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Understanding Tax Evasion: Combining the Public Choice and New Institutionalist Perspectives

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Understanding Tax Evasion: Combining the Public Choice and New Institutionalist Perspectives 30 Understanding Tax Evasion: Combining the Public Choice and New Institutionalist Perspectives Klarita Gërxhani and Ronald Wintrobe 1 Introduction In the economic theory of tax evasion, individuals and corporations pay taxes only because they are forced to (i.e., because they believe that if they do not, they would be liable to prosecution by the state). If this were the case, it would be essential that the probability of being discovered for tax evading and the size of the penalty if caught and convicted are sufciently large to deter eva- sion. One problem with this standard view is that for some taxes, such as self- reported income taxes, it is hard to believe that the probability of being caught for evasion is very large. In fact, all countries do encounter tax evasion, even those with the most sophisticated systems for gaining compliance. To illus- trate, the United States Internal Revenue Service (IRS) estimates that the pro- portion of all individual tax returns that are audited was 0.5% in 2017 (down from 0.8% in 1990 and 4.75% in 1965). Civil penalties can add an addi- tional 85% to the underpayment, depending on whether there is a specifc misconduct such as negligence, substantial understatement, or substantial intentional wrongdoing. In very serious cases, criminal penalties may be K. Gërxhani (*) Department of Political and Social Sciences, European University Institute, San Domenico di Fiesole, Italy e-mail: [email protected] R. Wintrobe Western University London, London, ON, Canada © Te Author(s) 2021 785 E. Douarin, O. Havrylyshyn (eds.), Te Palgrave Handbook of Comparative Economics, https://doi.org/10.1007/978-3-030-50888-3_30 786 K. Gërxhani and R. Wintrobe applied. However, the penalties imposed are either small or infrequent (Alm 2019). Yet, the IRS estimates that, for the tax year 2015, 90.8% of income that should have been reported was in fact reported.1 Table 30.1 provides a comparison of the size of the shadow economy (total undeclared income), over the period 1991–2015, across developed, develop- ing, and (former) transition countries. Te table shows that shadow economy is particularly severe in developing countries. In Europe, countries from Central and Eastern Europe but especially those from the former Soviet Union appear to have the highest levels of shadow activities. Why is compliance lower in these countries? And why don’t these countries simply raise the pen- alties for non-compliance and solve the problem that way? An interesting literature has developed around these issues in recent years, centering around the idea that the willingness to pay taxes is culturally deter- mined and difers across countries. Studies in this vein include Freidman et al. (2000), Alm and Torgler (2006), Frey and Torgler (2007), Gërxhani and Schram (2006), Hammar et al. (2009), Renooy et al. (2004), Torgler (2003), Torgler (2007), Torgler and Schneider (2009), Zhang et al. (2016), and Alm (2019). Te willingness to pay taxes is sometimes viewed as a cultural norm or a product of values, which are specifc to a particular country. Tis allows both estimates to be made of this variable (the willingness to pay taxes) and indirectly to get at the elusive and quasi-mystical concept of “culture” by pro- viding a nice number quantifying at least one aspect of it—the propensity to pay taxes. Tus, Alm and Torgler (2006) suggest that the intrinsic motivation to pay taxes—their “tax morale”—difers across countries, and they provide evidence that this morale is much higher in the United States than in many European countries. Table 30.1 The average size of the shadow economy, over the period 1991–2015, across developed, developing, and (former) transition countries Countries/continents Size as % of GDP Developed Old EU member states 16.1 (Former) Transition countries Central and Eastern Europe 26.0 Former Soviet Union 45.1 Baltic States 23.7 Developing Africa 39.2 Latin America 38.9 Asia 27.0 Source: Own calculations based on Medina and Schneider (2018, Table 18) 1 All fgures in this paragraph are from the Internal Revenue Service Data Book (2018). 30 Understanding Tax Evasion: Combining the Public Choice… 787 Why these norms appear to difer so much is then a fundamental question. One idea is suggested by Kirchgässner (1999). He argues that in the northern states of Europe (in contrast to the south), state and religious authority were held by one person. Ofenses against the state were therefore also religious ofenses and consequently a sin. Tis “sinfulness” idea might explain why the propensity to pay taxes appears to be highest in the United States. Religiosity is much higher in the United States than in Europe. But this would be dif- cult to square with the fact that crime rates are also much higher in the United States. Also, in Canada, there is a similarly high propensity to pay taxes, but much lower levels of religiosity and crime. Frey and Torgler (2007) view the payment of taxes as an example of “pro- social” behavior. Tey take a further step by suggesting that taxpayers are will- ing to pay their taxes conditionally, depending on the pro-social behavior of others. Put simply, people are more willing to pay taxes when they believe others are paying them. Tey develop an index of tax morale defned this way. Using survey data from a number of Western and Eastern European coun- tries, they fnd a high (negative) correlation between perceived tax evasion and tax morale. Tey also relate tax morale to a number of variables, including political stability and the absence of violence, regulatory quality, and control of corruption. In this approach, “trust” enters the picture because even if a government is expected to provide exactly what the citizen wants in the way of public pro- grams, it is still usually rational for the individual to free ride and not pay her taxes if she expects she can get away with it. To put it diferently, there is no way the “exchange” of taxes for services can be legally enforced at typical pen- alties for tax evasion, and raising penalties is not necessarily the right solution, as discussed later in the chapter. So trust in government, and in other citizens, that is, the belief that other citizens are going to pay their taxes, flls this gap. In this respect, our view can be linked to fscal sociology and state capacity, which presents the development of the tax system and tax collection as the outcome of a continuous dialogue between the state and the wider population (see Moore 2004).2 Moreover, our view can also be linked to new institution- alism, arguing that informal institutions, as captured in trust, determine the extent of tax compliance (Feige 1997). Te importance of informal institu- tions is also stressed by Chhibber, for example: “Even when formal rules are similar, informal rules or social capital can in some situations explain a signifcant part of the reason why some societies progress faster than others” 2 For a discussion of fscal sociology applied to the transition region, see also Douarin and Mickiewicz (2017). 788 K. Gërxhani and R. Wintrobe (Chhibber 2000, p. 297). We support this view by combining the public choice approach to the problem of tax evasion with a new foundation based on institutionalist insights such as those found in the literature on tax morale. Te theoretical predictions we derive will be tested with a unique database for Albania where tax evasion and some informal institutions with respect to taxes are measured. Te chapter is organized as follows. Te next section describes the eco- nomic theory of tax evasion. Section 3 describes the public choice approach. Section 4 takes us a step further in understanding the issue of tax evasion by introducing the concept of “trust-based political exchange”, and providing precise defnitions of trust and related variables like social capital. Section 5 tests two theoretical predictions established in the previous section. Concluding remarks and some policy implications follow in Sect. 6. 2 Economic Theory of Tax Evasion Te standard economic view of tax compliance in tax theory is that taxes are a “burden” or windfall harm. Individuals do not consider taxes in relation to the other side of the government ledger—expenditures. Te chief problem in normative taxation theory is to devise taxes minimizing the “excess burden”, that is, how to minimize the total burden of taxation. In order to know more about this theory, let us have a look at the standard theoretical model (Allingham and Sandmo 1972; Yitzhaki 1974) in more detail. As is now common in the literature on tax evasion, the model visualizes an individual taxpayer facing a tax rate t on own income Y. If she chooses to evade taxes, she faces a punishment ftE, where E is the amount of unreported income and f is the size of the punishment (the fne rate) if caught. Tus, in one sense, the model adapts the standard crime model of Becker (1968) to the taxation case. In another sense, tax evasion is part of optimal portfolio choice: the individual who chooses to evade taxes in efect makes a risky bet that she will not be caught and convicted. However, the Yitzhaki (1974) model makes an odd prediction—namely, that an increase in the tax rate t actually leads to less tax evasion. Tis result holds in the model as long as individual absolute risk aversion decreases as income increases. Tis prediction is at variance with empirical evidence (e.g., Clotfelter 1983), the results of laboratory experi- ments (e.g., Friedland et al. 1978),3 and, it would seem, even with common 3 In these experiments, the single most important factor resulting in evasion was the tax rate.
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