Chapter 5

Tax Administration
Avoidance and Evasion
Why avoidance, evasion and administration
are important in public finance

 Most economic analysis of taxation presumes that tax liability

can be ascertained and collected costlessly.

 This is poor portrayal of the reality, as it is patently untrue.

 For example, in the U.S. the Internal Revenue Service

(henceforth IRS) estimates that about 17% of income tax liability
is not paid.
 Definition of a Tax Administration
 By definition, Tax Administrations administer taxes. They
implement and enforce tax laws, and receive their
mandates by law.
 The core business of the Tax Administration usually
comprises the following activities:
 Assessing, collecting and auditing government-imposed taxes, as
well as preventing fraud;
 Surveillance by customs of goods imported and exported (in order
to assess, collect and monitor the various duties linked with
import and export)
 Other assessment and collection activities on behalf of other
governmental agencies.
…
More specifically, functions of Tax administration include:

 Registration of taxpayers, including detection of non-registration

and
false registration;
 Processing of tax returns, withholdings and third-party information;
 Verification or examination of the correctness and completeness of
received information (including audit activities);
 Assessment of taxes due;
 Handling of administrative appeals and complaints;
 Provision of service and assistance to taxpayers;
 Detection and prosecution of tax fraud; and
 Imposing of penalties and interest payments.
OECD’s General Administrative Principles
 The primary responsibility of a Tax Administration is to
collect the proper amount of tax due to the
government:
 At the least possible cost to the public.
 In a manner which warrants the highest degree of public
confidence in the organization’s efficiency, integrity and
fairness.

 The most cost effective means of collecting taxes is

through the voluntary compliance of the public with the
tax laws.
 The more enforcement activities are necessary, the more
expensive is the administration of the tax system.
OECD’s Principles of Good Tax Administration – Practice
Note (1999), has put forward guidance along the
following lines, among others:

 Relations with tax payers

 Relations with employees
OECD Guidelines- Taxpayers:

The ways which revenue authorities interact with taxpayers impact

on the public perception of the tax system and the degree of
voluntary compliance.

Revenue authorities are encouraged to:

 Apply tax laws in a fair, reliable and transparent manner;
 Outline and communicate to taxpayers their rights and obligations as well
as the available complaint procedures and redress mechanisms;
 Consistently deliver quality information and treat inquiries, requests
and appeals from taxpayers in an accurate and timely fashion;
 Provide an accessible and dependable information service on taxpayers
rights and obligations with respect to the law;
 Ensure that compliance costs are kept at the minimum level necessary
to achieve compliance with the tax laws;
 Use taxpayer information only to the extent permitted by law;
OECD Guidelines- Employees
 Revenue authorities are encouraged to:
 Communicate and uphold high ethical standards in employees:
Ethical standards and rules of conduct for employees should also
be set down in writing
 Identify and resolve conflicts of interest between the public
duties and private affairs of employees;
 Recruit and promote its employees on the basis of merit and
equal opportunity and protect them against arbitrary dismissal;
 Communicate and uphold high professional standards by
providing effective training opportunities to employees to
enable them to address the complex taxation issues associated
with globalization;
 Remunerate employees at a level sufficient to attract and
retain competent individuals.
Tax Evasion and Avoidance

 Tax avoidance - an attempt to reduce tax liability by

legal means, for example, by exploiting loopholes;
• Legal exploitation of the tax regime to one’s own
advantage;
• Divorcing on paper so that wife’s income is not
added together with husband’s income is also a
common device for tax avoidance.
 Tax evasion - attempting to reduce tax liability illegally
(by breaking laws);
 It is an intentional misrepresentation or hiding of the
true state of taxpayers’ affairs;
 The distinction between tax avoidance and tax evasion is a
fine one,
 If you simply do not pay the taxes you owe or fail to report
income or claim a tax deduction that is not within the limits
of the law, then you are evading taxes. Examples:
 Deliberately understate their income;
 Over claim deductions,
 Deducting personal expenses
 Omission of income from irregular sources
Theory of Tax Evasion

11 of 33
• Theoretically, there are a number of factors causing tax
evasion:
• High tax rates- first and foremost reason for evasion which
makes the evasion attractive and profitable
• Complexity of tax laws- demanding lots of time and cost
to comply with:
• Low probability of audit-inadequacy of power and lack of
experienced personnel in the tax authority
• Low penalty rate-penalty in money terms or no penalty
• Level of education-lack of awareness of taxpayers
• Corrupt practices- the general environmental practices
• Peers’ evasion decision- a sense of equity … others are
doing it why not me?
Remedies for Tax Evasion:

 Thorough Overhauling of Tax Laws: One of the main

reasons for tax avoidance and tax evasion is loose
drafting of tax laws which contain several loop-holes
and weak points. Hence, it is necessary to re-draft the
tax laws thoroughly without any loopholes and weak
points.

 Reduction in Tax Rates: The prevalence of high rates is

the first and foremost reason for tax evasion. Hence,
the rate of tax should not be unreasonably high to make
evasion attractive.
…
 Changing the tax rate changes tax revenues through
five channels:
 Direct effect: A higher tax rate raises revenues on a fixed base
of taxation.
 Indirect effects:
 Gross income effect: lowering the amount of labor
supplied, or risk taking
 Reporting effect: a higher tax rate will cause individuals to
reclassify income in ways that are not subject to a tax
 Income exclusion effect: individuals take more advantage
of the deductions and exclusions from gross income that
are used in defining taxable income
 Compliance effect: Individuals’ tend to hide their income.
An example
 Suppose that Bob earns $45,000 per year in wages and
$5,000 per year in cash from mowing his neighbors’
lawns, yielding a total tax base of $50,000.

 Initially, there is a flat 10% tax on income so that Bob

pays $5,000 a year in taxes. Suppose now that the
government tries to double its revenue by raising taxes
to 20%.

 The following figure presents possible actions by BOB

and effect on tax revenue.
16 of 33
Remedies for Tax Evasion- Cont’d

 Replacement of Sales Tax & Excise Duties with VAT: As the

crosschecking is possible in the case of VAT, it is more effective.
Hence, such tax can be introduced instead of sales and excise duties.

 Look at how a VAT works for a kitchen table that has a retail sales
value of $100 and a VAT rate of 20% in the following table. Sales tax
would have the buyer pay $20 tax on the $100 table, offering strong
incentive for the retailer and the buyer to conspire to avoid the tax.

 The VAT proceeds by defining the value added at each stage of

production— the difference between the value of what is produced
and the price paid for the inputs from other firms—and taxing just the
value added.
 …

The total VAT payments are $20, the same as the 20% retail sales
tax on the table. But there is an important difference: the tax is
now self-policing, with each participant in the production chain
having a strong incentive to make sure that the other participants
report correctly.
Remedies for Tax Evasion- Cont’d

Maintenance of Proper Accounts:

Maintenance of proper accounts should be made
compulsory for persons whose business and
professional income exceeds a prescribed limit.

Tightening of Tax Enforcement: This may be

said to be the crucial remedy if the penalties for
violation of tax laws are strictly enforced, the
incidence of tax evasion could automatically be
reduced.
End of chapter