Week 3- Tax Evasion Flashcards
In the standard model, what do X, Y and t stand for?
Declared income level, real income level, marginal tax rate.
What is income when not caught?
Ync= Y-tX
What is income when caught?
Yc= Y[1-t] - Ft [Y-X]
Is the fine based on undeclared tax or undeclared income?
The undeclared tax.
Assuming the taxpayer behaves as if they maximise their expected utility-what does the optimal declaration X (the income declared) solve?
max(x) E[U(X)] = [1-p]U(Ync) + pU(Yc)
According to the evasion decision graph, which line joins the points for X=0 and X=Y?
The opportunity line- which shows all the sets of possible payoffs.
Give 3 statements about the opportunity line?
- Is on the 45° at the truthtelling point X=Y
- Is downward sloping, increasing X transfers income from the not-caught state to the caught state.
- Implies Ync>Yc for X
At what point is the optimal level of income reporting during the evasion problem?
At X*, where the indifference curve meets the opportunity line.
In the tax exasion graph, what is the difference between X=Y and X=0?
X*=Y means all income has been declared
X*=0 means that no income has been declared.
When do taxpayers evade at least some of their income?
When indifference curve at X=Y is steeper than the opportunity line.
What is the slope of the opportunity line?
-F
When does evasion occur?
p[1+F] < 1
How do you calculate the MRS (slope of the indifference curve) in the evasion decision?
dYc/dYnc = [1-p]/p
What is the levels puzzle?
The idea that all taxpayers should engage in tax evasion as p[1+F] is far below 1.
What happens when either p or F increases?
Evasion reduces.
What happens when there is an increase in the Fine Rate?
The opportunity line pivots around X=Y, leading the optimal choice to move closer to the honest declaration; thus lowering evasion.
What happens to the opportunity line when taxes increase?
The opportunity line shifts inward when taxes increase.
What is the effect on declaration when taxes increase?
This is not clear cut.
If absolute risk aversion decreases with income, what happens to evasion when taxes increase, and what is this called?
Evasion reduces- this is called the Yitzhaki puzzle.
What happens to absolute risk aversion as income increases?
Absolute risk aversion decreases- ie rich people are more likely to take risks.
Why does it seem strange that increasing taxes would reduce evasion?
As basic intuition would suggest that increasing taxes increases the inventive to avoid paying a higher tax- as most empirical evidence actually agrees with.
Explain the theory behind the Yitzhaki puzzle.
An increase in taxes leaves households poorer, which increases their risk aversion- so they reduce their exposure to risk and evade less!
Is there any substitution effect with the Yitzhaki puzzle?
No, as both the tax rate and the penalty rate increase proportionally with t, making the Yitzhaki puzzle arise purely from income effect.
If we are choosing to replace EUT with PT, how can we write the problem facing the taxpayer?
V=w(p)v(Yc-R) + w(1-p)v(Ync-R) where w() is a probability weighting function and v() as a payoff function that replaces U().
