TAX AVOIDANCE, EVASION, AND ADMINISTRATION*

1 Chapter 22 TAX AVOIDANCE, EVASION, AND ADMINISTRATION* JOEL SLEMRODThe University of MichiganSHLOMO YITZHAKIThe Hebrew University of JerusalemContentsAbstract 1425 Keywords 14251. Introduction Why avoidance, evasion and administration are central, not peripheral, concepts inpublic finance The evolution of tax structures Evasion, avoidance, and real substitution response General framework 14292. Theoretical models of evasion The Allingham-Sandmo-Yitzhaki model Jointness with labor supply Other uncertainty General equilibrium considerations 14353. General models of avoidance and evasion 14364.

2 Descriptive analysis of evasion and enforcement The extent of tax evasion Data problems Patterns of noncompliance Determinants of evasion Cross-sectional analysis Time-series analysis Controlled experiments 1442* We are grateful to Wojciech Kopczuk for valuable research assistance. Helpful comments on an earlierdraft were received from Jim Alm, Alan Auerbach, Len Burman, Brian Erard, Martin Feldstein, FirouzGahvari, Roger Gordon, Jim Hines, Jonathan Kesselman, Louis Kaplow, Jim Poterba, Agnar Sandmo,Dan Shaviro, Eric Toder, Gideon Yaniv, the participants at the NYU Law School Colloquium on TaxPolicy and Public Finance and the handbook conference held at the University of California at of Public Economics, Volume 3, Edited by Auerbach and M.

3 Feldstein 2002 Elsevier Science B. V All rights reservedJ. Slemrod and S. Yitzhaki5. Descriptive analysis of avoidance Dimensions of avoidance Retiming Tax arbitrage The classification of income The extent of avoidance 14446. Fundamentals of tax analysis Equity Vertical equity Horizontal equity Incidence Are changes in the social welfare function necessary? A taxonomy of efficiency costs Administrative costs Compliance costs The risk-bearing costs of tax evasion 14497. Normative analysis Optimal tax administration and enforcement Optimal penalties Optimal randomness The optimal extent of enforcement Optimal auditing rules Optimal allocation of enforcement resources Optimal tax systems The choice of tax instruments Presumptive taxes Optimal commodity taxes Optimal progressivity The marginal efficiency cost of funds 14598.

4 Conclusion 1463 References 14651424Ch. 22: Tax Avoidance, Evasion, and AdministrationAbstractTax avoidance and evasion are pervasive in all countries, and tax structures areundoubtedly skewed by this reality. Standard models of taxation and their conclusionsmust reflect these paper first presents theoretical models that integrate avoidance and evasion intothe overall decision problem faced by individuals. Early models of this area focusedon tax evasion, modeled as a gamble against the enforcement capability of the recently, the literature has examined more general models of the technology ofavoidance, with the additional risk bearing caused by tax evasion either being a specialcase of this technology or one aspect of the cost of changing behavior to reduce taxliability.

5 If the cost of evasion and avoidance depends on other aspects of behavior,the choice of consumption basket and avoidance become intertwined. The paper thenrelates the behavior predicted by the model to what is known empirically about theextent of evasion and avoidance, and how it responds to tax enforcement paper then turns to normative analysis, and discusses how avoidance andevasion affect the analysis of vertical and horizontal equity as well as efficiencycosts; a taxonomy of efficiency costs is presented. Acknowledging the variety ofbehavioral responses to taxation changes the answers to traditional subjects of inquiry,such as incidence, optimal progressivity, and the optimal mix between income andconsumption taxes.

6 It also raises a whole new set of policy questions, such as theappropriate level of resources to devote to administration and enforcement, and howthose resources should be deployed. Because there are a variety of policy instrumentsthat can affect the magnitude and nature of avoidance and evasion response, theelasticity of behavioral response is itself a policy instrument, to be chosen paper reviews what is known about these issues, and introduces a general theoryof optimal tax systems, in which tax rates and bases are chosen simultaneously withthe administrative and enforcement regimes.

7 We argue that the concept of the marginalefficiency cost of funds is a useful way to summarize the normative issues that arise,and expand the concept to include administrative costs, avoidance, and , evasion, enforcement, avoidanceJEL classification: H21425J Slemrod and S. Yitzhaki1. Why avoidance, evasion and administration are central, not peripheral,concepts in public financeMost economic analysis of taxation presumes that tax liability can be ascertained andcollected costlessly. As a description of reality, this is patently untrue. For example, inthe the Internal Revenue Service (henceforth IRS) estimates that about 17% ofincome tax liability is not paid '; the figure for most other countries is probably , the resource cost of collecting what is paid can be large, in the about 10% of tax collections 2.

8 The tax structures themselves are undoubtedlyskewed by the realities of tax evasion, avoidance, and administrative standard models of taxation and their conclusions need to be modified inthe light of these realities. Many practitioners of tax advice in developing countriesbelieve that this change in emphasis is essential; for example, Casanegra de Jantscher(1990, p. 179) goes so far as to say that, in developing countries, "tax administrationis tax policy" (1983), Mansfield (1988), and Tanzi and Pellechio (1997) areuseful summaries of the practical problems of the interaction of tax policy and taxadministration in this context,We believe that these issues are also critical in developed countries.

9 In this setting,the issue is not the feasibility of certain taxes, but rather the optimality of alternative taxstructures. For example, while in many developing countries an income tax that relieson self-reporting cannot be administered at all, in a developed country the question isto what extent optimal tax design should reflect the reality of evasion, the necessity ofenforcement, and the costs of collection. In fact, tax systems do reflect these issues,although there is little systematic guidance offered by the academic public financeliterature. The objective of this chapter is to collect and critique the now sizableliterature that addresses these The evolution of tax structuresScholars of the historical evolution of tax structure, notably Hinrichs (1966) andMusgrave (1969), have also stressed the importance of tax administration issues.

10 Theynote that modern tax structure development has generally been characterized by ashift from excise, customs, and property taxes to corporate income and progressivei Internal Revenue Service (1996).2 Slemrod (1996a).3 Others disagree. Groves (1974, p. 25) offers that: "Vetoing tax measures because of the difficulty ofadministering them is in most cases less compelling than doing so on the ground of their failure toconform to acceptable principles. Administration is usually amenable to improvement where violationof first principles is not. And administration of a given tax may often be improved most effectively inthe process of attempting to administer it.