Cheating Ourselves:

The Economics of Tax Evasion

Political Economy
Research paper

Dumitru Trifan,

WNE.UW. Warsaw 2011.

 Agenda

1.Introduction:............................................................................................................................................................3
2.Tax Evasion in United States...................................................................................................................................3
2.1Tax evasion by Sources of Income....................................................................................................................3
2.2 Who Evades?....................................................................................................................................................4
2.3Big Business and Tax Evasion...........................................................................................................................5
2.4U.S. Tax Evasion Compared to Other Countries...............................................................................................5
3.The Positive Effect of Tax Evasion: Models and Experiments................................................................................6
3.1The Deterrence Model of Tax Evasion..............................................................................................................6
3.2Behavioral Models.............................................................................................................................................6
3.3Normative Theory of Taxation and Policy Implications....................................................................................7
3.3.1Optimal Policy of Taxation.........................................................................................................................7
4.Conclusions.............................................................................................................................................................8
5.Personal Opinion.....................................................................................................................................................8
6.References...............................................................................................................................................................8

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 Cheating Ourselves: The Economics of Tax Evasion

1.Introduction:

In order to assure functionality of the state and economy, it have to exist a tax system. Taxes have to be
perceived as a duty of the citizens to contribute to the general welfare of the society. Is in the nature of the
humans that some people will fulfill this duty and others will not. The state provide many regulations and
laws that make the process of paying taxes a legal responsibility of the people. However, even that these
regulations, and punishments related to them exist, there always were some individuals that avoid to pay
them. If we analyse history, we can find many examples of tax evasion beginning with Roman empire
when people hide their coins in order not pay taxes; in eighteenth-century English homeowners bricked
up their fireplaces to escape notice of the hearth tax collector(Webber and Wildavsky, 1986, p. 141). This
paper will try to answer what are the reasons, the ways of tax evasion and the impact of respectively. One
remark must be done that the term evasion is used in the sense of willful noncompliance.

2.Tax Evasion in United States

In reality it is difficult to distinguish between the legal and illegal tax avoidance, but the US system is
very strict in this sense. The federal law in this direction say that the tax evasion refers to the case when a
person pay less than the law mandates, through commission or fraud, the sentence for this can be a period
in the prison, a fine, or both. There was find two types of tax paying: the willful and inadvertent. First
refers to the case when people don’t pay taxes consciously, the second refers to the case when some
people overpay taxes for different reasons (ignorance, confusion about the tax law). The difficulty imply
the need of an analysis that refers to terms as: evasion, noncompliance, misreporting, tax gap, etc.

2.1Tax evasion by Sources of Income

In US from 1979 exist the state organization called Internal Revenue Service(IRS), that in the frame of a
program of random audits(until 1988), called Taxpayer Compliance Measurement Program(TCMP),
estimate the overall tax gap, by understanding of volume of tax evasion in monetary units. However, the
main purpose of TCMP was the improvement of process of selecting returns for auditors. In 2001 was
launched National Research Program (NRP), which is similar to TCMP. IRS selected about 46,000
returns for examination and, it oversampled high-income returns as well as individual taxpayers who
reported sole proprietorship income. Specifically, of the 46,000 in the overall sample, 21,000 (46 %),
reported income, even though only about 6 percent of individual taxpayers. Auditors make an review of
these returns, and classified them in three categories of action: 1) accept the return as complete reported
by third parties; 2) contact the taxpayer and by correspondence to investigate the return; or 3) conduct an
in-person audit of the return. In contrast to the NRP, the TCMP performed audits on all returns, using a
modified version of the statistical correction procedure developed by Feinstein (1991) for the correction
of errors. Table 1 presents the tax gap figures for 2001. The overall gross tax gap is $345 billion, which
amounts to 16.3 percent of estimated actual tax liability. Is a fact that the noncompliance rate has
remained steady. Of the $345 billion estimate, the IRS expects to recover $55 billion, resulting in the
amount of tax not collected for tax year 2001 of $290 billion, which is 13.7 percent of the tax that should
have been paid. The individual income tax is 2/3 of all underreporting. Individual tax return, is accounted
for less than 10 percent, the corporation income tax makes more than 10 percent, and the employment-
tax gap makes 1/5 of total underreporting. 1 percent of salaries are underreported, and 4 percent of
taxable interest and dividends are misreported, self-employment income and over 57 percent of nonfarm
proprietor income is not reported. Feldman and Slemrod in U.S. find that, reported positive self-
employment income of $1.54 is associated with the same level of contributions as $1.00 of wage and

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salary income, which implies - a self-employment noncompliance rate of 35 percent for farm net income,
the noncompliance rate is 74 percent. In 2006 IRS reported a net misreporting rate of 53.9 per cent.

2.2 Who Evades?

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 Accordingly to 1988 TCMP study, higher-income people evade less than lower-income, in respect to
their true income: those with gross income above $500,000 on average reported 97.1 percent of their
incomes to IRS, compared to just 78.7 percent for those with gross income between $5,000 and $10,000.
One remark is that some of peoples categorized as low-income may have reported business losses, so that
they are not people with low permanent income. Tax noncompliance is related to characteristics of
taxpayers. Andreoni, Erard, and Feinstein (1998, pp. 821–22), married filers and taxpayers younger than
65 have significantly higher average levels of noncompliance than others. Baldry (1987) found evidence,
in an experimental setting, that men evade more than women. The TCMP studies concluded that, within
any group defined by income, age, or other demographic category, there are some who evade, some who
do not, and even some who overstate tax liability.

2.3Big Business and Tax Evasion

Accordingly to Table 1, the IRS estimates noncompliance with the corporation income tax in 2001 is
$30 billion, (rate of 17 percent). The estimated noncompliance rate of the larger companies is lower: 14
percent, compared to 29 percent for corporations (less than $10 million of assets). U.S. General
Accounting Office (1988) estimate that corporation income tax gap come from three sources: For small
corporations the IRS used TCMP data, adjusted for underreporting unlikely to be detected by that method.
In the case of medium-sized corporations, the gap was calculated, based on operational (non-TCMP)
audits from 1980s. For large corporations, examination results were used as the basis of estimates of the
tax gap. The Bureau of Economic Analysis also calculates an annual measure of corporate tax
misreporting(in 2000 - 13.8 percent of the ratio of misreporting to actual liability - close to, but lower
than, the extrapolated IRS estimate). Because of the complexity of tax law, it is hard to say exactly what
is actual tax liability—and therefore what is actual tax noncompliance - is not clear because: mistakes in
characterizing as noncompliance what is legitimate tax planning. Some of the proposed tax deficiency
may involve temporary adjustments in tax liability—due to depreciation that would not increase
respective year’s tax liability, but would in overall increase the present value of tax liability. Hanlon,
Mills, and Slemrod calculated that tax noncompliance of large corporations in the period 1983 to 1998
was 13 percent of true tax liability - lower than the IRS and Bureau of Economic analysis estimates, also
found that the companies with assets bigger than $5 billion have the percentage of tax deficiency almost
74 percent. The calculations show also that private companies have higher proposed deficiency rates than
public companies (17.1percent versus 12.5 percent) and that the annual executive compensation and the
equity incentives from exercisable stock options are in positive relation with proposed tax deficiency.

2.4U.S. Tax Evasion Compared to Other Countries

From general point of view in other countries it was not done a such powerful audit analysis like TCMP
in U.S., and the results of the analysis that was done are not published, the information being received
only by the tax authorities. However we find that Swedish Tax Agency (2004) estimated the overall gap
as a percentage of taxes to be 9 percent in 1997 and 8 percent in 2000. U.K. estimate a tax gap of a
similar magnitude(O’Donnell, 2004). A study in 2005 by the Forum on Tax Administration, a subsidiary
body of the OECD’s Committee on Fiscal Affairs, find that a few countries were prepared to publish their
estimates of overall noncompliance, which was between 4.0 and 17.5 percent (report of the President’s
Advisory Panel on Federal Tax Reform 2005, p. 202). The UK has a gap for its value-added tax in 2003–
2004 and 2004–2005 of 13.5 percent, (HM Revenues and Customs, 2005). Other studies in Europe found
a range of estimated noncompliance rates on this issue(Agha and Haughton, 1996): 40 percent of revenue
uncollected in Italy (Pedone, 1981); 6 percent for the Netherlands in 1976; and 8 percent for Belgium in
1980 (Oldman and Woods, 1983). Silvani and Brondolo (1993) report calculations of the net evasion rate
for the value-added tax in 19 mostly developing countries and report a median evasion rate of 31.5
percent, with New Zealand the lowest at 5.1 percent and Peru the highest at 68.2 percent. The evasion
rates were “prepared by the national authorities following a methodology which compares VAT revenue
collected to potential VAT base (times the average VAT tax rate). Also, there are estimates of relation to
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shadow, not official, economy, measured as a fraction of GDP. The methodology for estimating the
underground economy relies on measurable quantities (for example currency demand, or national general
indicators) and it is obvious that the shadow economy is based on cash. Tanzi (1980, 1983) proposed a
methodology based on regressions explaining the ratio of currency to M2, and he argue that the portion of
this ratio explained by changes in the tax level is an indication of changes in the size of the not official
economy. It is difficult to verify the accuracy of these estimates. According to the calculations of
Mummert and Schneider (2002, Table 1) based on the currency demand approach, in 2001–2002 the US
had the smallest underground economy (in relation with GDP) among 21 OECD countries, at 8.7 percent,
only just more than half the average of 16.7 percent. Italy (27.0 percent) and Greece (28.5 percent) were
the highest. It have to be mentioned that the cost of system of tax administration and enforcement also
have importance. In 2001 the US had the ratio of administrative costs to net-of-refund revenue
collections, at 0.52 percent, compared to a 1.11 percent average, and the lowest ratio of full-time staff of
the national revenue body to the labor force (OECD2004). Most of the registrations in the IRS system
was software operations, computer and computer compared with taxpayer registrations. US require that
individuals file tax returns, in the same time other countries tax authority sends taxpayers a tax return
based on the information they receive from third parties, requiring the taxpayer to check if the
information is correct.

3.The Positive Effect of Tax Evasion: Models and Experiments.

3.1The Deterrence Model of Tax Evasion

The model was proposed by Allingham and Sandmo in 1972. In the model we can find that taxpayers
decide to evade or not and in what amount, theory, was extended by Yitzhaki in 1974, he say that if the
penalty for evasion is proportional to the tax understated, then the tax rate don’t have effect on the terms
of the tax evasion game. If tax rate rises, the cost of a detected understatement of taxes, also rises in the
same proportion to the reward of successful understatement of taxes, so the reward-to-risk ratio is stable,
so a higher tax rate has an income effect , plus, risk aversion increases as after-tax income falls, a higher
tax rate will decrease then, tax evasion. Another level of tax evasion, is at the big companies. Decisions
referring to tax compliance are made by the agents of shareholders, like the chief financial officer or a
person with function responsible for tax matters. Enforcement strategies at the tax director and at the
corporation itself can impact corporate behavior differently, which create important changes in the
responsibility of misreporting. Verifying the model of Allingham and Sandmo, Clotfelter in 1983,
examines the data from TCMP and finds that noncompliance is in a positive relation with the marginal tax
rate. Feinstein, after 8 years finds a negative relation, he analyse using data from two different years in
which tax rate differs as a function of income. Slemrod, Blumenthal, and Christian in 2001 made a
controlled experiment in State of Minnesota Department of Revenue, analyzing the results, they found
that low and middle-income taxpayers that received a letter promising an audit reported more income than
those who didn’t receive this chain of letter. In general, high-income taxpayers that receive an audit
threat on average reported lower income. Also we can say that, noncompliance is related to ambiguity of
items, which argue about the probability of detection of evasion. Also as a example of a lack of
deterrence to tax compliance involves state use taxes, which are due on sales purchased from out-of-state
vendors but consumed in the state of residence, in this case taxes are almost unenforceable. The effect of
detecting noncompliance is important . The reduction of face-to-face audits is due of to computerized
checks as a substitute. In overall, the number of tax evasions detected by IRS declined by 50 percent in
the period 1992 - 2002 . The three main IRS instruments for collecting tax debts from recalcitrant tax
evaders: levies, liens, and outright seizures of property-also declined. From 2000 to 2005, the tax law and
other means of evading taxes increased in order to diminish the danger of tax evasion.

3.2Behavioral Models

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 Given the probability of audit, the penalties for noncompliance, and the knowledge about the risk,
noncompliance should be higher than it is, but is not like this, because the low average audit coverage
area, understates the chances that the average monetary unit of unreported income would be detected.
The salary of employee’s submitted by the employer and Social Security number electronically to IRS,
will be flagged for further scrutiny with a high probability(noncompliance rate of labor income from
Table 1contradict deterrence theory). A experiment of, Scholz and Lubell in 2001prove that there is a
negative relation between the rate of penalties and the cooperation with authorities. Another approach of
Falkinger and Cowell in 1990 did not find a relation between inequities in taxes and noncompliance rate.
The opinions of the peoples are different involving different arguments and attitudes toward government
policies and actions. The important fact is that people act based on these opinions, so for example if an
individual thinks that government act in his interest than he will be honest in paying the taxes, but if he
thinks that procedures are not correct, than he is more likely to decrease rate of tax paying. Perhaps, one
of the most powerful argument of the government is the appeal to the patriotism, this element was often
used in the history especially in the periods of wars (in this times, the argument have the best efficiency,
that can be understand by the reality context). In a context of peace, the instrument of patriotism does not
have much efficiency. An interesting survey was done in the U.S. by the World Values Surveys in 2002,
they find that peoples attitude towards the tax evasion (if they are or not justifiable) is 2.28 from a scale 1-
10(1<=not justifiable; justifiable=>10), for OECD is 2.34. So we can say that only fear of penalties and
higher taxes have the biggest impact on tax compliance, in a positive sense, but only if these actions are
justifiable by the government.

3.3Normative Theory of Taxation and Policy Implications

In developing an optimal policy, the government have to take into consideration if in the case of
elimination of a given level of tax evasion, the benefits will be in the direct interest of the population. Of
course, if this given amount will be obtained by the authorities they probably will spend it for public
interests, but we cannot know if that will increase the efficiency of management of public finances and
how will be then the public opinion towards these actions, plus, in the process of decreasing tax evasion,
will be also spend money. The policy makers must to keep in mind that peoples are predisposed to tax
evasion and they always search for arguments in order to do this, if the policy of the government will give
them these arguments. The tax evasion level depends also on costs of those actions that are alternatives to
official procedures, by meaning that peoples prefer to engage in those actions that not imply tax paying,
but if the costs of these actions will not be opportune, than they, probably will not do them, plus the tax
evasion imply costs of hiding noncompliance. It is important to mention that, the noncompliance reasons
serve as a motivation for the peoples to engage in the ‘black’ work as not official employees of the some
firms. These facts influence the market by lowering the prices for these services or goods produced and it
is also no right in relation to honest tax payers, that have bigger expenses and eventually more high
prices.

3.3.1Optimal Policy of Taxation

The level of tax evasion depend also on the value of penalties and normative regulations related to this
process. Of course the higher will be the penalties, the lower will be the rate of tax evasion, but it have to
be taken in consideration also another factors like: the profitability of doing so for the authorities, because
in order to assure a low rate of tax evasion, must be made many procedures as more audits or to engage
more people to monitor the situation, that is very costly; the probability of an increase in the level of
corruption in the system; the courts will tend to give bigger penalties, here is the case of an honest
mistake that will perceive the system as unfair; and others. So there is many factors that will cause costs
for the economy and state, in this context the process of reducing tax evasion may be not so profitable.
From the another point of view, the government must be more severe with the peoples that are really
guilty in the tax evasion, in order to increase efficiency of tax policies. A crucial factor in the efficiency
of work of tax authority is the ability to rely on reports from firms about wages and salaries paid, and
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other accounting elements and the ability to match correct firm-to-firm sales and firm-to-consumer sales,
in order to apply correct taxes, a more complicated case is about credit-invoice value-added tax (taxes on
input purchases are possible to deduct just if the seller produces an invoice for taxes paid). The ideal case
a would be uniform value-added tax and uniform retail sales tax, but this is the case of a world without
evasion and administrative costs, that is not possible in the reality.

4.Conclusions

It is almost impossible to eliminate tax evasion, this is an old phenomenon that always exist and will
exist in human nature. The heterogeneity across-countries of level of tax evasion depends on the feeling
of duty of taxes and the actions taken by the governments in this direction. However, as we see in the case
of U.S. the noncompliance rate is not so big, especially if we compare it with other countries. In order to
reduce the level on tax noncompliance, the information from different channels must be checked,
correlated with the economic indicators, in a as much as possible efficient process of wok of tax
authorities, in the same time keeping into consideration the possible effects of actions that will be taken,
because as was mentioned before, higher enforcement does not necessarily mean positive effects for the
economy, and eventually a better policy, plus the cost of a higher enforcement can be not profitable. This
issue is complicated and still need more research to be done on it.

5.Personal Opinion

From my point of view, tax evasion is an important problem not only for the authorities, but also for the
society. The full elimination of this phenomenon is impossible but an optimal tax policy can be efficient
in a long run. However an optimal policy does not mean more enforcement or higher penalties, an optimal
policy must be a compromise between the given conditions of present social-economic situation and
future anticipations. Very much depends on the work of tax authorities, that must be as efficient and
correct as possible.

6.References

Main source:
Article:“Cheating Ourselves: The Economics of Tax Evasion”, Joel Slemrod, Journal of Economic
Perspectives 2007.