Tax policy design aims to vanish evasion incentives but can also affect agents’ occupational choices. Tax schemes, auditing, and the size of the IRS affect agents’ decisions, and the government must be aware of this. This article summarizes a study of the optimal tax policy design when evasion and occupational decision coexist.
How should the tax system be designed? This is an open question that has always been relevant for governments. The centrality of this question arises in the necessity to vanish frictions and incentives that increase the tax gap and distort the economy. But are those elements complementary in the policy design? On the one hand, the government wants to increase tax revenue with minimum economic distortion, trying not to distort production efficiency. However, on the other hand, there are imperfections in the real world, like evasion and limited tax capacity. To complicate the analysis more, evasion facilities differ depending on your income-declaration technology: third-party report helps tax compliance while self-reporting facilitates evading taxes. If we also put on the plate innovation mainly done by self-employed workers or persons who start a small business, capital renters who self-report their earnings, and low-skilled workers that could be outside the formal sector, the analysis becomes enormously complicated.
In the working paper “Tax Policy Design in a Hierarchical Model with Occupational Decisions” (see FIT publications), I study the optimal tax policy design, including some of the abovementioned elements. This theoretical model intends to shed light on the optimal tax policy and research the distortions caused by evasion and occupational decisions. Why is this critical? As I mentioned, evasion facilities are different between occupations, and within each of them, evaders can have various incentives to evade. Hence, it is critical to understand how the tax system changes when evasion and occupational choice coexist.
I model an economy where a government interacts with a tax agency (the IRS) and a continuum of taxpayers deciding between working as self-employed or wage-earners. To match with empirical facts, taxpayers only can evade in the self-employment sector. The tax policy is defined as a marginal tax rate (equal for all taxpayers), a public good provision, a budget for the IRS (this determines the agency’s size), and an auditing function. The paper studies the central elements behind the tax policy and compares them with past literature. Particularly, the benchmark is a study made by Isabel Sanchez and Joel Sobel (Sanchez and Sobel, 1993), showing the consequences of considering occupational decisions in this setting. Hence, the main contribution is the last point.
The IRS deals with an informational problem: self-employed can hide information about their earnings. For this reason, auditing should accomplish two missions: deter evasion and give incentive to truth reports. The paper shows that if the budget is insufficient to audit all self-employed, the IRS impedes evasion in the low and medium-income levels, allowing small reports in the high-income zone. This implies two things. First, audits fulfill two missions, prevent evasion and be a threat to evaders. Since auditing is more vigorous in low and middle income, the IRS deters evasion at this level and impedes evaders declare in this zone, otherwise, they be audited and should pay penalties. Secondly, to ensure that non-audited taxpayers report their actual income, they receive the incentive to pay fewer taxes than wage earners with the same earnings, precisely the same as the last audited taxpayer. This shows that evasion becomes more regressive the tax system, impacting occupational decisions as well. The audit function distorts the occupational decision in favor of self-employment, generating a lack of high-skilled workers in the wage-earner sector.
The public goods provision is the same as in the context without evasion and frictions. This means that self-employed who evade pay fewer taxes (percentage-wise) enjoy the same public goods. But also, wage-earners and audited self-employed increase their tax paid (percentage-wise) to finance public goods. This is an evidence of the distortive effect of evasion and the impact on inequality over groups that cannot “escape” from taxes.
Taxes should be smaller than in a setting without occupational decisions. At first look, this result could be interpreted as imposing a zero-rate tax, but this is not the case. The result says that the government should impose smaller taxes to revert distortions because of evasion and its effect on occupational decisions. Critically for this result is the budget shortage for the IRS that impedes audit of all self-employment sector. Hence, because of non-audited taxpayers, fall taxes are optimal to diminish evasion gains. When taxpayers move from wage-earner to self-employment, their increase their welfare, which is good for a social welfare maximizer government, but also pays fewer taxes. Hence, the government deals with the increase in welfare and less revenue when deciding the optimal tax rate. For this reason, taxes cannot be zero and are smaller than without the occupational decision.
The budget for the IRS is insufficient to audit all self-employment sector but larger than without occupational decisions. Occupational decision generates a new way to increase revenue by incentivizing agents to be wage-earners and pay their owed taxes. The marginal benefit of an extra euro for the IRS is more significant than the case without occupational decisions. This effect decreases when the budget rises. Since more vigorous auditing narrows the earning difference between occupations, the extra euro in revenue decreases and the cost is still the same. This means giving enough budget to audit all self-employed is not optimal.
At the equilibrium, the government implements the same public good level as without evasion, a smaller tax rate and a larger budget for the IRS than without occupational decisions. However, the budget is insufficient to audit all self-employed, producing that high-income self-employed are not audited and pay fewer taxes. This distorts occupational decisions in favor of self-employment in this zone, creating a lack of high-skilled workers in the wage-earner sector. This solution is the second-best tax implementation but produces a distortion in the allocation of workers, the production input in this model. Hence, the Diamond-Mirrlees theorem (Diamond and Mirrlees, 1971a,b), or the efficiency in production in a second-best tax scheme, is not attained. This result comes from distortions in the occupational decision by evasion and auditing.
Also, this paper studies the possibility of implementing differential taxation, one marginal tax rate in each occupation. The study demonstrates that this option represents a Pareto improvement from the former case, or the government attains higher social welfare if it designs one tax scheme for each occupation. Differential taxation requires larger taxes for self-employed. This comes from the necessity to vanish evasion incentives. However, this distorts, even more, the allocation of workers compared to the former scenario. What does this mean for the comparison with the Diamond-Mirrlees theorem? This result shows that, in a low tax compliance setting, societies could benefit from an inefficient productivity tax policy if its increases revenue and social welfare. This result was empirically shown before by Best et al. (2015), and now this paper addresses this from a theoretical perspective.
The policy recommendations based on this study can be divided into two. First, the optimal tax policy design implies different tax schemes for different occupations, gathering them by their evasion facilities. Second, if the last option is not possible, the tax policy requires considering the occupational decisions having smaller taxes and a more extensive IRS to fight against evasion. In both cases, the institutional settings produce a distortion in productivity, impeding attaining efficiency on it. This evidence the necessity to explore other policies to improve the effectiveness of the tax policy without distorting production efficiency, as can be shaming or persuasion policies. Also, the condition of designing all instruments together to diminish the tax policy’s distortion in the economy.
The FIT Working Paper “Tax Policy Design in a Hierarchical Model with Occupational” is available in the Publication page of this site.
Photo: Jonne Renvall, Tampere University