Tax Evasion

Fundamental Tax Reform 25
25.1 Why Fundamental Tax Reform?

25.2 The Politics and Economics of Tax Reform
25.3 Consumption Taxation
25.4 The Flat Tax
25.5 Conclusion
Public Finance and Public Policy Jonathan Gruber Fourth Edition Copyright © 2012 Worth Publishers 1 of 43
C HAPTE R 2 5 ■ F UNDAM E NTAL TAX RE F O RM
25
Fundamental Tax Reform
• In 2011, Republican Presidential candidate hopeful
Herman Cain proposed the “9-9-9” plan for fundamental
tax reform.
o Replaces all current taxes with a 9% corporate tax, 9%
personal income tax, 9% payroll tax.
o Eliminates all tax deductions.
o Example of a “flat tax.”
• This chapter explores such “fundamental tax reform.”
Chapter Overview
We discuss fundamental tax reform in four steps.
First, the three major arguments for moving to a low-rate,
broad-based tax system:
• tax compliance
• tax simplicity
• tax efficiency.
Second, the difficult political and economic barriers to
fundamental reform of the tax system.
Third, reform of the tax system that long has been of interest to
public finance economists: moving from an income base to
a consumption base for taxation.
Fourth, the flat tax, and discuss its promises and pitfalls.
25.1
Why Fundamental Tax Reform?
There are three major arguments for fundamental tax reform.
1. Improve tax compliance: Tax compliance is the willingness of
individuals or corporations to obey the tax laws.
o Tax compliance: Efforts to reduce tax evasion.
o Tax evasion: Illegal nonpayment of taxation.
o Tax avoidance: Legal action to reduce tax burden. Legal
activities undertaken by individuals to shift income from taxable
to nontaxable forms.
1. Tax simplicity: Make the tax code simpler.
2. Tax efficiency: Improve tax efficiency.
25.1
Theory of Tax Evasion
• The theory of tax evasion emphasizes the trade-offs involved:

o Save money on unpaid taxes if not caught.
o The costs are the risk of getting caught and the penalty
to be paid if caught.
o Higher taxes increase the benefit of avoidance without
increasing the cost, increasing evasion.
o Increased penalties increase the cost of evasion and
therefore reduce it.
25.1
Research Findings
Clotfelter (1983) found that noncompliance is

correlated with the marginal tax rate.
• An elasticity lies somewhere between 0.5 and
about 3.0
• It implies that each 1% rise in the marginal tax
rate leads to 0.5% to 3% more noncompliance.
25.1
Theory of Tax Evasion
Marginal cost
Effect of MC2 Marginal
and benefit of
increased cost, MC1
non-reported
income, in penalties
dollars
MB2 (marginal
$0.60 tax rate = 60%)
C
0.50 Marginal
B A benefit, MB1
Effect of
increased (marginal tax
tax rate rate = 50%)
0 E2 E1 E3 Amount of
Non-reported income,
in dollars
25.1
Why Should We Care About Tax Evasion?
1. Efficiency
o Tax evasion narrows the base, reducing efficiency.
2. Vertical equity
The wealthy can evade more easily, reducing their tax burden at
the expense of poorer citizens. The wealthy have a much greater
scope for tax evasion than do lower –income groups
3. Especially: horizontal equity
A tax evader with the same income as a non-evader clearly has a
lower tax burden. Thus, two individuals in very similar
circumstances will be treated differently by the tax code if one is
honest and the other is not. This is a clear violation of horizontal
equity principles
25.1
Evidence on Tax Evasion
• Tax evasion is pervasive in the United States and around the
world.
o U.S. “tax gap” between taxes owed and taxes paid is $345
billion, 16.2% of tax revenue.
o Similar to New Zealand’s 10.2% in 1994.
o Worse in developing countries: 73% tax gap in the
Philippines.
• Evidence suggests that evasion increases with tax rates,
decreases with threats of audits.
25.1
Making the Tax Code Simpler
A common demand for tax reform is to increase tax simplicity by

eliminating or limiting the complex administrative difficulties
associated with paying taxes.
Tax simplicity is also consistent with other equity and efficiency
goals.
The IRS’s instructions for tax filers are 100 pages long.
• In 2000, tax payers spent 3.2 billion hours and $18.8 billion filling
out tax forms.
• Reducing exemptions or deductions would simplify the tax code.
o But this may increase reporting requirements, with an
unclear total impact on simplicity.
25.1
Improving Tax Efficiency
The motivation for many fundamental reforms, such as the flat tax
advocated by Steve Forbes, is to reduce the marginal tax rates that
potentially distort decisions on how hard to work, how much to
save, or how much risk to take.
Efficiency of the tax code depends on elasticity of revenues with
respect to the tax rate. As the elasticity rises, the deadweight loss
from taxation rises, highlighting the equity–efficiency trade-off.
• Tax code changes have two effects on revenue:
o Direct effect of tax changes: A higher tax rate that raises
revenues on a fixed base of taxation.
o Indirect effects of tax changes: A higher tax rate that lowers
the size of the revenue base on which taxes are levied.
25.1
Indirect Effects of Tax Changes on Efficiency
Tax changes can have four indirect effects:

• Gross income effect: A higher tax rate reduces gross income by
lowering labor supply, savings, or risk taking.
• Reporting effect: For a given level of gross income, a higher tax
rate causes people to report less income.
• Income exclusion effect: For a given reported income, a higher
tax rate causes people to take more deductions and exclusions.
• Compliance effect: Finally, higher tax rates may reduce
revenues through increased tax evasion.
25.1
Changes in the Tax Base as Tax Rates Rise
25.1
Evidence on the Revenue Consequences of Higher
Tax Rates
• A large, growing literature explores how taxable income
responds to tax rates.
• Central estimate: 4% decline in the base of taxable income for
each 10% rise in tax rates.
• Most of this response comes from the indirect effects of
reporting, income exclusion, and compliance, and not from
the indirect effect of gross income earning.
• Most, if not all, of this response comes from the rich.
25.1
Summary: The Benefits of Fundamental Tax Reform
Fundamental tax reform helps address all three of the tax

reform goals:
• Improves tax compliance and tax efficiency by expanding
the tax base and lowering tax rates.
• Simplifies tax filing by ending many detailed exemptions
and deductions, and taxing different forms of income at the
same rate.
25.2
The Politics and Economics of Tax Reform
• TRA 86 broadened the base and reduced rates,

representing a “victory” for tax reform.
• But this victory was short lived:
o In 1993, tax top rates rose.
o 1997 Taxpayer Relief Act gave many new credits.
o Tax reforms in 2001 and 2003 continued to
complicate the tax code.
• Why is it so hard to maintain a simple, broad-based
tax code?
25.2
Political Pressures for a Complicated Tax Code
• Political pressures are strongest when the winners are
concentrated and have much to gain, and the losers are diffuse
and don’t lose much per person.
o Continuation of Bush tax cuts would save 3% of Americans
$810 billion.
o The reductions and eventual repeal of the estate tax,
for example, will affect only 50,000 households, but it will save
those households a total of $30 billion a year.
A particularly strong pressure for tax code complication is the
perception of politicians that naïve voters are opposed to new
government spending programs but support the same goal when
financed by a tax expenditure, despite identical budget implications.
25.2
Economic Pressures Against Broadening the Tax
Base
• Any attempt to broaden the base may simply

encourage additional tax shelters, undoing the base
increase.
• Tax shelters: Activities whose sole reason for existence
is tax minimization.
• Tax shelters have real economic costs but save the
shelters’ creator money by reducing the tax burden.
25.2
The Conundrum
• Political and economic pressures are significant

barriers to moving to a broad-based system.
• Political forces are constantly pushing for the use of
the tax code to deliver benefits to particular groups,
at the cost of potentially inefficient and inequitable
holes in the tax base.
25.3
Consumption Taxation
• Consumption taxation is a radical reform preferred by

many economists.
• Taxing consumption: Taxing individuals based not on
what they earn but on what they consume (such as
through a sales tax).
• Used by state and local governments, and many
governments around the world.
25.3
Consumption Taxation in OECD Nations
25.3
Consumption Taxes Improve Capital Allocation
• The current tax system encourages some kinds of
investment over others.
o Real estate favored through tax-exempt status.
• A particular source of inefficiency in our current tax
system is the lack of a “level playing field” across
investment choices.
• Better allocation improves economic efficiency.
25.3
Consumption Taxes Are Simple
• Another advantage of the consumption tax is

simplicity.
• In principle, it is much more straightforward to simply
tax individuals on their purchases than on a
complicated definition of income.
25.3
Why Might Consumption Be a Worse Tax Base?
• Consumption taxes reduce vertical equity.

o Rich people save more, so consumption taxes are
regressive.
o Net lifetime savings are bequests, so an estate tax might
help, but estate taxes are very unpopular.
o A progressive expenditure tax could correct this, but would
introduce other complications.
25.3
Why Might Consumption Be a Worse Tax Base?
• Differences between Savers and Non-Savers
The government ideally wants to redistribute from high -ability to
low -ability individuals. Earning is an imperfect measures of ability.
Taxing savings might help tax high-ability people.
• Transition Issues
Seniors could be devastated by the transition. Those individuals
have paid their income taxes. If that consumption is then taxed at
a high consumption tax rate, they are taxed twice
• Compliance
o Harder to measure consumption than income.
• Cascading
o One business’s output is another’s input, making it difficult
to avoid double taxation.
25.3
Designing a Consumption Tax: Value-Added Tax
• A value-added tax addresses cascading and

compliance.
o Value-added tax (VAT): A consumption tax levied
on each stage of a good’s production on the
increase in value of the good at that stage of
production.
• VATs are widely used around the world.
• Since one firm’s tax burden is another’s tax burden,
VATs encourage reporting.
25.3
Value-Added Tax in Practice
Agent Purchase Sale Value Tax Paid

Price Price Added (20% VAT)
Logger $0 $25 $25 $5
Manufacturer 25 75 50 10
Retailer 75 100 25 5
Total tax paid 20
25.3
Design a Consumption Tax: Expenditure Tax
• An alternative to a VAT is an expenditure tax.

• Expenditure tax: A consumption tax levied on yearly
consumption rather than on specific sales.
• It is straight forward to make an expenditure tax progressive,
making the consumption tax system more vertically equitable.
• Difficult to track expenditures throughout the year, however.
25.4
Advantages of a Flat Tax
• Efficiency gains from having one flat rate on a broad

income definition.
• Enormous simplicity.
• Compliance improvements:
o The simpler tax system would make it harder to
find ways to evade taxes.
o For almost all taxpayers, their entire tax bill could
be collected through withholding from earnings.
25.4
The Problems with the Flat Tax
• The problems with the flat tax are similar to those

raised with consumption taxation:
o While a flat tax can be made fairly progressive for
low- and middle-income earners, it will be much
less progressive for high-income earners than our
current system.
o There are difficult transition issues raised by the
flat tax.
25.4
Distributional Implications of the Flat Tax: Average
Tax Rates, by Income Level
Income Current Tax Code Hall-Rabushka Flat

Tax
$25,000 1.2% 0%
$50,000 6.9 9.5
$100,000 13.0 14.3
$300,000 24.2 17.4
$1,000,000 31.7 18.5
25.5
Conclusion
• The complications, economic distortions, and
redistribution inherent in the system of income taxation
leave many unhappy with the income tax as the nation’s
primary source of revenue raising.
• Fundamental reform of the income tax is not easy.
• Moving to fundamental reform, such as replacing income
taxation with consumption taxation or a flat tax, raises
difficult issues about the appropriate trade-off between
efficiency and equity in the tax code.

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Fundamental Tax Reform 25

25.1 Why Fundamental Tax Reform?

• The theory of tax evasion emphasizes the trade-offs involved:

Clotfelter (1983) found that noncompliance is

A common demand for tax reform is to increase tax simplicity by

Tax changes can have four indirect effects:

Fundamental tax reform helps address all three of the tax

• TRA 86 broadened the base and reduced rates,

• Any attempt to broaden the base may simply

• Political and economic pressures are significant

• Consumption taxation is a radical reform preferred by

• Another advantage of the consumption tax is

• Consumption taxes reduce vertical equity.

• A value-added tax addresses cascading and

Agent Purchase Sale Value Tax Paid

• An alternative to a VAT is an expenditure tax.

• Efficiency gains from having one flat rate on a broad

• The problems with the flat tax are similar to those

Income Current Tax Code Hall-Rabushka Flat

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