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HMRC-HMT Economics of Taxation 2011

http://darp.lse.ac.uk/HMRC-HMT

10.1 Tax Evasion and Compliance10.1 Tax Evasion and Compliance

14 December 2011

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Overview...Background

TAG model

Interaction models

Evidence

Tax Evasion and Compliance

How compliance fits into public economics

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Tax compliance: Questions

Fundamental questions about Fundamental questions about nonnon-compliance-compliance How much?How much? What is it?What is it? What drives it?What drives it?

The The how much?how much? question: question: simple quantificationsimple quantification does it matter?does it matter?

The The what is it?what is it? question: question: tax evasion important special casetax evasion important special case to be distinguished from tax avoidance?to be distinguished from tax avoidance? several ways of drawing the line between the twoseveral ways of drawing the line between the two

The The what drives it? what drives it? question:question: how to represent non-compliance in an economic modelhow to represent non-compliance in an economic model how does tax evasion fit into the economics of taxation?how does tax evasion fit into the economics of taxation? complex relation between the individual taxpayer and society as a wholecomplex relation between the individual taxpayer and society as a whole

Begin with numbers…Begin with numbers…

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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)

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UK Tax Gap Estimates

5

  2004-05 2005-06 2006-07 2007-08 2008-09 2009-10

      per cent     

Value Added Tax (VAT) 11.7 15.2 13.5 12.4 15.5 13.8

Excise duties and other indirect taxes

8.6 7.8 8.6 7.7 7.7 6.5

Income Tax, National Insurance Contributions,

Capital Gains Tax

6.2 5.4 5.4 5.2 5.2 5.8

Corporation Tax 14.7 11.1 10.6 9.3 10.3 11.7Other direct taxes 8.4 7.2 7.5 7.5 6.5 4.9

Total tax gap 8.5 8.3 8 7.4 8.1 7.9

      £bn      

Total tax gap 35 36 37 36 39 35

Source, Source, HMRC (2011) Tables 1.2, 1.3 Tables 1.2, 1.3

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Tax compliance: broader issues Tax gapTax gap

Lack of information? (Lack of information? (McManus and Warren 2006)) US, UK evidence is not badUS, UK evidence is not bad but elsewhere can be scantybut elsewhere can be scanty

Shadow economy Shadow economy broader than tax evasion / avoidancebroader than tax evasion / avoidance includes other illegal, unobserved actrivitiesincludes other illegal, unobserved actrivities estimates from estimates from Schneider and Enste (2000) based on currency demand based on currency demand

19601960 19951995SwedenSweden 2%2% 16%16%DenmarkDenmark 4.5%4.5% 17.5%17.5%NorwayNorway 1.5%1.5% 18%18%GermanyGermany 2%2% 13.2%13.2%United StatesUnited States 3.5%3.5% 9.5%9.5%AustriaAustria 0.5%0.5% 7%7%SwitzerlandSwitzerland 1%1% 6.7%6.7%

Should we find this alarming?Should we find this alarming? definition of shadow economy is not always consistentdefinition of shadow economy is not always consistent shadow economy estimates vary enormously according to methodshadow economy estimates vary enormously according to method difficult to test proposition that change in relationship due to non-compliance difficult to test proposition that change in relationship due to non-compliance

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Public sector and the Public (1)Roman

[ + ] [ − ]

(, B) (, A)

(, D) (, C)

[ + ]

[ − ]

Gre

ek

Roman[ + ] [ − ]

(, B) (, A)

(, C) (, D)

[ + ]

[ − ]

Gre

ek

Case 1Case 1•A large tax-financed public sector may be A large tax-financed public sector may be perceived as desirable (perceived as desirable (, B) , B) •People will still try to default on taxesPeople will still try to default on taxes•Need a “policeman”Need a “policeman”

Case 2Case 2•““policeman” may still be needed…policeman” may still be needed…•……to avoid disaster (to avoid disaster (, D) , D) •……to avoid inequity (to avoid inequity (, C) or (, C) or (, A) , A)

Case 1 – a large economy?

Case 1 equilibrium Case 2 – a small economy?

Case 2 equilibria

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Agenda

Outline main approaches to tax complianceOutline main approaches to tax compliance 1 TAG1 TAG 2 Strategic interaction2 Strategic interaction 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

Will lay basis for policy lectureWill lay basis for policy lecture Literature overviews: Literature overviews:

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

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Overview...Background

TAG model

Strategic interaction

Evidence

Tax Evasion and Compliance

Risk-taking behaviour and compliance

Social interaction

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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 to this when tax and enforcement parameters what happens to this when tax and enforcement parameters

change?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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Extending the 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...Background

TAG model

Interaction models

Evidence

Tax Evasion and Compliance

Reporting models. Climate of evasion and social sanction

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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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Social interaction 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

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...Background

TAG model

Interaction models

Evidence

Tax Evasion and Compliance

What do we know? What can we know?

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Empirical evidence

Few governments/agencies publish dataFew governments/agencies publish data For survey see For survey see Andreoni et al (1998)

Best data (TCMP) enable one to address only a restricted set of questionsBest data (TCMP) enable one to address only a restricted set of questions Focus is on false Focus is on false reportsreports. Limited info on non-filers. . Limited info on non-filers. Last full TCMP in 1988Last full TCMP in 1988 recently (2005/6) updated in National Research Programrecently (2005/6) updated in National Research Program

Private data must be treated with cautionPrivate data must be treated with caution Survey data obviously problematicSurvey data obviously problematic Experimental data sometimes useful (Experimental data sometimes useful (Alm et al. 1990 ))

Indirect methods are often seriously flawedIndirect methods are often seriously flawed Focus on aggregate Focus on aggregate expenditure/income gaps or the demand for currencyexpenditure/income gaps or the demand for currency neglect measurement error and other sources of discrepancyneglect measurement error and other sources of discrepancy

Some micro-data studies are usefulSome micro-data studies are useful focus on relationship between expenditure and income for self-employed on focus on relationship between expenditure and income for self-employed on

regularly employed (regularly employed (Pissarides and Weber 1989)) focus on charity giving and different types incomefocus on charity giving and different types income ((Feldman and Slemrod 2007))

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Personal compliance Behaviour varies by income type and population groupBehaviour varies by income type and population group (TCMP) (TCMP)

Personal taxpayers income-elasticity of underreporting: 0.3Personal taxpayers income-elasticity of underreporting: 0.3 Farm business income income-elasticity of underreporting: 0.65Farm business income income-elasticity of underreporting: 0.65 Source of income rather than level which is a significant determinant of evasion.Source of income rather than level which is a significant determinant of evasion. Married people evade more than single personsMarried people evade more than single persons

Effect of tax rates:Effect of tax rates: Less compliance in audit classes with higher marginal tax rates? Less compliance in audit classes with higher marginal tax rates? Corroborated by evidence on the reporting of capital gainsCorroborated by evidence on the reporting of capital gains Corroborated also by time series?Corroborated also by time series?

Enforcement parameters work in expected direction (TCMP):Enforcement parameters work in expected direction (TCMP): weak relationship with probability of auditweak relationship with probability of audit weak relationship with severity of penalties weak relationship with severity of penalties

Detection is imperfect (TCMP): Detection is imperfect (TCMP): variation in detection rates at least as important as…variation in detection rates at least as important as… variations in personal characteristicsvariations in personal characteristics

Slemrod et al (2001) controlled experiment controlled experiment results:results: as expected for modest incomesas expected for modest incomes and for those with high opportunity to evadeand for those with high opportunity to evade But high-income people reported less than those in control groupBut high-income people reported less than those in control group

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Compliance by firms

Surveys: Surveys: Nur-tegin (2008),, Slemrod (2004) Evidence: Rice (1994) based on TCMPEvidence: Rice (1994) based on TCMP Highlights lack of ...Highlights lack of ...

theoretical modelstheoretical models corporate income tax compliance microdata;corporate income tax compliance microdata; confidence in microdata on tax complianceconfidence in microdata on tax compliance

Two key results:Two key results: compliance positively associated with being publicly traded compliance positively associated with being publicly traded

and belonging to a highly regulated industryand belonging to a highly regulated industry having low profits relative to the industry median is having low profits relative to the industry median is

correlated with higher corporate tax evasioncorrelated with higher corporate tax evasion

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Evidence: summary

TCMP evidence is broadly in line with evidence of TCMP evidence is broadly in line with evidence of responses from TAG modelresponses from TAG model

Confirmation as to evasion patterns by different groups Confirmation as to evasion patterns by different groups according to income and personal characteristicsaccording to income and personal characteristics

However implied detection probability suggests that However implied detection probability suggests that there is far too little tax evasion going on…!there is far too little tax evasion going on…! may neglect heterogeneity of effective detection probabilitymay neglect heterogeneity of effective detection probability also taxpayer ignorancealso taxpayer ignorance

Responses are also borne out by experimental evidence Responses are also borne out by experimental evidence ((Alm et al.1990 ))

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

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