Andrew Young School of Policy Studies, Georgia State University
Illegal and intentional actions taken by individuals or firms to reduce their tax payments.
Tax evasion is one of the most common economic crimes, and has been present since the introduction of taxes. People do not like paying taxes, and they pursue many avenues to reduce their payments. Legal methods known as "tax avoidance" take full advantage of the tax code. "Tax evasion" represents illegal and intentional actions by which evaders fail to pay legally due obligations. Individuals and firms evade taxes by underreporting incomes, sales, or wealth; by overstating deductions, exemptions, or credits; or by failing to file appropriate tax returns.
Tax evasion is important for many reasons. It reduces tax collections, thereby affecting taxes that compliant taxpayers face and public services that citizens receive. Evasion creates misallocations in resource use when individuals and firms alter their behavior to cheat on their taxes. Its presence requires that government expend resources to deter noncompliance, to detect its magnitude, and to penalize its practitioners. Tax evasion alters the distribution of income unpredictably; unless tax evaders are caught, they pay fewer taxes than honest taxpayers. Evasion may contribute to feelings of unfair treatment and disrespect for the law, creating a self-generating cycle that feeds upon itself and leads to even more evasion. 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 evasion.
Tax evasion raises many issues. How extensive is it? What leads individuals and firms to cheat on their taxes? What is the evidence on behavioral responses? What are appropriate government policies toward evasion? Each issue is considered. (For comprehensive surveys on various aspects of tax evasion, see Roth, Scholz, and Witte 1989; Cowell 1990; Elffers 1991; Andreoni, Erard, and Feinstein 1998; Alm 2000; and Slemrod and Yitzhaki 2002.)
Measurement of tax evasion
A major difficulty in analyzing evasion is in its measurement (Schneider and Enste 2002). After all, individuals have incentives to conceal their cheating. Several direct and indirect methods have been developed to measure evasion, all subject to imprecision and controversy.
One direct method relies on information generated by the tax authority as part of its audit process. For example, from 1965 to 1988 the United States Internal Revenue Service (IRS) conducted line-by-line audits of individual tax returns for its taxpayer compliance measurement program (TCMP) on a roughly three-year cycle. These audits yielded an estimate of the taxpayer's "true" income, allowing measures of individual and aggregate tax evasion to be calculated. However, TCMP data had some serious deficiencies. The audits did not detect all underreported income (especially income arising from the "underground economy"), nonfilers were not often captured, honest errors were not identified, and final audit adjustments were not included. TCMP information is now quite outdated.
Another direct method involves surveys. These surveys are typically designed to elicit taxpayers' attitudes about their reporting, but such 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.
Indirect methods attempt to infer the magnitude of unreported income from its traces in other, observable areas. One approach looks at discrepancies between income and expenditures in budget surveys or in national income accounts. Another looks at discrepancies between "official" labor force participation rates and estimates of "true" participation rates. A third approach looks for traces of unreported income in monetary aggregates. All these methods are subject to serious criticisms. They may simply compound measurement errors, they attribute all discrepancies to unreported income, and often they are able to estimate only the change in unreported income over some period, not its absolute level.
Despite these measurement difficulties, it appears that tax evasion is a widespread and growing problem in the United States. The most reliable estimates project the amount of the federal "tax gap"-or the amount of federal income taxes due but not collected-at $127 billion for 1992 and suggest an annual growth rate of roughly 10 percent since 1973 (Internal Revenue Service 1996). More recent IRS estimates put the 2002 tax gap at $311 billion. State and local governments also report problems with noncompliance and evasion. Evidence from other countries suggests that tax evasion is even more widespread than in the United States.
Theories of tax evasion behavior
The basic theory used in nearly all compliance research builds on the economics-of-crime model, in which an individual maximizes the expected utility of the tax evasion gamble, balancing the benefits of successful cheating against the risky prospect of detection and punishment. This approach concludes that compliance depends largely upon audit and fine rates. Indeed, its central conclusion is that an individual pays taxes only because of the fear of detection and punishment, and will pay more taxes with an increase in the fine or audit rate. Surprisingly, an increase in the tax rate generally has an ambiguous effect on reported income; under plausible assumptions, compliance actually rises with higher tax rates.
However, it is clear to many observers that compliance cannot be explained entirely by the level of enforcement. The levels of audit and penalty rates are set at such low levels that most individuals would evade if they are rational because it is unlikely that cheaters will be caught and penalized.
This observation suggests that the compliance decision must be affected by factors not mentioned in the basic model, or must be affected in ways not captured appropriately by the theory. Many attempts have been made to expand the basic model to include other factors, such as
- government services,
- uncertainty enforcement,
- tax complexity,
- endogenous audit rules,
- use of paid preparers,
- labor supply and occupational choice,
- tax avoidance,
- structure of taxation,
- overweighting of low probabilities, and
- tax amnesties (see tax amnesty).
Other factors may well be relevant. In particular, there is increasing evidence that societal institutions, including the existence of a "social norm" of compliance and the presence of an effective but service-oriented tax administration, are crucial and influence the magnitude of tax evasion; indeed, these institutions are closely linked, and work together to help determine the extent of tax evasion. However, no single theory has been able to incorporate more than a few of these factors in a meaningful way.
Evidence on tax evasion behavior
There is a growing body of empirical literature on the responses of individuals in their tax evasion behavior, largely focusing on the United States. As emphasized above, availability of data is a major difficulty, and the evidence is drawn creatively from many sources. The most extensively used source is TCMP data. Others include taxpayer returns, survey data, national income accounts, and laboratory experiments.
In its entirety, this work suggests the following patterns of evasion:
- Tax evasion varies greatly across types of income. The percentage of wage income that is voluntarily reported is much higher than that for self-employed income.
- Unreported income increases (but less than proportionately) with income.
- A higher audit rate leads to more compliance, at least to a point, with an estimated reported income-audit rate elasticity ranging from 0.1 to 0.2.
- A higher fine rate leads to marginally more compliance, with an estimated reported income-fine rate elasticity less than 0.1.
- A higher tax rate leads to less compliance, with an estimated reported income-tax rate elasticity of -0.5 to -3.0.
- There is strong evidence that audit rates are endogenous and that this endogeneity increases the efficiency of the tax agency.
- An increase in tax complexity leads to greater use of a tax practitioner, and the average level of noncompliance is higher for returns prepared with paid assistance.
- Prior audit experience has an uncertain impact on subsequent compliance. Experimental studies suggest that post-audit compliance increases, while empirical evidence indicates little if any effect on future reporting behavior.
- The audit selection criteria of state and federal enforcement agencies are somewhat different, suggesting that sharing information could increase agency revenues.
- Rewards can provide a significant positive inducement for greater compliance. More broadly, the provision of taxpayer services can increase compliance.
- Many individuals substantially overweight the probability of an audit.
- Individuals pay more in taxes when faced with a public program that they have selected, that they value, and that they know enjoys widespread support.
- The social norm of compliance can be affected by the institutions that face individuals and by individual participation in the selection of those institutions.
- Demographic variables are important determinants of behavior. For example, at an individual level, compliance tends to be higher for individuals over the age of 65, for females, and for households in which the household head is married. When the voluntary compliance rate is examined at the ZIP Code level, compliance is higher when the non-white proportion of the population is lower, among other things.
Given the underlying data problems, these patterns need to be viewed cautiously. Still, these results indicate that the enforcement agency can increase compliance by changing its enforcement strategy, but that there are limits to strategies based only on greater enforcement.
Governments everywhere wish to increase tax compliance. The standard policy prescription has long been an increase in penalty and audit rates. Both theoretical and empirical work indicates that greater enforcement can increase compliance. Sufficient-and draconian-increases in penalties and audit rates could substantially eliminate evasion. Conversely, lower enforcement is predicted to generate greater levels of noncompliance.
Indeed, one explanation for the increase in the United States tax gap over time is the secular decline in IRS enforcement activities. The percentage of individual returns that are audited has fallen from 6 percent in the 1960s to a current level of roughly 0.5 percent. More recently, the IRS staff, including field compliance personnel, has declined significantly. At the same time, the opportunities for evasion have increased, as reflected in a large increase in the number of tax returns (especially those of individuals with "large" incomes) and in the increased use of illegal tax shelters or questionable individual and corporate tax practices.
Nevertheless, it is unlikely that extreme enforcement measures will be implemented. There is a widespread belief that "the punishment should fit the crime." Moreover, higher penalty and audit rates entail 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, it may be inappropriate to increase the IRS budget, even if a dollar spent on more 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. Instead, the optimal amount of government enforcement must equate its marginal costs and benefits, where the benefits should include added revenues but also should reflect the impacts of government-induced honesty and the loss in individual expected utility.
It may well be that the best government policy is a pragmatic one that recognizes that evasion cannot-and should not-be completely eliminated. Such a policy should include greater enforcement, but should also emphasize the use of source withholding, a reliance on computers, social obligations of compliance, positive rewards, the wise use of taxpayer dollars, and individual participation in the decision process. Until more is known about evasion, this strategy may well be the best.
In this regard, it should be remembered that people exhibit 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, and many who seem to be guided by such things as a social norm of compliance. Any government approach toward tax compliance 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 a strategy but not a good ending point. Instead, what is needed is a multifaceted approach that emphasizes enforcement, but that also emphasizes the much broader range of actual motivations that explain why people pay taxes.
There is much that we do not know about tax evasion. We are constantly struggling to measure its extent, to discover its motivations, to estimate individual responses, and to implement appropriate policies. As long as there are taxes, this struggle will continue.
Alm, J. "Tax Compliance and Administration." In Handbook on Taxation, edited by W. B. Hildreth and J. A. Richardson (741-68). New York: Marcel Dekker, Inc., 2000.
Andreoni, James, Brian Erard, and Jonathan Feinstein. "Tax Compliance." The Journal of Economic Literature 36, no. 2 (1998): 818-60.
Cowell, Frank A. Cheating the Government: The Economics of Tax Evasion. Cambridge, MA: MIT Press, 1990.
Elffers, Henk. Income Tax Evasion: Theory and Measurement. Deventer: Kluwer, 1991.
Internal Revenue Service. Federal Tax Compliance Research: Individual Income Tax Gap Estimates for 1985, 1988, and 1992. Publication 7285. Washington, DC: U.S. Department of the Treasury, 1996.
Roth, Jeffrey A., John T. Scholz, and Ann Dryden Witte, eds. Taxpayer Compliance. Vol. 1, An Agenda for Research and Vol. 2, Social Science Perspectives. Philadelphia: University of Pennsylvania Press, 1989.
Schneider, Friedrich, and Dominik H. Enste. The Shadow Economy—An International Survey. Cambridge, MA: Cambridge University Press, 2002.
Slemrod, Joel, and Shlomo Yitzhaki. "Tax Avoidance, Evasion, and Administration." In Handbook of Public Economics, edited by Alan J. Auerbach and Martin Feldstein (1423-70). Amsterdam, The Netherlands: Elsevier Science Publishers B.V., 2002.
Cross references: income tax, federal; tax administration, federal; tax amnesty; taxpayer compliance measurement program.