Tax Evasion in the Presence of Negative Income Tax Rates

TAX EVASION IN THE PRESENCE OF NEGATIVE INCOME TAX RATES

TAX EVASION IN THE PRESENCE OF NEGATIVE INCOME TAX RATES DAVID JOULFAIAN * & MARK RIDER *

Abstract - This paper examines the among other policy instruments, on tax impact of marginal tax rates, which compliance. The availability of the incorporate the earned income tax earned income tax credit (EITC) allows credit (EITC) as it existed in 1988, on the us to extend such studies by examining reporting of income by low-income an interesting and generally overlooked taxpayers. We generally find that question: the effect of negative tax rates misreported income is not affected by on reported income.1 Furthermore, the tax rates, except for proprietors. EITC enables us to examine the response Negative marginal tax rates, which occur of low-income taxpayers to relatively in the phase-in range of the EITC, do not high marginal tax rates. Because the appear to affect the amount of income EITC initially increases with income, overreported, irrespective of the source marginal tax rates are negative for some of income. Furthermore, the amount of recipients. Some low-income taxpayers, income underreported does not appear however, face relatively high positive tax to be affected by the relatively high rates as the credit is phased out. In marginal tax rates which occur in the 1988, the year of our focus, marginal phase-out range, except for proprietors. tax rates ranged from –0.14 to 0.37 for Even in the case of proprietors, the credit recipients.2 effect on the understatement of income is modest. In order to study the response of taxpayers to the negative tax rates and the high positive tax rates under the EITC, we employ a random sample of income tax returns examined by the INTRODUCTION Internal Revenue Service (IRS) as part of the 1988 Taxpayer Compliance Mea- Since the seminal work of Allingham surement Program (TCMP). The TCMP and Sandmo (1972), a number of data provide detailed information on studies have examined the influence of sources of income, deductions, credits, tax rates, audit rates, and penalties, and tax liabilities, among other taxpayer attributes, before and after adjustment upon audit. The subsample used in the

*Office of Tax Analysis, U.S. Department of the Treasury, present study consists of 3,219 low- Washington, D.C. 20220. income households, with about one-

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third ineligible for the credit but Following the standard comparative included in the sample as a control static results, the theoretical literature group. shows that reported income varies positively with income, audit rate, and Our empirical strategy permits us to penalty rate, with the tax rate effect identify the determinants of a ambiguous. If we assume that declared household’s choice to underreport, income decreases with tax rates overreport, or accurately report income. (Clotfelter, 1983) and credits (negative Conditional on this choice, we also taxes) are treated symmetrically, as identify the determinants of the amount required by the axioms of the expected of income misreported. We find that utility hypothesis, then it follows that marginal tax rates have a moderate declared income increases as the credit 3 influence on the reporting of income: rate increases. The reverse, of course, the estimated elasticity of under- should be observed if declared income reported income with respect to the tax increases with tax rates (Feinstein, 1991; rate is 0.27, and it is not significantly Graetz and Wilde, 1985). different from zero for income overstated. The credit, primarily in the THE TCMP DATA phase-out range, has a moderate effect on the understatement of income, but In order to evaluate the influence of tax only for proprietors, explaining less than and credit rates on the reporting of ten percent of the amount of income income, we use data from the IRS’s understated, or less than two percent of 1988 TCMP. The 1988 TCMP study income. consists of a randomly selected sample of 54,090 tax returns. Each return in this sample is subject to an extensive The remainder of the paper is organ- line-by-line audit. Thus, we observe the ized as follows. First, we briefly review amount of income reported by the the literature on tax evasion, describe taxpayer and, as corrected upon audit, the structure of the EITC, and take a tax and credit rates, among other preliminary look at the observed pat- variables, for every observation.4 tern of compliance. Then, we discuss our econometric model of tax evasion Since we focus on the impact of both and the construction of the variables. negative and high positive marginal Finally, we report the empirical results rates on low-income taxpayers, we and provide some concluding com- eliminate all returns with adjusted gross ments. income (AGI), or labor income, greater than $18,575 and returns reporting nonpositive income. Furthermore, we BACKGROUND AND DATA SOURCES eliminate the returns of taxpayers who Allingham and Sandmo (1972), Yitzhaki are either under 18 or over 64 years old, (1974), and Pencavel (1979) adapt the married taxpayers filing separately, expected utility framework to the study individuals claimed as dependents by of tax evasion. In these models, the others, single individuals, and taxpayers amount of declared income is a function subject to the alternative minimum tax. of the individual’s income, income tax We also exclude observations where the rate, audit rate, and penalty rate filing status and/or the number of conditional upon the individual’s dependent children changed upon attitude toward risk. audit.5 After excluding these taxpayers,

554 TAX EVASION IN THE PRESENCE OF NEGATIVE INCOME TAX RATES

we are left with a sample of 3,219 AGI exceeds labor income, the credit taxpayers of which 2,153 are eligible for may be reduced and consequently the the credit. The remaining 1,066 obser- combined marginal tax rates may be vations are low-income, childless joint higher for given levels of income. filers who are ineligible for the credit.6 Column 1 shows that individuals with income under $8,350 face a statutory THE STRUCTURE OF THE EITC tax rate of zero. Columns 2 and 3 show In 1988, the tax code provided for a tax that the phase-in range of the credit credit of 14 cents per dollar of earned creates a negative marginal tax rate income. The maximum credit was $874, (–0.14) if the taxpayer’s income is less which would be attained at $6,225 of than $6,225. On the other hand, if the earned income. The credit was phased taxpayer’s income is between $6,225 out at the rate of 10 cents per dollar of and $8,300, both the statutory and the greater of earned income or AGI in credit rates are zero. When income is excess of $9,850 and, thus, completely between $8,300 and $9,850, the phased out at an income of $18,576. statutory rate is 0.15, while the credit Unlike wage earners, whose payroll rate remains at zero. The phase-out taxes are withheld by the employer, the range2 occurs between $9,850 and self-employed report their payroll tax $18,576, where the statutory tax rate is liability when filing their income tax 0.15 and the phase-out rate is 0.10 for return. Consequently, when we com- a2 combined rate of 0.25. Columns 4 pute the tax liability of the self-em- and 5 show how these rates vary when ployed, we include their Social Security Social Security taxes are included.8 tax liability, which is equal to 0.1302 percent of income.7 The Observed Pattern of Compliance Table 1 provides a summary of the In Tables 2 and 3, we provide a snapshot marginal tax rates in effect in 1988 for of the compliance pattern for EITC eligible and ineligible taxpayers. Table 2 wages in the column labeled t w and self- employment income in the column shows the number and average amount of earned income overreported, labeled t s. In order to simplify the exposition, the table is constructed accurately reported, and underreported, assuming1 a single head of household according to EITC status and income with a dependent child and AGI class for the entire sample. The three consisting solely of labor income, or income classes are chosen so that wages, proprietorship, and farm taxpayers eligible for the EITC face income.1 It is important to note that, if either (1) the phase-in range, where

TABLE 1 MARGINAL TAX RATES IN 1988 Statutory Rate Due Combined Payroll Combined Rates Labor Rate to Credit Rates Tax Rate Plus Payroll Tax

Income ( t )(t c)(t w)(t p )(t s ) Under $400 0 –0.14 –0.14 0 –0.14 $400–$6,225 0 –0.14 –0.14 0.1302 –0.0098 $6,225–$8,300 0 0 0 0.1302 0.1302 $8,300–$9,850 0.15 0 0.15 0.1302 0.2704 $9,850–$18,576 0.15 0.10 0.25 0.1302 0.3704

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TABLE 2 OBSERVED COMPLIANCE BY INCOME CLASS: ALL TAXPAYERS (FREQUENCY, RELATIVE FREQUENCY, CONDITIONAL MEAN, AND STANDARD DEVIATION) EITC ELIGIBLE Adjusted Gross Income

Labor Income <$6,225 $6,225–$9,850 >$9,850 All Overreported 32 28 85 145 21.6% 9.4% 5.0% 6.8% 1,711 1,206 1,175 1,299 (2,282) (1,653) (1,832) (1,908)

Correctly reported 64 117 1,024 1,205 43.2% 39.4% 60.0% 55.9% 0 0 0 0 (0) (0) (0) (0)

Underreported 52 152 599 803 35.1% 51.2% 35.1% 37.3% 1,251 1,795 2,754 2,475 (1,224) (1,903) (2,827) (2,642)

Total 148 297 1,708 2,153

EITC INELIGIBLE Adjusted Gross Income

Labor Income <$6,225 $6,225–$9,850 >$9,850 All Overreported 18 15 40 73 17.8% 11.5% 4.8% 6.8% 1,443 2,581 1,291 1,593 (2,074) (2,635) (1,195) (1,844)

Correctly reported 20 38 472 530 19.8% 29.0% 56.6% 49.7% 0 0 0 0 (0) (0) (0) (0)

Underreported 63 78 322 463 62.4% 59.5% 38.6% 43.4% 1,471 2,104 2,950 2,606 (1,444) (2,232) (3,348) (3,033)

Total 101 131 834 1,066

negative rates occur (AGI less than and underreport income appear to be $6,225); (2) zero marginal rate (AGI invariant to credit eligibility. For those between $6,225 and $9,850); or (3) the eligible for the EITC, shown in the upper phase-out range (AGI greater than panel of Table 2, 6.8 percent overstate $9,850). Similarly, Table 3 reports this income by an average of $1,299, 55.9 information for the subsample of sole percent accurately report income, and proprietors. 37.3 percent understate income by an average of $2,475. While, as shown in Several patterns emerge from examina- the lower panel of Table 2, 6.8 percent tion of Tables 2 and 3. First, the propor- of the sample ineligible for the EITC tions that overreport, accurately report, overstate income by an average of

556 TAX EVASION IN THE PRESENCE OF NEGATIVE INCOME TAX RATES

TABLE 3 OBSERVED COMPLIANCE BY INCOME CLASS: SOLE PROPRIETORS (FREQUENCY, RELATIVE FREQUENCY, CONDITIONAL MEAN, AND STANDARD DEVIATION) EITC ELIGIBLE Adjusted Gross Income

Labor Income <$6,225 $6,225–$9,850 >$9,850 All Overreported 24 18 56 98 25.3% 9.9% 9.4% 11.3% 1,190 1,241 1,025 1,105 (1,447) (1,704) (1,551) (1,542)

Correctly reported 28 41 97 166 29.5% 22.7% 16.4% 19.1% 0 0 0 0 (0) (0) (0) (0)

Underreported 43 122 440 605 45.3% 67.4% 74.2% 69.6% 1,269 1,892 3,022 2,670 (1,250) (1,934) (2,970) (2,761)

Total 95 181 593 869

EITC INELIGIBLE Adjusted Gross Income

Labor Income <$6,225 $6,225–$9,850 >$9,850 All

Overreported 13 10 27 50 18.3% 11.0% 8.5% 10.4% 1,367 1,972 1,144 1,368 (2,216) (2,161) (1,192) (1,708)

Correctly reported 11 18 61 90 15.5% 19.8% 19.1% 18.7% 0 0 0 0 (0) (0) (0) (0)

Underreported 47 63 231 341 66.2% 69.2% 72.4% 70.9% 1,387 2,194 3,257 2,803 (1,384) (2,350) (3,522) (3,185)

Total 71 91 319 481

$1,593, 49.7 percent accurately report accurately report income. About 70 income and 43.4 percent understate percent of proprietors understate income by an average of $2,606. income, compared to only 40 percent for the entire sample. Second, the source of income appears to influence taxpayer compliance. For Third, observed overreporting may example, comparing Tables 2 and 3, sole simply reflect taxpayer mistakes. For proprietors, whether eligible or ineligible example, the top panel of Table 2 shows for the EITC, appear to be less compli- that individuals who are eligible for the ant than the population as a whole, at EITC and face negative tax rates are two least judging by the proportion that to four times more likely to overreport

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income than those in the other two taxpayer attributes. Though we do not income groups, or 21.6 percent versus observe the values of the index in each 9.4 and 5.0 percent, respectively. state, we do observe the state chosen, This pattern could lead one to con- denoted by I. clude that negative tax rates induce taxpayers to overreport income. Consider the following trichotomous However, the bottom panel shows choice model: that individuals ineligible for the EITC exhibit a similar pattern, although they do not face negative marginal tax rates 1 and thus do not have the same incentive to overreport income. The absence I *S = zSg + h S of an incentive for taxpayers who are ineligible for the EITC to overreport where s = 1, 2, or 3. income suggests that overreporting should be attributed to taxpayer Define as follows: mistakes, and not just to the negative es tax rates in the phase-in range of the EITC.9,10 2

e = max (I *) – h MODELING COMPLIANCE s j s

While the results in Tables 2 and 3 are where j = 1, 2, or 3; j ¹ s. suggestive, we turn to multivariate analysis in order to shed further light on the pattern of compliance and its Then correlates. The observed pattern of compliance reported in these tables raises certain econometric issues not I = s iff fes < zsg . traditionally addressed in the tax compliance literature. If the h s values are independent and follow identical extreme value distribu- tions, then, as Domencich and Econometric Issues McFadden (1975) show, As shown in Tables 2 and 3, we observe taxpayers underreporting, accurately reporting, and overreporting income. 3

g Accordingly, we assume taxpayers Z s P (I = s) = –––––e choose between these three states, 3 denoted by 1, 2, and 3, respectively. Let S eZ j g j=1 * us suppose an index I s represents the utility of a taxpayer in state s. Further- where P (I = s) is the probability of event more, suppose the taxpayer chooses the s. Consequently, we estimate the state with the maximum value of the probability of making choice s using a index. Finally, assume the value of the multinomial logit model. The error term index depends upon a vector zs of captures unobserved characteristics

558 TAX EVASION IN THE PRESENCE OF NEGATIVE INCOME TAX RATES

(e.g., preferences, attitudes toward risk, evasion literature for failing to distin- and mistakes) that lead individuals to guish between overreporters and those misreport income. who accurately report their income.11

For states 1 and 3, we assume the amount of income under- or overreported, Variable Construction ys , depends upon a vector x of personal In order to estimate equations 3 and 4 attributes including certain tax variables: and to examine the pattern of income misreporting and its determinants, we employ a number of variables tradition- 4 ally used in the literature to represent taxpayer attributes. The following is a y = x + u s sbs s brief description of the variables. where s = 1 or 3. Misreported Income: Our dependent variable is defined as the difference

We observe ys if and only if I = s. Again, (±$1) between corrected labor income we assume the error term represents and reported labor income. Labor, or unobserved characteristics that influence earned, income is defined as the sum of the amount of misreported income. The wage, proprietorship, and farm in- joint role of the unobserved characteris- come.12 tics, which influence the probability and the amount of misreported income, Detection Rate: Due to the withholding means the errors are likely to be feature of the U.S. income tax, correlated. misreported wage income is subject to nearly 100 percent probability of This situation differs from the usual detection, while misreported self- selectivity problem discussed by employment income has a much lower Heckman (1976), because the error term probability of detection. To account for in the first stage is not normally distrib- these differences in the probability of uted. Lee (1983) describes a generaliza- detection, we use the share of labor tion of Heckman’s two-stage procedure income attributable to wage income which can accommodate this situation. (wage share) as a proxy for the probabil- In the first stage, conventional multino- ity of detection. mial logit estimation is used to estimate the probabilities of noncompliance. In Marginal Tax Rate: We compute last the second stage, we obtain consistent dollar marginal tax rates by adding $1 estimates of b and corrected standard to reported income and calculate the errors by estimating the amount of change in tax liability net of the EITC. misreported income by ordinary least Since this tax rate is endogenous to the squares (equation 4) augmented by the amount of income misreported, we inverse Mill’s ratio computed as de- compute a predicted tax rate using a scribed by Lee. procedure similar to that described in Burman and Randolph (1994). First, we We believe this procedure is dictated by regress the last dollar tax rate on the the structure of the credit. It also first dollar tax rate and a vector of responds to criticisms of the customary taxpayer attributes: marital status, age, approach adopted in the empirical tax age-squared, AGI, and wage share.

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Second, the predicted tax rate is used in About 42 percent of the observations the multinomial logit equations to report income from proprietorships and estimate the probability of over- and 12 percent from farms, while 70 percent underreporting income. Third, we are married. The average labor income is compute the predicted tax rate by approximately $11,784, with an average including the inverse Mill’s ratio in the of $898 misreported or about $1,900 if first step. Finally, the predicted tax rate is we use the absolute value of used in the second stage regressions for misreported income. Paid preparers are the amount of income under- or employed by 62 percent of the filers; overreported.13 very few rely on IRS assistance. The credit was claimed by 67 percent of the Income: Income is defined as AGI as filers in the sample. corrected upon audit.

We include additional variables to EMPIRICAL RESULTS capture preferences and account for Our empirical strategy is shaped by the third party preparation of tax returns. striking fact reported in Table 4 that These variables are described below. most of those who misreport income are either proprietors or farmers. Marital Status: A dummy variable that is Accordingly, we stratify our sample into set equal to one when the filer is wage earners, proprietors, and farmers married. and examine the probability of misreporting income and the amount of Age: We use the age of the primary income misreported, following the taxpayer with a quadratic specification. framework described above.14 Distin- guishing between the compliance Preparer: We create two dummy behavior of entrepreneurs and laborers variables for returns prepared with (1) allows us to control for differences in paid professional help (certified public the rates of detection and audit rates accountant, attorney, or national tax and conforms to the empirical finding in service) and (2) other paid help. Clotfelter (1983) and the theoretical exposition of Pestieau and Possen Table 4 provides summary statistics for (1991).15 the sample of tax returns used in the present study. The table also reports summary statistics for three subsamples: The Decision to Misreport Income returns for which labor income is (1) Tables 5 through 7 report estimates underreported, (2) accurately reported, from multinomial logit equations for and (3) overreported. Table 4 shows that wage earners, proprietors, and farmers, 1,266 taxpayers understated labor respectively. In each set of equations, income, 218 overstated income, and the the dependent variable assumes values remaining 1,735 appear to have of 0, 1, or 2 depending upon whether accurately reported their income, the filer underreported, accurately according to the TCMP audit. reported, or overreported earned income, respectively. For each table, The average marginal tax rate for the column 1 examines the determinants of sample is 17.10 percent, or 19.75 the odds of accurately reporting income, percent using the first dollar tax rate. while column 2 examines the determi-

560 TAX EVASION IN THE PRESENCE OF NEGATIVE INCOME TAX RATES

TABLE 4 SAMPLE MEANS AND STANDARD DEVIATIONS

All Observations with Labor Income Variables Observations Understated Accurately Stated Overstated Last $ tax rate 0.1709 0.1634 0.1747 0.1845 (0.1129) (0.1249) (0.1020) (0.1216)

First $ tax rate 0.1973 0.2276 0.1802 0.1577 (0.1090) (0.1100) (0.1001) (0.1280)

Percent married 0.7002 0.8713 0.5493 0.9083 (0.4582) (0.3351) (0.4977) (0.2893)

Percent proprietor 0.4194 0.7472 0.1476 0.6789 (0.4935) (0.4348) (0.3548) (0.4680)

Percent farmer 0.1249 0.2228 0.0282 0.3257 (0.3306) (0.4163) (0.1657) (0.4697)

Age 40.54 42.56 38.76 42.99 (12.1750) (11.78) (12.24) (11.72)

Adjusted gross income 11,784 11,352 12,480 8,750.1 (4,419) (4,348.9) (4,203.6) (4,892.2)

Wages/labor income 0.5746 0.2173 0.8744 0.2637 (0.4552) (0.3225) (0.3126) (0.3547)

Amount misreported 897.7 2,523.1 0 1,397.7 (2,265.5) (2,790.6) 0 (1,887.5)

Percent IRS assisted 0.0028 0 0.0046 0.0046 (0.0528) 0 (0.0678) (0.0677)

Percent VITA* help 0.0084 0.0032 0.0133 0 (0.0912) (0.0561) (0.1144) 0

Percent unpaid help 0.0814 0.0316 0.1205 0.0596 (0.2735) (0.1750) (0.3256) (0.2374)

Percent professional help 0.2355 0.3168 0.1689 0.2936 (0.4244) (0.4654) (0.3747) (0.4565)

Percent other paid help 0.3834 0.4652 0.3153 0.4495 (0.4863) (0.499) (0.4648) (0.4986)

Percent North 0.1497 0.1414 0.1562 0.1468 (0.3569) (0.3486) (0.3632) (0.3547)

Percent Midwest 0.4101 0.3697 0.4369 0.4312 (0.4919) (0.4829) (0.4961) (0.4964)

Percent South 0.2432 0.2938 0.2000 0.2936 (0.4291) (0.4557) (0.4001) (0.4565)

Percent with credit 0.6688 0.6343 0.6945 0.6651 (0.4707) (0.4818) (0.4607) (0.4730)

Observations 3,219 1,266 1,735 218

*Volunteer Income Tax Assistance

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nants of the odds of overreporting reporting income by approximately income, both relative to understating 0.12, while an elasticity of 0.3 implies income. The marginal effects are that the probability of under reporting reported in columns 3 through 5. income will increase by 0.3 percent for each one percent increase in the Beginning with our sample of 1,521 marginal tax rate. In the case of wage earners in Table 5, we find that overstating income, the marginal effect 1,439 (94.6 percent) accurately report is –0.476 (column 5) with an implied their income and 10 (0.6 percent) elasticity of –0.72. overstate income. The estimated tax rate coefficient for the odds of accurately Finally, Table 7 reports estimates for the reporting income in column 1 is –0.895, sample of 402 farmers. We find that 49 with a standard error of 2.014, and is farmers (12.5 percent) accurately report statistically insignificant. Similarly, the their income and that 71 (17.4 percent) estimated coefficients for the remaining overstate income. Table 7 shows that all variables are insignificant, except for the variables are insignificant, with the marital status. The estimated coeffi- exception of tax rate and marital status. cients for the odds of overstating The tax rate coefficient is statistically income in column 2 are insignificant as significant in the odds of accurately well, reflecting the limited degrees of reporting income and overstating freedom. income equations. The marital status coefficient is statistically significant for Turning to our sample of 1,350 propri- the choice to accurately report income. etors in Table 6, we find that income is However, the marginal effects are accurately reported by 256 (19 percent) insignificant for all variables including and overstated by 148 (11 percent). For the tax rate. observations with income accurately reported, the estimated coefficient for In an alternative specification, we pool the tax rate in column 1 is –5.857, with the sample and interact the tax rate a standard error of 1.515. The estimates with dummy variables indicating the show that the probability of accurately source of income.17 These results are reporting income is positively correlated consistent with those reported in the with the wage share, which serves as a first two columns of Tables 5 through 7; proxy for the probability of detection the estimated coefficients vary by source and is negatively correlated with the use of income. For taxpayers with income of other paid help.16 accurately reported, the estimated tax rate coefficients are 2.529, –4.343, and Similarly, we find the tax rate coefficient –2.768 (standard error = 1.493, 1.100, is significant for observations with and 1.783) and, for those with income income overstated, in column 2. overstated, –2.168, –5.435, and –5.786 (standard error = 2.625, 1.303, and The estimated marginal effect for the 1.571) for wage earners, proprietors, probability of under reporting income and farmers, respectively. Using a Wald with respect to the tax rate, as reported test, we reject the null hypothesis that in column 3, is 1.232, which implies an the three coefficients are equal (x2 = elasticity of 0.30, computed at mean 20.608 and p = 0.01). values. The marginal effect implies that increasing the marginal tax rate by 0.1 Since they are receiving a tax benefit, will increase the probability of under taxpayers claiming the EITC may be less

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inclined to cheat because they may have significant relationship between the a more positive attitude toward the explanatory variables and the amount of government (see Carroll, 1992). income understated. As should be Therefore, it would be useful to test expected, given the limited degrees of whether EITC recipients and non- freedom, the coefficients in the amount recipients exhibit the same underlying of income overstated regression are attitude toward tax compliance. We test statistically insignificant. for this by including a dummy variable indicating EITC eligibility. The estimated On the other hand, the average amount coefficients for this credit indicator using of income understated by proprietors is the pooled data are 0.183 and 0.319 for $2,718 (24 percent of income) and the the samples which accurately and over average amount of income overstated report income, respectively, but they are is $1,194 (13 percent of income). not precisely measured, having standard Column 6 of Table 6 shows that the tax errors equal to 0.140 and 0.191, rate coefficient is equal to 17,497, respectively. Using a Wald test, we fail implying an elasticity of 0.27, and is to reject the null hypothesis that these more than twice the size of its standard two coefficients are equal to zero (x2 = error. The results also show that the 3.793 and p = 0.15). Otherwise, the amount of income understated varies estimated coefficients for the remaining positively with income and negatively right-hand-side variables, including the with the share of wages in earned tax rate, are unaffected. A similar test income. Finally, the amount of income was extended to proprietors. The overstated (column 7) does not appear estimated coefficients are 0.281 and to be affected by the explanatory 0.244 with standard errors of 0.185 and variables. The tax rate results for 0.231, respectively (x2 = 2.929 and p = taxpayers who understate income are 0.231). These results are consistent with qualitatively consistent with Clotfelter the credit participation rates observed in (1983), but contradict those in Feinstein Table 4. (1991). Our results, however, cannot be directly compared to those in the literature since we account for EITC and The Amount of Misreported Income Social Security taxes. Furthermore, we Now we turn to the amount of income limit our sample to low-income house- misreported. Columns 6 and 7 of holds. Tables 5 through 7 present estimated coefficients for regressions in which the Turning to farmers, the average amount dependent variable is the amount of of income understated is $2,320 (22 income misreported (under- and percent of income) and the average overstated). The independent variables amount of income overstated is $1,759 are identical to those employed in (25 percent of income). As with Table 5, augmented by the inverse Mills proprietors, the amount of income ratio. understated seems to vary inversely with wage share and positively with income. Beginning with wage earners in Table 5, The effect of wage share on the amount the conditional average amount of of income understated by proprietors income understated is $718 (5 percent and farmers is consistent with the high of income) and the average amount probability of detection for income overstated is $1,806 (15 percent of subject to third party withholding. As in income).18 We fail to find a statistically the case of wage earners and propri-

566 TAX EVASION IN THE PRESENCE OF NEGATIVE INCOME TAX RATES

etors, we are unable to account for the change, which lowers the maximum tax determinants of the amount of income rate from 0.3704 in Table 1 to 0.2704, overstated. decreases the probability of underreporting income by 5.02 percentage points and the amount underreported Some Simulations by an average of $180 and increases the Except for proprietors, misreported probability of overreporting income by income seems to be invariant to 1.96 percentage points. marginal tax rates, including the EITC rates. Accordingly, we simulate the Finally, we eliminate the credit alto- effect of credit rates on proprietors only. gether. This change reflects the offset- Using the estimated coefficients in Table ting effects of eliminating the phase-in 6, we undertake four experiments. In range and the phase-out range. As each experiment, we peel off a layer of demonstrated above, eliminating the the EITC, recompute the tax rate, and phase-in range will increase the prob- estimate the effect on compliance, ability of understating income, while holding all other variables constant. eliminating the phase-out range will reduce the probability of understating First, we eliminate the phase-in range of income. The net effect of eliminating the EITC and the corresponding credit the credit decreases the probability of rate of 0.14. Using row 2 and column 5 understatements by 3.34 percentage of Table 1 and assuming zero wage points and the amount of income income, eliminating the phase-in range understated by an average of $161. The increases the tax rate from -0.0098 to probability of overstatements increases 0.1302. This change in the credit rate by 1.64 percentage points with an increases the average probability of insignificant effect on the amount understating income from 0.6906 to overstated. 0.7074, or by 1.68 percentage points. It decreases the average probability of These simulations demonstrate that the overstatements from 0.1951 to 0.1873, phase-out range is the principal source or by 0.78 percentage points, and of income reporting errors by propri- increases the amount of income under- etors caused by the credit. One may reported by an average of $20. conclude, however, that misreported income is only a minor problem: overall, Second, we set all negative tax rates the credit has a negligible impact on the equal to zero. Again, using row 2 and probability of misreporting income and column 5 of Table 1, this change increases the amount of income increases the tax rate from -0.0098 to understated by approximately 9 percent zero. This increase in the tax rate of the amount of income understated or increases the probability of understating approximately 1.5 percent of income. income by 0.7 percentage points and lowers the probability of overstatements by 0.34 percentage points, with Concluding Comments negligible effects on the amount of We examine the influence of tax and income underreported. credit rates on reported labor income. Our sample consists of 3,219 low- Third, we eliminate the phase out of the income filers drawn from the 1988 credit and the corresponding increase of TCMP, with one-third ineligible for the 0.10 in the marginal tax rate. This credit. We stratify the sample accord-

567 NATIONAL TAX JOURNAL VOL. XLIX NO. 4

ing to occupational choice and obtain 1 For studies that assess the effectiveness of the EITC multinomial logit estimates of the odds by examining its labor supply effects and participation rates, see Browning (1993), Hoffman of accurately reporting income and the and Seidman (1990), Holtzblatt, McCubbin, and odds of overreporting income, both Gillette (1994), Kosters (1993), and Scholz (1990, relative to underreporting income. 1994). Also, see Killingsworth (1983). Conditional on the taxpayer’s choice, we 2 Under current law, these rates range from –0.40 to 0.49. See Munnell (1994) and Scholz (1994). We also examine the determinants of the include Social Security taxes in computing these amount of income misreported. rates. Also, see the Office of Management and Budget (1994) for the estimated cost of the Except for proprietors, misreported current EITC. 3 income seems to be invariant to tax See Kahneman and Tversky (1979) for a discussion of the inadmissibility of preference reversals in an and credit rates. We find that tax rates expected utility framework. play a moderate role in shaping compli- 4 Beron, Tauchen, and Witte (1992) discuss the ance behavior. The estimated elasticity importance of socioeconomic variables on taxpayer of income understated with respect to compliance. Unfortunately, tax data do not provide a very rich set of demographic variables. For the tax rate is 0.27, and not significantly a critique of TCMP data, see Long (1992). It different from zero for income over- should be noted that the TCMP does not stated. The marginal tax rates induced incorporate the effects of other IRS enforcement by the EITC do not appear to affect the activities. 5 amount of income overreported, It is our understanding that many of the adjustments to the number of dependents of low- irrespective of income source, nor, income households can be attributed to their except for proprietors, the amount of failure to satisfy the dependency requirements income underreported. Even in the case because these households receive government of proprietors, the effects of the EITC assistance. Since the data do not provide information on public assistance, such as Aid to on the understatement of income are Families with Dependent Children, we are unable modest: the credit, primarily the phase- to distinguish between an adjustment to the out range, explains less than ten per- number of dependents from failing to satisfy the cent of the amount of income under- dependency test and one due to claiming fictitious stated, or less than two percent of children in order to qualify for the EITC. Although misreporting filing status and the number of income. dependents is an alternative mode of tax evasion induced by the structure of the EITC, modeling the Note, however, that our results apply to simultaneity between misreporting of income, low-income taxpayers and may not filing status, and dependents is beyond the scope of this paper. For an investigation of multiple apply to taxpayers who have signifi- modes of tax evasion, see Klepper and Nagin cantly higher incomes, are subject to (1989) and Martinez-Vazquez and Rider (1994). higher audit rates, or enjoy greater 6 We choose low-income, childless joint filers opportunities to conceal income. In because two-member households more closely addition, our findings reflect 1988 law resemble the family structure of eligible taxpayers. 7 Note that one-half of the self-employment tax is and IRS administration, which differ deductible in computing individual income tax significantly from current tax law and liability. 8 administration. We define the marginal tax rate as follows: a · t w+

(1 – a ) · t s if eligible for the EITC, and a · t + (1 –

a ) · (t + t p – 0.5 · t · t p) otherwise, where a is ENDNOTES the wage share, t is the statutory income tax rate, t w is the statutory rate plus the credit rate, t p is

We would like to thank Lowell Dworin, Janet the Social Security tax rate, and t s = t w + t p –0.5 ·

Holtzblatt, Janet McCubbin, Ann Parcell, Karl t · t p. The marginal tax rates in effect in 1988 are Scholz, and three anonymous referees for their provided in the corresponding columns of Table 1. comments. The views expressed in this paper are Note that a more appropriate specification of the those of the authors and do not necessarily reflect marginal tax rate would account for state tax those of the U.S. Treasury. rates.

568 TAX EVASION IN THE PRESENCE OF NEGATIVE INCOME TAX RATES

9 Alternatively, MacKie-Mason (1992) speculates the right-hand-side variables, particularly the tax that overreporting may represent the true rate, then the parameter estimates may be biased. preference of taxpayers who do so in order to Since we use disposable AGI instead of labor reduce their probability of audit. income, endogenous labor supply may not 10 Including taxpayers who are ineligible for the EITC represent as serious a problem as it might in the sample helps alleviate two potential otherwise. problems. First, as explained above, observed non- 16 The reliance on paid preparers may not be compliance may simply reflect taxpayer mistakes. exogenous to the evasion decision (Erard, 1993; Including a control group is an alternative method Udell, 1995). Nevertheless, the estimated to that employed in Alexander and Feinstein coefficient on the tax rate, the variable of interest, (1986) and Rice (1992) to control for the “noise” does not change by much when we omit this created by unintentional mistakes. Other dummy variable. researchers could not pursue this strategy because 17 These results are not reported but are available they lacked the necessary data. Second, individuals from the authors upon request. in the two groups with identical incomes may face 18 For this subsample, we are unable to compute different marginal tax rates. Introducing such corrected standard errors because of the limited heterogeneity into the sample may help reduce the degrees of freedom. identification problem whereby the tax rate captures the income effect (Poterba, 1987; Feenberg, 1987). 11 MacKie-Mason (1992) argues that Tobit does not REFERENCES allow for the possibility that taxpayers may overreport income. The credit range of the EITC is not Alexander, Craig, and Jonathan Feinstein. the only feature of the tax code that creates an “A Microeconomic Analysis of Income Tax incentive for taxpayers to overreport certain Evasion.” Massachusetts Institute of Technology. income. For example, the tax treatment of capital Mimeo, 1986. gains creates incentives to overstate long-term Allingham, Michael G., and Agnar Sandmo. capital gains by misclassifying short-term capital “Income Tax Evasion: A Theoretical Analysis.” gains and other ordinary income. Therefore, over- Journal of Public Economics 1 No. 3 (1972): 323– reporting income need not be entirely inadvertent. 38. 12 A distinction should be made between actual Beron, Kurt J., Helen V. Tauchen, and Ann D. income, income reported for tax purposes, and Witte. “The Effect of Audits and Socio- income detected by a tax audit. An auditor may economic Variables on Compliance.” In Why not detect all income received which introduces a People Pay Taxes: Tax Compliance and potential source of bias. Feinstein (1991) presents a Enforcement, edited by Joel Slemrod, 67–89. partial detection model of tax evasion to control Ann Arbor: The University of Michigan Press, for such bias. Unfortunately, we do not have the 1992. necessary data to implement his technique. However, the difference between the amount of Browning, Edgar K. “Effects of the Earned evasion and the amount of detected evasion Income Tax Credit on Income and Welfare.” should not be as great for low-income returns as Texas A&M University. Mimeo, 1993. for high-income returns. Burman, Leonard E., and William C. 13 Note that the reported standard errors may be Randolph. “Measuring Permanent Responses understated because we do not account for the to Capital-Gains Tax Changes in Panel Data.” use of instrumental variables. American Economic Review 84 No. 4 (Septem- 14 The sample of wage earners consists of taxpayers ber, 1994): 794–809. whose only source of labor income is wages. The Carroll, John S. “How Taxpayers Think About sample of proprietors consists of taxpayers filing a Their Taxes: Frames and Values.” In Why Schedule C. The sample of farmers consists of People Pay Taxes: Tax Compliance and taxpayers filing a Schedule F. There are 32 Enforcement, edited by Joel Slemrod, 43–63. taxpayers that file both a Schedule C and a Ann Arbor: The University of Michigan Press, Schedule F and are included in the subsamples for 1992. proprietors and farmers. 15 However, we do not address two potential Clotfelter, Charles T. “Tax Evasion and Tax problems: partial detection and endogenous labor Rates: An Analysis of Individual Returns.” supply. For example, IRS auditors may not detect all Review of Economics and Statistics 65 No. 3 the income that is misreported. If the amount (August, 1983): 363–73. detected is correlated with the right-hand-side Domencich, Thomas, and Daniel McFadden. variables, then the parameter estimates may be Urban Travel Demand. Amsterdam: North- biased. Similarly, if labor supply is correlated with Holland Publishing Company, 1975.

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