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We characterize optimal individual tax evasion and avoidance when taxpayers “narrow bracket” the joint avoidance/evasion decision by exhausting all gainful methods for legal avoidance before choosing whether or not also to evade illegally. We find that (1) evasion is an increasing function of the audit probability when the latter is low enough, yet tax avoidance is always decreasing in the probability of audit; (2) an analogous finding to the so-called Yitzhaki puzzle for evasion also holds for tax avoidance—an increase in the tax rate decreases the level of avoided income and the level of avoided tax; and (3) that, holding constant the expected return to evasion, it is not always the case that the combined loss of reported income due to avoidance and evasion can be stemmed by increasing the fine rate and decreasing the audit probability.
Income Tax Avoidance and Evasion: A Narrow
Bracketing Approach
Duccio Gamannossi degl’Innocentiy
Matthew D. Rablenz
November 21, 2016
We characterize optimal individual tax evasion and avoidance when taxpayers “narrow bracket”
the joint avoidance/evasion decision by exhausting all gainful methods for legal avoidance before
choosing whether or not also to evade illegally. We …nd that (i) evasion is an increasing function
of the audit probability when the latter is low enough, yet tax avoidance is always decreasing
in the probability of audit; (ii) an analogous …nding to the so-called Yitzhaki puzzle for evasion
also holds for tax avoidance –an increase in the tax rate decreases the level of avoided income
and the level of avoided tax; and (iii) that, holding constant the expected return to evasion, it
is not always the case that the combined loss of reported income due to avoidance and evasion
can be stemmed by increasing the …ne rate and decreasing the audit probability.
JEL Classi…cation: H26, K42, D82, H21.
Keywords: Tax avoidance, Tax evasion, Narrow bracketing, Financial intermediaries.
Acknowledgements: We thank the Editor, James Alm, and two anonymous referees for helpful comments.
Gamannossi degl’Innocenti gratefully acknowledges …nancial support from the Ministero dell’Istruzione,
dell’Università e della Ricerca (cycle XXVIII) and from the European Commission (Erasmus mobility grant
yIMT School for Advanced Studies, Piazza S. Francesco 19, 55100, Lucca, Italy.
zDepartment of Economics, University of She¢ eld, She¢ eld, S1 4DT, UK.
1 Introduction
Individuals take a variety of actions to reduce their tax liabilities. The UK tax authority,
for instance, distinguishes three distinct types of action (HM Treasury and HM Revenue and
Customs 2011): those that breach tax law (tax evasion); those that “use the tax law to get
a tax advantage that Parliament never intended”(tax avoidance); and those that “use tax
allowances for the purposes intended by Parliament”(tax planning). By these de…nitions,
both tax evasion and tax avoidance are responsible for signi…cant losses in public revenue:
estimates provided by the UK tax authority put the value of tax avoidance at £ 2.7 bn. and
the value of tax evasion at £ 4.4 bn. (HM Revenue and Customs 2015). Given the …rst order
signi…cance of tax avoidance, it is of note that the …rst economic studies relating to tax
compliance (e.g., Allingham and Sandmo 1972; Srinivasan 1973; Yitzhaki 1974; Christiansen
1980) neglect the possibility of tax avoidance altogether, and the economic literature that
followed has largely retained this bias.
In this paper we introduce tax avoidance into the portfolio model of tax evasion (Yitzhaki
1974). To model the joint tax avoidance/evasion decision we build on insights developed
in psychology and behavioral economics. In particular, we allow for a pervasive propensity
among human decision makers facing multiple-dimension problems –that of narrow brack-
eting. In our context, a decision maker who narrow brackets would decompose sequentially
the joint decision {avoidance,evasion} into narrow brackets, e.g., {avoidance} followed by
{evasion}. A key feature of narrow bracketing is that the decision maker tends to choose
an option in each stage without full regard to the other decisions and circumstances that
he or she faces (Rabin and Weizsäcker 2009). In the present context, therefore, the choice
made …rst is made without the decision maker being assumed to have pre-meditated on
how the second choice will be made. Important in this context is whether the taxpayer is
more likely to make the avoidance or evasion choice …rst. This question – as to the order
in which a complex decision is mentally staged –is thought to depend heavily on mentally
focal qualitative features of the choice set. We argue that a focal feature of the choice set is
that avoidance is ostensibly legal whereas evasion is illegal. Indeed, judiciaries on both sides
of the Atlantic have long upheld the right of a citizen to challenge the proper interpretation
of tax law and to pay only the tax they owe in law. Thus, while tax avoidance can be seen
as the rightful exercise of a basic right by some lights, tax evasion lacks an equivalent in-
terpretation. Accordingly, if taxpayers qualitatively prefer avoidance to evasion, we suppose
they would focus on exhausting opportunities for legal tax avoidance before subsequently
focusing on opportunities for illegal evasion.
We are by no means the …rst to propose that taxpayers distinguish qualitatively between
avoidance and evasion, however. This distinction has previously been represented by sup-
posing that a cost owing to social stigma and/or personal guilt is attached to the illegal act
of tax evasion. This cost can be …nancial (e.g., Chetty 2009; Lee 2001) or psychic (e.g., Ben-
jamini and Maital 1985; Gordon 1989; Myles and Naylor 1996; Kim 2003; Dell’Anno 2009).
The concept of narrow bracketing o¤ers an alternative perspective on this distinction: in
our model, illegal evasion is not considered until all gainful avenues for legal avoidance have
been exhausted.1In this way our paper relates to a literature on two-stage decision making
(e.g., Gorman 1959; Strotz 1959; Blackorby et al. 1970). Unlike this literature, however, we
do not seek a sequential approach to the joint avoidance/evasion decision that coincides with
the outcome that would obtain were the joint decision assumed to be made simultaneously.
In addition to the legal distinction between avoidance and evasion, we further assume that
avoidance is costly whereas evasion is costless. Devising avoidance schemes that reduce a tax
liability without ostensibly violating tax law invariably requires a detailed understanding of
tax law, coupled with a degree of ingenuity. A classical form of avoidance scheme, for in-
stance, involves the implementation of a circular sequence of self-cancelling option agreements
that return the seller to his or her original position, but in the process create an allowable
loss. As, however, few taxpayers are equipped to conceive of and implement independently
such avoidance schemes, it is necessary to purchase them on the open market.2Satisfying
this demand for tax avoidance is a substantial industry dedicated to the development and
marketing of avoidance schemes (see, e.g., Sikka 2012; Committee of Public Accounts 2013;
Addison and Mueller 2015). By contrast, many forms of tax evasion require no technical
or legal expertise. Intentionally understating income on the tax return, for instance, may
readily be performed independently.
We …nd that, in two respects, allowing for tax avoidance importantly changes the charac-
teristics of optimal tax evasion. First, under plausible conditions, evasion is an increasing
function of the probability of audit. Second, we re-examine the …nding of Christiansen (1980,
1Strictly speaking, the stigma cost approach and ours and not mutually exclusive. To present our approach
in the simplest possible light, however, we do not allow for a stigma cost.
2People not only have di¢ culties in understanding tax law, but also show poor knowledge about tax rates
and basic concepts of taxation. For evidence that people often signi…cantly under-estimate marginal tax
rates see, e.g., Lewis (1978) and Gideon (in press).
391) that “if the …ne is increased, but the e¤orts to detect tax evaders are adjusted so as
to keep the expected gain from tax evasion unaltered, risk averters will always reduce their
tax evasion.”We are again able to prove this result, yet in our model it is the total amount
of lost tax (through both avoidance and evasion) that is economically pertinent. When we
consider both avoidance and evasion, however, it is possible that taxpayers declare more
income if the probability of audit is increased, and the …ne decreased, holding the expected
gain from tax evasion constant.
The paper adds to the small, but growing, economic literature on tax avoidance. The two
closest analyses to ours are Alm and McCallin (1990) and Alm (1988). The former describes
avoidance and evasion as risky assets –each asset has a return characterized by a mean and
variance, and the interdependence between the two returns is characterized by a covariance
while the latter characterizes avoidance as a riskless, albeit costly, asset. Whereas both
of these analyses consider the simultaneous determination of evasion and avoidance, in our
framework we argue that these are chosen sequentially. Di¤erent from Alm and McCallin,
we model the mean, variance and covariance of evasion and avoidance, rather than taking
these quantities as exogenous. Unlike in Alm (1988), we take avoidance to be risky, owing
to the possibility of e¤ective anti-avoidance measures by the tax authority.
Much of the remaining literature on tax avoidance is, however, concerned with whether
income tax has “real” ects upon labor supply, or simply leads to changes in the “form”
of compensation. Accordingly, in these studies the term “tax avoidance” typically refers to
all form-changing actions that reduce a tax liability.3This de…nition overlaps with ours,
but is broader in the sense that it also includes actions that fall in to our notion of tax
planning. In the context of this broader de…nition of tax avoidance, Slemrod and Kopczuk
(2002), Piketty, Saez, and Stantcheva (2014) and Uribe-Teran (2015) analyze theoretically
the elasticity of taxable income in the presence of avoidance. In the empirical literature,
Slemrod (1995, 1996) …nds pronounced tax avoidance e¤ects in the response of high-earners
to tax changes, while Feldstein (1999) …nds that accounting for tax avoidance signi…cantly
increases estimates of the implied deadweight loss of income taxation. Lang, Nöhrbaß, and
Stahl (1997) estimate that tax avoidance costs the German exchequer an amount equal to
around 34 percent of income taxes paid. Fack and Landais (2010) show that the response
of charitable deductions to tax rates is concentrated primarily along the avoidance margin
3For a detailed discussion of these “form-changing” actions see, e.g., Stiglitz (1985) and Slemrod and
Yitzhaki (2002).
(rather than the real contribution margin), while Gruber and Saez (2002) show that the
elasticity of a broad measure of income is notably smaller than the equivalent elasticity
for taxable income, suggesting that much of the response of taxable income comes through
deductions, exemptions, and exclusions.
The plan of the article is as follows: in section 2 we motivate the key behavioral assumptions
behind our analysis, from which section 3 develops a formal model. Section 4 performs the
main analysis and 5 compares our …ndings to the literature. We extend the model in section
6 to allow for risk in the tax authority’s e¤orts to illegalize avoidance schemes, and section
7 concludes. All proofs are in the Appendix.
2 Deciding to Avoid and/or Evade Tax
Two key features of our modelling of the joint decision to avoid and/or evade are that (i) the
taxpayer makes the avoidance and evasion decisions sequentially; and (ii) that the avoidance
decision is made …rst. The …rst feature –that complex decisions are routinely broken down
into smaller ones –is often termed narrow bracketing in the behavioral literature. The second
feature –the choice of how to stage the sub-decisions within the larger composite decision
is sometimes termed decision staging (Johnson et al. 2012). We discuss each of these
features in turn.
2.1 Narrow Bracketing
A mass of evidence suggests that people narrowly bracket: a decision maker who faces a
multi-dimensional decision tends to break the decision down sequentially, proceeding at each
stage to isolate a single dimension of the problem without full regard to the other dimensions
of the problem. In the context of monetary risk, Tversky and Kahneman (1981) present an
experiment that demonstrates how powerful this propensity is. In their experiment, people
narrowly bracket even when faced with only a pair of independent simple binary decisions
that are presented on the same sheet of paper. Narrow bracketing lies at the heart of
current explanations of phenomena such as the stock market participation puzzle (Barberis,
Huang, and Thaler 2006), the equity premium puzzle (Benartzi and Thaler 1995; Gneezy and
Potters 1997) and choice among lotteries (Camerer 1989; Battalio, Kagel, and Kiranyakul
1990; Langer and Weber 2001).
Cognitive limitations –in perception, attention, memory, and analytical processing – are
thought to be an important reason for narrow bracketing (Read, Loewenstein, and Rabin
1999). Accordingly, in the experiment of Read et al. (2001) subjects who were required
to resolve a complex choice problem sequentially actually made better choices than those
subjects who were required to proceed simultaneously. Clearly, however, decision making
outcomes under narrow bracketing can, in other contexts, appear worse than those arrived at
from a wide bracketing perspective. For instance, decision making under narrow bracketing
may violate …rst-order stochastic dominance (Rabin and Weizsäcker 2009) and, in a famous
example, the “one day at a time”bracketing observed among New York cab drivers fails to
maximize earnings per hour across days (Camerer et al. 1997). Thus, while the desirability
of narrow bracketing is still the subject of academic debate (see, e.g., Palacios-Huerta 1999;
oszegi and Rabin 2009), the pervasiveness of the phenomenon is not in doubt. It is thus of
relevance to understand the nature of the joint avoidance and evasion decision under narrow
2.2 Decision Staging
Having established that taxpayers may well mentally separate the joint avoidance and evasion
decision there remains the question as to how this is done. According to Kahneman (2003),
the way individuals will choose to stage or frame a decision is heavily shaped by the features
of the situation at hand that come to mind most easily – to use the technical term, by
the features that are most “accessible.” This notion is supported in the context of tax-
related decision making by McCa¤ery and Baron (2004, 2006). These authors employ a
slightly di¤erent terminology –the isolation e¤ect –which, however, refers to the tendency
of respondents in their study to “decide complex matters –and tax raises a host of complex
matters – by responding to the most salient or obvious aspect of a choice set or decision
In the context of the joint avoidance and evasion decision we argue that the most accessible
feature or aspect of the choice set is that tax avoidance and evasion are qualitatively distinct:
one is legal, and the right to practice it has often been defended by the judiciary, whereas
the other is a crime. Courts on both sides of the Atlantic have for many years upheld the
right of citizens to challenge the interpretation of tax law (Barker 2009; Prebble and Prebble
2010). In 1936 Lord Tomlin, ruling in a case involving the Duke of Westminster, surmised
that “[e]very man is entitled, if he can, to order his a¤airs so that the tax attaching under
the appropriate Acts is less than it otherwise would be. If he succeeds in ordering them so
as to secure this result, then, however unappreciative the Commissioners of Inland Revenue
or his fellow taxpayers may be of his ingenuity, he cannot be compelled to pay an increased
tax.”This so-called “Duke of Westminster principle”dominated UK tax avoidance law until
the 1980s and remains in‡uential today. Similarly, in the US, Judge Learned Hand stated
in 1947 (in Commissioner vs. Newman) that “[o]ver and over again courts have said that
there is nothing sinister in so arranging one’s a¤airs as to keep taxes as low as possible.
Everybody does so, rich or poor; and all do right, for nobody owes any public duty to pay
more than the law demands: taxes are enforced exactions, not voluntary contributions. To
demand more in the name of morals is mere cant.”
There is evidence that these traditional legal arguments continue to a¤ect public sentiment
towards tax avoidance. In the qualitative study of Kirchler, Maciejovsky, and Schneider
(2003) participants relate tax avoidance to lawful acts enabling tax reduction, to cleverness,
and to costs. Tax evasion, by contrast, is associated with illegal acts such as fraud, crim-
inal prosecution, risk, tax-audits, punishment, penalty, and the risk of detection. In this
sense, we argue that, for many taxpayers, tax avoidance is qualitatively preferred to evasion.
Accordingly, we argue that taxpayers would exhaust the scope for legal avoidance before
subsequently deciding whether or not they additionally wish to evade illegally (rather than
the other way round).
3 Model
Our model is a direct extension of the canonical portfolio model of Yitzhaki (1974). A
taxpayer has an income (wealth) wand faces a tax on income given by tw, where t2(0;1).
Taxpayers behave as if they maximize expected utility, where utility is denoted by U(z) =
log z.4The taxpayers true income is not observed by the tax authority, but the taxpayer
must declare an amount x2[0; w]. The taxpayer can choose to avoid paying tax on an
amount of income A2[0; w], and subsequently to evade illegally an amount of income
E2[0; w A], so x=wEA.
Evasion is …nancially costless but avoidance technology must be bought in a market in which
4Thus taxpayers are risk averse and have a constant (unit) co-e¢ cient of relative risk aversion. We adopt
the logarithmic form for reasons of analytic tractability. Other simple speci…cations such as constant absolute
risk aversion or mean-variance utility can instead be used and yield similar results. However, the assumption
of constant relative risk aversion has stronger empirical support (see, e.g., Wakker 2008; Chiappori and
Paiella 2011).
promoterssell avoidance schemes to “users”.5A common feature of this market is the “no
saving, no fee”arrangement under which the price received by a promoter is linked to the
amount by which their scheme stands to reduce the user’s tax liability. Although system-
atic information regarding the precise contractual terms upon which avoidance schemes are
typically sold is scarce, we understand from a detailed investigation in the UK that, for
the majority of mass-marketed schemes, the fee is related to the reduction in the annual
theoretical tax liability of the user, not the ex-post realization of the tax saved (Committee
of Public Accounts 2013, 11). This implies, in particular, that the monetary risks associated
with the possible subsequent detection and termination of a tax avoidance scheme are borne
by the user.6Accordingly, we assume that the promoter’s fee is a proportion 2(0;1) of
the amount by which the taxpayer’s tax liability stands to be reduced, tA. In this way,
may be interpreted as measuring the degree of competition in the market for tax avoidance
schemes, with lower values of indicating the presence of stronger competitive forces.
Although traditional arguments around the morality of tax avoidance continue to a¤ect im-
portantly public sentiment, there has nonetheless been a discernible shift in the attitudes
of the judiciary, beginning in the 1980s (Stevens 2013). Increasingly, as our opening de…-
nition of tax avoidance suggests, courts apply a purposive interpretation of the law. This
interpretation is summarized by Permanent Judge Ribeiro (in Collector of Stamp Revenue
vs. Arrowtown Assets Ltd.) who states that “the ultimate question is whether the rele-
vant statutory provisions, construed purposively, were intended to apply to the transaction,
viewed realistically.” Armed with this purposive interpretation of the law, tax authorities
now routinely seek to have particular avoidance schemes ruled illegal. Yet taxpayers may le-
gitimately continue to use an avoidance scheme while the (often lengthy) process of shutting
it down is ongoing. Moreover, if the scheme is eventually declared illegal the tax authority
can only seek the amount of tax that was properly due. That is, it cannot levy …nes for
tax evasion retrospectively once a scheme has been outlawed. Inherent in our de…nition of
tax avoidance (as distinct from tax planning) is that –should the tax authority learn of the
scheme –it will consider it illegal.
The taxpayers income declaration is audited with probability p2(0;1). If audited, Eand A
5For analyses of the market for tax advice see, e.g., Reinganum and Wilde (1991) and Damjanovic and
Ulph (2010).
6It is apparent that such arrangements give promoters incentives to mis-represent the level of risk involved
in particular schemes. Consistent with this point, Committee of Public Accounts (2013, 11) indeed …nds
evidence of such mis-selling.
are observed and the taxpayer has to pay [1 + f]tE on account of the amount of evaded tax,
where f > 0is the …ne rate. The tax authority mounts a legal challenge to the avoidance
scheme, which is successful with probability pL. In the event that the legal challenge is
successful, the tax authority obtains the right to reclaim the tax owed (but cannot levy a
ne). In this case, instead of paying tx in tax, the taxpayer must instead pay t[x+A].
The taxpayers expected utility is therefore given by
EU(A; E) = [1 p]U(wn) + ppLU(was) + p[1 pL]U(wau);(1)
where wnis the taxpayer’s wealth in the state in which they are not audited, wasis the
taxpayer’s wealth in the state in which they are audited and the tax authority’s legal challenge
is successful, and wauis the taxpayers wealth in the state in which they are audited and the
tax authority’s legal challenge is unsuccessful:
was(A; E) = wt[wE][1 + f]tE tA;(2)
wau(A; E) = wt[wAE][1 + f]tE tA;(3)
wn(A; E) = wt[wAE]tA: (4)
A key distinguishing factor between evasion and avoidance in this context is that avoidance
entails a cost tA in all states of the world. Thus, if avoidance is detected and the scheme
closed down a taxpayer is worse-o¤ for having chosen to avoid, even though they are not
ned on avoided income. To ensure that the amount of taxes, …nes and fees never exceeds a
taxpayer’s wealth for any A+E2[0; w]we must assume [1 t]=t > max f; f g.
We suppose that taxpayers choose their preferred level of avoidance and evasion sequentially:
gainful opportunities for tax avoidance are exhausted before the taxpayer decides whether
to engage additionally in evasion. Thus, taxpayers …rst choose avoided income as
A= arg maxAEU(A; 0) ; (5)
and then evaded income as
E= arg maxEEU(A; E). (6)
4 Analysis
We now present an analysis of the model of the previous section. For analytic tractability,
we shall consider the special case of the model with pL= 1, such that legal challenges by
the tax authority are always successful. In a later section we shall demonstrate numerically
how the results with pL= 1 relate to the results for the more general case with pL<1.
To begin, it is helpful to de…ne the function R(z) = [1 z]=z, such that, e.g., R(p)is the
classical odds ratio found in decision theory. We may then state our …rst Proposition:
Proposition 1 An interior optimum for avoidance and evasion satis…es
A=pR (t)
1[R(p)R()1] w
[1 p] [1 f R()]
R(p)R()>1> fR () ; pR(t)
[1 p] [1 f R()] + f[R(p)R()1]
Proposition 1 gives closed-form expressions for optimal avoidance and evasion when both
are at an interior maximum, and the conditions needed for a such an interior maximum to
arise. The …rst sequence of inequalities at the bottom of the Proposition guarantee that
A; E>0. The left-side inequality, R(p)R()>1, is the condition that the avoidance
gamble be better than fair. As a necessary condition for both inequalities to hold it must be
that R(p)R()> f R (), which implies R(p)> f. This is the standard restriction in the
portfolio model of tax evasion that the evasion gamble be better than fair. The right side
inequality at the bottom of the Proposition ensures that A+E< w. To gain insight into
how Aand Eare related, note that we may write one as a (linear) function of the other:
E(A) = p[wR (t)A] [R(p)f]
From (7) we note that
@A=f R() + R(p)
f[1 + R(p)] [1 + R()] <0;(8)
so the amount of evaded income Eis negatively related with the amount of avoided income
A. This …nding matches that of Alm, Bahl, and Murray (1990) using data from Jamaica,
who …nd that evasion and avoidance are substitutes. We now consider the comparative
statics of optimal avoidance and evasion:
Proposition 2 At an interior optimum for avoidance and evasion it holds for Athat
@w =A
@t =A
t[1 t]<0;
@f = 0;
@ =wR(t) [p+ (1 p)R()2] [1 + R()]2
@p =R(t)w
[1 ]<0;
and for Ethat
@w =E
@t =E
t[1 t]<0;
@f =E
[1 fR()] f<0;
@ =f[R()]2+ 1
[1 ] [1 f R()]E>0;
@p =R(p)1
1pE?0() R(p)?1:
Proposition 2 is derived via straightforward di¤erentiation of the expressions for Aand E
in Proposition 1 so we omit the proof. Beginning with the comparative statics of A, we
see that wealthier people are predicted to avoid more income than less wealthy people. The
second result is an extension of the well-known Yitzhaki paradox for evasion to the case of
avoidance –avoided income falls as the tax rate is increased. The intuition for this result is
analogous to that for evasion: a higher marginal tax rate makes the taxpayer feel poorer, and
thereby more risk averse. As would be expected, an increase in the competitiveness of the
market for avoidance schemes (a decrease in ) increases avoided income, and an increase
in the probability of audit decreases avoided income. Of course, knowing @A=@t < 0does
not warrant that the total tax avoided, tA, also falls. It is straightforward to show, however,
@t =1
t[1 t]1A<0:(9)
Turning to evasion, the logic of the chain rule implies that, for an arbitrary exogenous
variable z, it must hold that
@z =@E
@z A=cons:
@z ;(10)
where the …rst term on the right side is the direct e¤ect of zon evasion, and the second
term captures the indirect e¤ect on evasion arising from the e¤ects of zupon avoidance.
Intuitively, the indirect e¤ect is the income e¤ect imparted upon the evasion choice by
movements in avoidance. Noting from equation (8) that @E=@A<0it follows that if
@A=@z and @E=@zjA=cons: are of the same sign –as turns out to be the case for each of
the variables fw; t; f; pgthen the direct and indirect e¤ects in equation (10) oppose each
other. This observation notwithstanding, the …rst three results in Proposition 2 –those for
fw; t; f g–are each unambiguous and consistent with Yitzhaki (1974). Unambiguity in this
context arises as the direct e¤ect can be shown to always dominate the indirect e¤ect. To
take the e¤ect of the tax rate on evasion as an example, we …nd the direct e¤ect –using (7)
@t A=cons:
=w[1 + R(t)]2[R(p)f]
f[1 + R(p)] <0;(11)
Combining equation (11) with @A=@t in Proposition 1 and @E=@Awe can rewrite the
direct e¤ect in terms of the indirect e¤ect,
@t A=cons:
=[R(p)f] [1 + R(p)] R()
[R(p) + fR()] [R(p)R()1]
@t , (12)
such that, by equation (10), we obtain an alternative form for @E=@t to that given in
Proposition 2:
@t =[R(p)f] [1 + R(p)] R()
[R(p) + fR()] [R(p)R()1]
@t +@E
@t (13)
=R(p) [1 + R()] [1 f R()]
[R(p) + fR()] [R(p)R()1]
@t <0:(14)
As well as evaded income being decreasing in the tax rate, it is straightforward to show that
evaded tax, tE, is decreasing in the tax rate too. As it has no direct e¤ect on evasion,
the e¤ect of competition in the market for avoidance (as captured by ) is given by (10) as
simply @E=@ = [@E=@A] [@A=@]>0. That is, we …nd that a decrease in competition
in the market for avoidance increases evasion by making it more attractive relative to the
alternative of avoidance.
The …nal …nding is that tax evasion is increasing in the probability of audit if R(p)>1
(equivalently, p < 0:5) and decreasing otherwise. In this case there are again competing
direct and indirect e¤ects upon evasion, but now the direct e¤ect does not always dominate
the indirect e¤ect. From (7) we obtain the direct e¤ect as
@p A=cons:
=wR(t) [1 + R()] [1 + f R(p)R()]
f[1 + R(p)] R()<0;(15)
which is the pure income e¤ect …rst observed by Yitzhaki (1974). This may be rewritten in
the form @E
@p A=cons:
=[1 + fR(p)R()]
R(p) + fR()
@p ;(16)
such that
@p =[1 + f R(p)R()]
R(p) + fR()
@p +@E
@p (17)
=[R(p)1] [1 f R()]
R(p) + fR()
@p . (18)
From (18) it is immediate that the direct e¤ect dominates when R(p)<1and the indirect
dominates when R(p)>1.
How plausible is the condition p < 0:5required for evasion to be increasing in the probability
of audit? A-priori it appears highly plausible given that the IRS audits only around 0.96
percent of individual tax returns …led in calendar year 2012 were examined (IRS 2014). Even
if we suppose that these audits were concentrated on the 20 percent or so of people in the
US who are self-employed (and thus not subject to third-party reporting) this probability
rises to 4.8 percent, still well below the 50 percent level.
We now wish to characterize the total level of undeclared income, A+E:
Proposition 3 An interior optimum for avoidance and evasion it holds for A+Ethat
@w =A+E
@t =A+E
t[1 t]<0;
@f =@E
@f <0;
@ =p2wR(t)R(p)f1ff R (p) [R()]2g  f
[1 ]2f?0
() R(p)1ffR (p) [R()]2f?0;
@p =wR(t) [1 + R()] fR(p) [1 f2f R()] 1fg
f[1 + R(p)] R()?0
() R(p) [1 f2f R()] [1 + f]?0:
The …rst three results of Proposition 3 follow immediately from Proposition 2, for the com-
parative static e¤ects for both Aand Ego in the same direction. Both of the remaining
two e¤ects –those for and pmay go in both directions, however.7Thus, for instance, an
increase in audit probability can cause the total amount of hidden income to increase (albeit
avoided income must fall). Reassuringly, however, unlike the condition for Eto increase
in p, the condition needed for this …nding seems far from being satis…ed empirically. In
particular, it requires setting an especially low f, which, in turn, forces the tax rate to be
implausibly high. Similar remarks apply to the condition needed for A+Eto be increasing
in . The results of Proposition 3 allow us to characterize readily the comparative statics of
declared income x(wAE). For all exogenous variables except wwe obtain that the
ect for declared income will take the opposite sign to the e¤ect for total undeclared income,
i.e., @x=@ () = @[A+E]=@ (). For w, however, we obtain @x=@w =x=w > 0.
As a …nal perspective on the properties of optimal avoidance and evasion, we may characterize
the properties of the proportion (or share) of unreported income that is avoided: sA
A= [A+E]. This shall be instructive when we come to compare our results with the existing
7To demonstrate this by example, setting t= 0:85; p = 0:40;  = 0:51; f = 0:085 and w= 10 we
obtain fA; Eg=f0:64;9:36gand @[A+E]=@p = 0:74. Alternatively, setting t= 0:70; p = 0:40;
= 0:51; f = 0:02 and w= 10 we obtain fA; Eg=f1:54;8:46gand @[A+E]=@p =10:10. Turning
to , setting t= 0:80; p = 0:40;  = 0:51; f = 0:12 and w= 10 we obtain fA; E g=f0:90;9:10gand
@[A+E]=@ = 13:35. Alternatively, setting t= 0:80; p = 0:40; = 0:25; f = 0:10 and w= 10 we obtain
fA; Eg=f4:67;5:33gand @[A+E]=@=5:87.
Proposition 4 At an interior optimum for avoidance and evasion it holds that
@t =@sA
@w = 0;
@f =p2[1 p]R(p)# > 0;
@ =p2[1 pf p]R(p)# < 0;
@p =f[p]2[1 f R()] 1 + R(p)2R()# < 0;
where #nA
Proposition 4 clari…es that the share of undeclared income that is avoided is independent
of the tax rate (t) and the taxpayer’s wealth (w). This follows from the observation in
Proposition 1 that wand R(t)enter both avoidance and evasion as multiplicative factors.
We …nd that the probability of audit (p) unambiguously reduces the share of undeclared
income that is avoided, even though the e¤ect of pon evasion can be of either sign. The
results for the e¤ects of the …ne rate (f) and the cost of avoidance () follow immediately
from Proposition 2 (as these variables a¤ect avoidance and evasion in opposing ways).
5 Comparison with the literature
We now compare the …ndings of the previous section to the existing literature. First, where
our results overlap with the empirical …ndings on the interrelationship between evasion and
avoidance of Alm, Bahl, and Murray (1990), we observe agreement. These authors …nd that
the quantity [1 ft]1is negatively related to evaded income, implying that an increase in
either for treduces evasion (consistent with Proposition 2). They also …nd, again consistent
with Proposition 2, that avoided income is decreasing in the cost of avoidance (as measured
in our model by the parameter ). A caveat to these agreement in …ndings, however, is
that Alm, Bahl, and Murray identify avoidance as a riskless asset, somewhat di¤erent from
the de…nition of avoidance as a risky asset we employ here. Second, we may compare our
ndings for optimal evasion to those of Yitzhaki’s (1974) canonical model of tax evasion. Our
ndings for the e¤ect of wealth, the tax rate and the …ne rate on evasion are consistent with
Yitzhaki, but the …nding that evasion may increase in the probability of audit is derent
from that in Yitzhaki (where evasion is always decreasing in the probability of audit).
Third, we may compare our …ndings to those of Alm and McCallin (1990), who report
comparative statics results for reported income (x) and for the share of undeclared income
that is avoided (sA). Like these authors, we …nd that higher …nes for evasion increase reported
income and increase the share of undeclared income that is avoided. Di¤erent from these
authors, however, we retain the well-known result of Yitzhaki (1974) that a tax rate rise will
increase reported income (whereas Alm and McCallin report the opposite relationship) and,
whereas Alm and McCallin …nd that a tax rate rise increases the share of undeclared income
that is avoided, we …nd that this share is independent of the tax rate. It can be shown that
this independence is robust to allowing for pL<1, and allowing for a coe¢ cient of constant
relative risk aversion that is di¤erent from unity. We are unable, however, to follow Alm
and McCallin (1990) in examining the comparative statics e¤ects of quantities such as the
mean and variance of the return to evasion and avoidance, however, as in our model these
quantities are determined endogenously. Last, we may compare our …ndings to those of the
theoretical model of Alm (1988), albeit an important di¤erence between his model and ours
is that he models avoidance as a riskless asset. Alm presents comparative statics results
for the quantities wEand the share sx[wAE]=[wE] = x= [wE], i.e., the
fraction of income net of evasion that is avoided. In his very general framework, Alm nds
all comparative statics for the share sxto be ambiguous in sign. We similarly …nd that the
ects of and pon sxare ambiguous, but we …nd that the e¤ects of fand ton sxare
unambiguous –in both cases proportional to a positive constant:
@f /2p3[1 t]2R(p) [R(p)R()1] >0;
@t /pf 23R() [R(p)R()1] >0:
We …nd that sxis independent of a taxpayers wealth: @sx=@w = 0. The only other two
clear-cut results in Alm (1988) are that evasion is decreasing in the …ne rate and in the audit
probability. In our model the …rst of these e¤ects is preserved, but we …nd that evasion can
be increasing in the probability of audit.
5.1 Audit probability vs. ne rate
As a …nal comparison to the literature, we consider the …nding of Christiansen (1980) that,
for a constant expected return to evasion, the amount evaded is always reduced by increasing
the …ne rate and by decreasing the audit probability. Following Christiansen (1980), we …rst
restrict analysis solely to evasion. For a given level of avoidance the expected return to
evasion is given by Ep[1 + f]1. Holding this constant by appropriate variation of f,
and di¤erentiating Ewith respect to p, we obtain:
Proposition 5 An interior optimum for avoidance and evasion it holds that
@p E=cons:
=wR(t) ([1 R(p)] f2R() + [1 + 2f]R(p)f)
f2[1 ] [1 + R(p)] >0:
According to Proposition 5 we are able to replicate Christiansens …nding: it always worsens
evasion to raise the audit probability and lower the …ne rate, holding the expected return
to evasion …xed. In the context of a model containing both avoidance and evasion, however,
what will be relevant to a tax authority seeking to maximize tax revenue is the e¤ect of
varying pand fon the total level of income that does not get taxed. On this question we
have that:
@p E=cons:
=wR(t)f[1 p]f1 + f[3 2f R ()]g  f[1 + f]g
[1 ]f2?0:(19)
As the right side of (19) can take either sign, depending upon parameter values, we now
no longer nd that raising …nes is always superior to raising audit probability. Intuitively,
this …nding stems from the observation that increasing the …ne rate only a¤ects the evasion
decision, whereas increasing the audit probability a¤ects both avoidance and evasion. The
range of parameters for which audit probability can dominate the …ne rate is limited by
the fact that evasion is increasing in pbelow p= 0:5. We know of numerical examples,
however, that con…rm that audit probability can dominate the …ne rate even in the region
where @E=@p > 0.8
6 Probabilistic Anti-Avoidance Outcomes
Up until this point, the analysis has been undertaken with the simplifying assumption that,
if the tax authority mounts a legal challenge to the avoidance scheme, its challenge is always
successful. While important in securing a tractable model, clearly tax authorities are not
8To demonstrate this by example, setting t= 0:50; p = 0:40; = 0:53; f = 0:05 and w= 10 we obtain
fA; Eg=f2:93;5:60gand @[A+E]=@pjE=cons: = 40:65. Alternatively, setting t= 0:30; p = 0:055;
= 0:94; f = 2:5and w= 10 we obtain fA; Eg=f2:07;6:80gand @[A+E]=@pjE=cons: =91:56.
always successful in their attempts to shut-down avoidance schemes, so it is of interest to
understand how this consideration a¤ects our …ndings.
Solving for Ausing the de…nition in equation (5) and the full expression for expected utility
given in (1) we obtain
1[R(ppL)R()1] w; (20)
which can be obtained from the solution for Agiven in Proposition 1 (for the case of pL= 1)
simply by replacing pwith ppL.9It follows that the comparative statics results for Agiven
in Proposition 2 continue to hold, and that the e¤ects of pLupon avoidance are analogous
to those of p. The solution for Ecoming from (6) is complex, however. We note, though,
that the the taxpayer’s wealth and the tax rate both still enter the solution multiplicatively
as they do also for Ain equation (20) –so these two variables stay independent of the
share of undeclared income that is avoided, sA.
To make further progress we assess the properties of optimal evasion via a numerical opti-
mization procedure that locates optimal avoidance and evasion for a speci…ed set of para-
meter values. Figure 1 depicts optimal avoidance and evasion as pLis allowed to vary on
the unit interval.10 For very low values of pLin the interval denoted [0;^pLjE=0]avoidance is
seen to be maximal, and the taxpayer does not evade. In a second interval, denoted in the
gure by [^pLjE=0;^pLjA+E=w], the taxpayer both avoids and evades, and reports no income
(A+Ewis binding). In a third interval, denoted [^pLjA+E=w;1], the taxpayer again
both avoids and evades, but now A+E< w (this is the case to which our comparative
statics analysis applies). Within this interval we observe that optimal evasion increases as
the probability of a successful legal challenge increases. This is as expected, for an increase
9Whereas the expression for Agiven in Proposition 1 is the unique solution to a …rst order condition
linear in A, the expression for Ain (20) is one of a pair of solutions to a …rst order condition quadratic in
A. The other solution to this …rst order condition is A=wR (t)=[1 ]<0, which however, may be
dismissed as, by de…nition, A0.
10 The parameter values that produce Figure 1 are: w= 10; p = 0:5; t = 0:8; f = 0:1;  = 0:22. We note
that these values are chosen purely to illustrate cleanly the full range of possible outcomes of the model. As
is well-known, models such as ours, which implicitly assume taxpayers know the true probability of audit,
signi…cantly over-predict non-compliance if calibrated realistically (see, e.g., Alm, McClelland, and Schulze
(1992), footnote 3). This di¢ culty does not appear especially consequential in this context, however, for
insights such as probability weighting (Kahneman and Tversky 1979) have been shown to dramatically reduce
predicted levels of non-compliance, while not importantly a¤ecting its comparative static properties (these
being our interest in this paper).
in pLleaves the returns to evasion una¤ected, but reduces the returns to avoidance, making
evasion more attractive relative to avoidance.
In Figure 2 we explore the e¤ect of varying pLon our earlier …nding that evasion can be
increasing in the probability of audit.11 On the interval of Figure 2 where both optimal
evasion and avoidance are interior, we see that reducing pLbelow unity reduces to a value
below one-half the threshold audit probability above which evasion is decreasing in p. Thus
lower values of pLimply a smaller set of parameter values for which evasion is observed to
be increasing in audit probability.
Other numerically generated results we have analyzed – which we do not report here for
brevity –indicate that the qualitative nature of the results given in propositions 2-4 continue
to hold. In particular, the taxpayer’s wealth and the tax rate continue to act as multipliers in
the expressions for optimal avoidance and evasion, and A+Emay be either an increasing
or decreasing function in and p.
7 Conclusion
Although the economic literature has largely limited itself to the study of tax evasion, tax
avoidance is empirically observed alongside tax evasion. We therefore examine the choice of
a taxpayer of how much tax to avoid and how much to evade, under the assumptions that
(i) a taxpayer narrow brackets the joint avoidance/evasion decision –breaking the decision
down into separate avoidance and evasion sub-decisions, and taking the …rst of these two sub-
decisions in isolation from the second; and (ii) that a taxpayer will decide …rst on whether
and how much tax to avoid legally before deciding whether and how much tax to evade
illegally. Among our results are, …rst, that an analogous …nding to the so-called Yitzhaki
puzzle for evasion also holds for tax avoidance –an increase in the tax rate decreases the level
of avoided income and the level of avoided tax. Second, for a small enough audit probability,
evasion is an increasing function of the audit probability. Although tax avoidance is always
decreasing in the probability of audit, in some circumstances even the total amount of income
lost to evasion and avoidance can be increasing in the probability of audit. Last, holding
constant the expected return to evasion, it is not always the case that combined loss of
11 The parameter values that produce Figure 2 are: w= 10; t = 0:85; f = 0:11;  = 0:17; pL2 f0:7;1g.
The same qualitative conclusions obtain if the parameter values used to draw Figure 1 are instead used, but
these alternative parameter values yield improved visual clarity.
reported income due to avoidance and evasion can be stemmed by increasing the …ne rate
and decreasing the audit probability.
We …nish with some possible avenues for future research. First, it would be of interest to
allow for imperfect audit e¤ectiveness, as in Rablen (2014) and Snow and Warren (2005a,b),
for it might be that evasion and avoidance di¤er in the amount of tax inspector time required
to detect them. Second, it might also be of interest to model more carefully the market for
avoidance. In practice there are a range of providers of tax advice, ranging from those
that o¤er solely tax planning, to those that are willing to o¤er aggressive (or even criminal)
methods, making it important to understand the separate supply- and demand-side e¤ects.
A last suggestion is to embed the model within a general equilibrium framework (see, e.g.,
Alm and Finlay 2013; Neck, Wächter, and Schneider 2012), for the partial equilibrium setting
explored here may miss some important wider interactions between avoidance and evasion
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Proof of Proposition 1: From (1) we have that
@EU(A; 0)
@A =[1 p][1 ]
A[1 ] + wR(t)p
wR(t)A (A.1)
=p R(p)R()
A[1 ] + wR(t)1
wR(t)A . (A.2)
Solving for the point @EU(A; 0) =@A = 0 gives
A= arg maxAEU(A; 0) = pR (t)
1[R(p)R()1] w. (A.3)
Rewriting Ain (A.3) as A=wR(t) [1 p]1[1 ]1, substituting this expression
for Ainto (1), and di¤erentiating with respect to Egives
@EU(A; E)
@E =[1 p]
[1 p]wR(t) + Epf [1 ]
pwR(t)Ef [1 ](A.4)
=p R(p)
[1 p]wR(t) + Ef R()
pwR(t)Ef [1 ]:(A.5)
Evaluating at @EU(A; E)=@E = 0 and solving for Egives
E= arg maxEEU(A; E) = pR(t)
1[1 p] [1 f R()]
fw. (A.6)
From (A.3) and (A.6) we see that
A>0() R(p)R()>1; E>0() fR()<1:(A.7)
From (A.3) and (A.6) we compute
1[1 p] [1 f R()] + f[R(p)R()1]
fw, (A.8)
A+E< w () pR(t)
1R(p)f+fR(p) [R(p)R()1]
f<1. (A.9)
Proof of Proposition 5: Noting that
@p@f E=cons:
=wR(t)f2 [1 + f]R(p)fg
f3[1 ] [1 + R(p)] <wR(t) [1 + 2f]
f2[1 ] [1 + f]<0;(A.10)
it follows that if @E=@pjE=cons: >0when fapproaches its maximum possible value, i.e.,
f!R()1, then @E=@pjE=cons: >0for all f < R ()1. At f!R()1we indeed have
@p E=cons:
=wR(p)R(t)R() [1 + R()]
[1 ] [1 + R(p)] >0:(A.11)
Figure 1: Optimal avoidance and evasion for pL2[0;1].
Figure 2: Optimal avoidance and evasion for pL<1and pL= 1.
... A European study purported that tax avoidance was typically seen alongside tax evasion; being options actively considered by taxpayers who weighed the consequences of both. Typically, the taxpayer deployed as much tax avoidance as possible, exhausting that opportunity, and then decided how much tax evasion they could get away with without significantly increasing the likelihood of being audited (degl'Innocenti and Rablen, 2017). ...
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A study of the tax behavior of overseas Americans, both individuals and small firms is proposed. The researcher aims to discover and model behavior, through text analysis of data collected from a wide range of sources using interviews, surveys, blog and forum postings, published reports as well as personal communications, to demonstrate and inform using the pattern matching method initially proposed by Trochim (1989). Text mining and modeling techniques, using unsupervised machine learning facilitate large-scale analysis, and have been widely deployed in a range of language-based studies, driven by human-machine interaction. Major multinational corporations are excluded, and the study focuses on individuals and the smaller-scale juristic persons such as small and medium enterprises (SME). Behavioral approaches to taxation will motivate a better understanding of the phenomenon tax avoidance and tax evasion, once quantitative modeled. Overseas Americans are taxable, no matter where they reside globally, on the basis of having American citizenship. Non-citizens with a USA connection may also be subject to US taxes. The range of US taxable entities operating overseas include corporations, individuals, estates and trusts, and many of the small businesses filing as flow-through entities under the individual code, namely S-corporations, sole proprietorships, and partnerships, will be included in the study. There are an estimated 9 million taxable overseas Americans corporations and business entities. The Congressional Research Service (Gravelle, 2015), reported that as many as 100 billion U.S. dollars may go uncollected, due to tax evasion and a similar tax shortfall figure of 100 billion dollars is due to tax avoidance. Avoidance tends to be attributed to U.S. origin, multinational corporations and evasion by the smaller entities. The tax collection is exacerbated by changes to the 2018 tax code, which encourages compliance through tax cuts to a fixed 21% rate for the corporate sector, and reduced taxes for individual , opening up new avenues for aggressive tax avoidance strategies. A gap in the literature is the uncertainty regarding changing of the U.S. tax code in 2018 and how it will affect overseas American tax entities.
... A European study reported that tax avoidance was typically seen alongside tax evasion in and that the taxpayer actively considered consequences of both. Typically, the taxpayer deployed as much tax avoidance as possible, exhausting that opportunity, and then decided how much tax evasion they could get away with without significantly increasing the likelihood of being audited [7]. ...
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A study of the tax behavior of overseas American individuals and small firms, where the researcher models behavior, through text analysis, using data mining technologies of KH Coder, with data collected from a wide range of sources using interviews, surveys, blog and forum postings, published reports as well as personal communications, to demonstrate and inform using the pattern matching method. Text mining and modeling techniques, using unsupervised machine learning facilitate large-scale analysis of behavioral approaches to taxation to motivate a better understanding of the phenomenon tax avoidance and tax evasion. There are an estimated 9 million taxable overseas Americans corporations and business entities and estimated that as many as 100 billion U.S. dollars may go uncollected, due to tax evasion. A similar shortfall of 100 billion dollars is due to tax avoidance. The researcher proposes a model explaining tax avoidance behavior by the US taxable entities.
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Meskipun Specific Anti-Avoidance Rule (SAAR) menjadi salah satu instrumen dalam mengurangi penghindaran pajak, aturan ini masih menyisakan ruang bagi penghindaran pajak tertentu yang tidak diatur. Oleh karena itu, berbagai negara dengan sistem hukum yang berbeda memberlakukan General Anti-Avoidance Rule (GAAR) untuk menangkal aksi penghindaran pajak yang tidak dapat tertangani oleh SAAR. Namun, Indonesia belum menerapkan GAAR sebagai aturan anti penghindaran pajak. Penelitian ini bertujuan untuk mengonstruksi usulan desain GAAR yang ideal bagi Indonesia dengan mengkomparasikan implementasi Statutory GAAR pada tiga negara dengan sistem hukum berbeda, yakni Afrika Selatan, Singapura, dan Republik Rakyat Tiongkok. Untuk menjawab pertanyaan ini, metodologi penelitian yang digunakan adalah studi pustaka dan wawancara kepada berbagai pemangku kepentingan, yakni pembuat kebijakan, konsultan pajak, dan akademisi. Analisis tematik digunakan untuk mengolah hasil pengumpulan data menjadi usulan desain Statutory GAAR Indonesia yang terdiri atas empat skema, yaitu skema umum, administrasi, hierarki aturan GAAR dalam peraturan perpajakan, dan kendala pengaplikasian GAAR
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We study an intertemporal utility maximization problem where taxpayers can engage in both tax avoidance and tax evasion. Evasion is costless but is ned if discovered, while avoidance is costly but might be successful (i.e. deemed legitimate) with a given probability (β) upon audit. We nd that traditional deterrence instruments (ne and frequency of audit) reduce optimal evasion but, in contrast with results in a static framework, they have no impact on optimal avoidance. In fact, tax avoidance depends negatively on its marginal cost and positively on both its probability of success (β) and the tax rate. We show that non-compliance behavior may result in a Laer curve for scal revenues and that the revenue maximizing tax rate is lower the higher β. We characterize the optimal level of β by taking into account dierent government objectives: minimizing evasion, minimizing non-compliance (evasion plus avoidance), or maximizing revenues. Our results suggest that specic policies (e.g., tax simplication) need to be implemented to deter avoidance and we illustrate their impact on evasion.
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Recent years have witnessed the growth of mass-marketed tax avoidance schemes aimed at the middle (not top) of the income distribution, with significant implications for tax revenue. We examine the consequences for the structure of income tax, and for tax authority anti-avoidance efforts, of tax avoidance of this type. In a model that allows for both demand- and supply-side considerations, we find that (1) there is an endogenous threshold income below which taxpayers do not avoid, and above which they avoid maximally; (2) the per-dollar price of tax avoidance is decreasing in income under progressive taxation; (3) endogenous adjustments in the price of avoidance make supply less responsive to anti-avoidance activity than thought previously; and (4) that avoidance may drive a non-monotone relationship between tax rates and tax revenue. The findings suggest that new approaches to anti-avoidance, beyond legal enforcement, may be needed.
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Portuguese corporate income tax has a special feature rarely seen in other countries. Autonomous taxes are levied on an extensive set of corporate expenses, irrespective of corporate profitability. Fiscal revenue from the autonomous taxation of expenses comprises about 12 % of corporate income tax receipts, which illustrates its relevance for the tax authorities and the corporate world. As autonomous tax rules are usually interpreted and applied to certain corporate expenses by chartered accountants (CAs) when computing income tax liabilities and filling in tax returns, the purpose of this paper is to present an empirical study of the perceptions of Portuguese CAs regarding key dimensions of autonomous taxation of expenses (ATE), as these influence corporate tax management. Using a sample of 665 CAs surveyed, and applying factor analysis, the paper concludes that tax complexity, tax compliance and tax planning are the main dimensions of ATE perceived by respondents. Besides the corporate income tax impact on fiscal management, new layers of complexity, planning opportunities and compliance costs are perceived to be added by ATE. Additionally, by applying cluster analysis, the paper finds that sociodemographic characteristics of CAs (e. g. age, gender, professional environment, level of expertise) generate clusters of CAs with different perceptions of the role and consequences of ATE in the management of corporate tax affairs.
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The analysis of the individual's choice of illegal tax evasion has typically ignored an alternative, legal method by which taxes can be reduced: tax avoidance. This article analyzes the joint individual choice of evasion and avoidance; it also examines optimal government policy in such a world. Its principal conclusion is that the existence of another channel for tax reduction alters many of the conclusions of the simpler evasion literature. Specifically, government policies that reduce evasion may not increase the tax base because avoidance may increase instead, and tax rate reductions may be a powerful tool for generating tax base increases because reductions make both evasion and avoidance less attractive. In addition, optimal government choices depend critically upon its objectives. The government selects larger values for its instruments when its goal is net revenue maximization or when those individuals who evade are not valued highly in its welfare function. It also appears that greater tax complexity generates more tax revenues.
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This article uses data from survey questions fielded on the 2011 wave of the Cognitive Economics Study to uncover systematic errors in perceptions of income tax rates. First, when asked about the marginal tax rates (MTRs) for households in the top tax bracket, respondents underestimate the top MTR on wages and salary income, overestimate the MTR on dividend income, and therefore significantly underestimate the currently tax-advantaged status of dividend income. Second, when analyzing the relationship between respondents’ self-reported average tax rates (ATRs) and MTRs, many people do not understand the progressive nature of the federal income tax system. Third, when comparing self-reported tax rates with those computed from self-reported income, respondents systematically overestimate their ATR while reported MTR are accurate at the mean, the responses are consistent with underestimation of tax schedule progressivity.
Conference Paper
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I build a macroeconomic model with heterogenous households that determine how much to deduct from a broad definition of income in order to compute the taxable income. This tax avoidance mechanism is crucial to obtain a better matching for the empirical facts regarding households' responses to tax reforms and the available data about allowable deductions and exemptions for the United States. When tax avoidance is present, the optimal policy mix implies a capital income tax rate of 53% and a labour income tax rate of 10%, both lower compared to a setting where tax avoidance is absent. Additionally, in the former economy the government relies more heavily on consumption taxation in order to finance the stream of public expenditure.
This paper explores some important behavioral aspects of tax evasion — subjective probability bias, perception of other people’s behavior, social stigma — by building on work of Tversky & Kahneman (1979, 1981), Sagi & Weinblatt (1982) and Benjamini & Sagi (1983). The conventional expected-utility model of optimal tax evasion is portrayed graphically, then modified to include stigma and fear of apprehension, probability bias and misinformation. A game-theoretic model of tax evasion emphasizes the importance of one’s expectation about other people’s decision to evade or be honest. The next section develops a formula for optimal government policy against evasion, once evasion behavior is known. The final part of the paper describes a game-simulation study of tax evasion that relates underreporting of income to both tax parameters and individual personality.
Purpose – The purpose of this paper is to discuss the rhetorical framings that can be discerned by applying discourse analysis to a publicly available transcript of a Public Accounts Committee (PAC) inquiry in the UK. Design/methodology/approach – In particular, the authors examine the discursive tactics used during the 2013 investigation by the House of Commons PAC, “Tax Avoidance: The Role of Large Accountancy Firms”. Findings – Two opposing rhetorical framings of “tax avoidance” are analysed which the authors see developing incrementally and directly opposing each other. Metaphors are used by the PAC to exemplify the dark side of professions, including potentially transgressing the boundaries of what constitutes “tax avoidance”. This is counteracted by the Big Four portraying an alternative market-oriented/neo-liberal view of professions pursuing a societal good through dedication to promoting market competition. Originality/value – Whilst one rhetorical framing is predicated on being able to draw a clear distinction between tax evasion and tax avoidance, the alternative rhetorical framing contests this distinction and contributes to an existing cultural account that paints the dark side of some of the professions. Extending the work of Creed et al. (2002) and Alexander (2011), the authors demonstrate the bridging between micro-level discursive acts and broader cultural accounts, at the macro level. As such the authors discuss the pertinence of this multi-level discursive contest, within post-inquiry sensemaking, for understanding the “dark side” of professions.
Gorman [2] has derived necessary and sufficient conditions for the existence of category expenditure functions which yield the optimal allocation of a consumer unit's income to each of a number of groups of commodities as functions of total income and group price indices. These conditions take the form of certain restrictions on the structure of the utility function. Gorman, however, did not address the problem of how these functions are derived. In this paper, we construct an algorithm (a budgeting procedure) for deriving the category expenditure functions and show that the necessary and sufficient condition for this procedure to be consistent is that the utility function be separable into homothetic parts.
Most classical tests of constant relative risk aversion (CRRA) based on individual portfolio composition use cross-sectional data. Such tests must assume that the distributions of wealth and preferences are independent. We use panel data to analyze how individuals’ portfolio allocation between risky and riskless assets varies in response to changes in total financial wealth. We find the elasticity of the risky asset share to wealth to be small and statistically insignificant, supporting the CRRA assumption; this finding is robust when the sample is restricted to households experiencing large income variations. In addition, we find a small but significant negative correlation between wealth and risk aversion. Various extensions are discussed.
This paper analyzes the problem of optimal taxation of top labour incomes. We develop a model where top incomes respond to marginal tax rates through three channels: (1) the standard supply-side channel through reduced economic activity, (2) the tax avoidance channel, (3) the compensation bargaining channel through efforts in influencing own pay setting. We derive the optimal top tax rate formula as a function of the three elasticities corresponding to those three channels of responses. The first elasticity (supply side) is the sole real factor limiting optimal top tax rates. The optimal tax system should be designed to minimize the second elasticity (avoidance) through tax enforcement and tax neutrality across income forms, in which case the second elasticity becomes irrelevant. The optimal top tax rate increases with the third elasticity (bargaining) as bargaining efforts are zero-sum in aggregate. We then analyze top income and top tax rate data in 18 OECD countries. There is a strong correlation between cuts in top tax rates and increases in top 1% income shares since 1975, implying that the overall elasticity is large. But top income share increases have not translated into higher economic growth, consistent with the zero-sum bargaining model. This suggests that the first elasticity is modest in size and that the overall effect comes mostly from the third elasticity. Consequently, socially optimal top tax rates might possibly be much higher than what is commonly assumed.