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Tax Evasion in the Presence of Negative Income Tax Rates

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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- 553 NATIONAL TAX JOURNAL VOL. XLIX NO. 4 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 over- stated. 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 555 NATIONAL TAX JOURNAL VOL. XLIX NO. 4 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.
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