Survey
* Your assessment is very important for improving the workof artificial intelligence, which forms the content of this project
* Your assessment is very important for improving the workof artificial intelligence, which forms the content of this project
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 264 R.J. Cebula 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 266 R.J. Cebula 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. 268 R.J. Cebula 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. 270 R.J. Cebula REFERENCES Allingham, M.G., and A. Sandmo, “Income Tax Evasion”, Journal of Public Economics, 1, 1972, pp. 323-338. Alm, J., B. Jackson, and M. McKee, “Institutional Uncertainty and Taxpayer Compliance”, American Economic Review, 82, 1992, pp. 1018-1026. Alm, J., G. McClelland, and W.D. Schulze, “Institutional Uncertainty and Taxpayer Complinace”, Kyklos, 52, 1999, pp. 141-171. Baldry, J.C., “Income Tax Evasion and the Tax Schedule: Some Experimental Results”, Public Finance/Finances Publiques, 42, 1987, pp. 357-383. Bawley, D., The Subterranean Economy, New York: McGraw-Hill, 1982. Cebula, R.J., “Impact of Income-Detection Technology and Other Factors on Aggregate Income Tax Evasion: The Case of the United States”, Banca Nazionale Del Lavoro Quarterly Review, 53, 2001, 401-415. Cebula, R.J., and C. Paul, “A Note on Determinants of Public Dissatisfaction with Government”, American Journal of Economics and Sociology, 61, 2002, pp. 495-501. Cebula, R.J., and I.S. Saltz, “An Empirical Note on Tax Auditing and the Size of the Underground Economy in the United States, 1962-1980”, International Review of Economics and Business, 68, 2001, pp. 119-124. Clotfelter, C.T., “Tax Evasion and Tax Rates: An Analysis of Individual Returns”, Review of Economics and Statistics, 65, 1983, 363-373. Council of Economic Advisors, Economic Report of the President, 2003, Washington, D.C.: U.S. Government Printing Office, 2003. Das-Gupta, A, “A Theory of Hard-to-Tax Groups”, Public Finance/Finances Publiques, 49, 1994, pp. 28-39. Erard, B., and J.S. Feinstein, “The Role of Moral Sentiments and Audit Perceptions in Tax Compliance”, Public Finance/Finances Publiques, 49, 1994, pp. 70-89. Falkinger, J, “Tax Evasion and Equity: A Theoretical Analysis”, Public Finance/ Finances Publiques, 43, 1988, pp. 388-395. Feige, E. L., The Underground Economies: Tax Evasion and Information Distortion, Cambridge: Cambridge University Press, 1989. Feige, E. L., “The Underground Economy and the Currency Enigma”, Public Finance/Finances Publiques, 49, 1994, pp. 119-136. Friedland, N., “A Note on Tax Evasion as a Function of the Quality of Information about the Credibility of Threatened Fines: Some Preliminary Research”, Journal of Applied Social Psychology, 12, 1982, pp. 54-59. http:///www.geocities.com/americanpresidencynet/approval.htm Internal Revenue Service, Annual Report of the Commissioner and Chief Counsel of the Internal Revenue Service, Washington, D.C.: U.S. Government Printing Office, 1956-1997. Tax evasion, audits, and taxes 271 Internal Revenue Service, Statistics of Income, Washington, D.C.: U.S. Government Printing Office, 2003. Klepper, S., D. Nagin , and S. Spurr, “Tax Rates, Tax Compliance, and the Reporting of Long-Term Capital Gains”, Public Finance/Finances Publiques, 46, 1991, pp. 236-251. Pestieau, P., U. Possen, and S. Slutsky, “Optimal Differential Taxes and Penalties”, Public Finance/Finances Publiques, 49, 1994, pp. 15-27. Pommerehne, W.W., and H. Weck-Hannemann, “Tax Rates, Tax Administration and Income Tax Evasion in Switzerland”, Paper presented at the Conference of the Applied Econometrics Association, Rome, Italy, 1989. Putnam, R. Bowling Alone, New York: Simon & Schuster, 2000. Slemrod, J. B, “An Empirical Test for Tax Evasion”, Review of and Statistics, 67, 1985, pp. 232-267. Economics Spicer, M. W., and S. B Lundstedt, “Understanding Tax Evasion”, Public Finance/Finances Publiques, 31, 1976, pp. 295-305. Spicer, M. W., and J.E. Thomas, “Audit Probabilities and the Tax Evasion Decision: An Experimental Approach”, Journal of Economic Psychology, 2, 1982, pp. 241-245. Tanzi, V., The Underground Economy in the United States and Abroad, Lexington, MA: Lexington Books, 1982. Tanzi, V., “The Underground Economy in the United States: Annual Estimates, 1930-1980”, IMF Staff Papers, 30, 1983, pp. 283-305. Thurman, Q. C., “Taxpayer Noncompliance and General Prevention: An Expansion of the Deterrence Model”, Public Finance/Finances Publiques, 46, 1991, pp. 289-298. 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 272 R.J. Cebula 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.