Download HISTORICAL EVIDENCE ON THE TAX EVASION IMPACT OF

HISTORICAL EVIDENCE ON THE TAX EVASION
IMPACT OF GOVERNMENT AUDITS AND
TAX RATES IN THE U.S.*
I. Introduction
Income tax evasion in the U.S. consists of taxable income that is
not reported or that is underreported to the IRS (Internal Revenue
Service). Studies of income tax evasion behavior can be classified into
three broad categories. First, there is a body of literature consisting
of theoretical models of income tax evasion behavior, including
Falkinger (1988), Allingham and Sandmo (1972), Klepper, Nagin, and
Spurr (1991), Das-Gupta (1994), and Pestieau, Possen, and Slutsky
(1994). Second, there is a body of literature consisting of studies
of tax evasion behavior that either use questionnaires or conduct
experiments, including Spicer and Lundstedt (1976), Friedland
(1982), Spicer and Thomas (1982), Alm, Jackson, and McGee
(1992), Baldry (1987), Thurman (1991), and Alm, McClelland, and
Schulze (1999). Third, there is a body of literature using what may
be referred to as “official data” for the U.S., i.e., data generated at
least in part by the IRS, including Clotfelter (1983), Slemrod (1985),
Erard and Feinstein (1994), Feige (1994), Cebula (2001), and Cebula
and Saltz (2001).
According to the “conventional wisdom,” the “relative degree
of aggregate income tax evasion” (hereafter, “DTE”) is positively
impacted by income tax rates [Tanzi (1982; 1983), Clotfelter (1983),
Slemrod (1985), Pommerehne and Weck-Hannemann (1989), Feige
(1994), Cebula (2001)]. Thus, the higher the income tax rate,
the higher the expected potential benefit, in terms of a reduced
tax payment, from not reporting or underreporting income. The
conventional wisdom also argues that the greater the risk associated
with tax evasion, as reflected perhaps in the percentage of tax returns
subjected to a formal tax return audit by IRS agents/personnel, the
*I am indebted to Vito Tanzi for data information.
R.J. Cebula
262
less the propensity to engage in tax evasion behavior [Friedland
(1982), Spicer and Thomas (1985), Alm, Jackson, and McKee (1992),
Errard and Feinstein (1994), Cebula (2001), Cebula and Saltz (2001)].
Within this context and using revised, updated estimates for
the DTE, this empirical study seeks to provide long term insights
into the tax-evasion impacts in the U.S. of two federal government
tax policies, IRS tax return audit rates and legislatively established
federal personal income tax rates. Although tax-evasion impacts of
IRS audit rates and federal income tax rates in the U.S. have been
studied in the past using official data, never before this study have
they been simultaneously investigated for such a long time frame.
For example, using data developed by Feige (1989; 1994), Cebula
(2001) finds that higher tax return audit rates discourage income tax
evasion and higher income tax rates encourage income tax evasion
over the 1973-1994 period, whereas using data developed by Tanzi
(1983), Cebula and Saltz (2001) obtain the same conclusions for the
1962-1980 period. The present study investigates the impact of IRS
personal income tax return audit rates and federal personal income
tax rates over a 41 year period (1957 through 1997) that includes both
of the above study periods combined plus several additional years
as well. Furthermore, certain additional variables/factors ignored in
previous studies are included in this analysis.
Section II provides the basic model. Section III describes the
data used to test the model and provides the empirical estimates.
Finally, concluding observations are found in Section IV.
II. The
model
The present framework involves a system consisting of economic
agents who generate economic value reflected in the form of taxable
income. These same agents then choose the extent to which they
report their taxable income to the IRS. Naturally, when/if this
income is reported to the IRS, a tax liability is incurred.
The probability that the representative economic agent will
not report his/her taxable income to the IRS, pnr, is treated as an
increasing function of the expected gross benefits to the agent of not
reporting income, eb, and as a decreasing function of the expected
gross costs to the agent of not reporting income, ec [Cebula (2001)].
Accordingly, the probability of not reporting income to the IRS,
pnr, is described for the representative economic agent by:
pnr = f(eb, ec), feb > 0, fec < 0
(1)
Tax evasion, audits, and taxes
263
The expected gross benefits from not reporting income to the
IRS are hypothesized to be an increasing function of the income
tax rate. To measure the federal personal income tax rate, this study
adopts the AEPT, the average effective federal personal income tax
rate. The conventional wisdom argues that the higher the income tax
rate, the greater the incentive to underreport income, ceteris paribus.
In the U.S., however, inflation indexing was introduced into the
Internal Revenue Code under provisions of the Tax Reform Act of
1986 (hereafter, the TRA). The objective of this provision of the
TRA presumably was to prevent or at least limit “bracket creep,”
i.e., the movement of individuals into higher marginal income tax
brackets due simply to the impact of inflationary forces on their
gross taxable income. We allow for this provision in the TRA by
including a dummy variable, INDEX. Presumably, to the extent that
inflation indexing has reduced bracket creep, it also at the margin
has reduced the incentive to undertake tax evasion. Hence, to begin
with, it is expected that:
eb = g(AEPT, INDEX), gAEPT > 0, gINDEX < 0
(2)
A factor that has been heretofore ignored in the tax evasion
literature is the impact of sentiment regarding the Vietnam War
on taxpayer behavior. In the U.S., the Vietnam War was extremely
controversial and divisive, pitting “hawks” (those supportive of the
War) against “doves” (those opposed to the War). This study argues
that to the extent that taxpayers in the aggregate were on balance
disenchanted with the Vietnam War, they might have expressed
some of that sentiment with a course of action intended to deny
funds to the Treasury and thereby to indirectly deny financial
support for the War. In particular, the Vietnam War may well have
provided taxpayers an incentive to engage in tax evasion because of
the expected benefits from expressing disapproval of the war and its
political supporters [Putnam (2000, pp. 146, 187, 257)]. A dummy
variable, WAR, is adopted in this study to reflect this possibility.
It also is expected that an increased level of public distrust of
government and/or of elected officials may contribute to the DTE
in the economy [Feige (1994), Cebula (2001)]. A recent study by
Cebula and Paul (2002, p. 499) finds that “Among other things,
the evidence strongly indicates that the Watergate scandal acted to
significantly increase the public’s distrust of government in general
and elected officials in particular…and to create a sense of being
politically disenfranchised…” Accordingly, it is hypothesized in
this study that the Watergate scandal, which ultimately led to the
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resignation of Richard M. Nixon from the Presidency, may have
caused certain segments of the population to become disenchanted
with government and to become either distrusting or more distrusting
of elected officials than before the Watergate incident. Furthermore,
it is hypothesized here that one plausible public reaction to a
government and elected officials who are distrusted is the public’s
increased desire to withhold resources from that government and
those officials. Thus, this study includes a preliminary test of the
hypothesis that the Watergate incident (WATERGATE) induced
an increase in income tax evasion in the U.S. This variable also is
generally neglected in the tax evasion literature for the U.S.
Of course, in the U.S., there exist legal forms of tax avoidance.
Arguably, the most common of these is the interest received from
ownership of municipal bonds. The latter are debt obligations issued
by state and local governments, the interest paid on which is free
from federal income taxation (subject to certain statutory conditions).
Thus, an individual wishing to earn interest income but also wishing
to not pay federal income taxes on that interest income has the legal
option of purchasing tax-free municipals issues. Clearly, the higher
this tax-free interest rate yield (TF) relative to, say, the taxable
interest yield on U.S. Treasury issues (TI), the lower the appeal of
(expected benefits from) income tax evasion.
Accordingly, given the above considerations, equation (2) is
expanded to the following:
eb = h(AEPT, INDEX, WAR, WATERGATE, TF/TI), hAEPT
(2’)
> 0, hINDEX < 0, hWAR > 0, hWATERGATE > 0, hTF/TI < 0
The expected gross costs of not reporting income to the IRS
are hypothesized to be an increasing function of the risks thereof.
Presumably, these risks (potential costs) are enhanced by an increase
in AUDIT, the percentage of filed federal personal income tax
returns that is formally audited by IRS personnel [Cebula (2001),
Cebula and Saltz (2001)]. Indeed, the experience of an IRS tax audit
would imply non-pecuniary (“psychic”) costs as well as pecuniary
costs (such as outlays for legal or other representation), along with
the value of one’s own time above and beyond any potential added
taxes and penalties (including interest) that might result from the
audit. Thus, we have:
(3)
ec = j(AUDIT), jAUDIT > 0
Substituting from (2’) and (3) into (1) yields:
pnr= f(AEPT, INDEX, WAR, WATERGATE, TF/TI, AUDIT),
fAEPT > 0, fINDEX < 0, fWAR > 0, fWATERGATE > 0,fTF/TI < 0,fAUDIT < 0 (4)
Tax evasion, audits, and taxes
III. Empirical
265
analysis
In the framework based on (4), the income tax rate measure is
the average effective federal personal income tax rate, as in Feige
(1994) and Cebula (2001). The inclusion of variables to reflect the
possible tax-evasion impacts of inflation indexing, the Vietnam War,
and the Watergate scandal is unique to this study.
The data for AEPT and AUDIT were obtained from the
IRS (1956-1997) and the IRS (2003). The Watergate variable
(WATERGATE) is a binary (dummy) variable, as are the INDEX
and WAR variables.
The data for computing variable TF/TI were obtained from
the Council of Economic Advisors (2003, Table B-73). Finally, the
data for measuring the DTE are the Tanzi (1983, Table 4) data,
beginning with 1957 and extended through 1997. The Tanzi data
express aggregate federal personal income tax evasion as a percentage
of GDP.
Initially, the following reduced-form equation is to be
estimated:
log(AUGTI/GDP)t= a0 + a1 log(AEPT)t-1 + a2 INDEXt + a3 WARt
+ a4 WATERGATEt + a5 log(TF/TI)t-1 + a6 log(AUDIT)t-1 + u (5)
where:
a0 = constant term;
log(AUGTI/GDP)t= the natural log of the estimated AUGTI
(aggregate unreported gross taxable income) in the economy in year t
as a percentage of GDP in year t, t = 1957,...,1997;
log(AEPT)t-1 = the natural log of the average effective federal
personal income tax rate in year t-1, i.e., total federal personal
income tax collections in year t-1 divided by the total reported
taxable income in year t-1, as a percentage;
INDEXt = a dummy (binary) variable for the years during which
inflation indexing was introduced into the Internal Revenue Code:
INDEX = 1 for 1986 and thereafter and INDEX = 0 otherwise;
WARt = a dummy (binary) variable to represent the years in which
the U.S. military was substantially involved in the Vietnam War:
WARt = 1 for the years 1965 through 1972, the year just prior to the
withdrawal of U.S. troops from Vietnam, and WARt = 0 otherwise;
WATERGATEt = a dummy (binary) variable indicating the years
following the Watergate scandal: WATERGATEt = 1 for the years
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following the Watergate scandal and WATERGATEt = 0 otherwise;
log(TF/TI)t-1 = the natural log of the ratio of the tax-free interest
rate yield on high grade municipal bonds in year t-1 to taxable
interest rate yield on ten year U.S. Treasury notes in year t-1;
log(AUDIT)t-1 = the natural log of the percentage in year t-1
of filed federal personal income tax returns that was subjected to a
formal audit by IRS personnel;
µ = stochastic error term.
The time series examined in this study are annual and cover
the 41 year period 1957-1997. Estimating in log form has the virtue
of generating elasticities, which can be more easily interpreted by
policymakers than mere coefficients. The Phillips-Perron (P-P) test
statistics indicate that all of the non-dummy variables in equation (5)
are stationary as specified with a simple linear trend variable (TREND).
Estimating equation (5) by OLS, adopting the Newey-West
heteroskedasticity correction, yields:
log(AUGTI/GDP)t = +0.61 +0.408 log(AEPT)t-1 – 0.089 INDEXt
(+2.01)(+3.46)
(-3.23)
+0.07 WARt + 0.153 WATERGATEt - 0.172 log(AUDIT)t-1
(+4.14)(+5.46)
(-6.52)
- 0.2215 log(TF/TI)t-1 - 0.0037 TREND
(-1.87)(-1.67)
R2 = 0.88, adjR2 = 0.85, DW = 1.92, Rho = 0.04, F = 30.34 (6)
where terms in parentheses are t-values. All six of the explanatory
variables exhibit the expected signs. Five of the six are statistically
significant at the one percent level, and one is significant at the
seven percent level. The F-statistic is significant at far beyond the
one percent level. The DW and Rho statistics reveal the absence
of any serious serial correlation problems. Finally, the coefficient of
determination indicates that the model explains approximately seveneighths of the variation in the dependent variable.
As shown in equation (6), the estimated elasticity on the income
tax variable is positive and significant at the one percent level. Thus,
in accordance with traditional tax evasion theory, it appears that the
higher the average effective federal personal income tax rate, the
larger the DTE.
The estimated coefficient on the INDEX variable is negative and
significant at the one percent level. Presumably, this result implies
that the inflation indexing introduced into the Internal Revenue Code
Tax evasion, audits, and taxes
267
may have acted effectively to at least mitigate bracket creep and to
eliminate at least some of the incentive for the public to engage in
income tax evasion that had previously been attributable to the effects
of inflation per se on gross taxable earned income. Meanwhile, the
estimated coefficient on the dummy variable for the Vietnam War
is positive and significant at the one percent level. Thus, there is
plausible evidence that the Vietnam War, i.e., opposition to the War,
may have created an incentive or rationale for certain segments of
the taxpaying public to engage in greater income tax evasion. The
coefficient on the WATERGATE dummy is positive and significant,
possibly suggesting that as the public became more distrustful of
elected officials as a result of the Watergate scandal, some of the
public may have chosen to underreport income so as to deny resources
to politicians (while also enhancing their own economic well being).
The estimated elasticity on the TF/TI variable is negative, as
expected and significant at the seven percent level. Thus, there is
modest evidence that the higher the tax-free interest rate yield relative
to the taxable interest rate yield, the less the appeal of income tax
evasion. Finally, the estimated elasticity on the AUDIT variable is
negative (as hypothesized) and statistically significant at the one
percent level. This finding implies, as suggested most recently by
Cebula (2001) for the period 1975-1997 and by Cebula and Saltz
(2001) for the period 1962-1980, that the higher the IRS personal
income tax return audit rate, the greater the perceived risks associated
with tax evasion and hence the less the DTE.
In the effort to gain potential further insight into the determinants
of income tax evasion as well as to test the robustness and
dependability of the findings shown in equation (6), this study next
offers an alternative estimate, using equation (5) as the core model.
In particular, we introduce two additional variables that effectively
have not previously been considered in this literature. The first of
these variables is the public’s approval rating of the U.S. President
(PRESAPP). Arguably, the higher the public’s approval rating for the
President, the more favorably the public may be disposed towards tax
compliance, ceteris paribus, because of the increased popularity of the
President and/or his policies. The second additional variable is the
unemployment rate of the civilian labor force (UR). Arguably, the
higher the UR, the greater may be the fear of future unemployment
among still-employed workers. Thus, the higher the UR, the greater
may be the public’s incentive to engage in tax evasion so as to be
able to set aside evaded (unpaid) taxes as “rainy day funds” to be
used in the event of their own employment being terminated.
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Accordingly, equation (5) is expanded to the following:
log(AUGTI/GDP)t = b0 + b1 log(AEPT)t-1 + b2 INDEXt + b3 WARt
+ b4 WATERGATEt + b5 log(AUDIT)t-1 + b6 log(TF/TI)t-1
(7)
+ b7 log(PRESAPP)t-1 + b8 log(UR)t-1 + b9 TREND + u’
where:
log(PRESAPP)t-1= the natural log the average percentage public
Presidential approval rating in year t-1;
log(UR)t-1 = the natural log of the average unemployment rate of
the civilian labor force in year t-1, expressed as a percentage.
The data for the PRESAPP variable were obtained from: http://
www.geocities.com/americanpresidencynet/approval.htm. Values for
the PRESAPP variable range between 0.00 and 100.00. Over the
study period, the mean for this variable was 53.33, and its standard
deviation was 10.62. According to the P-P test, the PRESAPP
variable is stationary in log form and is thusly expressed in the new
estimate. On the other hand, the UR variable is not stationary as
expressed, i.e., in log form. However, log(UR)t-1 is stationary in first
differences; hence, the variable is expressed in the new estimate as
the first difference of the log of UR.
The OLS, Newey-West corrected estimate of equation (7) is
given by:
log(AUGTI/GDP)t = + 0.80 + 0.383 log(AEPT)t-1 – 0.077 INDEXt
(+1.94)(+3.07)
(-3.47)
+ 0.063 WARt + 0.147 WATERGATEt – 0.164 log(AUDIT)t-1
(+2.68)(+4.73)
(-5.06)
-0.26 log(TF/TI)t-1 -0.0334 log(PRESAPP)t-1 +0.04 δlog(UR)t-1
(-2.07)(-0.64)
(+0.86)
-0.0036 TREND
(-1.42)
R2 = 0.88, adjR2 = 0.84, DW = 1.90, Rho= 0.04, F= 22.43
(8)
where “δ” is the first differences operator. In equation (8), the
estimated elasticity on the PRESAPP variable fails to be statistically
significant, as does the estimated coefficient on the log UR variable.
Thus, it appears that neither of these factors exercised a significant
impact on aggregate income tax evasion over the study period. On
the other hand, the remaining results in equation (8) are entirely
Tax evasion, audits, and taxes
269
compatible with their counterparts in estimation (6). Indeed, the
estimated elasticity on the tax avoidance variable, (TF/TI), is not
only still negative but now is also significant at the four (as opposed
to only the seven) percent level. Thus, it appears that this factor did
indeed significantly reduce the degree of aggregate federal personal
income tax evasion in the U. S. over the study period.
IV. Conclusions
Based on the empirical findings in this study for the period
1957-1997, it appears that the DTE is an increasing function of the
average effective federal personal income tax rate and a decreasing
function of the IRS personal income tax return audit rate, the ratio
of the tax-free interest rate yield on high grade municipal bonds to
the taxable yield on U.S. Treasury notes, and the inflation indexing
introduced into the Internal Revenue Code under provisions of the
TRA. It also appears the DTE was increased as a result of both the
Vietnam War and the Watergate scandal.
Among other things, it appears that growth in the DTE might,
at least in theory, be diminished by reduced average effective federal
personal income tax rates and increased IRS audit rates. Judging from
equations (6) and (8), it appears that for every one percent reduction
in the average effective federal personal income tax rate, there would
be a 0.38-0.41 percent reduction in the DTE. In addition, from (6)
and (8), it appears that for every one percent increase in the IRS
audit rate, there would be a roughly 0.164-0.172 percent reduction in
the DTE. Of course, whereas the public would likely not object to
a tax rate cut, it remains to be seen whether an increased IRS audit
rate is politically feasible. Moreover, such a policy action must also be
carefully evaluated in a general equilibrium cost-benefit framework.
Richard J. Cebula
Armstrong Atlantic State University, Savannah, Georgia, U.S.A.
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R.J. Cebula
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ABSTRACT
This study empirically investigates the impact of federal personal income
tax rates and IRS personal income tax return audit rates on aggregate income
tax evasion over the 1957-1997 period. This period represents the longest over
which the potential tax-evasion impacts of these two factors in the U.S. have
ever been formally investigated. In a model that allows for the effects of a
variety of other factors, it is found that the degree of aggregate income tax
evasion is decreased by higher audit rates and increased by higher average
effective personal income tax rates.
JEL Classification: H26
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RIASSUNTO
Evidenza “storica” sull’impatto dell’evasione fiscale a seguito dei
controlli fiscali e aliquote di imposta negli U.S.A.
Questo articolo valuta empiricamente l’impatto delle aliquote federali
dell’imposta sul reddito delle persone fisiche e le relative verifiche fiscali
dell’IRS (Internal Revenue Service) sulla evasione delle imposte sul reddito nel
periodo 1957-1997. Questo rappresenta il periodo più lungo su cui siano mai
stati formalmente studiati i potenziali impatti sull’evasione fiscale di questi due
fattori. In un modello che tiene conto degli effetti di una serie di altri fattori,
si mostra che il grado di evasione fiscale sul reddito aggregato è diminuito a
seguito dei maggiori audit rates ed aumentato a causa di un incremento medio
delle aliquote di imposta sul reddito personale.