Tax evasion is an enormous threat in developing nations, reducing tax revenue and impeding economic development. Therefore, governments must exert efforts to curb its practice.
This study proposes three policies to significantly raise the unit cost of tax evasion: increasing punishments and fines, lowering tax rates and raising detection likelihood. Each proposal will have different impacts on the economy.
1. It hampers social welfare
The economic theory of tax evasion has been developed through various means. Some authors present stylized models with individual risk aversion and borrowing constraints; other authors construct more elaborate penal structures and labor supply choices; typically these models are used to analyze how tax evasion affects revenue collection performance.
Some studies use general equilibrium models to examine the distributional impacts of tax evasion. These models take into account changes in incentive structures caused by tax evasion that lead to shifts in consumption, production, and relative product price shifts.
These models often neglect to account for the indirect impacts of tax evasion on the economy, for example by neglecting to consider how it decreases aggregate savings and increases wealth inequality due to reduced taxpayer payments reducing resources available for public goods and services spending by governments.
2. It hampers budget
Tax evasion in the US accounts for around one of every six dollars that is owed, amounting to roughly three-quarters of its federal deficit. Income taxes (which cover wages, salaries, self-employment income etc) see the highest evasion rates while payroll and sales taxes see much lower ones; furthermore the top end of income distribution has an especially disproportionate evasion rate.
Successful tax evaders’ efforts can encourage others to join them, thus diminishing any residual tax advantage. This effect resembles labor market matching wherein a shortage of labor leads to reduced wage rates.
Standard analyses of tax impact tend to disregard general equilibrium adjustments in product and factor prices that have major distributional ramifications, leading to greater understanding of tax evasion effects and effective policies to combat it. A more holistic approach that incorporates such adjustments may greatly increase our knowledge about its impacts while at the same time improving ways in which it’s combated (see also this EconoFact on tax evasion). Better international coordination could also play a part by taxing multinationals, sharing information on offshore assets, and creating fair carbon pricing schemes–all these areas need our consideration.
3. It hampers investment
As much as these studies represent an advance over previous research, none fully incorporate all essential elements for understanding tax evasion’s distributional impacts, such as factor mobility and uncertainty; accounting for different levels of evasion among individuals; or understanding how an economy responds to changes in tax rate.
The traditional approach to analyzing tax evasion neglects these factors and provides an incomplete view of its distributional effects. It assumes that all taxpayers and tax evaders behave similarly; however, avoiders may not reap all of the advantages from previous activities of their evader counterparts, possibly impacting labor markets negatively.
As inequality widens, so too do chances of tax evasion for wealthy people – as inequality worsens, their ability to avoid paying is increased as more resources can be invested into schemes to lower taxes while protecting against potential collectors.
4. It hampers employment opportunities
Recent work on the economics of tax evasion and wealth inequality reveals that wealthy households often use offshore structures to hide income and avoid paying taxes, further exacerbating wealth disparity by allowing evaders to retain more earnings than non-evaders. Even within formal economies, those remaining use various strategies to reduce taxes; some include increasing firm size to avoid payroll and sales taxes or concealing cash receipts from business operations or moving wealth abroad.
Other studies have examined the dynamic effects of tax evasion using modern heterogeneous agent models. These analyses track how any initial advantage from tax evasion shifts to consumers through changes to relative prices and productivity. [3, 4]
Utilizing an Ohio businessman as an example, they determined that his initial welfare gain from evading income taxes is only 1.1-3.4% greater than his post-tax welfare were he to have fully comply with the law; any further gains are ultimately offset by other evaders and shifts in labor/product supply through mobility.
