Determinants of aggregate income-tax-evasion behavior: The case of the US

Banca Nazionale del Lavoro Quarterly Review, Sep 1998 by Cebula, Richard J

Determinants of Aggregate Income-Tax-Evasion Behavior: The Case of the US

1. Introduction

Edgar Feige (1994, p.119) has observed that "Federal Reserve surveys [...] of currency usage by American households determined that adult U.S. residents admit to holding only 12% of the nation's currency in circulation outside the banking system". Feige further observes that "Allowing for U.S. business holdings of currency, the whereabouts of perhaps 80% of the nation's [US] currency supply is presently unknown". He proceeds to conclude that "Our inability to identify the holders and location of a large fraction of the U.S. currency stock gives rise to a $240 billion problem of `missing money"'. It is hypothesized by Feige (1994, pp. 119 and 121) as well as by others that this missing currency is a critical component of the so-called "underground economy", both in the US and in other nations.

There is a highly developed literature dealing with issues surrounding the size of the underground economy and tax evasion behavior. First, there are a variety of principally theoretical models of tax evasion behavior (Falkinger 1988; Allingham and Sandmo 1972; Klepper, Nagin and Spurr 1991; Das-Gupta 1994; Pestieau, Possen and Slutsky 1994). In addition, there are a number of studies of taxevasion behavior using a) questionnaires or experiments (Spicer and Lundstedt 1976; Friedland 1982; Spicer and Thomas 1982; Benjamini and Maital 1985; Alm, Jackson and McKee 1992; Baldry 1987; De Juan 1989; Thurman 1991), or, in some cases, b) what De Juan, Lasheras and Mayo (1994) refer to as "official data" (Clotfelter 1983, Slemrod 1985, Pommerehne and Weck-Hannemann 1989, Erard and Feinstein 1994, Feige 1994).' In effect, the issue of the size of the underground economy consists essentially of economic transactions (or income) that are not reported or that are underreported to the government tax-collection authority. At the economy-wide level, most of these unreported or underreported transactions reflect private decisions regarding income-tax-evasion behavior.

It is generally accepted that, as a reflection of aggregate incometax-evasion-behavior, the size of the underground economy should be affected by income tax rates (Clotfelter 1983, Slemrod 1985, Pommerehne and Weck-Hannemann 1989, Feige 1994). Presumably, the higher the pertinent income tax rate, the greater the economic benefit (in terms of a reduced tax liability) from not reporting or from underreporting taxable income, ceteris paribus. Clearly, every time a new federal income tax statute is enacted, it alters effective income tax rates and by so doing alters the incentive to underreport or not report income to the tax-collection authority. It is also commonly argued that the greater the perceived risk associated with participating in the underground economy, the less the extent to which economic agents will choose either to not report or to underreport income, ceteris paribs (Friedland 1982; Spicer and Thomas 1982; De Juan 1989; Alm, Jackson and McKee 1992; Erard and Feinstein 1994).

Within this context and based on revised and updated data through 1994 on the relative size of the underground economy in the US, this study empirically seeks to provide updated and hopefully improved insight into determinants of aggregate income-tax-evasion behavior as reflected by the relative size of the underground economy. In particular, this study investigates the potential impact on the relative size of the underground economy in the US of the following factors: the federal personal income tax rate, the social security tax rate, the federal corporation income tax rate, the public's dissatisfaction with government, IRS (Internal Revenue Service) audit rates (the percentage of federal income tax returns that is investigated by the IRS), and IRS penalty assessments (penalties plus interest) on detected unreported income. The findings presented in this study may have potential policy implications not only for the US but also for other developed nations, especially those whose income tax systems bear at least some resemblance to that in the US.

Section 2 provides the model that constitutes the basis for the empirical estimates, whereas Section 3 describes the data used in this study. The initial empirical estimations are found in Section 4, with additional estimates provided in Section 5. Finally, conclusions are presented in Section 6.

2. A general model

The economic system consists of a variety of economic agents. These agents generate economic value: income. Each of these economic agents has a choice as to whether or not to report (or underreport) their income to the tax-collecting authority. To the extent that income is reported to the government tax-collecting authority, a tax liability may be incurred.

For simplicity, since the values for pnr will likely vary across different sectors of the economy, pnr may be viewed as a weighted average of these various probabilities. Expressing probabilities in relative terms such as shown in (1) reflects the form of the data, i.e., data where the magnitude of the underground economy is expressed in relative terms.