Tax Evasion in Developing Countries

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Tax Evasion in Developing Countries

Term Paper (Development Economics) DSE

According to Swiss Coalation of Development Organisations, harmful tax practices is leading to a loss of at least USD 50 billion a year for the Developing Countries. This amount is equivalent to the amount required by the World Bank and UNDP to achieve its Millenium Development Goals.It is also equivalent to the annual official aid given by the OECD countries to Developing Countries. And the tax burden is ultimately shifting from the rich to the poor.


After the opening up of the financial markets tax evasion and money laundering have come up as serious problems for macroeconomists. Even though tax evasion was always a concern for the economists it has now increased to a much larger extent,due to the fact that many of the new financial markets assit the tax evaders by providing them with an easier way of hiding their black money.This amount which would have been used for economic and social development purposes is used for either criminal activities or for riskier low-quality investments like gambling.This money on entering the stock market also brings about a lot of instability. In a study done by Alex Cobham,for low-income countries ,shadow economy forms 32.7% of the GDP and also has a potential tax revenue of 13.7%. And therefore, by bringing down tax evasion a lot of funds can generated and used for more welfare oriented investments.

Earlier Studies

1.Theoretical studies:

The first classical model on tax evasion was made by Allingham and Sandmo in 1972 where an individual tries to maximise his expected utility from evasion of taxes. The model considers a monetary fine along with a loss of reputation as a penalty and had static as well as dynamic versions of the same. It also included comparative static results with respect to actual income, tax rate , penalty and probability of detection concluded that probability of detection and penalty rate both or a combination of the two can be used for reducing tax evasion. But they assumed that fines are assessed on income evaded by the tax payer. So, the affect of increase in taxes was unclear as the substitution effect (higher marginal tax rate makes evasion more attractive) and income effect (high tax rate lowers income) offset each other incase of risk aversion( as low income makes taxpayer less willing to take risk).

However, in 1974 Yitzhaki showed that substitution disappears when fines are assessed on taxes evaded and not income evaded and solved the ambiguity related to effect of tax rate in Allingham-Sandmo model. After this the Allingham-Sandmo-Yitzhaki model was used as the benchmark for all other later models. All these models assumed the tax payer to be corrupt but not the tax collector which may be true for the developed nations but not for the developing countries. However, the models by Becker and Stigler (1974), Rose-Ackerman (1975), Klitgaard (1989 &1995), Basu Bhattacharya and Mishra (1992) Mookherjee and Png (1995) and Nadeem Ul Haque and Ratna Sahay (1996) assume tax collector be corrupt as well and used the principle-agent problem to find the solution to tax evasion and corruption. Among these the model by Nadeem Ul Haque and Ratna Sahay shows that by increasing the incomes of government employees more skilled individuals can be attracted to the job and also higher government wages also weakens the incentive compatibility condition of corruption, for the tax collector thereby reducing corruption and tax evasion. Generally all these models assume the tax payer to be dishonest but the model by Brian Erard and Jonathan S.Feinstein assumed that not all tax payers are dishonest and used an asymmetric information static game to build up their model and had results very dissimilar to the others. The theoretical models...
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