Tax evasion, market adjustments, and income distribution Updated

The standard approach to tax evasion and some extensions

The originators of the standard approach to tax evasion applied the economics of crime model directly to tax evasion (see [5] for a recent assessment). The basic model is essentially a portfolio approach in which a rational individual compares the expected utility of being detected and paying a penalty for tax evasion to the expected utility of being able to keep the evaded tax income. In this simple formulation, the successful evader is the exclusive beneficiary and keeps the entire gains.

However, the portfolio model and its many extensions assume that underlying “prices” (especially income in the simplest form of the model) are fixed and exogenous, and it ignores the broader economic context in which an individual makes the tax evasion decision, including how to spend the evaded tax income. This approach ignores market forces that work to eliminate the tax advantage created by evasion opportunities, as factors and products flow into and out of affected activities and thereby change both factor and product prices. These forces can be analyzed only in a general equilibrium framework.

Several studies have used a general equilibrium approach to examine tax evasion, but, as will be discussed below, no single study has included all of the elements that are essential for a full analysis of the distributional effects of tax evasion. One study uses a multi-consumer, multi-sector general equilibrium model to make qualitative and quantitative assessments of the effects of tax rate changes on evasion activity, relative output prices, and real tax revenues [6]. The study finds that higher tax rates drive resources out of the compliant sector into the evading sector if government consumes products from both sectors in the same proportion as households and if higher tax rates do not affect evasion costs. However, if higher tax rates raise tax evasion costs for individuals who would otherwise comply and if government purchases are biased toward the compliant sector, then higher tax rates could lower tax evasion. Despite the many insights from this work, it is incomplete because it does not allow for uncertainty in individual evasion decisions.

Some other studies allow for uncertainty but have other missing elements. One study analyzes a model with two labor markets that offer differing evasion possibilities and looks at the effects of changes in tax, penalty, and audit rates on the allocation of labor across markets [7]. However, although the study allows for labor markets, it does not consider capital markets and so cannot examine the full range of general equilibrium effects that evasion may create, especially the effects of factor mobility on capital prices and the distribution of capital income.

Another study develops an expected utility model with two types of actors: evaders and compliers [8]. Individuals do not know the true audit rates but learn them over time by looking at the behavior of others. These information cascades are shown to explain the connections between a potential evader, the number of evaders caught in previous periods, and the total number of evaders. However, despite allowing for mobility between evaders and compliers, the study assumes that prices are not affected by this movement.

A more recent study uses a dynamic general equilibrium model to investigate how tax evasion by self-employed taxpayers affects aggregate outcomes and inequality [9]. Self-employed agents can evade a share of their income, but they face the risk of being detected by the tax authority, while workers in these sectors cannot evade taxes and make only consumption and saving decisions. The numerical analysis for US data suggests that tax evasion by self-employed taxpayers affects aggregate outcomes and, through these general equilibrium impacts, also affects inequality. As a result, evasion increases the size of the self-employment sector, but decreases the average size and the productivity of self-employed businesses. Moreover, the economy with tax evasion produces higher aggregate savings and more output than the economy with perfect enforcement. Because higher saving rates lead to lower interest rates and increases in labor productivity lead to higher wages, wealth inequality is actually reduced by evasion. However, while this model incorporates general equilibrium effects and uncertainty in the decision to evade taxes, the model assumes that labor supply is inelastic, it includes only workers and self-employed owners of small businesses, and it allows only for a single consumption good.

Pitfalls in the distributional analysis of tax evasion

The failure to consider all general equilibrium adjustments invariably leads to incorrect conclusions about the incidence of tax evasion [4].

Empirical studies of tax compliance typically take the economic environment as fixed and unaffected by individual compliance decisions. Frequently, findings are adjusted to take into account the impact of existing evasion, such as professionals who do not report income or unskilled workers who are employed in the informal (untaxed) sector of the economy. However, these adjustments are made under the assumption that the evading groups benefit exclusively and fully from the assumed tax evasion. This implicit assumption leads to a variety of errors.

As one example, a study using this type of analysis for Jamaica estimates the tax evasion that occurs through income underreporting and nonreporting and uses these estimates to calculate the true burden of taxation [10]. However, because the study assumes that tax evaders retain all benefits from their evasion, the resulting estimates of the true burden of taxation are misleading. As a second example, another study of income tax reform in Jamaica assumes that, if labor income is more likely than capital income to be generated in the untaxed or informal sector, then the existence of tax evasion makes the tax system more progressive [11]. However, this conclusion will be wrong if the advantages realized by workers get capitalized or competed away by market processes. With easy labor entry into, say, the Jamaican tourism industry, it may not be undocumented workers in the sector who benefit from successful tax evasion but rather the consumers of tourism services, who benefit from lower prices for the services produced by workers who do not pay taxes.

These types of errors are also found in important work that analyzes the historical development of inequality, which generally finds that tax evasion exacerbates inequality. For example, a recent study combines data from random tax audits, leaked information from offshore financial institutions, and national wealth records from Scandinavian countries to estimate the magnitude and distribution of tax evasion [2]. The authors assume that evasion increases wealth disparity because opportunities to evade taxes increase with income. The study finds that taxpayers at the upper end of the wealth distribution (or the top 0.01%) hold 50% of the assets in offshore tax havens and evade almost 30% of personal taxes, compared to an average across all taxpayers of approximately 3%. A subsequent study estimates how tax evasion affects the wealth share of the top 0.01% of the wealth distribution across a sample of developed and developing countries [12]. The authors find that accounting for offshore assets increases the wealth share of the wealthiest substantially, with effects that vary considerably across countries. However, while important, these studies are incomplete because they do not consider general equilibrium effects of tax evasion.

Some essential elements of a complete model on the effects of tax evasion

While some of these studies have added considerably to an understanding of the general equilibrium adjustments that occur with tax evasion, they do not fully address the main distributional effects.

The features that a model must have to capture these distributional effects are [4]: first and foremost, the model should capture the potential general equilibrium effects of tax evasion that induce changes in the relative prices of factors of production and products. Any tax advantage from evasion will be reflected in expected factor income or firms’ expected profits. The potential mobility of resources, especially labor, will then lead to the necessary price adjustments until the advantage is eliminated. The general equilibrium model should also allow for differences in endowments and preferences, so that different groups may benefit differently from changes in relative prices.

Second, the model should incorporate uncertainty in an individual's or a firm's decision to evade taxes in at least one sector of the economy. This uncertainty simply reflects tax evasion as an opportunity facing the individual or firm that has a random payoff; that is, evasion may be successful or it may be detected by authorities, each with associated probabilities and consequences.

Third, the model should allow for varying degrees of competition or entry across sectors, including the sectors in which tax evasion is prevalent. This includes factor mobility, such as labor in the case of income tax evasion; it also includes free firm entry, as in the case of sales tax or corporate income tax evasion. Mobility is critical for showing how much of the tax advantage is retained by the initial tax evaders and how much is shifted elsewhere through factor and product price changes.

A complete analysis of the incidence of tax evasion therefore requires the consideration of general equilibrium effects in a setting in which agents can differ in preferences and endowments, uncertainty is present, and mobility can vary across sectors. At one extreme there might be a case of no shifting at all because, for example, there is no factor mobility or no free entry. In this case, successful evaders keep all unpaid taxes, and there are no changes in relative prices of factors of production or products as a result of the evasion activity. Examples include occupations with strict entry requirements or strong regulations that make mobility difficult. At the other extreme there might be a case in which the tax advantage gets fully shifted because entry is unrestricted and the supply response is large enough to compete away any residual tax advantage. This could happen if there was a very elastic supply of potential taxpayers who had no choice but to work in the untaxed or informal sector. Examples are the presence of a pool of unskilled laborers in a developing economy with limited opportunities for employment or of undocumented workers in a developed economy who also have limited opportunities. It is unlikely that these workers would be able to keep any tax evasion benefit from working in an informal sector. Instead, the likely beneficiaries are buyers of the products and services produced in the informal sector.

These guidelines are used in the following sections to illustrate weaknesses in several recent approaches that analyze the impacts of tax evasion in a general equilibrium framework.

Three examples of computable general equilibrium modeling

This section presents three numerical simulation models that use many of the essential elements for analyzing the general equilibrium effects of tax evasion. These models maintain the basic features of the simplest general equilibrium model of tax incidence: “factor substitution effects” (e.g. the taxed factor bears more of the burden), “factor intensity effects” (e.g. the factor used intensively in the taxed sector bears more of the burden), and “demand effects” (e.g. consumers who purchase more of the taxed product bear more of the burden). These basic features determine the final pattern of the benefits of tax evasion.