SYMPOSIUM ON INCOME COMPLEXITY AND ENFORCEMENT

WHAT IS AN “OPTIMAL” TAX SYSTEM? JAMES ALM *

Abstract - A central issue in public enhance our understanding of appropri- economics is the appropriate design of a ate in several ways: it can tax system. This paper argues that illuminate and quantify with a common previous attempts to derive an “optimal yardstick the various -offs that tax system” are largely irrelevant to necessarily create, it can highlight practical tax design, because they the areas that require additional typically ignore a range of consider- research, and it can provide specific ations reflecting fiscal and societal guidelines that tax policies should take institutions that are essential elements in particular country circumstances, in the normative and positive analysis of guidelines that seem often likely to be taxation. In particular, the standard significantly different than those that optimal taxation methodology often emerge from the optimal taxation ignores the and efficiency effects approach. that arise because taxes must be collected, at some cost both to the tax agency and the taxpayer, and this collection must be enforced, again at some cost to the agency and the INTRODUCTION individual. However, the paper also argues that there are ways in which A central issue in is many of these relevant institutional the appropriate design of a tax system. features can be incorporated into a Such a system is usually viewed as framework more general— but also balancing the various desirable at- more cumbersome, at least in its most tributes of taxation: taxes must be general form —than that characteristic raised (revenue-yield) in a way that of the optimal taxation methodology. treats individuals fairly (equity), that Such a framework will never be able to minimizes interference in economic capture all of the incredible complexity decisions (efficiency), and that does not that characterizes the real world and impose undue costs on taxpayers or tax that must be considered in the actual administrators (simplicity). design and reform of tax systems. However, the suggested framework can One way in which at least some of these attributes have been analyzed is in an area of research that is commonly

*Department of Economics, University of Colorado at Boulder, known as “optimal taxation.” This is an Boulder, CO 80309-0256. explicitly normative approach to tax

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analysis that is based on standard tools ways in which many of these relevant of welfare economics, as applied in a institutional features can be incorpo- world when the first-best allocation of rated into a framework more general— resources and distribution of income but also more cumbersome, at least in cannot be achieved. There have been its most general form—than that many insights from this literature characteristic of the optimal taxation (Auerbach, 1985; Stern, 1987). How- methodology. Such a framework will ever, even its adherents would, I believe, never be able to capture all of the admit that the practical applicability of incredible complexity that characterizes its basic theorems has been remarkably the real world and that must be limited to date. Indeed, there often considered in the actual design and seems a schism, if not an animosity, reform of tax systems. However, I between those who work on the believe that the suggested framework rarefied heights of optimal tax theory can enhance our understanding of and those who toil in the trenches of appropriate tax policy by illuminating practical tax design. and quantifying with a common yardstick the various trade-offs that In this paper, I argue that optimal taxes necessarily create, by highlighting taxation as it has been practiced is in the areas that require additional fact largely irrelevant to practical tax research, and by providing specific design, because it typically ignores a guidelines that tax design and tax range of considerations reflecting fiscal reform should take in particular and societal institutions that are country circumstances, all in a more essential elements in the normative and comprehensive manner than previously positive analysis of taxation. In particu- undertaken. I also believe that the tax lar, the standard optimal taxation guidelines that emerge from this methodology often ignores the equity framework will often be significantly and efficiency effects that arise because different than those that emerge from taxes must be collected, at some cost the optimal taxation approach. It is both to the tax agency and the taxpayer, toward the establishment of this and this collection must be enforced, research framework that this paper is again at some cost to the agency and largely addressed. the individual. Because most analyses in the optimal taxation tradition ignore In the next section, I discuss the these features, their basic policy standard optimal taxation methodology prescriptions are unlikely to lead to an and present several of its more widely improvement in welfare, when com- known results. The following sections pared to those policy rules derived from outline some of the important consider- a less formal but more realistic perspec- ations that have been largely ignored by tive; in fact, they are even unlikely to be this methodology and also discuss implemented or to be taken as serious recent research on these considerations. guides to policy. Admittedly, this I then present a suggestion for research argument is not new (Slemrod, 1990; that systematically incorporates the Bird, 1992). It is also somewhat various institutional features. In the overstated, especially given some recent final section, I speculate on the ways in work in the optimal taxation methodol- which the standard optimal tax results ogy that examines some of these issues. seem likely to be modified by these Nevertheless, I also argue that there are considerations.

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THE OPTIMAL TAX APPROACH implying marginal tax rates of 100 percent. However, on efficiency The standard approach to optimal grounds, marginal tax rates should be taxation is based on several method- lower the more responsive are individu- ological assumptions: the government is als in their labor decisions, the smaller is required to raise a specified amount of the spread in the skills of the individuals, revenues; it is limited in the types of tax the less concerned with equality is instruments that it has available to it, society, and the lower is the amount of such as only commodity taxes, only revenue that government must collect. income taxes, or both types; its deci- In fact, the marginal on the sions must be consistent with individual single richest individual should be zero. and firm optimization; and it makes its choices in order to maximize a “social Optimal Tax Mix welfare function,” which indicates the value that society places on the welfare On efficiency grounds, the optimal tax of different individuals. mix requires simply a lump-sum income tax, and commodity taxes are not used. The major results that have been derived On equity grounds, both income and from this framework can be classified commodity2 taxes should be used in according to the types of tax instru- general; however, under some restrictive ments that the government can select conditions, the optimal form of com- (see Auerbach [1985] and Stern [1987] modity2 tax rates that are imposed in the for a detailed discussion of these presence of an optimal income tax results), as illustrated in the following requires that the commodity tax rates be subsections. uniform, so that taxation of commodi- ties at different rates is not optimal and Optimal Commodity Taxes only the optimal income tax is used.

On efficiency grounds, commodity tax The framework discussed in the previous rates should be chosen to achieve equal subsections is, of course, a highly proportional reductions in the (compen- stylized one that by necessity ignores a sated) demands for all commodities, so number of relevant considerations. Still, that goods with more elastic demands it is a useful framework, at least in part should1 be taxed at lower rates (the because it forces the analyst to make “Ramsey Rule”). However, on equity explicit the trade-off between equity (via grounds, goods consumed more heavily the social welfare function) and effi- by those with lower income (or, more ciency (via an array of individual and generally,1 by those whose welfare is firm behavioral effects) in the choice of weighted more heavily by society) taxes. should be taxed at lower rates. For example, consider optimal commod- Optimal Income Taxes ity taxes. Commodities with more inelastic demands should be taxed more On equity grounds, income taxes should heavily in order to reduce the excess be higher on those with greater income; burden of taxation; however, if these indeed, under some special conditions, goods are consumed predominantly by income taxes should be chosen to those with lower incomes, then equity equalize after-tax incomes, thereby concerns argue for lower tax rates.

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Similarly, optimal income taxes must complicated tax forms, seeking profes- balance the equity gains that higher sional advice, filling out returns, and the marginal tax rates allow with the like are legion and legendary. efficiency losses that higher tax rates generate. In general, the optimal tax Furthermore, even casual economic rules involve balancing these equity and analysis clearly indicates that we should efficiency considerations. always3 expect paying taxes to imply incurring costs. No one likes the loss of However, there is little dispute that the income from taxes, and people will standard optimal framework ignores, or clearly take actions to avoid (or reduce) at least does not adequately consider, a their liability. It is a standard result in number of important considerations in economics that agents will increase their the design of taxes. In particular, these actions up to the point where the optimal tax rules depend primarily upon marginal benefits of their actions—in the preferences of the individuals (as this case, the reduced taxes—equals the well as upon the tax instruments marginal costs—or the compliance available to government). These rules costs—of the actions. On the margin, neither consider the costs imposed upon then, the costs of paying taxes should the taxpayer and the government of be approximated by the tax savings collecting the taxes, nor do they from the array of legal consider the costs imposed on the schemes that taxpayers have pursued, respective agents of enforcing this the accuracy of the approximation collection. Now if it can be argued that depending largely upon the way in these considerations are sometimes which the marginal costs of compliance relevant but seldom central to the increase with the extent of their design of taxes, then the failure to magnitude. model them systematically would be irritating but unimportant. However, as Finally, and most importantly, there are I argue in the next sections, the failure now a number of estimates, derived to address these different costs of taxes from a variety of methodologies, of the is far from inconsequential. actual magnitudes of the individual and firm compliance costs in the United States. For individuals, Slemrod and INDIVIDUAL AND FIRM COMPLIANCE Sorum (1984) and Blumenthal and COSTS Slemrod (1992) use surveys of taxpayers to estimate that the compliance cost of Implicit in much of the optimal taxation the individual income tax may approach literature is the assumption that it is about seven percent of its revenues. costless for individuals and firms to pay Using a different approach based upon their taxes. There is little question that econometric analysis of individual tax this assumption is simply wrong, for a returns, Pitt and Slemrod (1989) number of reasons. calculate that the compliance cost of itemizing deductions in 1982 totaled On a purely anecdotal basis, it has been nearly 0.5 percent of revenues. On the evident for some time that there are corporate side, Blumenthal and Slemrod substantial individual and firm “compli- (1995) conclude from a survey of ance costs” from taxation. Taxpayer “large” corporations that corporate complaints about keeping records compliance costs are over three percent throughout the year, deciphering of total federal and state corporate

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income tax collections. Evidence for the taxes and can sometimes be substan- United Kingdom (Sandford, 1995), tially higher (Vaillancourt, 1989; (Pope, Fayle, and Duncanson, Sandford, 1995). Unfortunately, there is 1990), and Canada (Vaillancourt, 1989) little information on how these costs suggests that compliance costs can vary with various policy tools; that is, it range from 2 to 24 percent of revenues seems likely that the administrative costs for selected taxes. change in large and discrete amounts with the scale of collections (or they In total, these studies clearly indicate may exhibit “discontinuities”) and that that the compliance costs of taxation they may also display economies of are significant, often of comparable or scale in their collections (or they may even larger values than the more exhibit “nonconvexities”), but these traditional calculations of the excess aspects of the collection cost technology burden of taxation. In part because of are not known. these results, economists have begun to add compliance costs to their standard The administrative dimension of theoretical analyses of individual taxation has long been recognized by taxpayer behavior (Alm, 1988; Slemrod, tax administrators, especially those 1995). There is also some theoretical working on tax policy in developing work that has begun to incorporate countries (Bagchi, Bird, and Das-Gupta, some aspects of individual compliance 1995). However, it has not been until costs in an optimal tax framework recently that administrative costs have (Slemrod, 1994; Slemrod and Yitzhaki, been formally incorporated in the 1994). However, despite the insights analysis of optimal taxation. Mayshar from this work, it is still subject to some (1991) assumes that there are costs to limitations: it typically examines only a the taxpayer and to the government limited number of tax instruments, such from collecting a generic form of taxes as those that apply to individuals only; it and determines the conditions that is based upon very stylized assumptions characterize the optimal use of the tax. about individual behavior; and it seldom Other work has examined the optimal deals precisely with the exact nature of choice of tax instruments in the pres- the compliance costs to individuals. ence of positive administrative costs. Clearly, there is more that needs to be For example, Wilson (1989) examines done to model, as well as to measure, the optimal number of commodities to the compliance cost of taxes. be taxed, where there is some cost to government from the expansion of the THE ADMINISTRATIVE COSTS OF optimal commodity tax base; he TAXATION concludes that the optimal size of the tax base balances the extra administra- Although there is considerably less tive costs from taxing more commodities systematic work on the costs to the with the efficiency (and revenue-yield) government of collecting taxes (or the gains from the base expansion. Differ- “administrative costs” of taxation), the ent aspects of the optimal administra- available evidence from government tion of the individual income tax have budgetary information clearly indicates also been considered. Stern (1982) that the budget cost of collecting assumes that the characteristics of the individual income, business income, and taxpayers cannot be observed with sales taxes is generally in excess of one certainty, and Slemrod and Yitzhaki percent of the revenues from these (1994) analyze the trade-off between

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more accurate measurement of income is important for many via itemized deductions and less costly reasons. In the context of the discussion measurement via the standard deduction. here, it affects the efficiency of the tax system by creating misallocations in These analyses have generated numer- resource use as agents alter their ous insights. However, to repeat some behavior—and incur costs (or “noncom- points made about the analyses of pliance costs”)—to cheat on their taxes. compliance costs, they are also largely Evasion also has equity effects because based on fairly arbitrary assumptions it alters the distribution of income in about such things as the available tax unpredictable ways. Because it causes instruments (e.g., only commodity or the government to expend resources (or income taxes can be used), the behav- “enforcement costs”) to reduce its ioral responses of taxpayers (e.g., magnitude and it also reduces the taxes taxpayers have only some particular and that individuals pay, tax evasion affects restrictive forms of preferences), the the tax rates that compliant taxpayers administrative costs to government face and the public services that all (e.g., the administrative costs increase citizens receive. More broadly, it is not smoothly and continuously from policy possible to understand the true impact changes), and the like. Clearly, there is of taxation without recognizing the more that needs to be done to model existence of evasion. It is clearly not and, again, to measure the administra- possible to design an optimal tax system tive cost dimension. without appropriate consideration of tax evasion and its effects on individuals TAX EVASION AND ENFORCEMENT and on government.

The standard optimal tax approach In comparison to the other areas of assumes that individuals and firms research discussed above, there is an voluntarily pay all of their tax liabilities. extensive literature devoted to the This assumption is wildly inaccurate. theoretical and empirical analysis of tax Individuals pursue many illegal avenues evasion (Cowell, 1990). The theoretical to reduce their payments, such as analysis of tax evasion most often builds underreporting incomes, overstating on the economics-of-crime model first deductions and exemptions, or failing to applied to tax evasion by Allingham and file returns. Despite obvious measure- Sandmo (1972). The focus of nearly all ment difficulties, there is widespread of this work is on the behavior of a evidence that tax evasion is extensive representative individual who faces an and commonplace in nearly all coun- individual income tax. The individual is tries. For the United States, the most viewed as maximizing the expected reliable estimates project the amount of of the evasion gamble, weighing unpaid federal income taxes at $127 the benefits of successful cheating billion for 1992, with an annual growth against the risky prospect of detection rate of roughly ten percent since 1973 and punishment, and the individual pays (U.S. Government Accounting Office, taxes because he or she is afraid of 1995). Other taxes at other levels of getting caught and penalized. This government are also subject to nonpay- approach gives the plausible and ment. Evidence from other countries productive insight that compliance suggests that the American experience depends upon audit and fine rates. is not an isolated one. Indeed, the central conclusion of this

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approach is that an individual pays taxes (2) Endogenous audit selection rules: only because of this fear of detection The agency may use information and punishment, and an increase in the from the tax returns to determine fine or the audit rate can be shown to strategically whom to audit, so increase compliance. Surprisingly, an that the probability of audit is increase in the tax rate generally has an endogenous, dependent in part on ambiguous effect on reported income in the behavior of the taxpayer and the standard model; under plausible the tax agency (Reinganum and assumptions, compliance actually rises Wilde, 1985). with higher tax rates, in contrast to the (3) Use of paid preparers: Paid common perception that higher tax preparers may both reduce rates have contributed to evasion. taxpayer confusion and encour- age noncompliant behavior on ambiguous items (Erard, However, it is clear to a number of 1993). observers that at least some forms of (4) Tax avoidance: An individual compliance cannot be explained entirely simultaneously chooses the by the level of enforcement (Graetz and amounts of tax evasion and tax Wilde, 1985). The levels of audit and avoidance (Alm, 1988). penalty rates are set so low that most (5) Structure of taxation: Some kinds individuals would either underreport of taxes are easier to evade than income not subject to source withhold- others (Kesselman, 1989). ing or overclaim deductions not subject to independent verification if they were purely “rational,” because it is unlikely To date, however, no single theory has that such cheating would be caught and been able to incorporate more than a penalized. few of these factors in a meaningful way, and it seems unlikely that such a general model will be forthcoming. In part because of this quandary, there have been numerous extensions of the basic theoretical model, to consider Empirical analysis of individual behav- other factors not included in the basic ioral responses has also grown dramati- theoretical model or to consider other cally in the last 20 years. The main factors not captured appropriately by difficulty in this work is finding informa- the theory. These extensions include tion on the compliance behavior of such things as government services, individuals. Because of this problem, overweighting of low probabilities, the empirical work draws creatively on a social norms, and labor supply choices. variety of data sources. The most Of particular relevance here, the theory extensively used source for the United has also expanded to include the State relies on information generated by following. the Internal . Other sources include taxpayer returns, survey (1) Uncertainty and complexity: data, national income accounts, and Individuals may not know with laboratory experiments. In its entirety, certainty their tax liability or the this work suggests the following tax agency’s enforcement strategy conclusions relevant to the discussion (Cronshaw and Alm, 1995). here.

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(1) An increase in tax complexity leads policies (Sandmo, 1981; Kaplow, 1990; to greater use of a tax practitioner, Cremer and Gahvari, 1993; Boadway, and the average level of noncom- Marchand, and Pestieau, 1994). The pliance is higher for returns standard policy prescription has long prepared with paid assistance been an increase in penalty and audit (Erard, 1993). rates; indeed, at least the theoretical (2) A higher audit rate leads to more work suggests that sufficient—and compliance, at least to a point, draconian—increases in penalty and with an estimated reported audit rates could substantially eliminate income–audit rate evasion. ranging from 0.1 to 0.2 (Dubin and Wilde, 1988). However, it is unlikely that such extreme (3) A higher fine rate leads to margin- measures will actually be implemented, ally more compliance, with an at least in part because there is a estimated reported income–fine widespread belief that “the punishment rate elasticity less than 0.1 (Alm, should fit the crime.” Moreover, it Bahl, and Murray, 1993). should be remembered that, although (4) A higher tax rate leads to less higher penalty and audit rates generate compliance, with an estimated benefits, they also entail costs, both to reported income–tax rate elasticity the government that must use real ranging from –0.5 to –3.0. resources in its efforts and to the (Clotfelter, 1983). individuals who suffer a loss in utility (5) Audit rates are endogenous, in from greater enforcement. These that they depend in part on the considerations clearly suggest that choices of taxpayers (Feinstein, government should not expand its 1991). enforcement actions to the point where an additional dollar of enforcement There is now also some empirical work costs yields an additional dollar of on corporate income tax compliance revenues: the former involves a real (Rice, 1992) and on firm resource cost to the economy, while the compliance (Murray, 1995). latter is simply a transfer from the private to the public sector (Slemrod and Given the underlying data problems, this Yitzhaki, 1987; Alm, 1988). Instead, empirical work needs to be treated most analyses of the optimal amount of cautiously. Still, these results indicate government enforcement conclude that that individuals incur costs and change optimal enforcement must equate the their behavior in response to enforce- marginal costs of enforcement with the ment activities and that the enforce- marginal benefits, where these benefits ment agency can increase compliance should include the added revenues but by taking advantage of these responses should also reflect the impact of greater in its choice of an enforcement strategy. induced honesty and the loss in indi- They also clearly indicate that there are vidual expected utility. Consequently, it limits to strategies based only on greater seems clear that optimal enforcement enforcement. should not eliminate all tax evasion (Polinsky and Shavell, 1984). As noted There has also been much work on above, there is also clear theoretical optimal government policy in the face evidence that the optimal enforcement of tax evasion, including theoretical policy should utilize information from analysis of optimal tax cum enforcement the tax returns in the selection of

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returns for audit (Reinganum and Wilde, considered in its effects on the other 1985). Such “endogenous” audit three dimensions of a desirable tax selection rules are able to generate system. higher levels of compliance than equal cost rules in which returns are selected The omission of simplicity as an explicit randomly (Alm, Cronshaw, and McKee, measure and its incorporation in other 1993). goals is important and needs some justification; this justification also serves A FRAMEWORK FOR ANALYSIS to illustrate the ways in which compli- ance, administrative, noncompliance, It is obviously difficult to know how all and enforcement costs can be incorpo- these considerations will affect the rated in the analysis. The reasons for standard optimal taxation rules. Indeed, this omission are best illustrated by it is difficult even to know where to start means of some examples. Consider, say, to analyze in a systematic way the the introduction of some specific tax effects of these factors on the appropri- provision that affects individuals via the ate design of tax systems. individual income tax (e.g., the deduc- tion of business-related expenses). This Still, I believe that a careful examination change is often discussed as involving a of these factors suggests that they all balancing of simplicity, efficiency, equity, involve trade-offs among essentially and revenue-yield effects. The change three main criteria: allows the tax to be imposed on a more accurate measure of an individual’s (1) How does the choice of taxes ability to pay, and it encourages, or at affect the yield of the tax collec- least does not discourage, the individual tions, where the yield is defined from engaging in those business-related broadly in terms of the gross activities that generate income. How- collections in excess of administra- ever, there are clearly added costs tive and enforcement costs imposed on individuals from this (revenue-yield)? feature. There are compliance costs to (2) How does the choice affect the the individual because records of these distribution of the burden of expenses need to be maintained, and taxation on individuals, where the these costs reduce the individual’s burden is defined broadly in terms income. There are also added adminis- of the tax burden, the compliance trative costs that lower net revenues, cost burden, and the noncompli- since these deductions complicate the ance cost burden on taxpayers administration of the tax. Further, (equity)? individuals may fraudulently claim these (3) How does the choice affect the expenses, which implies that the decisions of individuals and firms, government must expend resources where the decisions are defined enforcing the provision, at some cost broadly in terms of the responses both to the government and to the of the agents to the entire tax, taxpayer. Finally, the deduction itself compliance, and enforcement will generate some revenue loss to the parameters (efficiency)? government.

Note in particular that I do not define a However, these various aspects will be separate criterion for simplicity. Instead, incorporated in the standard measures simplicity is implicitly assumed to be of equity, efficiency, and revenue-yield.

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The direct effect of the deduction on behavior in the face of the stricter revenues enters in an obvious way, as enforcement. Because different do the impacts of the extra administra- individuals will be affected in different tive costs and enforcement costs on ways, the distribution of income will government revenues net of these costs. also be altered, thereby creating equity The effects on efficiency are reflected in effects. All of these effects will be any lost output that arises from behav- captured by the usual standards of ioral responses to the tax provision itself, revenue-yield, efficiency, and equity. from the individuals’ efforts to establish the legitimacy of the deductions, from Consequently, analysis of taxation the noncompliance actions of the requires balancing the trade-offs individuals, and from the enforcement between equity, efficiency, and revenue- activities of government, all of which are yield, where each is broadly defined and represented by the standard measure of commonly measured. Still, analysis of the excess burden of taxation. The even these three factors is obviously a effects of the tax provision on equity are daunting task. It seems to me that the captured by the differential impact of best option involves a threefold strategy. the provision on the income of different individuals and by the weights of those First, empirical work must continue to individuals in the social welfare function; be performed to estimate both the that is, the provision both increases an magnitude of the compliance costs of individual’s income (because it generates different taxes and the determinants of tax savings) and decreases income those compliance costs (or the individual (because it produces compliance and and firm “compliance cost function”). noncompliance costs), and these equity At least for the United States, most effects are measured in the social previous work has focused on the cost welfare function by the combination of to individuals of the individual income the change in individual income and the tax and, to a lesser extent, on the cost social weights on the welfare of those to large corporations of the corporate individuals who experience these income tax. However, there are clearly changes. (Note that these comments compliance costs from many other pertain to the vertical equity of taxes. major taxes, costs that are borne largely The effects on horizontal equity are by firms. Firms of all sizes incur costs in more difficult to determine; indeed, as the collection of sales and taxes, argued by Kaplow (1989), even the payroll taxes, severance taxes, user fees, existence of a separate notion of and so on; the costs incurred by “small” horizontal equity is controversial.) A and “medium” size firms are largely separate criterion for simplicity is unknown. Further, the ways in which therefore not needed. these compliance costs are affected by different tax design features is essential Or consider a change in enforcement in the determination of government policy (e.g., an increase in audit cover- policies but again is not known. How age). There is a range of effects that do compliance costs increase with determines the desirability of this policy special provisions of the taxes? Are change. The government will incur compliance costs affected by progressive some added administrative and enforce- tax rates? What is the magnitude of the ment costs but will also generate some costs in the “start-up” phase of new extra revenues. The level of output will taxes or of new tax provisions? How be affected as individuals change their significant are scale economies in tax

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compliance? How do individuals and component of the optimal design of firms respond in their decisions to taxes, and the analysis of these re- changes in government tax policies, sponses must continue. such as an increase in the standard deduction or a strengthening of Second, the equity, efficiency, and reporting requirements? These and revenue-yield effects generated by these other questions are unanswered. behavioral responses must be incorpo- rated into an analysis in which they can Similarly, although there is budgetary be measured on a common scale. As information on the administrative costs argued above, these effects are cap- of various taxes, there has been little tured by standard measures, known and systematic analysis of the determinants used by economists. Note again that of these administrative costs and the the consideration of (vertical) equity effects of these determinants on the effects requires that explicit judgments quantity and the quality of tax about the relative social worth of administration (the “administrative cost different individuals must be made by function”). In particular, it seems likely the analyst. Such judgments are always that there are significant fixed costs made, perhaps especially when they are when a new tax is imposed or when not made explicitly. the features of an existing tax are changed. For similar reasons, it seems Third, I think it unavoidable that likely that the expansion of, say, an rigorous analysis of the range of existing sales tax to include new considerations relevant to tax design commodities involves a stepwise, or requires numerical analysis, perhaps in a discontinuous, increase in costs. Also, computable general equilibrium there may well be some economies of framework, in which the different scale, or nonconvexities, in tax adminis- considerations are sequentially layered, tration. However, these issues have one atop another, until the full model received little attention, at least by captures the relevant factors. The economists. Similar questions surround numerical analysis would necessarily noncompliance (the “noncompliance incorporate the empirical analyses of cost function” for taxpayers) and compliance cost, administrative cost, enforcement (the “enforcement cost noncompliance cost, and enforcement function” for tax agencies). There is cost functions. clearly much scope for empirical analysis, and such analysis is a necessary The reason for reliance upon numerical input in the design of taxes. analysis is easily stated. Even simple theoretical models of optimal taxation It is, however, important to emphasize quickly become unwieldy and incapable that a focus on the measurement of of interpretation or generalization. At compliance, administrative, noncompli- best, these models only characterize the ance, and enforcement costs does not optimal tax rules by defining the mean that empirical work on the more numerous conditions that must be common behavioral responses to taxes satisfied if taxes are to be optimal; that should be ignored. There is an enor- is, these models specify a system of mous—and surprising—amount that we equations that must hold simultaneously simply do not know about how indi- in order for the tax rates to be optimal. viduals and firms react to taxes. Empiri- However, these models do not actually cal work on these aspects is the central determine the precise pattern of the

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taxes. Unless the exact forms of the efficiency effects of taxes and when various equations are specified, it is there are no compliance costs, adminis- clearly impossible to solve analytically trative costs, noncompliance costs, or the system of equations for the actual enforcement costs? This analysis would tax rates; even with these specifications, consider a numerical representation of a there is obviously no guarantee that the specific economy in which consumer equations can be solved for unique tax and firm decisions are modeled with rates. Further, these models almost functional forms whose parameter always assume that the various func- values replicate the real world outcomes tions change smoothly and continu- of that economy. The outcome of this ously, an assumption that allows the use simulation would be the standard of differential calculus. However, as optimal commodity tax result that tax discussed above, it seems likely that the rates should be higher on commodities various cost functions, especially the with less elastic demands. administrative and enforcement cost functions, are characterized both by This analysis would then be modified to large discrete changes and by econo- incorporate efficiency and equity mies of scale. The search for purely concerns: If individuals differ and if analytical solutions seems a dead end. government is concerned with raising revenues to meet efficiency and equity There are now many examples of goals, how should commodity tax rates numerical analyses in the optimal tax be chosen? Note that this analysis tradition. There is also a growing requires explicit assumptions about the literature on general equilibrium social worth of different individuals. modeling (Shoven and Whalley, 1992). The combination of these literatures A third layer of analysis would then add seems a fruitful path of research. Like the compliance costs on firms (and, the standard optimal taxation approach, perhaps, on individuals) of commodity such a framework requires an explicit taxes. This analysis would be based on modeling of the behavioral effects of estimates of the compliance cost taxation, as well as an explicit recogni- function generated from empirical tion of the welfare weights placed on studies of firm behavior, and its results different classes of individuals. Impor- would indicate the effects of compliance tantly, it also requires explicit incorpora- costs on the simple optimal tax rules. A tion of the different cost functions. The possible complication in this stage is the numerical specification necessarily potential for discontinuities and pertains to the characteristics and nonconvexities in the compliance cost institutions of a particular country. function. These are difficult to analyze in theoretical models, but there are now For example, consider the process by methods for incorporating such factors which optimal commodity taxes could in numerical models. be determined in such a framework. The analysis would begin with the A fourth layer would incorporate simplest case, which forms the basis of administrative costs, using administra- the standard optimal commodity tax tive cost function estimates that allow problem: How should tax rates on for discontinuities and nonconvexities. commodities be chosen to raise a A fifth layer would consider noncompli- specified amount of revenues when the ance. Some commodity taxes are easier government is concerned only with the to collect, and some are easier to evade,

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than others (e.g., commodities versus present, we do not know many of the services). How does the presence of characteristics of the relevant functions. noncompliance with commodity taxes Still, my own guess is that a full analysis affect the optimal commodity tax of these factors will lead to modification structure? The enforcement of com- of the standard optimal tax rules, as modity taxes would then be added in a discussed in the following subsections. final layer, based on the individual noncompliance and the agency enforce- ment cost functions. Obviously, other Optimal Commodity Taxes sequences could be usefully considered. Commodity tax rates should be largely Similar steps can be followed for proportional. rates optimal income taxes. The first stage reduce compliance costs and administra- would examine the optimal form of a tive costs because they eliminate the (linear) income tax, when the govern- necessity of separate measurement of ment is concerned with equity only and the tax bases. For similar reasons, they when there are no compliance costs, lower the enforcement costs to the administrative issues, noncompliance government. Proportional tax rates also problems, or enforcement difficulties; reduce the incentives for noncompli- transfer (or welfare) programs would ance, and they reduce the distortions also be separately incorporated. Then from changes in the relative prices of the following sequence of layering commodities. Divergences from would be analyzed: equity only; equity proportional commodity tax rates should and efficiency; equity, efficiency, and be minimal and should largely take the compliance costs; equity, efficiency, form of marginally higher tax rates on compliance costs, and administrative goods that are unresponsive to price costs; equity, efficiency, compliance changes (e.g., necessities, for efficiency costs, administrative costs, and noncom- reasons), on goods that generate pliance costs; and equity, efficiency, significant negative spillovers (e.g., compliance costs, administrative costs, alcohol or tobacco, also for efficiency noncompliance costs, and enforcement reasons), on goods consumed by higher costs. The result of this (or some other income groups (e.g., luxuries, for equity sequence) would be a much more reasons), and on goods for which taxes detailed and realistic set of policy can be easily and cheaply collected (e.g., prescriptions for the appropriate design goods versus services, for administrative of tax policies in a specific setting. cost and revenue-yield reasons).

Conclusions: Optimal Taxation In Optimal Income Taxes The Real World Income taxes should be imposed at What would be the form of the tax rules constant marginal tax rates on broadly that would emerge from such a defined tax bases above some level of framework? It is risky to make general income determined by generously statements. Indeed, I think it certain defined exemptions and (standard) that the tax rules would vary, perhaps deductions with minimal use of special significantly, across the different tax incentives. Constant marginal tax economies subject to this analysis. Tax rates reduce compliance costs by design must always consider the reducing the incentive to engage in tax particular circumstances at hand, and at shifting schemes; for related reasons,

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they reduce administrative costs. direct and indirect taxes in theory is Broadly defined tax bases allow lower unlikely to hold in practice. “General” marginal tax rates to generate a given sales taxes are never general, due to level of revenue, and so reduce the difficulties in administration and distorting effects of taxes on behavior, enforcement. Similarly, income taxes including behavior related to noncompli- are never imposed and collected on all ance. Generously defined exemptions incomes. When it is also recognized help achieve equity goals with reduced that compliance costs for income and compliance and administrative costs and commodity taxes differ in both their imply that lower income individuals will magnitude and their incidence, that the pay negative taxes. Standard deduc- taxes differ in their costs of collection, tions reduce the equity of the income that some individuals are better able to tax but lower administrative, compli- evade income taxes than others while ance, noncompliance, and enforcement most individuals are unable to cheat on costs; in contrast, tax incentives increase commodity taxes, that enforcement of the range of taxpayer and tax agency income taxes is generally more difficult costs with uncertain impacts on their than that for commodity taxes, then in desired ends. Income taxes should also such circumstances I think it plausible be collected by source withholding, that both taxes should be used. In thereby lowering compliance and short, it is the fact that each tax is administrative costs. imperfect—and that each is imperfect in different ways—that suggests that both Optimal Tax Mix should be used.

Both direct and indirect taxes should be Although it is comforting that these levied. Use of both taxes allows each broad guidelines are similar to those tax to be imposed at lower marginal tax suggested by others (Bird, 1992), more rates, which reduces distortions and, systematic analysis of these issues is most likely, noncompliance. Use of both obviously needed, and such analysis taxes also gives the government more may well lead to different guidelines. flexibility to achieve its equity and its There is clearly a pressing need for revenue-yield goals, especially given the analyses in which specific features of a limitations that administrative consider- particular country are incorporated and ations impose on the scope and even analyzed in useful and usable simulation the use of some taxes. models. I believe that such analyses serve at least three ends: they indicate The optimal tax mix guidelines are the and quantify with a standard measure most uncertain and the most in need of the trade-offs that taxes necessarily additional research. It is easily estab- create; they indicate the areas in which lished that proportional income and our knowledge is incomplete; and they commodity taxes are equivalent when provide specific guidelines for tax design each is imposed on a comprehensive and , in particular country base. Given such equivalence, only one circumstances. I also believe that the of these taxes need be used; indeed, the guidelines that emerge from such incorporation of the range of costs analyses are in most cases likely to be discussed above clearly implies that only significantly different than those that one should be used. However, it is also emerge from the optimal taxation easily recognized that the equivalence of approach.

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It is, unfortunately, important to keep in implement fully the prescriptions of mind that this exercise may ultimately optimal tax theory. There are simply too prove futile. The informational require- many tax features that are possible ments for the kind of analysis outlined candidates for action but that cannot be here are daunting, and there is too modeled to consider fully their use. much that we do not and, indeed, that Still, this should not discourage the we cannot know. It is also impossible to search for specific tax design—and, consider all possible aspects that are especially, tax reform—guidelines that relevant in the optimal design of tax apply to a single country at a point in systems; even if all of the factors time and that incorporate the range of discussed at length above were to be considerations discussed here. Such incorporated, there would necessarily guidelines will necessarily be couched in remain omissions. Perhaps most general terms. However, if the guide- important among these omissions, the lines are generated from models that optimal taxation methodology does not incorporate the factors discussed here, I consider the positive aspects of the believe that they will offer a better map enactment and the enforcement of tax for tax policy than those derived from rules. The individuals who pass the tax the standard optimal tax framework. laws have interests that may not always coincide with the somewhat amorphous ENDNOTE notion of social welfare that is used in optimal taxation; that is, there is a I have benefited greatly from comments by Richard Bird, Louis Kaplow, and . political dimension to tax policies that may well outweigh the purely normative considerations at the foundation of REFERENCES optimal taxation (Hettich and Winer, Allingham, Michael, and Agnar Sandmo. 1988). As one example, these interests “Income Tax Evasion: A Theoretical Analysis.” may lead individuals in authority to Journal of Public Economics 1 No. 3/4 (1972): enact complex tax rules because of the 323–38. political gains from complexity, even Alm, James. “Compliance Costs and the Tax though such complexity may have Avoidance–Tax Evasion Decision.” Public Finance Quarterly 16 No. 1 (January, 1988): 31–66. efficiency, equity, and revenue-yield Alm, James, Roy Bahl, and Matthew N. costs. Appropriate government policy Murray. “Audit Selection and Income Tax must also recognize that the individuals Underreporting in the Tax Compliance Game.” responsible for administering and Journal of Development Economics 42 No. 1 enforcing the tax rules may well need (October, 1993): 1–33. oversight as well. There is widespread Alm, James, Mark B. Cronshaw, and Michael evidence of corruption by government McKee. “Tax Compliance with Endogenous Audit Selection Rules.” Kyklos 46 No. 1 (1993): officials, and the ways in which this 27–45. corruption should be controlled must be Auerbach, Alan J. “The Theory of Excess considered (Chander and Wilde, 1992). Burden and Optimal Taxation.” In Handbook of Public Economics, Vol. 1, edited by Alan J. In short, the search for a general Auerbach and Martin S. Feldstein, 61–128. scheme that specifies, for all countries Amsterdam: North-Holland, 1985. and all times, the details of an optimal Bagchi, Amaresh, Richard Bird, and Arindam Das-Gupta. “An Economic Approach to Tax tax system is certain to fail. There are Administration Reform.” Discussion Paper No. 3. simply too many details that must be Toronto, Canada: International Centre for Tax known but that are unknowable to Studies, University of Toronto, 1995.

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