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

29 commitment to enforcing the tax laws. If the perception becomes widespread that the government is not willing to detect and penalize evaders, then such a perception legitimizes tax evasion. The rejection of sanctions sends a signal to each individual that others do not wish to enforce the tax laws and that tax evasion is in some sense socially acceptable, and the social norm of compliance disappears. Such an outcome is common in many countries, such as the Philippines and Italy where it seems to be accepted that tax evasion is the norm. The introduction of a tax amnesty may also affect the social norm of compliance. A tax amnesty gives individuals an opportunity to pay previously unpaid back taxes without being subject to the penalties that the discovery of evasion normally brings. Such amnesties may reduce compliance if honest taxpayers resent the tax forgiveness given to tax cheats (and if individuals believe that the amnesty may be repeated again). 16 B. Normative Considerations in Tax Administration As noted above, the economics-of-crime approach to tax compliance suggests that compliance can be increased by greater enforcement efforts. However, the desirability of such a policy is not as obvious as it seems, for several reasons. For one thing, there is a widespread belief that "the punishment should fit the crime." Imposing draconian penalties on, say, small amounts of noncompliance would likely violate most peoples' notions of tax equity. A similar notion is that penalties should be chosen to ensure deterrence on the margin (Stigler, 1970). Moreover, although higher penalty and audit rates entail benefits from increased tax revenues and so expanded 16 See Andreoni (1991) and Malik and Schwab (1992) for theoretical analyses of tax amnesties. Empirical and experimental analyses of amnesties are discussed later. 27

30 public services, they also involve costs, both to the government that must use real resources in its efforts and to the individuals who suffer a loss in utility from greater enforcement. Finally and relatedly, it may be inappropriate to increase the tax authority's budget, even if a dollar spent on enforcement increases collections by more than one dollar: the additional budget allocation represents a real resource cost, while the additional revenues are simply a transfer from the private to the public sector (Slemrod and Yitzhaki, 1987; Alm, 1988a). Put differently, a standard benefit-cost criteria for tax administration -- increase the enforcement budget until another dollar of administrative expenditures generates an additional dollar of revenues (Goode, 1981) -- is almost certainly inappropriate. Instead, the optimal size of a tax administration agency must involve equality between the marginal costs and benefits of its enforcement budget, where the benefits should include the added revenues but should also reflect the impact of greater induced honesty and the loss in individual expected utility. 17 In short, it may well be that the best government policy is a pragmatic one, which recognizes that evasion cannot -- and should not -- be completely eliminated (Polinsky and Shavell, 1984). Such a policy should include greater enforcement, but should also emphasize many of the factors noted above: the use of source withholding, third-party sources of information, efficient record keeping, computerization, appropriate audit selection, an emphasis on the social obligations of compliance, the wise use of taxpayer dollars, and so on. Until more is known about evasion, this strategy may well be the best 17 These considerations have also been examined in several theoretical analyses of the optimal tax cum enforcement policies (Sandmo, 1981; Usher, 1986; Kaplow, 1990; Cremer, Marchand, and Pestieau, 1990; Cremer and Gahvari, 1995). The central focus of these papers is the characterization of the optimal tax structure in the presence of tax evasion. 28

31 that is available. V. Empirical Evidence on Taxpayer Compliance and Tax Administration Empirical work has expanded enormously, especially in the last decade. The obvious difficulty here is the absence of reliable information on individual reporting behavior. This information is hard to come by, either for the United States or for other countries: it is difficult to measure something that by its very nature people want to conceal. This difficulty has not stopped researchers. However, there are obvious problems with the data that make much of this empirical work somewhat suspect. For example, most empirical work for the United States has utilized data provided by the IRS through its Taxpayer Compliance Measurement Program (TCMP). As noted earlier, these audits yield an IRS estimate of the taxpayer's "true" income so that a measure of individual tax evasion can be calculated. However, until recently most researchers have not had access to the individual, micro-level data, and instead have been forced to use TCMP data aggregated to the 3-digit zip code level, an aggregate measure likely to comprise disparate elements of underreporting that reflect very different motivational factors. Also, TCMP data also have some well-known limitations, notably that the audits do not detect all underreported (or unreported) income and that the audits cannot distinguish between honest errors and intentional evasion. Importantly, as suggested by the theoretical analyses of audit selection, the audit rate is almost certainly endogenous, so that it cannot be used as an explanatory variable in evasion equations unless appropriate econometric techniques are applied. Data for other countries are even more flawed. 29

32 To avoid the problems with the TCMP data, some researchers have used aggregate measures of evasion, such as the amount of income reported or the gap between income reported on tax returns and income in the national income accounts. By necessity, these studies focus on the aggregate, not the individual, response. Other researchers have used surveys of taxpayers, in part to assess factors such as taxpayer perceptions of the probability of detection, the fairness of taxation, and the responsiveness of government in the respondent's reporting decision. Although survey data often have much useful sociodemographic information, these surveys are also subject to a number of methodological problems that makes the reliability of their data highly suspect, as discussed above. State amnesty data have also been used by researchers. Amnesty participants must declare previously unreported income, so that their amnesty declaration can be used as a measure of evasion. However, only some individuals opt to participate in an amnesty, and these participants may not be representative of all taxpayers. In its entirety, this work generates a number of conclusions. Some of the more important are discussed. A. Estimating the Determinants of Taxpayer Compliance 1. Audit Rates Estimation results suggest that a higher audit rate leads to more compliance, with an estimated reported income-audit rate elasticity ranging from 0.1 to 0.2. Witte and Woodbury (1985) and Dubin and Wilde (1988) use cross section information from the 1969 TCMP aggregated to the 3-digit zip code level, and generally find that higher audit rates discourage evasion. Dubin, Graetz, and Wilde (1990b) use pooled time series-cross 30

33 section information on actual IRS collections at the state level for the period They estimate that the decline in federal audit rates from roughly 2 1/2 percent in 1977 to 1 percent in 1986 reduced tax income tax collections by $41 billion; of this, $34 billion represented "spillover effects," or a reduction in payments independent of revenues generated directly from the audits and penalties themselves. Kinsey (1992) and Sheffrin and Triest (1992) examine individual survey data, and also find that compliance increases with a greater (perceived) probability of audit. 2. Tax Rates Most empirical evidence suggests that a higher tax rate generally leads to less compliance, with an estimated underreported income-tax rate elasticity of -0.5 to Clotfelter (1983) uses individual TCMP data for 1969 to estimate using Tobit maximum likelihood methods the determinants of underreported income, for several different types of taxpayers and several different audit classes. He finds that noncompliance increases significantly with marginal tax rates. Crane and Nourzad (1992) examine Michigan tax amnesty data; they also find that evasion is positively affected by marginal tax rates. Slemrod (1985) finds with individual tax return information that the proportion of taxpayers who cluster in the top quintile of a tax reporting bracket tends to rise modestly with marginal tax rates, a result that suggests that individual compliance falls with higher tax rates. In contrast to these studies, Feinstein (1991) pools data from the 1982 and 1985 TCMPs in order to separate more efficiently the effects of marginal tax rates from those of income, and finds no significant impact of marginal tax rates on noncompliance. Recall that the theoretical analysis of compliance generally suggests that a higher tax rate will increase underreported income, so that the bulk of this research is directly counter to the 31

34 theory. 3. Income Higher (true) income leads to higher reported income, with an estimated reported income-income elasticity between 0 and 1 (Witte and Woodbury, 1985; Dubin, Graetz, and Wilde, 1990b; Crane and Nourzad, 1992). 4. Tax Practitioners An increase in tax complexity leads to greater use of a tax practitioner, users of practitioners have different characteristics than nonusers, and the average level of noncompliance is higher for returns prepared with paid assistance. Erard (1993) estimates an endogenous switching model with a micro-level data from the 1979 TCMP, in which the taxpayer jointly chooses whether to seek assistance and whether to comply. He finds that taxpayers who select professional assistance tend to be those who have more (and more complex) tax forms to complete, are older, are married, and face higher tax rates; these results are largely consistent with other work using other data sources (Long and Caudill, 1987; Klepper, Mazur, and Nagin, 1991; Dubin, Graetz, Udell, and Wilde, 1992). Importantly, Erard (1993) also finds that the use of an accountant or an attorney significantly increases cheating. 5. Sociodemographic Variables Sociodemographic variables are important determinants of behavior. The analysis of TCMP data suggests that compliance tends to be lower for individuals who are younger, who are single, and who are self-employed (Clotfelter, 1983; Witte and Woodbury, 1985; Dubin and Wilde, 1988; Dubin, Graetz, and Wilde, 1990b; Feinstein, 1991; Beron, Tauchen, and Witte, 1992). The effects of many other variables, such as race, sex, and 32

35 education, are uncertain. Survey data generally have much richer sociodemographic variables. Analyses of these data suggest similar patterns. B. Assessing the Effectiveness of Tax Administration 1. Audit Selection There is strong evidence that audit rates are endogenous. Dubin and Wilde (1988) and Dubin, Graetz, and Wilde (1990b) use instrumental variables methods to control for the likely endogeneity of audit rates in their aggregate estimates. 18 Perhaps more convincingly, Erard and Feinstein (1996) and Alm, Erard, and Feinstein (1996) combine micro-level TCMP data with similar data from the Oregon Department of Revenue to estimate the factors that determine audit selection. They find that the probability of audit selection is determined by a number of individual tax return items, a result that is consistent with endogenous audit selection. Surprisingly, Erard (1992) finds with microlevel TCMP data that the impact of a prior audit on subsequent compliance behavior is statistically insignificant. There is also evidence that the audit selection criteria of state and federal enforcement agencies are somewhat different (Alm, Erard, and Feinstein, 1996), which suggests that information sharing could increase agency revenues. These results are consistent with a revenue gain from strategic audit selection. In fact, Alm, Erard, and Feinstein (1996) and Erard and Feinstein (1996) estimate that the "shadow value" of additional IRS audit resources ranges from 1 to 8, depending on the audit class; that is, 18 Note that an obvious difficulty here is the selection of an appropriate instrument. Dubin and Wilde (1988) and Dubin, Graetz, and Wilde (1990b) use the IRS state operating budget per return as an instrument; however, this variable may not in fact be exogenous. Note also that Witte and Woodbury (1985) do not control for endogeneity in their analysis of the same data set, so that their equations are misspecified. 33

36 providing $1 to the IRS generates somewhere between $1 and $8 in additional tax collections. The shadow value of additional state audit resources is lower, from 1 to Detection There is convincing evidence that it is important in empirical work to control for the inability of an audit to detect all tax evasion. Feinstein (1990, 1991) and Erard (1997) use what they term "detection controlled estimation" methods to estimate with micro-level TCMP data a two-stage system: first, is a taxpayer noncompliant and, second (conditional on noncompliance), is noncompliance detected? They find that the impact on noncompliance of numerous variables is significantly altered relative to estimation methods that do not control for detection. Their results also suggest that IRS auditors differ significantly in their ability to detect noncompliance, with a detection rate of roughly onehalf of true taxpayer evasion. 3. Tax Amnesties Most evidence shows that a tax amnesty generates relatively small amounts of additional tax revenues, and also seems to have relatively small effects on post-amnesty compliance (Mikesell, 1986; Fisher, Goddeeris, and Young, 1989; Alm and Beck, 1992). 4. Social Norms There is little empirical work on the role of social norms. Pommerehne and Weck- Hannemann (1989) find that tax compliance in Swiss cantons is affected by the process by which collective decisions are made and by individuals' attitudes about the fairness with which they believe they are treated by government officials. These studies have expanded enormously our understanding of the factors that 34

37 affect taxpayer compliance. Given the underlying data and econometric problems, this empirical work needs to be treated cautiously. Further, the various estimated responses vary greatly across the different studies, both in magnitude and even sometimes in sign. Still, these results indicate that taxpayer compliance decisions are affected in largely predictable ways by the fiscal system in which they operate. The results also suggest that the enforcement agency can increase compliance by changing its enforcement strategy but that there are limits to strategies based only on greater enforcement. VI. Experimental Evidence on Taxpayer Compliance and Tax Administration Difficulties with the existing theoretical and empirical literatures have led to the use of experimental economics as an additional approach to compliance research. The use of laboratory experiments in economics began in the early 1960s with work on resource allocation under alternative forms of market organization. Growth in its applications came with the establishment of a well-defined framework for experimental work by Smith (1976, 1982), and laboratory methods are now widely accepted as a methodological approach in the analysis of theory and policy. 19 Laboratory experiments seem particularly well-suited for the study of some aspects of the taxpayer reporting decision. Unlike theoretical work, experiments are not as constrained by the same degree of simplification required in analytical studies of reporting, which allows the impact of numerous factors not amenable to theoretical work to be examined precisely and unambiguously. Unlike empirical work, experiments generate data 19 Davis and Holt (1993) survey much of the experimental literature. 35

38 under different settings in which there is control over extraneous influences. As discussed later, there are some obvious limitations of experimental methods. However, given the weaknesses of other methodologies, there are compelling reasons for the use of experiments. In fact, experimental work has examined a remarkedly rich range of factors in the individual compliance decision, factors that to date have not proven amenable to either theoretical or empirical analyses. A. Creating a Microeconomic System in the Laboratory Experimental economics involves the creation of a real microeconomic system in the laboratory, one that parallels the naturally occurring world that is the subject of investigation. The essence of such a system is control over the environment, the institutions, and the preferences that subjects face. Of these, control over preferences is particularly crucial. As emphasized by Smith (1976), "[s]uch control can be achieved by using a reward structure to induce prescribed monetary value on actions." Smith (1982) identifies several (sufficient) conditions that must be satisfied for control over preferences to be established: CNonsatiation: subjects must prefer more to less CSaliency: the rewards received by subjects must be related to their decisions, so that subjects recognize that their actions affect their outcomes CReward Dominance: rewards must be large enough to offset any subjective costs or benefits that subjects place on participation in the experiment, which requires the payment to subjects of an amount comparable to what they could earn outside the laboratory CPrivacy: each subject must know only his or her own payoffs so that they do not receive any subjective value from the payoffs of other subjects. 36

39 Several other procedures should also be followed in experimental economics. For example, the experiment should be administered in a uniform and consistent manner to allow replicability. The experiment should not be excessively long or complicated, since subjects may become bored or confused. Subjects must believe that the procedures described to them are the procedures actually followed. The instructions provided to subjects should be understandable, should avoid the use of examples that lead subjects to anchor on certain choices that are the subject of the experiment, and should be phrased in "neutral" rather than "loaded" terms, to mask the context of the experiment and to avoid direct reference to the real-world phenomena under investigation. Neutrality increases the experimenter's control over subject preferences and avoids leading subjects to invoke different "mental scripts," which may enable them to fill in (potentially) missing information in the instructions but which also may unpredictably influence their choices. It is sometimes claimed that the use of neutral instructions limits the ability to generalize from the experimental to the naturally occurring setting. In fact, however, it is not possible to generalize beyond the laboratory unless one uses neutral instructions, since the experimenter cannot control (or induce) the values that subjects associate with loaded terms. Applying this framework to the study of tax compliance is straightforward, and the basic design of most compliance experiments is similar. Human subjects in a controlled laboratory are told that they should feel free to make as much income as possible. At the beginning of each round of the experiment, each subject is given income and must decide how much income to report. Taxes are paid at some rate on all reported, but not on underreported, income. However, underreporting is discovered with some probability, and 37

40 the subject must then pay a fine on unpaid taxes. This process is repeated for a given number of rounds. At the completion of the experiment, each subject is paid an amount (the accumulated earnings) that depends on his or her performance during the experiment. Into this microeconomic system, various policy changes can be introduced, such as changes in audit probabilities or audit rules, in penalty rates, in tax rates, in public good provision, in institutions that affect tax equity or social norms, and in other relevant policies or institutions. Results from experimental analyses of tax compliance are discussed next. B. Experimental Results The first experimental study of tax compliance was conducted by Friedland, Maital, and Rutenberg (1978), who examined subject responses to changes in tax, penalty, and audit rates. Numerous experimental analyses have followed. These experimental studies suggest several conclusions, many of which parallel those of the empirical studies but several of which are quite different. 1. Experimental Results on Taxpayer Compliance Audit Rates. Nearly all studies have found that a higher (random) audit rate leads to more compliance, with an estimated reported income-audit rate elasticity ranging from 0.1 to 0.2 (Friedland, Maital, and Rutenberg, 1978; Beck, Davis, and Jung, 1991; Alm, Jackson, and McKee, 1992a, 1992b; Alm, Cronshaw, and McKee, 1993). However, Alm, McClelland, and Schulze (1992) find that this impact appears to be small and nonlinear, so that the deterrent effect of a higher audit rate eventually diminishes. They also find that many subjects appear to substantially overweight the probability of an audit, so that there is far more compliance than is predicted by expected utility theory; indeed, this result is 38

41 nearly universal across all experimental designs. Also, Spicer and Hero (1985) and Webley (1987) find that individuals who have been audited report more income post-audit than individuals who have not been audited. Penalty Rates. In the relevant range of penalty rate changes, compliance increases but only slightly with increases in the fine rate on unpaid taxes (Friedland, Maital, and Rutenberg, 1978; Beck, Davis, and Jung, 1991; Alm, Jackson, and McKee, 1992a, 1992b; Alm, McClelland, and Schulze, 1992). A higher fine rate leads to marginally more compliance, with an estimated reported income-fine rate elasticity less than 0.1. Tax Rates. A higher marginal tax rate often leads to less compliance, with an estimated underreported income-tax rate elasticity of roughly -0.5 (Friedland, Maital, and Rutenberg, 1978; Alm, Jackson, and McKee, 1992b). However, Beck, Davis, and Jung (1991) and Alm, Sanchez, and de Juan (1995) find that reported income rises with higher tax rates. Income. Higher (true) income leads to higher reported income, with an estimated reported income-income elasticity of roughly 3/4 (Alm, Jackson, and McKee, 1992b). Public Good Provision. The presence of a public good financed by voluntary tax payments increases subject tax compliance in a nonlinear manner (Becker, Buchner, and Sleeking, 1987; Alm, McClelland, and Schulze, 1992; Alm, Jackson, and McKee, 1992a, 1992b) The precise public good mechanism differs somewhat across the studies, but typically tax payments are summed across the subjects, this sum is increased by some multiple to reflect the (potential) consumers' surplus that individuals derive from government provision of a public good, and the resulting amount is then divided equally among the subjects. Note that a multiplier greater than one implies that individuals as a group receive more than they pay in taxes. All experiments clearly indicate that compliance is greater in the presence of the public good than in its absence; also, compliance increases in a nonlinear way with the multiplier. These 39

42 Positive Rewards. Like group rewards, individual rewards can provide a significant positive inducement for greater compliance (Alm, Jackson, and McKee, 1992b). When audited and fully compliant taxpayers are eligible for a lottery whose expected value equals the average subject per round income, or when audited and fully compliant taxpayers are given an immediate reward of comparable value, compliance is significantly higher than in other experiments in which rewards were not given but the fine and audit rates were adjusted to keep the expected value of the evasion gamble constant. Tax Complexity and Uncertainty. The presence of taxpayer uncertainty about taxable income and the various fiscal parameters has an ambiguous impact on subject compliance (Spicer and Thomas, 1982; Friedland, 1982; Beck, Davis, and Jung, 1991; Alm, Jackson, and McKee, 1992c). For example, Beck, Davis, and Jung (1991) generally find that greater taxpayer uncertainty about true taxable income leads the taxpayer to report higher taxable income, although the effect depends upon the level of tax, penalty, and audit rates, as well as upon the taxpayer's attitude toward risk. Alm, Jackson, and McKee (1992c) find instead that the impact of greater taxpayer uncertainty about the tax, penalty, and audit rate depends upon the presence of absence of a public good, financed by individuals' tax payments. When subjects receive something for their tax payments, greater uncertainty always lowers compliance; when there is no public good greater uncertainty raises compliance. Sociodemographic Variables. The impacts of only a small number of sociodemographic variables have been examined in the laboratory. Friedland, Maital, and results are consistent with the enormous experimental literature on voluntary provision of public goods (e.g., Bagnoli and McKee, 1991). 40

43 Rutenberg (1978) and Baldry (1987) find that older individuals are more compliant than younger ones. Baldry (1987) also finds that women evade less than men. 2. Experimental Results on Tax Administration Audit Selection. Audit selection methods that utilize information provided on the tax return are far more effective in generating tax compliance than purely random selection methods, even when the random audit rate is 20, 30, or 50 percent (Collins and Plumlee, 1991; Alm, Cronshaw, and McKee, 1993). A cutoff rule, in which a taxpayer who reports less than some cutoff level of income is audited with certainty, is the most effective in increasing compliance, although it requires a large number of audits. Another rule requires that an audited individual will face some back audits if found to be noncompliant in the current period (a conditional back audit rule); this rule is also able to increase compliance significantly, and the audit rate is far lower than the cutoff rule. Auditing an individual found to be noncompliant in the current period with certainty for a number of future periods (a conditional future audit rule) appears to be the least effective of the endogenous rules, although compliance still exceeds that under all random audit rules. Fiscal Institutions. Compliance is affected by the uses of tax revenues and the decision process by which these uses are chosen. Alm, Jackson, and McKee (1993) find that subjects pay more in taxes when they choose via voting the use of their taxes than when the identical use is imposed upon them, that compliance is somewhat greater when the vote is decisive than when the vote is close, and that compliance is significantly and dramatically lowered by the imposition of an unpopular program. Surprisingly, Martinez- Vazquez, Harwood, and Larkins (1992) find that compliance does not seem to be significantly affected by withholding systems, at least beyond the obvious channel that 41

44 withholding reduces the opportunities for evasion. Subjects who find themselves unexpectedly underwithheld do not behave much differently than subjects who are correctly anticipate the underwithholding, and there is little difference in compliance between taxpayers who are under- or overwithheld. Tax Amnesties. Alm, McKee, and Beck (1990) find that a tax amnesty lowers postamnesty tax compliance, largely because the introduction of an amnesty increases taxpayers' expectations of another, future amnesty. However, they also find that a "welldesigned" amnesty, or one in which post-amnesty enforcement efforts increase, can overcome and even reverse the typical post-amnesty decline in compliance. In fact, their results show that compliance is higher when an amnesty is followed by greater enforcement than when enforcement alone increases by an equal amount. Social Norms. The social norm of compliance can be affected by the institutions that face individuals, by individuals' attitudes toward these institutions, and by individual participation in the selection of those institutions. Webley, et al. (1991) find that individuals who have a negative attitude toward government comply less in taxes as a result. Alm, Jackson, and McKee (1993) demonstrate that government can affect compliance by ensuring that individuals have a say in the decision process and by spending taxes in ways consistent with citizen preferences. Also, Alm, McClelland, and Schulze (1997) find that compliance is decreased, often collapsing virtually to zero, when there is a social expression via group selection of the fiscal regime of a willingness to tolerate tax evasion. It is as if the group decision ratifies each individual's decision to evade his or her taxes, and post-vote individual noncompliance is in some sense now justified by the revealed actions of others. However, they also find that compliance can be increased when there 42

45 is a social expression of an unwillingness to tolerate tax evasion. Spicer and Becker (1980) find that perceptions of "fiscal inequity" affect compliance: compliance is lower (higher) among subjects who are told that their tax rate is higher (lower) than that of others. Alm, Sanchez, and de Juan (1995) demonstrate that there are significant differences in the compliance behavior of student subjects in similar experiments but in different countries (Spain versus the United States), thereby suggesting that societal attitudes toward compliance exert a measurable impact on tax compliance. C. Limitations of Experimental Economics There are sound reasons for caution in interpreting and generalizing experimental results. Some early compliance experiments did not follow some now widely accepted procedures of the experimental paradigm, such as the use of repeated experiments and neutral instructions. Much early work also lacked realism because values of the various policy parameters did not approximate real-world values. Although more recent experimental research has generally addressed these problems, some concerns remain, some of which are more real than others. A common criticism of experimental economics is that the student subjects typically used may not be representative of taxpayers. However, there is now much evidence that the experimental responses of students are no different than the responses of other subject pools (Plott 1987); there is also no reason to believe that the cognitive processes of students are different from those of "real" people. Another common criticism is that it is not possible to control for many relevant factors in the laboratory. However, if one cannot control for such factors in the laboratory where the experimenter establishes the institutions, the rules, and 43

46 the reward structure, then one cannot hope to control for these factors in the "naturally occurring world." Of more legitimate concern, the results may well be sensitive to the specific experimental design, so that replication is crucial. It is also possible that subjects may modify their behavior simply because they know that they are participating in an experiment. Most importantly, there is a certain artificiality in a laboratory setting. A decision to report $2 in an experiment is clearly different from a decision to report actual income on an annual tax return, even if the laboratory incentives are salient. In particular, the laboratory setting cannot capture a catastrophic loss such as jail, and it cannot capture the social stigma that some surveys suggest is an important factor in taxpayer reporting. In short, one must use the results from laboratory experiments with some care. However, such use depends largely upon the purpose of the experiment. According to Roth (1987), experiments can be classified into three broad categories that depend upon the dialogue in which they are meant to participate. "Speaking to Theorists" includes those experiments designed to test well-articulated theories. "Searching for Facts" involves experiments that examine the effects of variables about which existing theory has little to say. "Whispering in the Ears of Princes" identifies those experiments motivated by specific policy issues. To date, most experiments on taxpayer reporting have fallen into the first two categories. Although this now seems to be changing somewhat, there remains a natural skepticism among policy makers about the ability of experimental analyses to illuminate some aspects of tax compliance. VII. Conclusions 44

47 It is, I hope, apparent that enormous amounts have been learned about tax compliance and administration in the last 25 years. We have more and better estimates of the extent of tax evasion. We have a much deeper understanding of the factors that motivate individuals to cheat on their income taxes. We have a better comprehension of the tradeoffs that face government in the design and enforcement of tax laws. We know much more about the magnitude of individual behavioral responses, to changes in audit rates, tax rates, and many other policies, both from empirical and experimental work. However, it should also be apparent that enormous amounts remain to be learned about tax compliance and administration. Let me conclude by discussing ten particular areas that I believe require more attention. First, nearly all theoretical analyses of taxpayer behavior, and the empirical analyses that follow from them, are based upon expected utility theory. As emphasized earlier, there are significant limitations in the ability of this theory to explain major aspects of individual compliance behavior; in fact, there is growing dissatisfaction with this approach in the analysis of many other individual choices under uncertainty. Clearly, it is important to apply other theories of behavior to tax evasion, theories that allow the introduction into the compliance decision of numerous factors beyond simply enforcement: overweighting of low probabilities, differential responses to gains versus losses, the presence of social norms and moral sentiments, notions of fairness, satisfaction with government programs, and so on. Approaches that seem particularly useful for detailed investigation include prospect theory (Kahneman and Tversky, 1979) and generalized expected utility theory (Quiggin, 1993). Second, the intertemporal aspects of tax compliance have received little attention. 45

48 Individuals pay taxes over a number of years, and they undoubtedly recognize that their decisions today affect their chances of audit, both now and in the future. With the exception of work by Landsberger and Meilijson (1982), Rickard, Russell, and Howroyd (1982), and Greenberg (1984), the ways in which individuals and the tax agency respond and interact to such intertemporal incentives have largely been ignored. Also, an individual's willingness to comply can change over time in response to such events as the establishment of a tax amnesty or the erosion of other people's willingness to pay taxes. Evolutionary game theory seems a promising avenue for the investigation of these dynamics of tax evasion (Friedman, 1991). Third, the basic model of individual choice has centered on the individual's choice of the total amount of income to declare. However, this decision is not really a single choice, but actually consists of a number of other decisions on the reporting of income types, personal exemptions, deductions, credits, tax schedules, and the like, and the chances of detection of fraudulent claims certainly vary across these many choices. More analysis of the multidimensional nature of reporting decisions is needed. In this regard, the work of Klepper and Nagin (1989a) and Martinez-Vazquez and Rider (1995) represent important recent contributions. Fourth, nearly all analyses of tax evasion in the United State have examined the factors that lead individuals who file tax returns to underreport their incomes. However, there is now some evidence that nonfiling of tax returns is also a serious problem, especially for some occupations (Erard and Ho, 1995). More analysis of nonfilers is an important area for future research. Fifth, most analyses of tax evasion have focused on individual compliance with the 46

49 income tax. Clearly, however, compliance is an important issue for all other taxes, especially the firm decision to comply with the corporate income tax and with sales and excise taxes. For example, Rice (1992) and Greene (1997) have examined some aspects of corporate tax compliance, and Murray (1995) has analyzed firm compliance with sales taxes. More such work is required. Sixth, although individuals may cheat on the taxes they pay to government, they also may cheat on the benefits they receive from government, especially for welfare transfers and tax credits. Compliance with government transfer and benefit programs has only recently begun to receive much needed attention (Scholz, 1994; Joulfaian and Rider, 1996). Seventh, there have been relatively few systematic analyses of compliance in other countries, despite the fact that noncompliance is almost certainly more of a problem in, say, developing countries than in the United States. Data availability is obviously an important reason for this omission. However, recent work by Alm, Bahl, and Murray (1990, 1993) for Jamaica, as part of a comprehensive tax reform, indicates the potential for such work. Working with the full cooperation of the Government of Jamaica, they were able to construct data sets that allowed them to estimate the responses both of employees and of the self-employed to changes in tax, penalty, and audit rates in the individual income tax; they were also able to estimate the criteria by which self-employed income tax returns were selected for audit. Their results demonstrate that Jamaican taxpayers respond in significant ways to the various incentives and that audit selection is endogenous. Eighth, the analysis of strategic tax agency audit selection has considerably expanded our understanding of agency behavior. However, as emphasized earlier, both 47

50 the principal-agent and the game-theoretic approaches have major weaknesses, especially in their implications for optimal audit selection rules. Further analysis of strategic behavior is sorely needed. In particular, the work by Erard and Feinstein (1994a) illustrates the vital role of assumptions about the prevalence of honest and dishonest taxpayers. Also, the ways in which federal and state tax agencies can share information in their selection and audit of returns merits further work (Alm, Erard, and Feinstein, 1996). Experimental analysis of these models is a promising approach. Ninth, although there is budgetary information on the administrative costs of various taxes, there has been relatively little systematic analysis of the determinants of these administrative costs and the effects of these determinants on the quality of tax administration. Put differently, the nature of the tax agency production and cost functions are largely unknown. It seems likely that there are significant fixed costs when a new tax is imposed or when the features of an existing tax are changed, that these policies will involve a stepwise increase in costs, and that there will be economies of scale in tax administration. These costs must clearly affect the ability of the tax administration to enforce compliance with these taxes. As shown by Allers (1994), Sandford (1995), and Hunter and Nelson (1996), there is much scope for systematic empirical analyses of these issues. Especially important here is the estimation of the shadow value of an additional dollar of audit resources. Lastly, recent work by Gould (1996) emphasizes that it is grossly misleading to represent a complex system by a single, so-called representative agent, who behaves in some average or typical way. Instead, most systems have incredible variety -- or a "full house" of individual behaviors -- and the proper understanding of any system requires 48

51 recognition of this basic fact. Indeed, Gould (1996) argues that the way in which a system changes over time is attributable largely to changes in the amount of variation within the system, rather than to changes in some largely meaningless "average" behavior across its individual members. This lesson is especially apt for tax compliance. People exhibit a remarkable diversity in their behavior. There are individuals who always cheat and those who always comply, some who behave as if they maximize the expected utility of the tax evasion gamble, others who seem to overweight low probabilities, individuals who respond in different ways to changes in their tax burden, some who are at times cooperative and at other times free-riders, and many who seem to be guided by such things as social norms, moral sentiments, and tax equity. These findings suggest that it is unlikely that a single unifying theory of tax compliance can ever be devised, one that incorporates the incredible variation in individual behavior exhibited by the many analyses of taxpayer compliance, one that explains the behavior of all individuals at all times, or even one that explains the actions of the same person at all times. Perhaps our research should still be devoted to the pursuit of such a holy grail. More importantly, however, our research needs to recognize that a "theory" of taxpayer compliance must really consist of a "full house" of theories, each explaining the behavior of different individuals at different times. Any tax administration must also recognize that it must address this "full house" of behaviors in devising policies to ensure compliance. Consequently, a government compliance strategy based only on detection and punishment may well be a reasonable starting point for tax administration but not a good ending point. Instead, what is needed is a multi-faceted approach that emphasizes enforcement, but that also emphasizes the much broader range 49

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