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HMRC-HMT Economics of Taxation 2011

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

10.2 Policy design10.2 Policy design

14 December 2011

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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 Strategic

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Issues in enforcement policy design

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

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

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

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

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Government

Taxpayers

The principal economic actors

Tax Authority

The key players

Delegation Tax farming

Corruption model

Control & reporting, simple constitution

Further delegation

Inspector InspectorInspector

Control & reporting, full delegation

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Government Control? Government is denied direct information about citizens

Is therefore denied some measure of control Multi-layered structure

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

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

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

Version 2 (Tax authority, taxpayer). A simplified model of delegation. 2 Corruption: focus on incentives facing the inspector level

Taxpayer offers payment to inspector to reduce prob of punishment Inspector is monitored by authority.

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Questions in enforcement policy

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

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

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

Implications for tax design?

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Connection with previous topic Related to compliance lecture Examine general issues of “breakdown” in fiscal

relationships tax under-reporting is one example also black/shadow economy

And the mechanisms that may act as insulation institutions social factors

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Overview...Background

Objectives and constraints

Optimal policy C&B

Policy Design

Limitations of standard utilitarian model

Optimal policy Strategic

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Modelling issues

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

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

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

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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) in general depends on both tax and enforcement parameters (p, s, t) and

on 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) where y = y , a = a (representative taxpayer) (so we can drop y, a from optimal evasion response)

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Fundamental constraints Realities for the government / tax agency

a fixed revenue requirement R cost of enforcement (p) where is an increasing function in utilitarian modelmay include private compliance costs

Government budget constraint R R which implies ty –rte – (p) R where r is the expected rate of return to evasion, 1– p – ps zero evasion if p p0 where (p0) = ty –R

Welfare contour for utilitarianism [1 – p] u([1 – t] y + te) + p u([1 – t] y – ste) = const where e = e(p, s, t)

Evasion eliminated where rate of return is zero: s = [1−p]/p gives zero-evasion contour where welfare is u([1 – t] y) = W0 so determines boundary of “honesty set”

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Model types

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

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

Keep s or p fixed unmovable penal system inflexible police system trade off tax against an enforcement parameter

Vary p, s, t together Total 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 AWelfare contoursB: 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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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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The problem if p,s,t all variable

01

s

pA

objective

constraint

Optimisation problem againTransform the problem

“Enforced honesty” set

Revenue increases to North-East

R = constant

reve

nue

Tax authority moves this way?

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Overview...Background

Objectives and constraints

Optimal policy C&B

Policy Design

A utilitarian approach

Optimal policy Strategic

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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 auditMarginal benefit of auditOptimum 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...Background

Objectives and constraints

Optimal policy C&B

Policy Design

Strategic approach to audit policy

Optimal policy Strategic

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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)

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

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

Iyengar, R. (2008) “I'd rather be Hanged for a Sheep than a Lamb:  The Iyengar, R. (2008) “I'd rather be Hanged for a Sheep than a Lamb:  The Unintended Consequences of 'Three-Strikes' Laws,” NBER Working Paper, 13784Unintended Consequences of 'Three-Strikes' Laws,” NBER Working Paper, 13784

Iyer, G.S. , Reckers, P.M.J. and Sanders, D.L. (2010) “Increasing Tax Compliance Iyer, G.S. , Reckers, P.M.J. and Sanders, D.L. (2010) “Increasing Tax Compliance in Washington State: A Field Experiment,” in Washington State: A Field Experiment,” National Tax JournaNational Tax Journal, l, 6363,7-32,,7-32,

Reinganum, J. F. and L. L. Wilde (1985) “Income tax compliance in a principal-Reinganum, J. F. and L. L. Wilde (1985) “Income tax compliance in a principal-agent framework agent 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 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-, 739-760. 760.

* Slemrod, J. and Yitzhaki, S. (2002) “Tax avoidance, evasion and * Slemrod, J. and Yitzhaki, S. (2002) “Tax avoidance, evasion and administration,” administration,” Handbook of Public EconomicsHandbook of Public Economics, Volume 3, pp 1423-1470, North-, Volume 3, pp 1423-1470, North-Holland, ElsevierHolland, Elsevier