Income tax evasion revisited: the impact of interest rate yields on tax-free municipal bonds

Southern Economic Journal, Oct, 2004 by Richard J. Cebula

The aggregate AGI gap data are compiled by the Bureau of Economic Analysis (BEA), which computes the discrepancy between the aggregate AGI reported to the IRS and an independent estimate of the aggregate AGI derived from the National Income and Product Accounts estimate of aggregate personal income.

A second approach is that prepared by the IRS based on its TCMP. In each year when the TCMP is prepared, a sample of roughly 55,000 taxpayers is subjected to a detailed examination by IRS auditors. In 1973, the IRS estimated that tax evasion, expressed as the ratio of aggregate unreported adjusted gross income (UAGI) to aggregate reported adjusted gross income (RAGI), was 0.1484, that is, 14.84%. (2)

A third approach relies on some variant of the CR model, including the GCR model, which is perhaps best described in Feige (1989). This model can take a number of forms. In its simplest and most restrictive form, the CR model assumes that (i) currency is the exclusive medium of exchange for unreported transactions, (ii) the ratio of currency to checkable deposits is affected only by the growth of unreported domestic transactions, (iii) the income velocities of reported and unreported transactions are equal to one another, and (iv) in some base year, unreported income (expressed as the ratio UAGI/RAGI) was known, so that the observed currency/checkable-deposit ratio (as a percentage) in that base year serves as a surrogate for the currency ratio associated with that degree of tax evasion. As the observed currency/checkable-deposit ratio rises and falls over time, so accordingly does the degree of income tax evasion; that is, so does the estimated ratio (UAGI/RAGI).

In this study, the data set used to measure the DTE is the series by Edgar Feige; this series is available for the period 1973-1997. Feige (1989, 1994) has generated revised and updated estimates of UAGI as a percentage of RAGI, employing the estimated IRS ratio for UAGI/RAGI of 14.84% for 1973 as the base year. Feige actually uses a variant of the CR model, namely, the GCR model, which somewhat relaxes the assumptions previously listed for the CR model. Interestingly, the Feige data and the well-known series on the size of the "underground economy" as a percentage of GNP developed by Tanzi (1982, 1983) are very highly correlated ( 0.93) for the years the two series have in common.

Based on the model in Equation 4, the following reduced-form equation is to be estimated:

(5) [(UAGI/RAGI).sub.t] = [a.sub.0] [a.sub.1] [MAXFPTR.sub.t-1] [a.sub.2] [AEPT.sub.t-1] [a.sub.3] [AUDIT.sub.t-1] [a.sub.4] [PEN.sub.t-1] [a.sub.5] [DIS.sub.t] [a.sub.6] [MATCH.sub.t] [a.sub.7] [(TF/TEN).sub.t-1] u,

where

[a.sub.o] = constant term;

[(UAGI/RAGI).sub.t] = aggregate unreported AGI as a percentage of aggregate reported AGI in year t as estimated by Feige (1989, 1994);

(2) For a detailed discussion of the TCMP data. see the two studies by Feige (1989, 1994).

[MAXFPTR.sub.t-1] = the maximum marginal federal personal income tax rate in year t - 1 as a percentage;