Understanding Tax Evasion

As regular blog readers will know, I’m a big fan of randomisation. In the context of tax audits, this is particularly useful. Though politically controversial, random audit experiments like the US TCMP have taught us a lot about who underreports tax. And now a new two-stage experiment in Demark is revealing other lessons. Perhaps Australia – which has never had a random audit of personal income taxpayers – could follow suit.

Unwilling or Unable to Cheat? Evidence from a Randomized Tax Audit Experiment in Denmark (gated stable link, ungated unstable link)
Henrik Kleven, Martin Knudsen, Claus Kreiner, Soren Pedersen and Emmanuel Saez
This paper analyzes a randomized tax enforcement experiment in Denmark.  In the base year, a stratified and representative sample of over 40,000 individual income tax filers was selected for the experiment.  Half of the tax filers were randomly selected to be thoroughly audited, while the rest were deliberately not audited.  The following year, "threat-of-audit" letters were randomly assigned and sent to tax filers in both groups.    Using comprehensive administrative tax data, we present four main findings.  First, we find that the tax evasion rate is very small (0.3%) for income subject to third-party reporting, but substantial (37%) for self-reported income.  Since 95% of all income is third-party reported, the overall evasion rate is very modest.  Second, using bunching evidence around large and salient kink points of the nonlinear income tax schedule, we find that marginal tax rates have a positive impact on tax evasion, but that this effect is small in comparison to avoidance responses.  Third, we find that prior audits substantially increase self-reported income, implying that individuals update their beliefs about detection probability based on experiencing an audit.    Fourth, threat-of-audit letters also have a significant effect on self-reported income, and the size of this effect depends positively on the audit probability expressed in the letter.  All these empirical results can be explained by extending the standard model of (rational) tax evasion to allow for the key distinction between self-reported and third-party reported incomes.

One thought on “Understanding Tax Evasion”

  1. Meh. Tax regimes have no way of determining where on the range a self-declaring taxpayer sits.

    They would like us to think so – witness the annual ATO and IRS campaigns. The reality is they can only make educated guesses.

    Therefore so long as a self-declaring taxpayer declares income that sits between the second and that quartile of income ranges for their profession or business, with a limited moving average, the likelihood of an audit reduced to that tax regime’s audit rate for that industry.
    The ATO practices this principle this by maintaining audit rates of its own staff to 25%. Three guesses for how well this works…


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