Effects of Tax Evasion

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International Tax and Public Finance, 7, 177–194, 2000.
c 2000 Kluwer Academic Publishers. Printed in The Netherlands.

Decomposing Revenue Effects of Tax Evasion and Tax Structure Changes ARINDAM DAS-GUPTA* oldmonk87@yahoo.com Gokhale Institute of Politics and Economics, B MCC Road, Pune 411004, Maharashtra, India IRA N. GANG gang@economics.rutgers.edu Department of Economics, Rutgers University, New Brunswick, NJ 08901-1248 USA

Abstract
This paper proposes a method for evaluating the impact of tax structure changes on tax revenue. The technique consists of decomposing the gap between actual revenue and potential revenue into components attributable to changes in (i) the tax rate structure (ii) deductions and (iii) tax evasion. Our results indicate that, for the Indian reform episode we examine, there were initial gains which could not be sustained over time. The magnitude of the gains from the reform were limited and failed to significantly curtail losses from tax evasion. JEL Code: H20, H24, H23, H26

1.

Introduction

This paper proposes a method for examining the impact of changes in the structure of a tax on tax revenue. The technique consists of decomposing, via an identity, the gap between actual and potential revenue from the tax into components attributable to changes in (i) the tax rate structure (ii) exclusions and (iii) tax evasion. Potential revenue is taken here to mean the revenue that would have resulted from the tax in the absence of base-narrowing exclusions and tax evasion. The decomposition can be extended further, if data are available, to sub-categories of these components or to different taxpayer groups. Our method can be used to analyze structural changes in any broad-based tax. Here we focus on the personal income-tax. Two types of studies are related to the methodology developed here. The first studies fiscal capacity and fiscal effort. This is done, for example, by the Advisory Commission on Intergovernmental Relations (ACIR) in the United States.1 The purpose of the ACIR’s exercises is to compare revenue performance across states in the U.S. Confining attention to income tax, the ACIR notion of taxable capacity plays the same conceptual role that potential revenue plays here. However, taxable capacity is defined in terms of the average performance of the group of states being examined. Thus, the tax base for the taxable capacity estimate is the total Federal income tax base of a state’s residents, and the tax rate * We wish to thank, without implicating, Rosanne Altshuler, Jack Mintz, Janet Stotsky and two anonymous referees for very helpful comments. The first draft of this paper was completed while Das-Gupta was a Visiting Fulbright Scholar at Rutgers University. Support from the Fulbright Scholarship and the hospitality of Rutgers University is gratefully acknowledged.

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applied to this is the average rate prevailing across states. Tax effort is then found residually by comparing actual revenue with taxable capacity. Since states are treated impartially, the ACIR method is of use in making inter-state comparisons. The ACIR estimates cannot, however, be used to shed any light on the sources of low effort in any individual state, for example, whether low effort is due to relatively extensive tax evasion or relatively generous exclusions. Furthermore, ACIR estimates cannot be used to evaluate how the performance of any given state has changed over the years. The second type of study partitions the difference between potential revenue and tax collection into components reflecting taxpayer identification, non-filing, under-reporting and underpayment.2 This amounts, essentially, to a further disaggregation of the evasion component of our decomposition, which can easily be incorporated if data are available. We illustrate the use of the decomposition methodology by examining income-tax reforms in India during 1984–89. Besides data availability, the selection of the...
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