The University of Michigan
The Hebrew University of Jerusalem
Tax avoidance and evasion are pervasive in all countries, and tax structures are
undoubtedly skewed by this reality. Standard models of taxation and their conclusions
must reflect these realities.
This paper first presents theoretical models that integrate avoidance and evasion into
the overall decision problem faced by individuals. Early models of this area focused
on tax evasion, modeled as a gamble against the enforcement capability of the state.
More recently, the literature has examined more general models of the technology of
avoidance, with the additional risk bearing caused by tax evasion either being a special
case of this technology or one aspect of the cost of changing behavior to reduce tax
liability. If the cost of evasion and avoidance depends on other aspects of behavior,
the choice of consumption basket and avoidance become intertwined. The paper then
relates the behavior predicted by the model to what is known empirically about the
extent of evasion and avoidance, and how it responds to tax enforcement policy.
The paper then turns to normative analysis, and discusses how avoidance and
evasion affect the analysis of vertical and horizontal equity as well as efficiency
costs; a taxonomy of efficiency costs is presented. Acknowledging the variety of
behavioral responses to taxation changes the answers to traditional subjects of inquiry,
such as incidence, optimal progressivity, and the optimal mix between income and
consumption taxes. It also raises a whole new set of policy questions, such as the
appropriate level of resources to devote to administration and enforcement, and how
those resources should be deployed. Because there are a variety of policy instruments
that can affect the magnitude and nature of avoidance and evasion response, the
elasticity of behavioral response is itself a policy instrument, to be chosen optimally.
The paper reviews what is known about these issues, and introduces a general theory
of optimal tax systems, in which tax rates and bases are chosen simultaneously with
the administrative and enforcement regimes. We argue that the concept of the marginal
efficiency cost of funds is a useful way to summarize the normative issues that arise,
and expand the concept to include administrative costs, avoidance, and evasion.
taxation, evasion, enforcement, avoidance
1.1. Why avoidance, evasion and administration are central, not peripheral,
concepts in public finance
Most economic analysis of taxation presumes that tax liability can be ascertained and
collected costlessly. As a description of reality, this is patently untrue. For example, in
the U.S. the Internal Revenue Service (henceforth IRS) estimates that about 17% of
income tax liability is not paid ‘; the figure for most other countries is probably higher.
Furthermore, the resource cost of collecting what is paid can be large, in the U.S.
probably about 10% of tax collections 2. The tax structures themselves are undoubtedly
skewed by the realities of tax evasion, avoidance, and administrative costs.
The standard models of taxation and their conclusions need to be modified in
the light of these realities. Many practitioners of tax advice in developing countries
believe that this change in emphasis is essential; for example, Casanegra de Jantscher
(1990, p. 179) goes so far as to say that, in developing countries, “tax administration
is tax policy”3 . Bird (1983), Mansfield (1988), and Tanzi and Pellechio (1997) are
useful summaries of the practical problems of the interaction of tax policy and tax
administration in this context,
We believe that these issues are also critical in developed countries. In this setting,
the issue is not the feasibility of certain taxes, but rather the optimality of alternative tax
structures. For example, while in many developing countries an income tax that relies
on self-reporting cannot be administered at all, in a developed country the question is
to what extent optimal tax design should reflect the reality of evasion, the necessity of
enforcement, and the costs of collection. In fact, tax systems do reflect these issues,
although there is little systematic guidance offered by the academic public finance
literature. The objective of this chapter is to collect and critique the now sizable
literature that addresses these questions.
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