THEORIES OF TAX EVASION

AND THE HIDDEN

ECONOMY

Nordic Workshop on Tax Evasion

AGNAR SANDMO

Norwegian School of Economics (NHH)

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.

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.

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.

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.

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).

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.

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”.

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.

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).

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”.

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.

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.

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.

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.

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

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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).

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.