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The author would like to thank the participants in a Fiscal Affairs Department seminar for their helpful comments on an earlier version of this paper.
Eleven bills proposing a one-time general income tax amnesty were introduced in the 99th Congress (see Ross (1986)); others were introduced in the 100th Congress.
Mikesell (1986) and IRS (1987) point out, for example, that states where tax receivables were eligible for amnesty reported much higher “yields” than those where taxpayers already under investigation were not eligible. These yields should be adjusted downward for payments that would have been received in the absence of an amnesty.
This is not to imply that tax rates and compliance are independent.
It would also entail expenditure to control the effects of the increased incentive for corruption. On this point, see Virmani (1987).
The maximum “fair” penalty may not be independent of the audit rate. In a situation where the audit rate is very low and tax laws are not being enforced, it may be thought unfair to heavily penalize those who are caught. If a decision is then made to strictly enforce laws and raise the audit rate, the maximum “fair” penalty as judged by society might increase. Indeed, one plausible reason why amnesties are often introduced when enforcement is improved is that it is thought unfair to apply harsher penalties to evasion that took place under the previous weak administration.
One can increase the complexity of the decision-making process by making the taxpayer uncertain as to whether the tax authority will bother to prosecute his/her evasion. See Reinganum and Wilde (1988).
As noted by Smith (1986), the optimality condition for the government would entail choosing a level of enforcement that would equalize the cost of raising a dollar’s worth of revenue through tax enforcement with the cost of raising revenue in other ways, taking into account the social value of deadweight loss.
Many more sophisticated models of tax evasion have been constructed. The aim here is to present a simple model capable of being used to analyze the importance of expected audit rates and their formation.
In the discussion of the multiperiod model later in the paper, this assumption is relaxed.
The fulfillment of the second order condition is ensured by concavity of the utility function.
One important factor in the real world is that penalty structures are often nonlinear. There is often a stigma or cost to being caught that is independent of the degree of evasion. This stigma probably deters a significant amount of evasion. Furthermore, the probability of being detected will, in most cases, rise with increasing evasion.
This presumes that full compliance would occur with α = 1, and the government would not gain more revenue by enticing some individuals to evade and then trying to catch them. One interesting aspect of this incredible solution is that it minimizes the cost of tax enforcement.
The Nash equilibrium is a set of individual strategies having the property that each player’s strategy is optimal, given the equilibrium strategies of all other players. For this reason, it is sometimes referred to as a “no regret” equilibrium.
While it is difficult to think of an infallible way to precommit to a particular audit rate, governments may invest in technology that lowers the marginal cost of auditing and thereby raises the optimal audit rate and decreases the incentive to be deceptive about its audit rate.
The taxpayers’ problem could be complicated by assuming that the audit rate is observed with an error and that the individual must solve a stochastic inference problem. An early treatment of this topic in a macroeconomic context with rational expectations is Taylor (1975). The assumption adopted here—that individuals are able to observe the audit rate, ex post, without any distortion—serves to highlight the fact that only a “little” incomplete information is sufficient to derive the results.
The correct decision in this case would no doubt be to eliminate or reduce distortionary taxes in the economy rather than reduce tax enforcement. Apart from equity considerations, which would tend to favor maintaining tax enforcement levels, it is quite difficult to reverse a deterioration in tax compliance, should such a reversal ever become necessary.
This is often an important determinant of the success of anti-inflation plans.
While the discussion has been carried on as if there is only one tax in the economy, in practice, an individual will face several. If evasion of one type of tax is positively correlated with evasion of others, this may be an additional incentive to minimize behavior that might draw an audit.
Perhaps the clearest example of this are the participants in the “underground” economy who may be quite reluctant to begin reporting income from sources that they previously had failed to report. For more information on the underground economy, see Tanzi (1982).
In some of the U.S. states with amnesty programs, participants who filed amended declarations with payments were ensured they would not be audited for the corresponding years during which they had evaded taxes. This led some individuals to purchase “insurance” against tax investigations by filing “one-penny” returns—returns that disclosed trivial amounts of evasion. This points out the care with which amnesties must be designed.
For details on the operation of this system, particularly the practical problems with implementation, see Angelini (1987) or Ross (1986). One interesting question debated at the time was whether a person should be permitted a voluntary payment if an associate was being investigated for tax evasion.
Of course, with an imperfect legal system, such penalties would discourage those who are innocent from defending themselves out of fear of “type I” error—being found guilty when, in fact, they are not. (This analogy has been used by Kmenta (1971)).
Here it is assumed that interest is always charged.