Income tax compliance and evasion: a graphical approach.
Linster, Bruce G.
I. Introduction
Individual income tax compliance has been one of the most significant
applications of Becker's [6] economic approach to criminal activity
and punishment. This paper considers an approach to optimal audit
policies that relies on the dIstribution of risk aversion among
taxpayers and is consistent with some stylized facts about the U.S. tax
system. Rather than considering the tax evasion situation as a game
between the tax collector and identical taxpayers, this model has the
tax collector choose an audit probability to maximize expected tax
revenues net of audit costs knowing that each taxpayer has a reservation
audit probability - the smallest audit probability that would evoke truthful reporting - depending on how averse to risk she is. As the
heterogeneity in the population vanishes, this problem becomes the same
as the tax compliance problem analyzed in Graetz, Reinganum, and Wilde
[9].
This paper extends earlier contributions by analyzing income tax
evasion and compliance with a population that is heterogeneous with
respect to risk aversion. How other parameters of the problem influence
optimal audit probabilities as well as the equilibrium proportion of tax
evaders will be explored. The diversity in preferences over lotteries
leads to some interesting comparative static results. For example, the
impact of an increase in the penalty for lying is ambiguous in this
model. The graphical approach taken here allows us to identify the
relevant factors and how they interact. Additionally, this analysis
makes it clear why the distribution of risk aversion in the population
affects the equilibrium audit probability, but not the proportion of tax
evaders.
This problem has been approached in several different ways.[1] For
example, Clotfelter [7], Slemrod [15], Alm and Beck [2], and Witte and
Woodbury [16] have studied this phenomenon econometrically, but the
dearth of reliable data has made empirical analysis difficult. Other
economists - most noteworthy, Alm, McClelland, and Schulze [5] and Alm,
Jackson, and McKee [4] - have taken a different tack, employing the
methods of experimental economics. While these seminal studies have shed
substantial light on taxpayer behavior, a leap of faith is required to
extrapolate from the laboratory to actual tax compliance decisions.
The theoretical tax compliance literature originally focused on the
behavior of the taxpayer, as in Allingham and Sandmo [1]. That is,
individuals were modeled as expected utility maximizers with exogenously
given audit probabilities. More recent contributions to the theoretical
literature, Reinganum and Wilde [12; 13], and Graetz, Reinganum, and
Wilde [9] for example, have focused on the interaction between taxpayers
and the tax collector. The taxpayers are still modeled as expected
utility maximizers, and the tax collector is assumed to maximize
expected net revenue. The probability an individual taxpayer will be
audited is endogenously determined and depends on the amount of income
the individual reports. Our understanding of the tax compliance problem
has significantly improved because of these studies; however, their
approaches to the problem treat all taxpayers as homogeneous with
respect to risk aversion, avoiding the issue of heterogeneous taxpayers
altogether.
The equilibria in the game theoretic models described above have
properties that may seem implausible. For example, Graetz, Reinganum,
and Wilde [9] require that if the tax collector audits with probability
[Pi] [element of] (0, 1), then both the tax collector and taxpayers are
indifferent between their pure strategy choices - "audit" and
"don't audit" for the tax collector and "report
truthfully" and "lie" for the taxpayer. The first-order
optimization conditions insure that the tax collector will be
indifferent as to whether or not he should audit another return.
However, it is certainly true that only a very small group of taxpayers
will be truly indifferent between lying and being truthful when
reporting tax liability.
An important goal of the research reported here was to develop a
model consistent with certain stylized facts about the U.S. tax system.
The first observation is that the Internal Revenue Service relies on
"voluntary" reporting of the amount of tax owed while having
information on each taxpayer's gross income from employers and
financial institutions. An audit frequently involves the verification of
deductions claimed by the taxpayer. Second, individuals in similar
financial situations frequently respond differently on tax returns. This
may be due to different feelings of social responsibility, but certainly
risk aversion is an important element in tax reporting decisions.(2)
Finally, distinct income groups are audited with different
probabilities. The model described here conforms to the above
observations.
The next section describes the basic framework of the model. Although
similar to the one used by Graetz, Reinganum, and Wilde [9], this model
is substantially more general than its predecessors since it allows for
populations that are not homogeneous with respect to risk aversion. In
the subsequent sections, the equilibrium outcome is discussed, and some
comparative static results are explored. Finally, the results are
summarized.
II. The Model
Since this model focuses primarily on income tax compliance and
evasion, income levels, tax rates, and fines are exogenously determined.
Pencavel [11] and Sandmo [14] have explored the relationship between tax
evasion and labor supply, but the issue is assumed away in this paper.
Treating tax rates and fines as exogenous is reasonably realistic since
they are, after all, usually set by the legislative branch of government
and not the tax collection agency. In order to keep the model tractable,
this analysis assumes there are two possible levels of tax, [T.sub.H]
and [T.sub.L]([T.sub.H] [greater than] [T.sub.L]) for a given gross
income I. We can think of the tax collector receiving reports from
employers and financial institutions, allowing it to sort taxpayers
according to their gross income. However, based upon personal
circumstance, the taxpayer with gross income I is legally obliged to pay
either [T.sub.H] or [T.sub.L]. A taxpayer who is supposed to pay
[T.sub.H] can be thought of as having few deductible expenses while one
who owes [T.sub.L] has more. Further, the proportion of individuals
actually owing the low tax is [Rho].
Each taxpayer with income I will report [T.sub.H] or [T.sub.L] to the
tax collector who chooses [Pi], the probability of an audit for those
reporting [T.sub.L]. Certainly, taxpayers reporting [T.sub.H] should
never be audited. If a "high tax" individual is audited and
discovered to be untruthful, she pays the difference between [T.sub.H]
and [T.sub.L] plus a fine F. It is further assumed that the government
knows the proportion of the population, [Rho], that can truthfully
report [T.sub.L]. A truthful "high tax" individual will have
after-tax income I - [T.sub.H]. An untruthful "high tax"
taxpayer will have an after-tax income of I - [T.sub.L] if she is not
audited and I - [T.sub.H] - F if she is audited. A "low tax"
individual will have after-tax income I - [T.sub.L] in any case.
Taxpayers in this model are allowed to have different preferences
over lotteries, but for ease of exposition they are all assumed to have
expected utility functions for which their risk aversion can be
parameterized. Specifically, the constant absolute risk aversion (CARA)
utility function is used in this analysis.(3) Each taxpayer's
preferences are represented by the von Neumann-Morgenstern utility
function u(y) = -[e.sup.-ay], so the Arrow-Pratt measure of absolute
risk aversion is A(y) = -u[double prime] (y)/u[prime] (y) = a. A higher
value of a represents more risk aversion. The individuals in each income
class are identical in every respect except their attitudes towards
risk.
Measures of absolute risk aversion are distributed according to p: A
[approaches] [0, 1] (where A is the set of possible risk aversion
measures) so that p(a) represents the proportion of the population with
risk aversion parameter a. Further, the cumulative probability
distribution function, P(a) = [summation over z [less than or equal to]
a] p(z), represents the proportion of the population with risk aversion
measure no greater than a. A very large population is assumed so p(a)
can be approximated as a continuous probability density with probability
distribution function P(a) = [integral of] p(z)dz between limits a and
-[infinity].
The taxpayers and the tax collector simultaneously choose from their
respective strategy sets. That is, taxpayers choose to "lie"
or "report truthfully." The tax collector in this model
chooses an audit probability in order to maximize net tax revenue, or
expected gross tax revenue less audit costs which are assumed to be
constant at c per taxpayer audited. It must be true that c [less than]
(1 - [Rho])[[T.sub.H] - [T.sub.L] + F], or the cost of an audit is less
than the maximum possible expected return to an audit.
III. Equilibrium Tax Evasion
Equilibrium is achieved in this model when the tax collector has
chosen the audit probability, [Pi], to maximize expected net revenue
given the proportion of taxpayers reporting untruthfully, and each
taxpayer reports a tax obligation, either [T.sub.L] or [T.sub.H], so as
to maximize expected utility given the probability she will be audited.
When everyone is acting optimally given what others are doing, neither
the tax collector nor any taxpayer will have any regrets.
Solving for the equilibrium outcome is most easily accomplished in
steps. First, notice that a "low tax" individual will always
report [T.sub.L]. A "high tax" taxpayer optimizes by
truthfully reporting [T.sub.H] when
-[Pi][e.sup.-a(I - [T.sub.H] - F)] - (1 - [Pi])[e.sup.-a(I -
[T.sub.L])] [less than or equal to] -[e.sup.-a(I - [T.sub.H])].(1)
She will report [T.sub.L] otherwise. Using the above, we can define
the function [Mathematical Expression Omitted] which assigns to each
possible combination of [Pi], [T.sub.H], [T.sub.L], and F a risk
aversion measure indicating which type of "high tax"
individual will be just indifferent between lying and reporting
truthfully. Another way of looking at this is to note that [a.sup.*]
([Pi], [T.sub.H], [T.sub.L], F) assigns to each vector ([Pi], [T.sub.H],
[T.sub.L], F) the smallest level of risk aversion a "high tax"
individual can have and maximize her expected utility by reporting
truthfully. Specifically, [a.sup.*]([Pi], [T.sub.H], [T.sub.L], F)
implicitly solves
[[e.sup.-[a.sup.*](I - [T.sub.H])]] - [e.sup.-[a.sup.*](I -
[T.sub.L])]]/[[e.sup.-[a.sup.*](I - [T.sub.H] - F)] -
[e.sup.-[a.sup.*](I - [T.sub.L])]] - [Pi] = 0
([e.sup.[a.sup.*][T.sub.H]] -
[e.sup.[a.sup.*][T.sub.L])/[[e.sup.[a.sup.*]([T.sub.H] + F)] -
[e.sup.[a.sup.*][T.sub.L]]] - [Pi] = 0. (2)
It is not difficult to show that (a) [Delta][a.sup.*]/[Delta][Pi]
[less than] 0 and [Delta][a.sup.*]/[Delta]F [less than] 0, or as audit
probability or the fine increases, less risk averse individuals will
begin reporting truthfully; and (b) [Delta][a.sup.*]/[Delta][T.sub.H]
[greater than] 0 and [Delta][a.sup.*]/[Delta][T.sub.L] [less than] 0, or
as the difference between the two taxes increases, "high tax"
individuals who are more risk averse optimize by lying. The intuition for the above results is straightforward and reflects that individuals
will respond in a predictable way if the expected benefit from lying
increases or decreases. It is worth noting that the actual values of the
above partial derivatives depend on the values of [Pi], [T.sub.H],
[T.sub.L], and F.
For notational convenience, [a.sup.*] ([Pi], [T.sub.H], [T.sub.L], F)
will be denoted as [a.sup.*] ([Pi]) until considering comparative
statics. This notation emphasizes that the only choice variable for the
tax collector is [Pi]. Hence, if the tax collector audits with
probability [Mathematical Expression Omitted], any "high tax"
individuals with risk aversion measures of at least [Mathematical
Expression Omitted] will optimize by reporting [T.sub.H], and those less
risk averse will report [T.sub.L].
Analyzing this income tax compliance problem graphically is
straightforward. The tax collector solves the following program
[Mathematical Expression Omitted].
In the above, [Gamma] represents the proportion of high tax
individuals who report untruthfully.
Some simple algebra reveals that the tax collector's optimal
audit probability ([[Pi].sup.*]) is zero if [Gamma] [less than or equal
to] [Rho]c/[(1 - [Rho])([T.sub.H] - [T.sub.L]+ F - c)] and [[Pi].sup.*]
= 1 if [Gamma] [greater than or equal to] [Rho]c/[(1 - [Rho])([T.sub.H]
- [T.sub.L] + F - c)]. In other words, the best reply for the tax
collector is to audit nobody if the proportion of the high tax
individuals reporting [T.sub.L] is smaller than [[Gamma].sup.*] =
[Rho]c/[(1 - [Rho])([T.sub.H] - [T.sub.L] + F - c)]. If the proportion
is greater, the tax collector optimizes by auditing every taxpayer
reporting [T.sub.L], and auditing with any probability [Pi] [element of]
[0, 1] is optimal if the proportion of high tax individuals reporting
[T.sub.L] is [[Gamma].sup.*] = [Rho]c/(1 - [Rho])([T.sub.H] - [T.sub.L]
+ F - c), which does not depend on P(a). To analyze this portion of the
problem graphically, consider the tax collector's best reply to the
proportion of "high tax" individuals reporting [T.sub.L].
Based on the above, the optimal response by the tax collector is
represented by [BR.sub.TC] in Figure 1.
The taxpayers' aggregate response, [R.sub.TP], can also be
summarized graphically, but a four quadrant diagram is required. The
function [a.sup.*]([Pi]) is plotted in the northwest quadrant. Below
that, in the southwest quadrant, the probability distribution function
P(a) is represented. Through the use of a 45 degree line, the
taxpayers' aggregate response, [R.sub.TP] = [Gamma]([Pi]) =
P[[a.sup.*]([Pi])], is reflected into the northeast quadrant. It is
easily shown that [Gamma][prime]([Pi]) =
p([a.sup.*])[Delta][a.sup.*]/[Delta][Pi] [less than] 0, or [R.sub.TP] is
downward sloping.
The equilibrium audit probability ([[Pi].sup.*]) and proportion of
the "high tax" individuals reporting untruthfully
([[Gamma].sup.*]) is found at the intersection of the tax
collector's best reply and the aggregate taxpayers' response
curves in the northeast quadrant. It is interesting to note that the
equilibrium proportion of tax evaders does not depend on the
distribution of the risk aversion parameter in the population. Instead,
it depends only on [Rho], c, [T.sub.H], [T.sub.L], and F. The optimal
audit probability, on the other hand, depends on all the parameter
values.(4) In the next section, the comparative statics of the
equilibrium will be discussed.
IV. Comparative Statics
Some simple comparative static results can be derived from the
graphical solution. First, consider what happens to the optimal audit
probability and proportion of tax evaders if the proportion of "low
tax" taxpayers ([Rho]) or the cost of an audit (c) increases.
Changes in [Rho] or c have unambiguous implications for equilibrium [Pi]
and [Gamma] because they only change the tax collector's best
reply. Specifically, the vertical portion is shifted rightward if either
[Rho] or c increases. Since the taxpayers' aggregate response is
downward sloping, the result is a higher proportion of tax evaders and a
lower audit probability. The underlying intuition is clear.
Now consider changes in any of the other parameters of the problem,
[T.sub.H], [T.sub.L], and F. As before, the graphical approach will
provide some insight that is much more difficult to obtain through
standard calculus techniques. Suppose the fine changes by a small amount
[Delta]F. The vertical portion of [BR.sub.TC] then shifts by
approximately [Delta][[Gamma].sup.*] [congruent] - [Rho]c/[(1 -
[Rho])[([T.sub.H] - [T.sub.L] + F - c).sup.2]][Delta]F which will have a
sign opposite that of [Delta]F. If the fine increases, for example, the
vertical portion of [BR.sub.TC] shifts to the left. The intuition here
is that if the fine increases, the tax collector will be indifferent
between auditing and not auditing at a lower proportion of tax cheaters.
The difference between the comparative statics in this situation and
when only [Rho] or c changes is that the taxpayers alter their behavior
when [T.sub.H], [T.sub.L], or F vary. To complete the comparative static
analysis of the above situation we must examine how taxpayer behavior
will be affected by a change in F. First, notice that if the fine
increases by [Delta]F, the level of risk aversion at which "high
tax" taxpayers become indifferent to reporting truthfully and lying
when the audit probability is [[Pi].sup.*] changes by
[Delta][a.sup.*] = [a.sup.*]([[Pi].sup.*], [T.sub.H], [T.sub.L], F) -
[a.sup.*]([[Pi].sup.*], [T.sub.H], [T.sub.L], F + [Delta]F) [congruent]
[[Delta][a.sup.*]([[Pi].sup.*], [T.sub.H], [T.sub.L],
F)/[Delta]F][Delta]F.
This change is represented in Figure 2 and has a sign opposite that
of [Delta]F.(5) This change, [Delta][a.sup.*], is translated into the
proportion of taxpayers through the cumulative probability distribution
function in the southwest quadrant. This leaves the change in the
proportion of "high tax" individuals who will cheat as
[Delta][Gamma]([[Pi].sup.*]) [congruent] p[[a.sup.*] ([[Pi].sup.*],
[T.sub.H], [T.sub.L], F)][Delta][a.sup.*] [congruent] p[[a.sup.*]
([[Pi].sup.*], [T.sub.H], [T.sub.L], F)][[Delta][a.sup.*]([[Pi].sup.*],
[T.sub.H], [T.sub.L], F)/[Delta]F][Delta]F.
Figure 2 shows us that the equilibrium audit probability will
decrease if
[Mathematical Expression Omitted],
and the equilibrium audit probability will increase if the inequality is reversed. This result is somewhat counterintuitive since the previous
literature on this subject held that an increase in the fine would cause
a decrease in the equilibrium audit probability. Here an increase in the
fine can cause an increase in equilibrium audit probability if the
conditions are right. Specifically, if the slope of the probability
distribution function (probability density) is small enough or the
reservation level of risk aversion is sufficiently unresponsive, an
increase in the fine can lead to an increase in equilibrium audit
probability.
A similar exercise can be used to examine the comparative statics
associated with changes in [T.sub.H] and [T.sub.L]. It can easily be
verified that the equilibrium audit probability will decrease if
[Mathematical Expression Omitted]
or
[Mathematical Expression Omitted]
and the equilibrium audit probability will increase if the
inequalities are reversed.
Another interesting question is what will happen to the equilibrium
audit probability if there is a change in the distribution of risk
aversion in the population. For example, suppose there is a median
preserving spread in the distribution. It can be seen that the effect
such a change will have on the equilibrium audit probability depends on
the equilibrium proportion of high tax individuals who are lying. Notice
in Figure 3 that [BR.sub.TC] is unaffected by a change in the
distribution of risk aversion. However, [R.sub.TP], changes so that a
median preserving (this is also mean preserving if the distribution is
symmetric) increase in the variance of the distribution will lead to an
increase in the audit probability if [[Gamma].sup.*] [less than] 0.5.
However, if [[Gamma].sup.*] [greater than] 0.5, the opposite is true.
The implication is that if [Rho]c/[(1 - [Rho])([T.sub.H] - [T.sub.L] + F
- c)] [less than] 0.5, a median preserving increase in the variance will
lead to an increase in the equilibrium audit probability. The
equilibrium audit probability will decrease if the inequality is
reversed.
Finally, suppose only the mean of the risk aversion parameter
distribution changes. Specifically, suppose the mean increases while all
other parameters of the distribution stay the same. It is clear that
such a change will lower the aggregate taxpayer response without
changing the tax collector's best reply. The result will be an
unambiguous decrease in equilibrium audit probability and the proportion
of high tax individuals who lie will remain constant. A change of this
type is represented with dashed lines in Figure 3.
V. Conclusions
This analysis sheds new light on the issue of tax evasion. The
graphical approach presented here allows us to analyze what happens as
parameter values vary. It is possible to make reasonable assumptions
about the distribution of risk aversion in a population, allowing an
analysis of how changes in audit probability will alter net expected
revenue given the proportion of "low tax" individuals, the
cost per audit, and the levels of taxes and fines.
One seemingly restrictive assumption in this model is that each
individual has a CARA utility function. The importance of this
assumption can at least be partly diminished when we consider that we
are looking at individuals in a particular income group. As long as the
difference between the after-tax incomes realized for each contingency
is relatively small for an income group, the results will not be
significantly altered. The meaningful results from this paper do not
depend on the CARA utility function. The important issue is that
disparate individuals feel differently about risk, and any tax
compliance model should take that into account. How risk aversion is
distributed throughout the population will have an important impact on
optimal audit policies. Additionally, it should be remembered that the
tax collector can solve many similar problems simultaneously. If
individuals are categorized by gross income, each group will pose a
separate problem for the tax collector, resulting in different optimal
audit probabilities depending on income.
Another strong assumption in this model is the restriction to only
two possible levels of tax for each income group. This simplification
was made primarily for tractability. A similar analysis could be
accomplished with individuals choosing an amount of tax to report
between [T.sub.L] and [T.sub.H]. However, this would complicate the
problem while obscuring the central idea in this analysis, which is that
the distribution of risk aversion is important in choosing optimal tax
compliance policies.
The model described in this paper conforms with certain stylized
facts about tax compliance with information requirements that are
similar to those we observe in the US. That is, the IRS has information
on gross income from employers and financial institutions, but it relies
on "voluntary" reporting for the actual amount of tax owed.
The model stresses the fact that individuals feel differently about
risk, and some taxpayers will be more compliant than others in similar
circumstances. Additionally, it allows different audit rates for
different income groups, letting higher income groups be subject to
different audit probabilities than lower income groups. Moreover,
different distributions of risk aversion among various income groups are
possible. For example, if higher income groups are believed to be less
risk averse than others, this can be modeled.
Individual tax compliance has been the topic of many studies. How
taxpayers feel about risk, though, must be an important element of any
model that attempts to explain compliance behavior. That populations
respond to higher fines and audit probabilities in the expected way has
been demonstrated in the studies noted earlier. This model forms a
theoretic basis for analyzing this problem.
1. An excellent survey of the tax compliance literature is given by
Frank A. Cowell [8].
2. Clearly, risk aversion cannot completely explain tax compliance
behavior, but those whose feelings of social responsibility compel them
to pay their full taxes regardless of audit probabilities can be thought
of as infinitely risk averse for the purposes of this analysis.
3. Another possibility for the kind of utility function desired for
this analysis is the constant relative risk aversion utility function,
u(y) = [y.sup.1-b]/(1 - b). Here the coefficient of relative risk
aversion, R(y) = A(y)y = b, is a constant. In either case, the level of
risk aversion is easily parameterized. For an excellent discussion of
useful utility functions, see Ingersoll [10, 39-40].
4. The analysis here doesn't depend on income only because CARA
utility functions are assumed. Adding gross income to the analysis is
straightforward. For example, if constant relative risk aversion utility
functions are used, income is easily incorporated into the model.
5. An affine relationship is assumed between [Pi] and [a.sup.*] for
simplicity. Although the slope ([Delta][Pi]/[Delta][a.sup.*]) can vary
as [T.sub.H], [T.sub.L], or F changes, such shifts will only affect the
magnitude of the audit probability change, not its sign.
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