Tax evasion Flashcards
Tax evasion
Simple Tax Evasion model assumptions
-Compliance decision is a gamble
-Builds on EUT
-p of being detected, p.
-Fixed income Y but only declares X, therefore X<=Y
-T is marginal tax rate
-Two states of the world, caught Yc and not caught Ync.
-Tax payer behaves to maximise utility
Income when caught and not caught
Ync = Y - tX
-Yc = Y(1-t) - Ft(Y-X)
-If caight fined at a rate F which is placed on the income that has been evaded (Y-X = income evaded)
Opportunity line
-Line joining X = 0 and X= y, shows all possible payoffs/
-Is on a 45 degree line
-Downward sloping, increasing in X, less income evaded.
Optimal declaration of income X* and corner solutions
-Occurs when highest indifference curve tangent with opportunity line.
-0<X*<Y
-Interior solution, some income declared some hidden.
-Corner solutions, indifference curve on corner of opp line, either all income or no income declared.
Describe evasion decision + where evasion occurs
-Taxpayers evade at least some of their income when their indifference curve at X = Y is steeper than the opportunity line.
-MRS is Dyc/dync at X=Y = -(1-p/)/p
-Opp line slope = -F
-Evasion occurs when p(1+F)<1
Describe yizthaki puzzle
-Puzzle rises from a pure income effect, no sub effect as tax and F increase proportionally with t.
-When tax increases individuals/tax payer is made poorer in expectation.
-Assuming risk aversion is decreasing in wealth, therefore higher tax –> lower wealth more risk averse.
-When the taxpayer feels poorer they therefore reduce their exposure to risk therefore evade less.
- However intuitively youd tihnk higher rates would incentive inciduals to evade more to pay less on higher rates. Plus data shows this.
-Models failure of these predictions/existence of pouzzles lead to alternative models, including pT.
Basic conclusions of the EUT model of tax compliance
-Massively under predicts real world compliance
-Predicts evasion decreases with the tax rate
What is the reference point in prospect theory and differnt ways in which R may be specified in evasion model
-A point in which serves as a benchmark to how gains and losses are evaluated by an individual.
-Different ways in which R is found are the expected value of the gamble (using PT), the level of income if declared honestly.
Poilatto and Rablen 2017 approach of how R should be specified in this model
-Write R as a weighted averaged of Yc and Ync given by:
R = ayc + (1-a)Ync
-Where 0< a <1 and a doesnt depend on X, amount declared.
Value function PT in evasion model and payoofs in the model
V = w(p)v(Yc-R) + w(1-p)V(Ync - R)
-R is reference level, W weighting function, V value function.
-Payoffs:
Ync - R > 0
Yc - R ) < 0
-Therefore if caught this is perceived as a loss according to pT and if not caught its perceived as a gain.
Explain how prospect theory and model of tax evasion helps resolve the levels puzzle (includes a graph)
-Start with simple version of prospect theory with no weighting or loss aversion. Adding loss aversion leads to predicted evasion to fall (aversion to possible loss reduces risk taking/less evasion), new line on graph reduces area (point to left of original). Adding probability weighting also reduces amount of predicted evasion (as tax payers psychologically feels overweight by p of being caught). Smaller atea on graph and new line point to left of next.
-Other factors such as audits are concentrated on around 20% of people who are self employed, who have a better ability to evade. Meaning p is actually higher than the ‘naive’ estimate.
Explain how the yitzhaki puzzle stands firm in this model
-Stands firm, as t increases must mean X has increased (formula for Ync - R shows this). Puzzle hasnt gone away t increases –> more evasion.
-Prospect theory can sometimes reverse the puzzle by rely on perverse phycology. Overcome by assuming tax payers feel richer after tax rise
Define levels puzzle
-As optimum X is greater 0 all logical taxpayers should engage in evasion. Reductions in evasion solve this puzzle
