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THEORIES OF TAX EVASION
AND THE HIDDEN
ECONOMY
Nordic Workshop on Tax Evasion
AGNAR SANDMO
Norwegian School of Economics (NHH)
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TAX EVASION: AN OVERVIEW
Point of departure: The expected utility theory of
personal income tax evasion, its assumptions and
predictions.
Extensions, e.g. interaction with labour supply,
indirect tax evasion, optimal taxation.
Relating the literature to the broader concerns of
public finance.
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A BRIEF HISTORY OF
THOUGHT
The older economists (Smith 1776, Pigou
1928) acknowledged the presence of tax
evasion but paid little attention to it.
Musgrave’s treatise (1959) does not mention
it. It entered the literature on public
economics in earnest around 1970. Theory:
Allingham and Sandmo (1972). Empirical
work: A number of studies based on the cash
balance approach.
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INCOME TAX EVASION: THE
PORTFOLIO APPROACH
Basic assumption: The risk averse taxpayer
chooses the amount of income to report with the
objective of maximizing expected utility, V.
V = (1-p)U(Y) + pU(Z),
where p is the (subjective) probability of detection
and Y and Z after tax income in the states of non-
discovery and discovery.
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AFTER TAX INCOME AND
EVASION
Let W be true income and e the amount evaded. Then
Y = W – t(W-e) = (1-t)W +te.
Z = W – t(W-e) – θe = (1-t)W – (θ-t)e.
Here t is the tax rate and θ the penalty rate. θ >t.
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INTERIOR SOLUTION: e > 0
∂e/∂θ < 0.
∂e/∂p < 0.
∂e/∂t = -[(W - e)/(1 – t)](∂e/∂W) + S.
Income effect (< 0) + substitution effect
(> 0).
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THE EXTENSIVE MARGIN
When is it optimal to choose e > 0 ?
Answer: When t > pθ.
Critics of the model have argued that since
this inequality is likely to hold for the large
majority of taxpayers, the model predicts too
much tax evasion.
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DOES THE MODEL PREDICT
TOO MUCH EVASION?
But note: When p = 1, e = 0.
For a large number of taxpayers their
income will be reported separately by the
source of their income, so that it is known to
the tax authority. In this case, no rational
taxpayer will attempt to evade.
In other words, part of W is “non-evadable”.
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FURTHER WORDS OF CAUTION
Taxpayers cannot be assumed to have exact,
objective knowledge of the magnitude of p and θ, and they may be likely to
overestimate them.
Alternatively, the taxpayers may have more
complex preferences than assumed in the
standard model.
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ALTERNATIVE VIEWS OF
TAXPAYER PREFERENCES
The standard model contains a view of taxpayers as calculating and cynical. Many of them probably are but some are not!
Social stigma: V = (1-p)U(Y) + pU(Z, s).
Bad conscience: V = (1-p)U(Y) + pU(Z) – B(e).
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IMPLICATIONS FOR THE
EXTENSIVE MARGIN
In the bad conscience case, the condition for
e > 0 to be optimal becomes
t > pθ + B’(0)/U’(W(1-t)).
The second term on the RHS can be
interpreted as a “conscience tax”.
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ETHICAL INFLUENCES ON
TAX EVASION
These two cases represent “flexible ethics”.
One could also envisage different kinds of
ethical influences, like Kant’s categorical
imperative: “Act according to the maxim
that you would wish to become a universal
law.”
In this case the taxpayer might adopt the
rule e = 0 as a constraint on his behaviour.
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THE ROLE OF PUBLIC
EXPENDITURE
Taxpayer preferences presumably also
include public expenditure, G, so that
V = (1-p)U(Y, G) + pU(Z, G).
As long as taxpayers take no account of the
government’s budget constraint, this does
not change the predictions of the model.
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DISCARDING EXPECTED UTILITY
Some have argued that expected utility makes unrealistic demands on taxpayer rationality and have explored “non-expected utility” alternatives.
One alternative is the Arrow-Debreu state preference theory.
V = Φ(Y, Z)
where Φ is an ordinal utility function.
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IMPLICATIONS OF STATE
PREFERENCE THEORY
Comparative static implications are similar
to the expected utility approach (for e>0).
But a weakness of the approach is that it
does not distinguish between attitudes to
risk and subjective probabilities in its
concept of ordinal preference.
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INTERACTIONS WITH LABOUR
SUPPLY
The portfolio model takes pre-tax income as
exogenous. To capture the interaction with
black labour markets one has to extend the
model to one of consumption-leisure
preferences and variable labour supply.
Time constraint: L + H + h = T
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VARIABLE LABOUR SUPPLY
Y = (1-t)WH + wh
Z = (1-t)WH + (1-θ)wh
The comparative static properties are more
complex than in the portfolio model, mainly
because of the opportunities for time
substitution.
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PARTICIPATION
CONDITION
When is it optimal to do some work in the
hidden economy?
In the simplest model the condition is
W(1-t) < w(1-pθ).
This generalizes the previous condition.
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LABOUR MARKET
EQUILIBRIUM
The study of market equilibrium should analyze the determination of the relative wage w/W.
This will depend both on tax policy parameters and the extent of collusion between employers and employees.
Since w/W is likely to differ between industries, tax evasion and black labour markets will have implications for industrial structure.
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TAX EVASION BY FIRMS
Indirect taxes: Opportunities differ by types of tax (VAT vs. environmental taxes). Can be studied via the portfolio approach, although with risk neutral firms (Marrelli 1984).
Corporate income tax: Essential to study the relationship between managers and owners (Crocker and Slemrod 2005). Requires a contract theoretic approach.
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INTERACTION WITH
OTHER TYPES OF CRIME
Tax evasion often forms part of other criminal
activities, e.g. violation of labour and immigration
acts, laws that regulate financial transactions etc.
Smuggling (Bhagwati and Hansen 1973) is to some
extent a special case of tax evasion but also
concerns import of goods where consumption is
prohibited, e.g. drugs.
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SOCIAL INTERACTION
To understand the extent of tax evasion and black market activity one needs to study the interaction between taxpayers (as in Schelling 1978). The perceived gains from evading taxes may depend on how common evasion is. E.g., the extent of evasion may determine perceptions of the probability of detection or the social stigma associated with detection. This may lead to multiple equilibria that could explain large differences in compliance behaviour between countries.
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CAN TAX EVASION BE IN THE
PUBLIC INTEREST?
Efficiency: By lowering effective tax rates,
tax evasion may – but need not! – lead to
smaller distortions and efficiency losses.
Equity: By relieving the tax burden on low-
income workers, tax evasion may – but need
not! – lead to a more equitable distribution
of after tax income.
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OPTIMAL TAXATION
Efficiency considerations may lead to lower taxes on goods (including labour) for which evasion is important. Intuition: Evasion implies a larger elasticity of the tax base.
But revenue losses must be compensated by increases in other taxes involving distortions and efficiency losses.
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OPTIMAL TAXATION (CONT.)
However, the choice of tax rates must be
considered together with the allocation of
resources to ensure compliance.
These considerations – together with
distributional concerns – lead to a
complicated exercise in the theory of
optimal taxation.
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FURTHER PROBLEMS FOR
OPTIMAL TAX THEORY
Many would argue that tax evasion is
morally objectionable. This raises doubts
about the “welfarist” framework of optimal
tax analysis. Judgements concerning the
fairness of income redistribution may relate
both to the outcome of the redistribution
process and to its moral acceptability.
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INTERNATIONAL DIMENSIONS
In recent decades the emergence of “tax havens”
has become important for the understanding of tax
evasion, particularly related to capital income
(Schjelderup et al. 2009).
This has implications for national and
international distribution of income as well as
international efficiency of resource allocation.
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THE TAX ADMINISTRATION
PERSPECTIVE
In the public finance literature the costs of taxation have mostly been related to the costs of price distortions while administrative costs have been neglected.
The theory of tax evasion can be seen as an attempt to include these costs, thereby contributing to a more balanced assessment of the social costs of taxation (Slemrod).
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THE WELFARE STATE
Tax evasion makes it more difficult to target
instruments to objectives in welfare state policy.
E.g., widespread income tax evasion makes the
progressive income tax less effective as an
instrument of redistribution.
Tax evasion may also reduce the social legitimacy
of the welfare state if some citizens are perceived
as escaping from paying their fair share.