DISCUSSION PAPERS IN ECONOMICS

Transcription

1 DISCUSSION PAPERS IN ECONOMICS Working Paper No Tax Compliance and Administration James Alm Department of Economics, University of Colorado at Boulder Boulder, Colorado March 1998 Center for Economic Analysis Department of Economics University of Colorado at Boulder Boulder, Colorado James Alm

2 TABLE OF CONTENTS I. Introduction II. Measuring Noncompliance III. Theoretical Foundations of the Individual Tax Compliance Decision A. The Basic Model of Individual Choice B. Extensions of the Basic Model IV. The Design and Administration of Tax Systems A. Government Efforts to Increase Tax Compliance B. Normative Considerations in Tax Administration V. Empirical Evidence on Taxpayer Compliance and Tax Administration A. Estimating the Determinants of Taxpayer Compliance B. Assessing the Effectiveness of Tax Administration VI. Experimental Evidence on Taxpayer Compliance and Tax Administration A. Creating a Microeconomic System in the Laboratory B. Experimental Results C. Limitations of Experimental Economics VII. Conclusions VIII. References

3 "When there is an income tax, the just will pay more and the unjust less." Plato I. Introduction Although it is commonly said that the only things certain in life are death and taxes, it is unmistakable that taxes are in fact far from inevitable. Individuals do not like paying taxes, and they take a variety of actions to reduce their tax liabilities. Some of these actions can be classified as tax avoidance, or the legal reduction in tax liabilities by practices that take full advantage of the tax code, such as income splitting, postponement of taxes, and tax arbitrage across income that faces different tax treatment. Tax evasion consists of illegal and intentional actions taken by individuals to reduce their legally due tax obligations. Individuals and firms can evade taxes by underreporting incomes, sales, or wealth; by overstating deductions, exemptions, or credits; or by failing to file appropriate tax returns. For its part, government must take actions to ensure compliance with the tax laws. As discussed in more detail later, tax evasion is difficult to measure. Still, there is widespread evidence that tax evasion is extensive and commonplace in nearly all countries. For the United States, the most reliable estimates suggest that the amount of unpaid federal individual and corporate income taxes totaled $127 billion for 1992, with an annual growth rate of 10 percent since 1973 (Internal Revenue Service, 1988, 1990, 1996). Other taxes at other levels of government are also subject to nonpayment. Evidence from other countries clearly indicates that the American experience is not an isolated one. Tax evasion is important for many reasons. The most obvious is that its presence reduces tax collections, thereby affecting taxes that compliant taxpayers face and public

4 services that citizens receive. Evasion creates misallocations in resource use when individuals alter their behavior to cheat on their taxes, such as in their choices of hours to work, occupations to enter, and investments to undertake. Its presence requires that government expend resources to deter noncompliance, to detect its magnitude, and to penalize its practitioners. Noncompliance alters the distribution of income in unpredictable ways. Evasion may contribute to feelings of unfair treatment and disrespect for the law. It affects the accuracy of macroeconomic statistics. More broadly, it is not possible to understand the true impact of taxation without recognizing the existence of tax evasion. In this chapter I discuss the current research on tax compliance and administration. This literature has grown enormously in only the last 25 years, and it has generated numerous and important insights. The vast bulk of this research has examined compliance and administration of the individual income tax in the United States, and it is this area that I examine. I focus in particular on several key issues in this research. How extensive is tax evasion? What factors motivate individuals to cheat on their taxes? What are appropriate government policies toward evasion? What is the evidence -- empirical and experimental -- on individual behavioral responses? What has been learned, and also what remains to be learned from this research? Each issue is discussed in turn. 1 II. Measuring Noncompliance A major difficulty in analyzing evasion is its measurement. After all, individuals 1 There are other comprehensive surveys of this literature. See in particular Cowell (1990), Elffers (1991), and Andreoni, Erard, and Feinstein (1996). Also, see Roth, Scholz, and Witte (1989) and Slemrod (1992) for useful collections of papers on various aspects of tax compliance. 2

5 have incentives to conceal their cheating. Several methods have been developed to measure evasion. All are subject to much imprecision and controversy. One method relies on information generated by the tax authority as part of its audit process. 2 In the United States, the Internal Revenue Service (IRS) has since 1965 conducted detailed line-by-line audits of a stratified random sample of roughly 50,000 individual tax returns on a roughly 3-year cycle for its Taxpayer Compliance Measurement Program (TCMP); the most recent TCMP was performed in These audits yield an IRS estimate of the taxpayer's "true" income, which allows measures of individual and aggregate income tax evasion to be calculated. Such estimates are probably the most accurate that are available. However, TCMP data have some serious and well-recognized deficiencies: the audits do not detect all underreported income, nonfilers are not often captured, honest errors are not identified, and final audit adjustments are not included. Another direct method involves surveys. 3 These surveys are typically designed to elicit taxpayer attitudes about the roles that such factors as perceptions of the probability of detection, the fairness of taxation, and the responsiveness of government play in their reporting decision. The surveys can also be used to estimate noncompliance. However, the accuracy of surveys is uncertain: individuals may not remember their reporting decisions, they may not respond truthfully or at all, and the respondents may not be representative of all taxpayers. 4 Surveys are also unable to control for many relevant 2 See Internal Revenue Service (1988, 1990, 1996). 3 A large number of surveys have been conducted and analyzed. See, for example, Westat, Inc. (1980) and Yankelovich, Skelly, and White, Inc. (1984), and Harris and Associates, Inc. (1988). 4 Elffers, et al. (1987) clearly document the inaccuracies of survey data. 3

6 determinants of noncompliance. Finally, surveys cannot determine the direction of causality between evasion and its determinants; that is, statements about, say, the inequity of the income tax may result from an ex post rationalization for noncompliance rather than be the ex ante cause of noncompliance. A variety of indirect methods have attempted to infer the magnitude of unreported income from its traces in other, observable areas. These methods have typically been used to measure the amount of activities that take place outside formal markets, in what has commonly been called the underground, shadow, irregular, subterranean, or black economy. One approach looks at the discrepancy between income and expenditure, either in budget surveys or in national income accounts. Another looks at the discrepancy between "official" labor force participation rates and estimates of "true" participation rates. A related approach assumes that there is a fixed and predictable relationship between some observable variable and the amount of unreported income; the most common application here looks for traces of unreported income in monetary aggregates, but other variables (e.g., electricity) have also been used. All of these methods are subject to serious criticisms. They may simply compound measurement errors, they attribute all discrepancies to unreported income, and they are often able only to estimate the change in unreported income over some period, not its absolute level. 5 Despite these measurement difficulties, tax evasion appears to be a widespread and growing problem in the United States. As noted earlier, the most reliable estimates for the United States project the amount of unpaid federal individual and corporate income 5 See Feige (1989) for an extensive discussion of approaches for estimating the size of the underground economy, for the United States and other countries. 4

7 taxes at $127 billion for Of this total, $94 billion is estimated as unpaid individual income taxes, consisting of $72.4 billion from underreporting of income, $10.2 billion from nonfiling of returns, and $11.4 billion from underpaying of taxes. Overall, roughly 85 percent of individual income taxes that are due are actually collected. Estimates from a variety of methods for other countries, such as Argentina (Herschel, 1978), the Netherlands (Hessing, et al., 1987), the Philippines (Manasan, 1988), Jamaica (Alm, Bahl, and Murray, 1990, 1993), and Spain (de Juan, Lasheras, and Mayo, 1994), indicate that tax evasion is a pervasive and extensive phenomenon. 6 III. Theoretical Foundations of the Individual Tax Compliance Decision Since Allingham and Sandmo (1972) and Srinivasan (1973), the standard approach to the analysis of tax compliance has relied upon the economics-of-crime methodology pioneered by Becker (1968). Here a rational individual is assumed to maximize the expected utility of the evasion gamble, balancing the benefits of successful evasion with the risky prospect of detection and punishment. Although their work has been extended in a variety of dimensions, nearly all models continue to use their basic approach. In this section I first review the basic model of individual compliance behavior. There have been numerous extensions to the basic model, and I then discuss these extensions. This overall literature is then assessed. A. The Basic Model of Individual Choice 6 There are also a number of confidential estimates of tax evasion that have been made over the years by the International Monetary Fund and the World Bank, as part of their technical assistance programs. 5

8 The standard economics-of-crime model of compliance is based upon the work of Allingham and Sandmo (1972) and Srinivasan (1973). In its simplest form, an individual is assumed to receive a fixed amount of income I, and must choose how much of this income to declare to the tax authorities and how much to underreport. The individual pays taxes at rate t on every dollar D of income that is declared, while no taxes are paid on underreported income. However, the individual may be audited with a fixed, random probability p; if audited, then all underreported income is discovered, and the individual must pay a penalty at rate f on each dollar that he or she was supposed to pay in taxes but did not pay. The individual's income I C if caught underreporting equals I C =I-tD-f[t(I-D)], while if underreporting is not caught income I N is I N =I-tD. The individual chooses declared income to maximize the expected utility õ U(I) of the evasion gamble, or õ U(I)=pU(I C )+(1- p)u(i N ), where õ is the expectation operator and utility U(I) is a function only of income. This optimization generates a standard first-order condition for an interior solution; given concavity of the utility function, the second-order condition will be satisfied. 7 Note that the probability of detection is assumed here to be fixed and random, so that the audit agency is not allowed to use information from the taxpayers' returns in determining whom to select for audit. It seems obvious that the tax agency can do better in identifying tax evaders if it uses this initial transmission of information from taxpayers 7 The first- and second-order conditions are, respectively, M õ U(I)/MD = pt(f-1)u'(i C ) - (1-p)tU'(I N ) = 0 M 2 õ U(I)/MD 2 = p[t(f-1)] 2 U"(I C ) + (1-p)t 2 U"(I N ) < 0, where each prime denotes a derivative. 6

9 than if it simply ignores the information and audits all taxpayers with equal frequency. Various audit schemes that allow the tax agency to adjust its audit selection in light of information provided by the taxpayer are discussed later, when the behavior of the tax authority is examined. Comparative statics results are easily derived. It is straightforward to show that an increase in the probability of detection p and the penalty rate f unambiguously increase declared income. 8 An increase in income has an ambiguous effect on declared income, an effect that depends upon the individual's attitude toward risk. 9 Surprisingly, an increase in the tax rate t has an ambiguous effect on declared income. A higher tax rate increases the return to cheating, which reduces the amount of declared income. However, a higher tax rate also reduces income; if, as is usually assumed, the individual exhibits decreasing absolute risk aversion, then the lower income makes the evasion gamble less attractive and declared income increases accordingly. In fact, Yitzhaki (1974) has shown that a higher tax rate will increase declared income when the penalty is imposed at a proportional rate on evaded taxes. This economics-of-crime approach gives the sensible result that compliance depends upon enforcement. However, it is essential to recognize that this approach also 8 For example, total differentiation of the first-order condition demonstrates that the impact of a change in the probability of audit on declared income is given by MD/Mp = -[t(f-1)u'(i C ) + tu'(i N )]/[pt 2 (f-1) 2 U"(I C ) + (1-p)t 2 U"(I N )]. Given the second-order conditions (and the obvious requirement that f>1), the sign of this expression is unambiguously positive. Other comparative statics results are similarly derived. 9 There are two standard measures of risk aversion that are considered in expected utility theory. One is absolute risk aversion A(I), equal to -U"(I)/U'(I). The second is relative risk aversion R(I)/-IU"(I)/U'(I). It is typically assumed that A(I) decreases with income, while R(I) increases with income. 7

10 concludes that an individual pays taxes because -- and only because -- of the fear of detection and punishment. Again, this is a plausible and productive insight, with the obvious implication that the government can encourage greater tax compliance by increasing the audit and the penalty rates. This theme is discussed in detail later when government policies are considered. However, it is clear to many observers that compliance cannot be explained entirely by the financial incentives generated by the level of enforcement (Graetz and Wilde, 1985; Smith and Kinsey, 1987; Elffers, 1991). Consider, for example, enforcement policies in the United States. The percentage of individual income tax returns that are subject to a thorough tax audit is quite small and has fallen in recent years to roughly 1 percent. Similarly, the penalty on even fraudulent evasion is only 75 percent of unpaid taxes, and these penalties are infrequently imposed; civil penalties on non-fraudulent evasion are even less (e.g., 20 percent of unpaid taxes). A purely economic analysis of the evasion gamble suggests that most rational individuals should either underreport income not subject to source withholding or overclaim deductions not subject to independent verification because it is extremely unlikely that such cheating will be caught and penalized. However, most individuals pay most of their taxes most of the time, and there are substantial numbers of individuals who apparently pay all of their taxes regardless of the financial incentives they face from the enforcement regime. This dilemma can be illustrated more precisely. Suppose that the utility function of the individual is I 1-e i /(1-e), where the subscript i refers to the state of the world (i=c,n) and e is a measure of the individual's constant relative risk aversion. Using the definitions of I C and I N, the expected utility maximization can then be solved for the optimum amount 8

11 of declared income D*. Now suppose that D* is calculated for specific, realistic values of the various parameters. For example, if t=0.4, f=2, p=0.02, and e=1, then the individual will optimally declare no income. Very large values for relative risk aversion are required to generate compliance consistent with actual U.S. experience. When e=3, declared income is only 14 percent of true income; when e=5, it is still only 44 percent; when e=10, it is 71 percent. Risk aversion must exceed 30 for compliance to exceed 90 percent. However, existing field evidence on the coefficient of relative risk aversion suggests that e ranges between 1 and 2. Risk aversion must be abnormally large for behavior to be even roughly comparable to actual observed choices. As a further illustration of the difficulties of the basic model, consider a slight reinterpretation. Denoting the taxes paid by the individual on declared income as T and the fine on unreported income as F, the expected utility of the individual if he or she declares no income is pu(i-f)+(1-p)u(i), while the certain utility if he or she declares all income is U(I-T). The maximum amount of taxes that the individual will voluntarily pay can be found by equating these two expressions and solving for T; that is; the individual will voluntarily pay taxes only until utility with full declaration equals expected utility with no declaration. Using a linear approximation for the utility function, which implies that the individual is risk neutral, the solution for T is pf, so that taxes equal the expected value of the penalty. An individual who paid more than the expected value of the penalty is worse off than if he or she took a chance in the audit lottery. Even if the fine is as high as half of income, a low value for the probability of detection suggests that voluntary compliance will also be low. 9

12 In short, the basic model of individual compliance behavior implies that rational individuals should report virtually no income. However, compliance with the individual income tax remains relatively high. It seems implausible that government enforcement activities alone can account for these levels of compliance; the basic model, in its reliance on expected utility theory, is certainly unable to explain this behavior. Indeed, the puzzle of tax compliance behavior is why people pay taxes, not why they evade them (Alm, McClelland, and Schulze, 1992). This observation suggests that the compliance decision must be affected by other factors not mentioned by the basic model, or it must be affected in ways not captured by the theory. 10 These considerations are discussed next. B. Extensions of the Basic Model The basic model of individual choice has undergone numerous refinements and extensions since first presented by Allingham and Sandmo (1972) and Srinivasan (1973). Nearly all models of evasion retain its basic features, especially its reliance on expected utility theory. Other models attempt to incorporate noneconomic factors in the compliance decision. Both areas are discussed. 1. Economic Models The vast bulk of the theoretical work has attempted to introduce formally other factors thought to be relevant to the individual compliance decision. One obvious 10 This problem with expected utility theory -- that it is unable to explain adequately much the behavior of many taxpayers -- is not limited to its tax compliance incarnation. Such anomalous behavior has frequently been found in many other areas of choice under uncertainty, particularly in those areas that involve low probability-high loss events (e.g., natural disasters), or in those areas where the decisions of individuals are interdependent and repeated (e.g., voluntary public good provision). Recent surveys by Machina (1987) and Quiggin (1993) document evidence showing that individuals do not typically behave in ways consistent with expected utility theory. 10

13 extension is to allow the individual to choose declared income jointly with additional variables, such as labor supply (Pencavel, 1979; Cowell, 1981), occupational choice (Pestieau and Possen, 1991), and tax avoidance schemes (Cross and Shaw, 1982; Alm, 1988a). Alternative penalty, tax, and tax withholding functions have been considered (Pencavel, 1979; Kesselman, 1989; Yaniv, 1988). The impact of complexity and uncertainty about the relevant fiscal parameters has been analyzed (Alm, 1988b; Beck and Jung, 1989a; Scotchmer and Slemrod, 1989; Cronshaw and Alm, 1995). An increasing number of individuals use paid practitioners in the preparation of their tax return, and the effects of such usage on compliance has been examined (Klepper and Nagin, 1989b; Scotchmer, 1989; Reinganum and Wilde, 1991; Erard, 1993). Individuals receive something from government for their tax payments, and the receipt of government services has been shown to affect the compliance decision (Cowell and Gordon, 1988); that is, individuals pay taxes because they value what they get for their taxes, and they pay more in taxes the more responsive is government in providing what they value. 11 A related aspect is that individuals may be responsive to positive rewards given to them if they are found in the audit process to be honest (Falkinger and Walther, 1991). As discussed later, individuals do not typically face a fixed and random probability of audit. Instead, the tax 11 There is also a large and growing literature on the voluntary provision of public goods that is related to compliance research. See, for example, Axelrod (1984). Much of this literature argues that voluntary provision of public goods may not always play as a "prisoner's dilemma" game, in which each individual has an incentive to free ride on the provision of others. Instead, in many instances individuals will in fact voluntarily contribute to a public good; that is, individuals will pay their taxes. This generally occurs when provision is both repeated and interdependent. In such a setting, one individual's decision to contribute -- or to comply -- depends upon his or her perception of what others will contribute, both now and in the future. If the individual believes that his or contribution is in some sense essential (or "pivotal") to the provision of the public good, then free riding is no longer the unique dominant strategy for the individual. Instead, cooperation -- or compliance -- may become optimal. 11

14 authority often uses information from the tax returns to determine strategically whom to audit, so that the audit probability is endogenous and dependent in part on the behavior of the taxpayer and the tax authority (Reinganum and Wilde, 1985, 1986; Graetz, Reinganum, and Wilde, 1986; Beck and Jung, 1989b; Cronshaw and Alm, 1995). A similar element that generates an endogenous audit selection rule is that individuals pay taxes repeatedly over time, and the audit agency can utilize this intertemporal information in the strategic selection of tax returns (Landsberger and Meilijson, 1982; Rickard, Russell, and Howroyd, 1982; Greenberg, 1984). Other factors are surely relevant. To date, no single theory has been able to incorporate more than a few of these factors in a meaningful way. Unfortunately, the numerous refinements and extensions considerably complicate the theoretical analyses, and generally render clear-cut analytical results impossible. Consider, for example, the addition of labor supply choice to the standard model. Even in the basic model with the assumption of fixed income, any change in the marginal tax rate has an ambiguous effect on compliance. With labor supply endogenous, a change in the marginal tax rate has the standard substitution and income effects on labor supply, thereby making the level of earned income endogenous. It should not be surprising that the effect of tax changes on declared income becomes even more complicated than in the basic model. Similar comments apply to other variations. 2. Noneconomic Factors There has also been some work to expand the basic model of individual choice by introducing some aspects of behavior or motivation considered explicitly by other social sciences. Many of these aspects can be incorporated in "prospect theory," as developed by Kahneman and Tversky (1979). Other approaches that consider such factors as 12

15 deviancy, personal and situational characteristics, social contexts, and attribution theory have also been usefully applied. 12 A first factor is the way in which individuals perceive probabilities. There is overwhelming evidence from psychology that individuals "overweight" the low probabilities that they face in tax compliance (Kahneman and Tversky, 1979); that is, even when fully informed, individuals will systematically act as if the probability of audit that they face is much higher than its actual probability. Overweighting may therefore provide an additional explanation for tax compliance. If taxpayers give more weight to the probability of an audit than they ought to (at least relative to an expected utility model), then compliance will be greater than the level predicted by the standard economics approach. Similar conclusions can be generated by generalized expected utility theory (Quiggin, 1993). A related factor suggested by Kahneman and Tversky (1979) is that many individuals apparently adapt to an unchanged environment and perceive stimuli relative to the environment. Many individuals react much differently to gains than to (equal-butopposite valued) losses. Kahneman and Tversky (1979) therefore suggest that individuals act on the basis of a "value function" (rather than the utility function in economic models). The value function is assumed to depend upon changes in income from some reference point, rather than the level of income itself. It is also assumed to be steeper for losses than for gains because a loss in income is disliked much more than an equal gain, and it is concave for gains (risk aversion) but convex for losses (risk seeking), so that individuals may exhibit risk-averse behavior when confronted with risky but positive gambles, while 12 See Smith and Kinsey (1987), Roth, Scholz, and Witte (1989), Long and Swingen (1991), and Webley, et al. (1991) for discussions and evaluations of many of these alternative theories. 13

16 the same individuals may become risk-lovers when faced with gambles that involve possible losses. The relevance of these assumptions for tax compliance is subtle yet powerful. Since some individuals frame any payment of taxes as a loss, these individuals will be likely to engage in risk-seeking behavior; that is, these individuals will declare less income than predicted by the basic model of expected utility theory. A third factor is that there is much evidence of what may be termed a "social norm" of tax compliance. Although difficult to define precisely, a social norm can be distinguished by the feature that it is process-oriented, unlike the outcome-orientation of individual rationality (Elster, 1989). A social norm therefore represents a pattern of behavior that is judged in a similar way by others and that therefore is sustained in part by social approval or disapproval. Consequently if others behave according to some socially accepted mode of behavior, then the individual will behave appropriately; if others do not so behave, then the individual will respond in kind. The presence of a social norm is also consistent with the framework suggested by Kahneman and Tversky (1979). It is also consistent with other approaches, such as those that rely upon social customs or upon individual feelings of morality, guilt, and alienation. 13 Overall, then, this last factor suggests that an individual will comply as long as he or she believes that compliance is the social norm. Conversely, if noncompliance becomes pervasive, then the social norm of compliance disappears. This perspective also suggests that, if government can affect the social norm of compliance, then such government policies represent another, potentially significant tool in government's battle with tax 13 See Gordon (1989), Erard and Feinstein (1994b), and Myles and Naylor (1996) for examples of these approaches. 14

17 evaders. Of course, policies to change the social norm of compliance are difficult to determine in theory. Some possible policies are discussed later when the behavior of the tax authority is considered. There is considerable intuitive appeal to the potential importance of social norms in tax compliance behavior. There is overwhelming evidence that many countries with roughly the same fiscal system exhibit far different patterns of compliance. There is also much survey evidence from many countries that indicates that compliance is strongly affected by the strength and commitment to the social norm of compliance. 14 These surveys conclude, among other things, that those who comply view tax evasion as "immoral," that compliance is higher if a "moral appeal" to taxpayer is made by government, that the low social standing of tax evaders can be an effective deterrent, that individuals with tax evaders as friends are more likely to be evaders themselves, and that compliance is greater in communities with a stronger sense of social cohesion. Other survey evidence suggests that some people won't pay their taxes if they dislike the way their taxes are spent, if they feel they have no say in the decision process, if they feel that government is unresponsive to their wishes, or if they feel that they are treated unfairly by government; there is also some empirical, experimental, and simulation evidence that compliance is affected by the nature of the collective decision process, at least in democratic countries (Pommerehne and Weck-Hannemann, 1989; Alm, Jackson, and McKee, 1993; Pommerehne, Hart, and Frey, 1994). It seems clear that such sentiments 14 See, for example, Westat, Inc. (1980), Yankelovich, Skelly, and White, Inc. (1984), and Harris and Associates, Inc. (1988) for the United States; Vogel (1974) for Sweden; Lewis (1979) for the United Kingdom; and de Juan, Lasheras, and Mayo (1993) for Spain. 15

18 play an important, perhaps a dominant role, in tax compliance. In their entirety, these various influences on the "social norm" of compliance can be classified into two basic categories. The first relates to how the taxpayer judges his or her own compliance behavior in light of the individual's own feelings about what is proper, acceptable, or moral behavior (what might be termed "internal norms"). The second relates to how the taxpayer feels he or she is treated by government in such areas as the payment of taxes, the receipt of government services, or the responsiveness of government decisions (or "external norms"). Both categories can be analyzed with prospect theory. They can also be usefully examined from a number of other perspectives. 15 Still, applications of all of these alternative approaches to tax compliance remain somewhat limited. Virtually all theoretical work on tax compliance continues to rely in some form upon the expected utility model. In its entirety, there is no question that the theoretical analysis of compliance behavior has generated many insights, especially regarding how an individual responds to greater enforcement activities. Paradoxically, however, this literature is in a sense both too complex and too simple. It is too complex because it is only in the simpler models that clear-cut analytical results can be generated on the compliance impact of basic policy parameters. When more complex dimensions of individual behavior are introduced, the theoretical results generally become ambiguous. It is doubtful that theoretical analysis will 15 See Roth, Scholz, and Witte (1989) for a critical evaluation of many of these alternative approaches. 16

19 yield more meaningful results in the future. The theoretical models of individual choice are also too simple. There are numerous factors that affect the reporting decisions of individuals; for example, the Internal Revenue Service (1978) has listed 64 factors that may affect the reporting decisions of taxpayers. However, theoretical models are capable of including only a few. In short, and as emphasized above, the limited ability to incorporate many relevant factors or to incorporate them in a meaningful way has meant that theories based largely upon expected utility theory are unable to explain the level of tax reporting, even when they have more success in explaining the change in reporting in response to policy innovations. In particular, these models generally imply that rational individuals should pay far less in taxes than they actually do. This is not a mere quibble. It goes to the heart of the basic model, as well as its many extensions, for explaining compliance. IV. The Design and Administration of Tax Systems All tax administrations exist to ensure compliance with the tax laws. This administrative dimension of taxation has long been recognized by tax administrators, especially those working on tax policy in developing countries (Goode, 1981; Bird, 1989; Bird and Casangera de Jantscher, 1992). However, there is relatively little systematic analysis of this dimension, at least by economists. The available evidence from government budgetary information clearly indicates that the budget cost of collecting individual income, business income, and sales taxes is generally in excess of 1 percent of the revenues from these taxes, and can sometimes be substantially higher (Sandford, 1995). In the United States, for example, the IRS collected $1.3 trillion with a budget of 17

20 $7.4 billion in 1994, so that the cost of collecting $100 of taxes was only $.58 (Internal Revenue Service, 1995). Unfortunately, there is little information on how these costs vary with various policy tools; that is, it seems likely that the administrative costs change in large and discrete amounts with the scale of collections and that they may also display economies of scale in their collections, but these aspects of the collection cost technology are not known. As emphasized by Bagchi, Bird, and Das-Gupta (1995), it is helpful to view the tax administration process as a production function, in which "inputs" (e.g., personnel, materials, information, laws, procedures) are used to produce output (e.g., government revenue, taxpayer equity, social welfare). The theoretical analyses discussed above suggest a range of inputs that government can pursue to increase at least one tax administrative output, or government revenues. However, an equally important aspect is the desirability of these policies, or their impacts on equity and welfare. Accordingly, I focus first on the positive analysis of policies to increase compliance; that is, what are the effects of different policy innovations on the level of compliance? I then examine the normative aspects of these policies; that is, what policies should government pursue, under various assumptions about the appropriate goals of government? Throughout, I focus on the broad design of tax administration and say little about its actual, practical details. A. Government Efforts to Increase Tax Compliance 1. Increasing Tax Enforcement The standard administrative prescription for increased tax compliance comes 18

21 directly and quickly from the basic model of individual choice. Recall that this analysis shows that increases in penalty and audit rates unambiguously increase tax compliance. Indeed, sufficient -- and draconian -- increases in penalty and audit rates could substantially eliminate evasion. Of these two instruments, penalty rates are often seen as the preferred tool, since penalties can be increased by the simple passage of a law while higher audit rates require the commitment of additional resources. There are a number of associated measures that a tax agency can take to increase enforcement efforts, as suggested by actual administrative experience in identification, filing, reporting, and collection practices (Bagchi, Bird, and Das-Gupta, 1995). Source withholding has been universally found to increase tax compliance, as long as the withholding agent is carefully monitored. Usage of third-party sources of information, which document things like transactions made and income received, are important in identifying taxpayers and in ensuring accurate reporting; receipts from financial institutions are particularly helpful in this regard. Record keeping within the tax agency is crucial for the most efficient utilization of information. Computers can aid considerably in this task, especially in the cross-checking and the analysis of information; as discussed later, the appropriate analysis of tax return information is a vital aspect of audit selection. Tax forms themselves may influence compliance (and taxpayer compliance costs) if they are unduly complicated, although the precise impact of complexity on compliance is unresolved. It is interesting that actual enforcement efforts in the United States over the last several decades have been somewhat inconsistent with these broad policy suggestions (Dubin, Graetz, and Wilde, 1990a). The percentage of individual tax returns subject to audit has fallen dramatically in recent years, from roughly 6 percent in the 1960s to only 19

22 1 percent in the 1990s. However, at the same time penalties on detected evasion have increased significantly. Also, government use of third-party sources of information, such as information returns and CP2000s, to track income has also increased, despite continued and serious IRS problems with its computer system. The effects of these policies on compliance are discussed when empirical evidence is examined. 2. Selecting Returns for Audit A factor intimately connected to enforcement efforts is the manner by which the tax agency selects tax returns for audit. There are many ways to select individual returns for a tax audit. The simplest and most widely studied is a random audit rule, in which each individual faces a fixed, predetermined probability of audit, regardless of his or her report. Many tax agencies do in fact randomly select some returns for audit. However, much audit selection is heavily dependent on the information received from taxpayers on their tax returns; that is, the government tax authority does not always select tax returns randomly for audit but instead often uses information from the returns to determine strategically whom to audit. The probability of audit is therefore not fixed and random, as assumed in the basic model, but rather is variable and endogenous, depending in part on the behavior of both the taxpayer and the tax agency. From this perspective, there are a number of ways in which the tax agency can utilize the transmission of information from taxpayers in the strategic selection of tax returns for audit. Endogeneity arises largely because the tax agency may choose whom to audit based on the information disclosed by the taxpayer in his or her tax return. The agency might decide which returns to audit based on a previously determined audit selection rule. For example, the IRS uses the results of its previous experience with audited returns to 20

23 devise a formula (the "Discriminant Index Function" or DIF score) that determines which current tax returns to audit based on items reported on the current returns. Selection of returns with a high DIF score increases the high probability that an audit of the return will generate additional assessments. In fact, IRS audits based on the DIF score generate significantly higher amounts of additional assessments than purely random audits, and roughly one-half of all audited returns are selected with this approach (United States General Accounting Office, 1976); many other countries follow a similar practice. Instead, the tax agency might decide which tax returns to audit only after all returns are filed and without an implied commitment to a previously determined audit selection rule. The first type of taxpayer-tax agency interaction is similar to the standard principal-agent model, in which the "principal" (or the tax agency) must design some rule to affect the behavior of the "agent" (or the taxpayer). The second type of interaction can be examined using the standard tools of game theory. Consider the theoretical analysis of each approach. The Principal-Agent Approach. The principal-agent model generates an audit selection rule typically referred to as a "cutoff rule" (Reinganum and Wilde, 1985; Border and Sobel, 1987; Mookherjee and Png, 1989; Sanchez and Sobel, 1993). Here the tax agency announces that any taxpayer who reports less than some minimum, or cutoff, level of income will be audited with certainty; if the taxpayer reports more than the cutoff level, then he or she will not be audited and will pay only the reported tax liability. Theoretical analysis of this cutoff rule indicates that it will raise at least as much revenue as a random audit policy if the cutoff level is chosen appropriately, so that the cutoff rule weakly dominates the random audit rule. Many tax agencies seem to follow an audit selection rule similar to a cutoff rule; that is, within a given audit class, many agencies audit low reports 21

24 with a high probability, while high reports are not audited at all. The optimal cutoff level of income Z can be derived as follows. Consider a taxpayer with true income I. Income of all taxpayers is assumed to be a random variable that is independently and identically distributed according to the cumulative distribution function H(I), where h(i)/h'(i). If I<Z, then the taxpayer will optimally declare D=I because the taxpayer knows with certainty that he or she will be audited and subject to a fine on unpaid taxes if I is not reported. On the other hand, if I$Z, then the taxpayer will declare D=Z because he or she will not be audited if Z is reported and a report higher than Z will merely increase the tax payment. Denoting the lower and upper bounds on the support of h( ) as I L and I U, government revenues R(Z) are therefore R(Z)=I IL Z (ti-c)h(i)di+iz I U tzh(i)di, where c is the constant cost per audit. The first term on the right-hand side of this equation represents the net revenues from those taxpayers whose reported (and true) incomes are less than the cutoff level and who are audited; the second term is the revenues from those who report the cutoff level. Assuming that the tax agency is not subject to a budget constraint and that its goal is revenue maximization, the tax agency will choose the optimal cutoff level of income Z* to maximize revenues. This first-order condition can be easily manipulated to give the condition for the optimal cutoff level as h(z*)/(1-h(z*))=t/c. In the special case of a uniform distribution, Z* has the simple form Z*=I U -c/t, so that Z* decreases in the audit cost, while Z* increases in the tax rate and the upper bound on income. There are several important features of the cutoff rule. One major -- and troubling -- implication is that the tax agency will only audit those taxpayers who report truthfully (e. 22

25 g., those below the cutoff level); that is, only honest taxpayers will be audited, and the agency knows before it selects the returns for audit that these taxpayers are reporting truthfully. This implication is wildly inconsistent with actual audit experiences, since a large percentage of audited taxpayers are in fact shown only in the course of the audit to underreport their income. Another implication is that underreported income increases with income for those above the cutoff level, since individuals with income above the cutoff point will report at the cutoff point; the empirical validity of this implication is not known precisely. A third implication is that audit effort declines the greater is taxpayer reported income; here, evidence is largely consistent with this prediction. The Game Theory Approach. Audit rules generated by a game-theoretic analysis are difficult to classify neatly, and depend upon the precise details of the theoretical model. Typically, these models assume that the taxpayer and the tax agency interact in a sequential-move game. At the beginning of the game, the taxpayer learns his or her income and the tax agency learns its audit technology. In the first stage of the game, the taxpayer decides how much income to report. In the second stage, the agency decides which returns to audit, based upon information contained in the return. The equilibrium of the game is one that specifies a simultaneously determined strategy for both participants: for the taxpayer the amount or the probability of underreporting, for the tax agency the probability of audit. This equilibrium is called a Bayesian Nash equilibrium; that is, both the individual's decision and the agency's decision must represent the best response to the other's action, so that neither has any incentive to change strategy. Unlike the principalagent models, here the tax agency does not precommit to an audit selection rule, but instead chooses its audit rule as a best-response to the taxpayer's decision. 23

26 A variety of these models have been examined, whose features differ in assumptions made about the information available to the individual and the agency, the cost of an audit, the budget of the tax agency, the levels of taxpayer income, the presence of "honest" taxpayers, and the nature of the tax and penalty functions (Reinganum and Wilde, 1986; Graetz, Reinganum, and Wilde, 1986; Beck and Jung, 1989b; Erard and Feinstein, 1994a; Cronshaw and Alm, 1995). Typically, there are many possible equilibria. Because of this feature, no single audit rule emerges from these analyses. Still, the general nature of the audit rule tends to be broadly the same in these models: tax returns with high levels of reported income will not be audited, while returns with low (and falling) reported income will be audited with a positive (and increasing) probability. Some more specific audit selection rules that emerge from these analyses can be called a "conditional back audit" rule and a "conditional future audit" rule. Each rule recognizes explicitly the dynamic aspect to compliance; that is, the tax agency may be able to make use of a taxpayer's history in targeting whom to audit. The conditional future audit rule says that taxpayers found to be noncompliant in the past will be audited more frequently in the future (Landsberger and Meilijson, 1982; Greenberg, 1984). Suppose instead that this same approach is applied to previous periods (the conditional back audit rule). Here individuals audited and found to be dishonest in the current period face the certain prospect that the tax agency will go back in time to previous periods' declarations (Rickard, Russell, and Howroyd, 1982). Both rules have been shown to be more effective in deterring evasion than a simple random audit rule based only on current period declarations. There are some results from these various game-theoretic models that seem quite 24

27 realistic and that are consistent with much actual IRS audit experience. For example, Erard and Feinstein (1994a) show that some audited taxpayers report fully while others do not, that the level of underreporting increases with taxpayer income, and that the agency does not know the true income of any taxpayer until the agency performs an audit. Some, though not all, of the other models generate similar results. However, it is surprising that these models all imply that in equilibrium the agency is indifferent between auditing and not auditing taxpayers. This is a necessary implication of the solution concept of these models, but it is nonetheless bothersome. Also, the comparative statics of these models are not always very intuitive, largely because in a mixed strategy equilibrium (e.g., where each player chooses a strategy with some probability) a player's strategy is chosen not simply to maximize his or her own payoff but rather to ensure that the other player is provided appropriate incentives to choose a mixed strategy. An illustrative example is provided by Cronshaw and Alm (1995). Suppose that the penalty on detected evasion increases. From the taxpayer's perspective, the probability of an audit must then fall to offset the increased penalty, as long as the taxpayer is to remain willing to follow a mixed strategy. From the tax agency's perspective, a higher fine makes auditing more attractive, which raises the probability of audit. However, as just noted, a higher audit probability will make the taxpayer unwilling to follow a mixed strategy. Instead, the audit probability must in fact fall, not rise, and the only way for the audit probability to fall is if the taxpayer cheating probability falls. In short, a higher penalty generates a lower cheating probability (which seems quite intuitive) but also a lower audit probability (which may not seem intuitive). Other game-theoretic models often generate similar counterintuitive results. 25

28 3. Changing Social Norms As noted earlier, social norms (internal and external) are likely to play a major role in the compliance decision. Evidence from other social sciences suggests that these norms can be affected by a variety of government institutions and policies. For example, there is much behavioral science evidence that implies that greater individual participation in the decision process will foster an increased level of compliance, in part because participation implies some commitment to the institution and such commitment in turn requires behavior that is consistent with words and actions. This notion implies that one dimension by which social norms can be affected is via individual participation in the decision process, say, by voting. Also, survey evidence suggests that compliance is higher when taxpayers feel that they have a voice in the way their taxes will be spent. Under such circumstances, they are likely to feel more inclined to pay their taxes. Another dimension by which social norms may be affected by government actions is related to the level of popular support for the government program. Widespread support tends to legitimize the public sector, and so imposes some social norm to pay taxes. This support may be obviously revealed through the voting process. However, the level of support seems likely to affect compliance even when the choice of the public good is imposed on members of the group. Consequently, it seems likely that there will be more tax compliance when the public good provided to a community is popular, even if individuals are unable to articulate directly their support via voting. Survey evidence is largely consistent with this hypothesis. Still another dimension by which social norms can be changed is the government's 26