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Tax Evasion (Allingham-Sandmo (Compliance Puzzle (AS model states that,…
Tax Evasion
Allingham-Sandmo
Formulation:
Original AS assumption: penalty = theta*e
- Penalty is a fraction of undeclared income
Under Yitzhaki (1974): penalty = theta*te
- Penalty is a fraction of undeclared income and tax rate
Comparative Statics
- Evasion is decreasing in probability of detection
- Evasion is decreasing in penalty rate
- If ARA is decreasing, evasion is increasing in true income
- If ARA if decreasing, evasion is decreasing in tax rate
- Under 4th result, as tax increases, evasion decreases
- This may seem counterintuitive, however it is because under Yitzhaki model, penalty rate is expressed as a function of tax
- Thus, with higher taxes, you have higher penalty rate which decreases evasion
- In reality, evasion increases when taxes increase, even if penalties increase
- Thus, the only way to remove this counter-intuitive result is to impose a non-linear penalty function
Compliance Puzzle
- AS model states that, around e=0 (i.e. undeclared income = 0), and marginal expected utility of evasion >0, then people will evade
- Compliance puzzle: AS model predicts that everybody evades taxes, but most people do not do so
- 3 possible reasons: third-party information reporting, misperception, psychology and culture
Third-Party Information Reporting
- AS model assumes pure self-reporting, but modern tax systems use extensive third-party reporting by firms
- E.g., not only do you report your income to HMRC, your employer also reports your income to HMRC. Thus, it becomes more difficult to evade taxes.
- If there is no collusion between taxpayer and the third party, matching of tax returns and third-party information reveal evasion. Thus, observed rate of audit is far below the rate of detection (which is close to 1).
- When taxpayers have both third-party and self-reported income, detection probability is endogenous to under-reported income
- According to IRS estimates, if there is substantial information reporting, tax evasion is 1%. If there is little or no information reporting, tax evasion is 63%.
Misperception
- AS model assumes perfect knowledge of deterrence parameters, but taxpayers may overestimate deterrence
- In other words, taxpayers think it is more difficult to evade taxes, or that there are higher penalties, than there actually is
Psychology and Culture
- Morals, norms, reciprocity, guilt, shame
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Background
Theory usually assumes perfect tax enforcement, i..e zero tax evasion at zero cost. In practice,
- Tax enforcement is costly (~10% of taxes collected in the US) for both the government and private agents
- Tax evasion is substantial in most countries (~15% of income in US federal tax) and particularly large in developing countries