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Frank Cowell: HMRC-HMT Economics of Taxation 14 December 2011 HMRC-HMT Economics of Taxation 2011 http://darp.lse.ac.uk/HMRC-HMT 10.2 Policy design Frank Cowell: HMRC-HMT Economics of Taxation Policy Design Overview... Background Locating the subject within public economics Objectives and constraints Optimal policy C&B Optimal policy Strategic Tax design 2 Frank Cowell: HMRC-HMT Economics of Taxation Issues in enforcement policy design Identify main policy rules Objectives reconcile with utilitarian goals? what guidance for tax agencies? Implications for tax policy based on utilitarian ethics using the principal model types what guidance for tax agencies? impact of level and structure of income tax on tax evasion? and vice versa? Feedback to tax design For overviews: Cowell (2004), Slemrod and Yitzhaki (2002) 3 Frank Cowell: HMRC-HMT Economics of Taxation The principal economic actors The key players Control & reporting, simple constitution Delegation Tax farming Further delegation Control & reporting, full delegation Government Corruption model Tax Authority Inspector Inspector Inspector Taxpayers 4 Frank Cowell: HMRC-HMT Economics of Taxation Government Control? Government is denied direct information about citizens Multi-layered structure Different types of concealed information and control failure? Leads to different types of economic model Fundamental difference between types of “control failure” 1 Tax-evasion: Assumes effectively a two-level model Is therefore denied some measure of control Version 1 (Government, taxpayer). Assumes complete internal compliance; external non-compliance. Version 2 (Tax authority, taxpayer). A simplified model of delegation. 2 Corruption: focus on incentives facing the inspector level Taxpayer offers payment to inspector to reduce prob of punishment Inspector is monitored by authority. 5 Frank Cowell: HMRC-HMT Economics of Taxation Questions in enforcement policy Policy questions from previous lecture Should we try to eliminate evasion? Often an implicit objective But on what grounds? Implications of devolution of function What is the optimum degree of enforcement? Can smart auditing improve efficiency? Move beyond this to broader questions Not just lack of control Also the type of objective function Implications for tax design? 6 Frank Cowell: HMRC-HMT Economics of Taxation Connection with previous topic Related to compliance lecture Examine general issues of “breakdown” in fiscal relationships tax under-reporting is one example also black/shadow economy And the mechanisms that may act as insulation institutions social factors 7 Frank Cowell: HMRC-HMT Economics of Taxation Policy Design Overview... Background Limitations of standard utilitarian model Objectives and constraints Optimal policy C&B Optimal policy Strategic 8 Frank Cowell: HMRC-HMT Economics of Taxation Modelling issues What is the appropriate objective? What institutional structure? Law enforcement? Eliminate evasion? Welfare of law-abiding citizens? Utilitarianism? Direct government-taxpayer relation? Tax collection/enforcement agencies? What components of the enforcement problem? requires a multi-stage approach see Cowell (1989) 9 Frank Cowell: HMRC-HMT Economics of Taxation Utilitarian enforcement problem Basic behavioural model Outcome of basic model taxpayer maximises expected utility Eu(c) = Eu([1 – t] y + r te) y: taxable income t: proportionate tax rate e: concealed income r : rate of return to evasion (= – s with prob p, 1 with prob 1 – p) determines optimal evasion response e* = e(p, s, t; y, a) in general depends on both tax and enforcement parameters (p, s, t) and on personal characteristics (y, a) Welfare model Take expected utility of representative taxpayer as welfare criterion W = [1 – p] u([1 – t] y + te) + p u([1 – t] y – ste) where y = y , a = a (representative taxpayer) (so we can drop y, a from optimal evasion response) 10 Frank Cowell: HMRC-HMT Economics of Taxation Fundamental constraints Realities for the government / tax agency Government budget constraint R R which implies ty –rte – f(p) R where r is the expected rate of return to evasion, 1– p – ps zero evasion if p p0 where f(p0) = ty –R Welfare contour for utilitarianism a fixed revenue requirement R cost of enforcement f(p) where f is an increasing function in utilitarian model f may include private compliance costs [1 – p] u([1 – t] y + te) + p u([1 – t] y – ste) = const where e = e(p, s, t) Evasion eliminated where rate of return is zero: s = [1−p]/p gives zero-evasion contour where welfare is u([1 – t] y) = W0 so determines boundary of “honesty set” 11 Frank Cowell: HMRC-HMT Economics of Taxation Model types Problem essentially has three control variables, p, s, t Three stages in the approach to the solution Keep t fixed Keep s or p fixed enforcement authority has considerable, but not total, discretion can trade off severity of penalty against probability of detection unmovable penal system inflexible police system trade off tax against an enforcement parameter Vary p, s, t together Total flexibility 12 The feasible set The “enforced honesty set” s W0 A: The zero-evasion point R R W0 welfare contour through A Welfare contours zero-evasion line Frank Cowell: HMRC-HMT Economics of Taxation The problem if t is fixed B: the optimum f(p0) = ty –R s [1−p]/p W0 satisfies s = [1−p]/p W Welfare increases “South-West” B 0 A p0 p 1 13 Frank Cowell: HMRC-HMT Economics of Taxation The problem if p is fixed Draw feasible set The “enforced honesty” set s A welfare contour Welfare contours 1−p —— p Optimum A R R W t 0 1 14 Frank Cowell: HMRC-HMT Economics of Taxation The problem if p,s,t all variable Optimisation problem again “Enforced objective honesty” set s Transform the problem Revenue increases to North-East Tax authority moves this way? constraint R = constant 0 A p 1 15 Frank Cowell: HMRC-HMT Economics of Taxation Policy Design Overview... Background A utilitarian approach Objectives and constraints Optimal policy C&B Optimal policy Strategic 16 Frank Cowell: HMRC-HMT Economics of Taxation Optimal degree of enforcement? Take a standard welfare-economics approach Basic utilitarian model income: y = wh consumption: c = [1 t]y + rte leisure: ℓ = 1 h utility: u(c, ℓ) Government/tax authority homogeneous population simple revenue target a type of cost-benefit approach to enforcement Individual (slightly extended) choose the optimal p, given fixed s, t enforcement cost per taxpayer: f(p) revenue requirement: R expected revenue leakage per tax dollar: r =1 p ps budget constraint: twh [1 p ps]t e(t, w) f(p) ≥R / n Utilitarian model, homogenous population objective function: v(t, w) = max Eu(c, ℓ) Lagrangean: v(t, w) + l [twh [1 p ps]t e(t, w) f(p) R / n ] 17 Frank Cowell: HMRC-HMT Economics of Taxation Choosing p for given (s,t) Probabilities, costs and benefits Marginal cost of audit fp Marginal benefit of audit Optimum investigation effort Bp p* 0 p 1 MC is marginal audit cost is monotonic increasing MB is marginal audit yields + supply side and risk effects may not be monotonic may go to zero Optimum where MB = MC fp = [1+s]te r te/p w0ℓ/p e(t, w) + vp/l 18 Frank Cowell: HMRC-HMT Economics of Taxation Extensions – agent interaction Cost-benefit approach is essentially individualistic Social interaction models recognise that agents may have better market information than tax authority exploit information about all agents’ behaviour Example: tax compliance by firms prevent epidemics? shift the equilibrium? manipulate expectations? Iyer et al 2010) raise search costs? Focus on smart use of information compute MB for each agent use of information: compare simple auditing with relative auditing relationships amongst firms is essential to the impact of policy choice Cournot behaviour: get effect on output as well as tax receipts collusion amongst firms – smart auditing less effective (Bayer and Cowell 2009) Examine smart auditing further in a reporting model 19 Frank Cowell: HMRC-HMT Economics of Taxation Policy Design Overview... Background Strategic approach to audit policy Objectives and constraints Optimal policy C&B Optimal policy Strategic 20 Frank Cowell: HMRC-HMT Economics of Taxation Tax-payer v. Tax-collector game Model ingredients tax rate t, surcharge s, cost of audit are exogenously determined tax enforcement powers are delegated, like contract farming To find a solution we need to look closely at: the structure of taxpayer population control that can be exercised by tax authority Essence of model is taxpayer heterogeneity differ by income and by attitude to tax-paying authority does not know individual taxpayer attributes and incomes... but does know distribution in the population Take a simple 2x2 version: type poor honest rich chancers income y0 y0 + D y y0 + D y attitude ??? always pay cheat if can pop proportion a0 a1 a2 21 Frank Cowell: HMRC-HMT Economics of Taxation A mixed-strategy approach Each side expects the other to play probabilistically: tax authority investigates low incomes with probability p taxpayer cheats with probability p Expected net tax receipts DT = [a1 + a2 [1 – p] ] t Dy + a2pp [[1 + s]t Dy – ] – a0p Marginal impact on receipts from increasing p is: a2p [[1 + s]t Dy – ] – a0 This is positive if p is greater than a threshold value: a0 p > p* := a2 [[1+s]t Dy – ] 22 Frank Cowell: HMRC-HMT Economics of Taxation Equilibrium concepts Taxpayers and tax agency each form beliefs about the other’s actions Equilibrium where each adopts a consistent set of beliefs What is the optimal “tailored” audit strategy? Two types of relationship between taxpayer and tax authority: tax authority precommits to a strategy tax authority does not precommit see Reinganum and Wilde (1985, 1986) 23 Frank Cowell: HMRC-HMT Economics of Taxation Precommitment: policy If the tax authority were permissive, net receipts would be low: If authority can commit it ought to audit all low-income reports: p = 0 if report is y0 + Dy p = 1 if report is y0 Tax receipts net of audit costs are DT|p=1,p=0 = a1 t Dy DT|p=0,p=1 = [a1 + a2] t Dy – a0 This amounts to a “Punish the poor” policy Is this in fact optimal? viability credibility 24 Frank Cowell: HMRC-HMT Economics of Taxation Precommitment: optimality? Condition 1 for financial viability is: Condition 2 for financial viability is: net return from investigating a false report must be non-negative [1 + s] t Dy – ≥ 0 Combining the two conditions DT|p=0,p=1 ≥ DT|p=1,p=0 [a1 + a2] t Dy – a0p ≥ a1t Dy a2t Dy ≥ a0 [1 + s] t Dy – ≥ [1 + s – [a2/a0]]t Dy satisfied if audit cost is not too high and there are not too many honest people Credibility: everyone sees that only the genuinely poor people are audited no revenue is ever raised in equilibrium policy may not be credible in a repeated setting 25 Frank Cowell: HMRC-HMT Economics of Taxation No commitment: outline Tax authority: Chancers: believes probability that a chancer will cheat is p perceived probability of catching an evader is q := a2p/[a0+a2p] expected net tax receipts can be written as: a0 const + [ p / p* 1] a0+a2p p* is pivotal value of belief believe that probability of audit is p expected utility if cheat is: pu([1 t]y0 + [1 t – st]Dy) + [1 p]u([1 t]y0 + Dy) expected utility if don’t cheat is: u([1 t][y0 + Dy]) there is a pivotal probability satisfied p* which equates these two utilities if u is risk neutral then p* = 1 / [1+s] Solution: tax authority’s best response given belief p defines reaction function p(p) chancers’ best response given belief p defines reaction function p(p) equilibrium where beliefs consistent – where reaction functions intersect 26 The strategy space Tax authority’s strategy p Chancer’s strategy Equilibrium 1 p(p) p* • p(p) tax authority reaction Frank Cowell: HMRC-HMT Economics of Taxation No commitment: Solution always cheat if probability of detection is believed low (p*,p*) taxpayer reaction 0 p* always audit if proportion of cheats is believed high p* = 1 / [1 +s] a0 p* = a2 [[1+s]t Dy – ] p 1 27 Frank Cowell: HMRC-HMT Economics of Taxation How the model works Response to tax-enforcement parameters: ∂p*/∂ > 0 ∂p*/∂t < 0 ∂p*/∂s < 0 ∂p*/∂ = 0 ∂p*/∂t ≥ 0 ∂p*/∂s < 0 Changing population proportions: ∂p*/∂a0 > 0 ∂p*/∂a2 < 0 ∂p*/∂a0 = 0 ∂p*/∂a2 = 0 28 Frank Cowell: HMRC-HMT Economics of Taxation Assessment Compliance is a central component of public economics Analysed using standard microeconomic techniques Incentives issues similar to those of labour supply Important to model the interactions involved in evasion Arises naturally from the issues concerning the provision of public goods Perceptions of others’ behaviour may be important. Also interaction between tax-payers and enforcement agencies Crucial issues on policy concern the institutional background What is the nature of the optimisation problem? Is a standard reporting model appropriate? What information should each party be assumed to have? 29 Frank Cowell: HMRC-HMT Economics of Taxation References Cowell, F. A. (1989) “Honesty is sometimes the best policy,” European Economic Review, 33,605-617 * Cowell, F. A. (2004) “Carrots and Sticks in Enforcement” in Aaron, H. J. and Slemrod, J. (ed.) The Crisis in Tax Administration, The Brookings Institution, Washington DC, 230-275 Iyengar, R. (2008) “I'd rather be Hanged for a Sheep than a Lamb: The Unintended Consequences of 'Three-Strikes' Laws,” NBER Working Paper, 13784 Iyer, G.S. , Reckers, P.M.J. and Sanders, D.L. (2010) “Increasing Tax Compliance in Washington State: A Field Experiment,” National Tax Journal, 63,7-32, Reinganum, J. F. and L. L. Wilde (1985) “Income tax compliance in a principalagent framework ,” Journal of Public Economics, 26, 1-18. Reinganum, J. F. and L. L. Wilde (1986) “Equilibrium verification and reporting policies in a model of tax compliance,” International Economic Review, 27, 739760. * Slemrod, J. and Yitzhaki, S. (2002) “Tax avoidance, evasion and administration,” Handbook of Public Economics, Volume 3, pp 1423-1470, NorthHolland, Elsevier 30