closer to A

Effect of increased Effect of increased ss:: point B moves downpoint B moves down for given utility function, tangency moves closer to Afor given utility function, tangency moves closer to A

Effect of increased Effect of increased tt:: assume decreasing absolute risk aversion (DARA)assume decreasing absolute risk aversion (DARA) amount “invested” in a risky asset increases with resourcesamount “invested” in a risky asset increases with resources so in this model, given DARA, evasion rises with so in this model, given DARA, evasion rises with yy but this will also imply that evasion but this will also imply that evasion fallsfalls with with tt

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Overview...Introduction

Basic model

Extensions

Policy

Tax Compliance

How to assemble the whole economy

•Individual taxpayer•Multiple taxpayers

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Forward from simple TAG model

Obvious difficulty with isolated individual modelObvious difficulty with isolated individual model reacts to exogenously given risk situationreacts to exogenously given risk situation no perceived effect of his behaviour on this situationno perceived effect of his behaviour on this situation no interaction with other aspects of public sectorno interaction with other aspects of public sector no interaction with other agentsno interaction with other agents

Start to put this right in this sectionStart to put this right in this section 1 aggregate individual risk-taking behaviour1 aggregate individual risk-taking behaviour 2 introduce public sector2 introduce public sector

Then, later in the lecture:Then, later in the lecture: 3 focus on interaction with tax agency 3 focus on interaction with tax agency 4 focus on interaction amongst agents4 focus on interaction amongst agents

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Components of model

Government budget constraint:Government budget constraint: R R ≥≥RR revenue actually raised revenue actually raised ≥≥ required target revenue required target revenue

Define economy-wide aggregatesDefine economy-wide aggregates aggregate income: aggregate income: YY := := ∫ ∫ yy d dFF((yy, , aa)) aggregate nominal tax receipts: aggregate nominal tax receipts: tYtY aggregate “leakage” from evasion: aggregate “leakage” from evasion: ∫ ∫ rere((, , yy, , aa) d) dFF((yy, , aa)) cost of enforcing probability cost of enforcing probability pp across economy across economy ((pp))

Composition of revenueComposition of revenue R R = = tY tY t t ∫ ∫ rere((, , yy, , aa)) ((pp))

So budget constraint becomesSo budget constraint becomes tY tY t t ∫ ∫ rere((, , yy, , aa)) ((pp)) ≥≥RR

But this ignores how the government revenue may be used…But this ignores how the government revenue may be used…

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TAG model: Public Sector Taxes are used to pay for a public good Taxes are used to pay for a public good zz Government budget constraint in this extended model is:Government budget constraint in this extended model is:

R R ≥ ≥ zz where where is the (constant) marginal rate of transformation is the (constant) marginal rate of transformation

Individuals benefit from provision of the goodIndividuals benefit from provision of the good ……but they prefer that someone else pay for itbut they prefer that someone else pay for it so there is still a motive for tax evasionso there is still a motive for tax evasion and expected utility is now and expected utility is now EEuu((cc,,zz), where ), where uuzz((cc,,zz) > 0) > 0

FOC for an interior maximum is:FOC for an interior maximum is: EE((rruucc((cc,,zz)) = 0)) = 0 essentially as beforeessentially as before

Response of Response of ee in this model is much the same for some cases: in this model is much the same for some cases: SurchargeSurcharge Probability of detectionProbability of detection

But for the tax rate But for the tax rate tt we have new insights… we have new insights…

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The effect of a rise in the tax rate

There are still the conventional “income” There are still the conventional “income” and “substitution” effectsand “substitution” effects

But But t t also affects amount of public good also affects amount of public good availableavailable

Increasing Increasing tt will: will: reduce private consumption reduce private consumption cc increase availability of public good increase availability of public good z z

Desirable to increase Desirable to increase tt?? depends on amount of public good already depends on amount of public good already

availableavailable Expect a “hump” shape:Expect a “hump” shape:

for for tt close to 0 we have close to 0 we have z z close to 0: raising close to 0: raising tt is desirableis desirable

for for tt close to 1 we may have satiation in close to 1 we may have satiation in zz: : lowering lowering tt is desirable is desirable

Eua

t

z > z*a z < z*a

“underprovision” “overprovision”

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Preferences for public and private goods

How is How is z* z* determined?determined? Optimal provision uses standard Optimal provision uses standard MRS = MRT MRS = MRT

rulerule Because of the risk component general formula Because of the risk component general formula

is unwieldyis unwieldy So take a simplified set of preferencesSo take a simplified set of preferences

uuaa(c(c, z, z) = ) = c + vc + vaa((zz)) mmaa := := uuzz

aa(c(c, z, z)/)/uuccaa(c(c, z, z) = ) = vvzz

aa((zz)) m m := := mma a = MRT= MRT

Evasion erodes effectiveness of tax in providing Evasion erodes effectiveness of tax in providing zz...... feeds back into effect of tax on evasionfeeds back into effect of tax on evasion change in (change in (etet) has sign of ) has sign of m m – y / z– y / ztt a simple criterion for determining under / over a simple criterion for determining under / over

provisionprovision

c

z

slope = m

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Effect of a rise in the tax rate If the public goods are…If the public goods are…

under-providedunder-provided: a rise in : a rise in tt increases the amount of evasion increases the amount of evasion over-providedover-provided: a rise in : a rise in tt decreases the amount of evasion decreases the amount of evasion Cowell and Gordon (1988)

But individuals differ in:But individuals differ in: risk aversionrisk aversion taste for public goodstaste for public goods incomeincome

So, different responses:So, different responses: constrained by constrained by e e ≤ ≤ yy high marginal evaluationhigh marginal evaluation low marginal evaluationlow marginal evaluation

Get a more complex relationship between Get a more complex relationship between tt and evasion overall and evasion overall

te

t

ty

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Overview...Introduction

Basic model

Extensions

Policy

Tax Compliance

An alternative model of the individual agent

•Firms•Strategic interaction•Social interaction

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Firms and non-compliance

Individuals or firms?Individuals or firms? fine line – status of self-employed?fine line – status of self-employed?

Two major issues in setting up the modelTwo major issues in setting up the model how to model market interactionhow to model market interaction how to model the output decisionhow to model the output decision

Several types of market situation captured in one modelSeveral types of market situation captured in one model just need a determinate demand curve.just need a determinate demand curve.

Output decision based on an expected-profit criterionOutput decision based on an expected-profit criterion

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Firms: a model Conventional (non strategic firm)Conventional (non strategic firm)

marginal production cost marginal production cost demand (sales) given by demand (sales) given by xx((PP)) PP is market price is market price

Tax Tax t t payable on sales payable on sales Firm conceals a proportion Firm conceals a proportion of sales of sales

concealment costs per unit of output concealment costs per unit of output GG(())

Expected tax rateExpected tax rate pp and and ss have same interpretation as before have same interpretation as before effective tax if not caught: [1 effective tax if not caught: [1 ]]tt effective tax if caught: [1 + effective tax if caught: [1 + ss]]tt so so EEt t := [1 := [1 pp][1 ][1 ] ] tt + + pp [1 + [1 + ss]]tt

Expected profits are: Expected profits are: EE = [ = [PP GG(() ) [1 [1 pp][1 ][1 ] ] tt + + pp [1 + [1 + ss]]t t ] ] xx((PP)) EE = [ = [PP gg(() ) EEtt] ] xx((PP) where ) where gg(() := ) := GG(())

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Firms: solution

Maximise Maximise EE w.r.t. w.r.t. and and xx.. From FOC for a maximum:From FOC for a maximum:

ddgg(())─── ─── = [1 = [1 pp psps] ] tt dd

marginal concealment cost = expected return marginal concealment cost = expected return For competitive firms:For competitive firms:

P P == + + g g + + EEtt price = expected augmented marginal costprice = expected augmented marginal cost

We have a separation resultWe have a separation result Output and evasion decisions are taken independentlyOutput and evasion decisions are taken independently

a neutrality argumenta neutrality argument applies to both competitive and monopolistic firmsapplies to both competitive and monopolistic firms result depends on risk-neutrality (result depends on risk-neutrality (Lee 1998))

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Firms: predictions

Effect of penalty surcharge is conventionalEffect of penalty surcharge is conventional ∂∂/∂/∂s s < 0< 0

∂∂EEtt/∂/∂s s > 0> 0 ∂∂PP/∂/∂s s > 0> 0

So is effect of detection probability So is effect of detection probability ∂∂/∂/∂p p < 0< 0

∂∂EEtt/∂/∂p p > 0> 0 ∂∂PP/∂/∂p p > 0> 0

Effect of nominal tax increase:Effect of nominal tax increase: ...raises proportion not declared ...raises proportion not declared ∂∂/∂/∂t t > 0> 0

...may or may not raise expected tax ...may or may not raise expected tax ∂∂EEtt/∂/∂p p 0 0 ...raises price ...raises price 0 < ∂0 < ∂PP/∂/∂t t <1<1

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Overview...Introduction

Basic model

Extensions

Policy

Tax Compliance

An alternative model of the individual agent

•Firms•Strategic interaction•Social interaction

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Strategic interaction

Based on a application of game theoryBased on a application of game theory Two players: tax authority and taxpayerTwo players: tax authority and taxpayer Tax authority chooses whether or not to investigateTax authority chooses whether or not to investigate Taxpayer chooses whether or not to cheatTaxpayer chooses whether or not to cheat

Intuition of simple strategic model: simultaneous move 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 if tax authority moves first, perhaps get a simple outcome

Develop this into a richer policy model? 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?

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Overview...Introduction

Basic model

Extensions

Policy

Tax Compliance

Climate of evasion and social sanction

•Firms•Strategic interaction•Social interaction

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Climate: motivation Different countries, different types of compliance behaviour?Different countries, different types of compliance behaviour?

develop a model of a compliance climate? (develop a model of a compliance climate? (Cummings, et al. 2009)) others’ evasion choices affect my evasion decision others’ evasion choices affect my evasion decision (Fortin et al. 2007) several possible foundations…several possible foundations…

1 Symmetric consumption externality 1 Symmetric consumption externality if you evade maybe I feel less pain if caught behaving antisociallyif you evade maybe I feel less pain if caught behaving antisocially social stigma (social stigma (Benjamini and Maital 1985, Benjamini and Maital 1985, Kim 2003))

2 Technological (production) externality2 Technological (production) externality the more others evade…the more others evade… ……the easier to find a corrupt accountantthe easier to find a corrupt accountant leads to reduction in “noncompliance costs”leads to reduction in “noncompliance costs”

3 May also be induced by tax authority3 May also be induced by tax authority auditing rules may induce a perceived interdependenceauditing rules may induce a perceived interdependence creates a “co-ordination game” – creates a “co-ordination game” – Alm and Mckee (2004)

Develop the first of these variants.Develop the first of these variants.

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Climate: model background

Evasion decisions affect outcomes in two waysEvasion decisions affect outcomes in two ways each person’s outcome affected by own choices (as before)each person’s outcome affected by own choices (as before) also affected by evasion of others (independently of public goods)also affected by evasion of others (independently of public goods)

Nature of the consumption externalityNature of the consumption externality aggregate evasion affects utilityaggregate evasion affects utility moral climate?moral climate?

Utility of an Utility of an aa-type is -type is VVaa((ee,,EE) where) where ee: Own evasion activity : Own evasion activity EE: aggregate evasion: aggregate evasion

In principle there are two subcases:In principle there are two subcases: 1 where aggregate 1 where aggregate EE increases utility increases utility 2 where aggregate 2 where aggregate EE reduces utility reduces utility

Focus on case 2Focus on case 2

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Interaction: model behaviour

E

Va(0,E)

Y

Va(y,E)

util

ity

aggregate evasion

The Evasion-Utility Space Payoffs if act honestly Payoffs if act dishonestly

Dominant behaviour Find equilibrium…

0

•

•

min min EE = 0, max = 0, max EE = = YY

Check incentive to switch

low low EE : individual switches to 0 : individual switches to 0high high E: E: individual switches to individual switches to yy

E*

•◦ E > EE > E**: switching increases : switching increases EE

E < EE < E**: switching decreases : switching decreases EE

Check stability…

Three equilibriaThree equilibria::•E E = 0 (stable)= 0 (stable)•E = EE = E** (unstable) (unstable) •E = YE = Y (stable) (stable)

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Overview...Introduction

Basic model

Extensions

Policy

Tax Compliance

A utilitarian approach

•Basic model & extensions •Strategic interaction

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Utilitarian enforcement problem

Basic behavioural model taxpayer maximises expected utility Eu(c) = Eu([1 – t] y + r te) y: taxable income t: proportionate tax rate e: concealed income r : rate of return to evasion (= – s with prob p, 1 with prob 1 – p)

Outcome of basic model determines optimal evasion response e* = e(p, s, t; y, a) depends on tax parameters (p, s, t) and personal characteristics (y, a)

Welfare model Take expected utility of representative taxpayer as welfare criterion W = [1 – p] u([1 – t] y + te) + p u([1 – t] y – ste)

Should evasion be eliminated? t fixed : don’t eliminate evasion p fixed: eliminate evasion p, s, t all variable: no solution

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Optimal degree of enforcement? Take a standard welfare-economics approach

choose the optimal p, given fixed s, t Basic utilitarian model

homogeneous population simple revenue target a type of cost-benefit approach to enforcement

Individual (slightly extended) income: y = wh consumption: c = [1 t]y + rte leisure: ℓ = 1 h utility: u(c, ℓ)

Government/tax authority enforcement cost per taxpayer: (p) revenue requirement: R expected revenue leakage per tax dollar: r =1 p ps budget constraint: twh [1 p ps]t e(, w) (p) ≥R / n

Utilitarian model, homogenous population objective function: v(, w) = max Eu(c, ℓ) Lagrangean: v(, w) + [twh [1 p ps]t e(, w) (p) R / n ]

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Choosing p for given (s,t)

MC is marginal audit cost is monotonic increasing

MB is marginal audit yields + supply side and risk effects may not be monotonic may go to zero

Optimum where MB = MC p = [1+s]te r te/p w0ℓ/p e(, w) + vp/

0 1

p

p

Bp

p*

Probabilities, costs and benefitsMarginal cost of audit

Marginal benefit of audit

Optimum investigation effort

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Extensions – agent interaction

Cost-benefit approach is essentially individualistic compute MB for each agent

Social interaction models prevent epidemics? shift the equilibrium? manipulate expectations? (Iyer et al 2010)) raise search costs?

Focus on smart use of information recognise that agents may have better market information than tax authority exploit information about all agents’ behaviour

Example: tax compliance by firms use of information: compare simple auditing with relative auditing relationships amongst firms is essential to the impact of policy choice Cournot behaviour: get effect on output as well as tax receipts collusion amongst firms – smart auditing less effective (Bayer and Cowell 2009)

Examine smart auditing further in a reporting model

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Overview...Introduction

Basic model

Extensions

Policy

Tax Compliance

Strategic approach to audit policy

•Basic model & extensions •Strategic interaction

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Tax-payer v. Tax-collector game

Model ingredientsModel ingredients tax rate tax rate tt, surcharge , surcharge s,s, cost of audit cost of audit are exogenously determined are exogenously determined tax enforcement powers are delegated, like contract farmingtax enforcement powers are delegated, like contract farming

To find a solution we need to look closely at:To find a solution we need to look 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

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

Take a simple 2x2 version:

type income attitude pop proportionpoor y0 ??? 0

honest rich y0 + y always pay 1

chancers y0 + y cheat if can 2

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A mixed-strategy approach

Each side expects the other to play probabilistically: tax authority investigates low incomes with probability p taxpayer cheats with probability

Expected net tax receiptsT = 12 – ty + 2p[[1 + s]t y – ] – 0p

Marginal impact on receipts from increasing p is:2[[1 + s]t y – ] – 0

This is positive if is greater than a threshold value:0

2[[1+s]t y – ]

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Equilibrium concepts

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

Equilibrium where each adopts a consistent set of beliefs

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

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

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Precommitment: policy

If the tax authority were permissive, net receipts would be low: T|=1,p=0 = 1ty

If authority can commit it ought to audit all low-income reports: p = 0 if report is y0 + y p = 1 if report is y0

Tax receipts net of audit costs are T|=0,p=1 = 12ty – 0

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

viability credibility

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Precommitment: optimality?

Condition 1 for financial viability is: T|=0,p=1 ≥ T|=1,p=0 12ty – 0p ≥ 1ty 2ty ≥ 0

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

Combining the two conditions sty – ≥ s – 2/0ty satisfied if audit cost is not too high and there are not too many honest people

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

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No commitment: outline

Tax authority: believes probability that a chancer will cheat is perceived probability of catching an evader is 2/[02] expected net tax receipts can be written as:

0const + 0+2

is pivotal value of belief Chancers:

believe that probability of audit is p expected utility if cheat is: pu(ty0t–

sty)pu(ty0y) expected utility if don’t cheat is: u(ty0y) there is a pivotal probability satisfied p which equates these two utilities if u is risk neutral then p = 1 / [1+s]

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

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No commitment: Solution

1

0 1

p*

taxpayerreaction

tax authorityreaction

p

p()

(p)

l (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

pp 1 / [1 + 1 / [1 +ss]]

00

22[[1+[[1+ss]]tt y – y – ]]

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How the model works

Response to tax-enforcement parameters:Response to tax-enforcement parameters: ∂∂/∂/∂ > 0> 0 ∂∂pp/∂/∂ = 0= 0 ∂∂/∂/∂t t < 0< 0 ∂∂pp/∂/∂t t ≥ 0≥ 0 ∂∂/∂/∂s s < 0< 0 ∂∂pp/∂/∂s s < 0< 0

Changing population proportions:Changing population proportions: ∂∂/∂/∂ > 0> 0 ∂∂pp/∂/∂ = 0= 0

∂∂/∂/∂ < 0< 0 ∂∂pp/∂/∂ = 0= 0

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Assessment

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

goods Analysed using standard microeconomic techniques

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

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

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

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

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References (1) Allingham, M. and A. Sandmo (1972) “Income tax evasion: a theoretical “Income tax evasion: a theoretical

analysis,” analysis,” Journal of Public EconomicsJournal of Public Economics, , 11, 323-338, 323-338 Alm, J. and Mckee, M. (2004) “Tax compliance as a coordination game,” “Tax compliance as a coordination game,”

Journal of Economic Behavior & OrganizationJournal of Economic Behavior & Organization 5454, 297-312, 297-312 Andreoni, J. Erard, B. and Feinstein, J. (1998) “Tax Compliance”, “Tax Compliance”, Journal of Journal of

Economic LiteratureEconomic Literature, , 3636, 818-860 , 818-860 **Bayer, R.-C. and Cowell, F. A. (2009) “Tax compliance and firms' strategic “Tax compliance and firms' strategic

interdependence,” interdependence,” Journal of Public EconomicsJournal of Public Economics, , 9393, 1131-1143, 1131-1143 Benjamini, Y. and Maital, S. (1985) “Optimal tax evasion and optimal tax Benjamini, Y. and Maital, S. (1985) “Optimal tax evasion and optimal tax

evasion policy: behavioral aspects,” in Gaertner, W. and Wenig, A. (eds) evasion policy: behavioral aspects,” in Gaertner, W. and Wenig, A. (eds) The The Economics of the Shadow EconomyEconomics of the Shadow Economy, Springer Verlag, Berlin, Springer Verlag, Berlin

Cowell, F. A. (1990) Cowell, F. A. (1990) Cheating the GovernmentCheating the Government, MIT Press, Cambridge MA, MIT Press, Cambridge MA **Cowell, F. A. (2004) “Carrots and Sticks in Enforcement” in Aaron, H. J. and “Carrots and Sticks in Enforcement” in Aaron, H. J. and

Slemrod, J. (ed.) Slemrod, J. (ed.) The Crisis in Tax AdministrationThe Crisis in Tax Administration, The Brookings Institution, , The Brookings Institution, Washington DC, 230-275 Washington DC, 230-275

Cowell, F. A. and Gordon, J. P. F. (1988) “Unwillingness to pay: tax evasion “Unwillingness to pay: tax evasion and public good provision,” and public good provision,” Journal of Public EconomicsJournal of Public Economics, , 3636, 305-321, 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 Tax morale affects tax compliance: Evidence from surveys and an artefactual field experiment, field experiment, Journal of Economic Behavior and OrganizationJournal of Economic Behavior and Organization, , 7070, 447-, 447-457457

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References (2) *Fortin, B., Lacroix, G. and Villeval, M.-C. (2007) “Tax evasion and social *Fortin, B., Lacroix, G. and Villeval, M.-C. (2007) “Tax evasion and social

interactions,” interactions,” Journal of Public EconomicsJournal of Public Economics, , 9191, 2089–2112, 2089–2112 Kim, Y. (2003) “Income distribution and equilibrium multiplicity in a stigma-based Kim, Y. (2003) “Income distribution and equilibrium multiplicity in a stigma-based

model of tax evasion”, model of tax evasion”, Journal of Public EconomicsJournal of Public Economics, , 8787 1591–1616 1591–1616 Iyer, G.S. , Reckers, P.M.J. and Sanders, D.L. (2010) “Increasing Tax Compliance in Iyer, G.S. , Reckers, P.M.J. and Sanders, D.L. (2010) “Increasing Tax Compliance in

Washington State: A Field Experiment,” Washington State: A Field Experiment,” National Tax JournaNational Tax Journal, l, 6363,7-32,,7-32, Lee, K. (1998) “Tax evasion, monopoly and nonneutral profit taxes,” Lee, K. (1998) “Tax evasion, monopoly and nonneutral profit taxes,” National Tax National Tax

JournalJournal, , 5151, 333-338., 333-338. 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

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

policies in a model of tax compliance,” policies in 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 Slemrod, J. (2007) “Cheating Ourselves: The Economics of Tax Evasion,” Slemrod, J. (2007) “Cheating Ourselves: The Economics of Tax Evasion,” Journal of Journal of

Economic PerspectivesEconomic Perspectives, , 2121, 25-48, 25-48 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