Write 2 paragraphs about "Income tax evasion: tax elasticity, welfare, and revenue'' Opinion of Fiscal Policies" article. No max word count, ONLY 2 PARAGRAPHS, or formatting requirements but must be submit to my tutor's work as my own.

Gillman, M. (2021). Income tax evasion: tax elasticity, welfare, and revenue. International Tax and Public Finance, 28(3), 533-566. https://4x10huuph-mp03-y-https-doi-org.proxy.lirn.net/10.1007/s10797-020-09632-3

Abstract

This paper provides a general equilibrium model of income tax evasion. As functions of the share of income reported, the paper contributes an analytic derivation of the tax elasticity of taxable income, the welfare cost of the tax, and government revenue as a percent of output. It shows how an increase in the tax rate causes the tax elasticity and welfare cost to increase in magnitude by more than with zero evasion. Keeping constant the ratio of income tax revenue to output, as shown to be consistent with certain US evidence, a rising productivity of the goods sector induces less evasion and thereby allows tax rate reduction. The paper derives conditions for a stable share of income tax revenue in output with dependence upon the tax elasticity of reporting income. Examples are provided with less and more productive economies in terms of the tax elasticity of reported income, the welfare cost of taxation and the tax revenue as a percent of output, with sensitivity analysis with respect to leisure preference and goods productivity. Discussion focuses on how the tax evasion analysis may help explain such fiscal tax policy as the postwar US income tax rate reductions with discussion of tax acts and government fiscal multipliers. Fiscal policy with tax evasion included shows how tax rate reduction induces less tax evasion, a lower welfare cost of taxation, and makes for a stable income tax share of output.

1 Introduction

The paper models tax evasion in a general equilibrium, representative agent, optimizing framework. Using closed form solutions, it derives the elasticity of labor income to a at tax, the welfare cost of the labor income tax, and the elect of productivity and tax rate changes on tax revenue. The paper uses a certainty-equivalence model of tax evasion as an optimal choice of the share of earned income to report for tax purposes.1 It contributes how the tax elasticity and welfare measures are based on structural utility, technology, and policy parameters rather than being behavioral, immutable, parameters. It is shown how rising goods sector productivity causes less tax elasticity, tax evasion, and welfare loss, and how falling income tax rates act similarly.2 The paper contributes analytic conditions for how income tax rate reductions can keep income tax revenue as a share of output constant over time. Given a trend up in goods sector productivity, the tax rate can trend down while keeping income tax revenue a constant share of output, as dependent upon one aspect: The tax elasticity of the tax revenue as a share of income. The higher is the elasticity in magnitude, the faster the tax rate can fall; as the tax elasticity magnitude falls over time due to the productivity rise, the rate of decrease in the income tax rate becomes smaller, while keeping the revenue share constant. This ashes out how the nature of the tax elasticity provides a rationale for the continually lower tax rates experienced worldwide. Given evidence of tax evasion through banks, the paper uses the microeconomics of the banking literature to present a model of tax evasion through the intermediation of the service using that banking production technology.3 This technology is of standard form (Cobb-Douglas) and can be interpreted more broadly as supplying tax avoidance, such as tax expenditures and shelters, as well as evasion.4 Here the probability of getting caught and fined is subsumed into a certainty equivalent parameterization of the productivity factor of the intermediation sector that supplies the tax evasion and/oravoidance service.5 The paper shows how tax evasion is optimally determined by setting the marginal cost of the evasion, which is the tax rate, equal to the marginal cost of avoidance through the intermediation sector. As enabled by the sectoral production approach, this marginal cost, in price-theoretic fashion, equals the marginal factor cost of intermediation labor divided by the marginal factor product of the labor. As the tax rate rises, the magnitude of the tax elasticity of taxable income rises. Tax evasion causes the magnitude of the tax rate elasticity of the reported income to be higher than in the economy without tax evasion for tax rates up to a moderately high threshold value of the tax rate. The role of tax evasion in raising the elasticity magnitude is supported by a literature nding it di cult to explain responses to tax reform through standard labor elasticities alone without considering evasion (Saez et al., 2012; Mertens and Ravn, 2014). Given the traditional relation between the magnitudes of the tax elasticity and of the welfare cost of the tax, the paper also shows how the welfare cost of the tax rises with the tax rate and how the welfare cost relates to the tax elasticity magnitude once evasion is allowed. Certain evidence suggests developed countries tend to have less tax evasion than developing countries, that developed countries such as the US post-WWII have lowered their tax rates sequentially over time, and that developing countries rely less on income taxes as a source of government revenue while increasing such reliance on income taxes as they develop. This paper can explain these phenomena jointly through the eect of goods sector productivity on tax evasion. As this productivity trends upwards, tax evasion decreases and can drive such experience. To illustrate the eect of productivity, an application is made with two example economies diering in productivity levels. It illustrates the eect of tax evasion on tax elasticities and welfare cost for low versus high productivity economies, typically characterized as less versus more developed countries (Lucas, 1990).6 The less productive economy has more tax evasion, a higher tax elasticity of taxable income and a higher welfare cost of the tax up to a certain threshold tax rate. The less productive country also exhibits a lower Laer curve with less tax revenue as a percent of income at each tax rate relative to the more productive economy. Greater leisure preference causes more goods to leisure avoidance of the tax while less goods productivity causes more evasion and less goods relative to leisure. Sensitivity analysis illustrates the eect of these factors of leisure preference and goods sector productivity on the tax elasticity and welfare cost. Greater leisure preference and lower goods sector productivity each cause a higher tax elasticity in magnitude but have opposite eects on the welfare cost of the tax. When the dierences in tax elasticity are due only to a lower goods productivity, it is shown that the higher tax elasticity corresponds also to a higher welfare cost, as in the Ramsey (1927) logic. A higher leisure preference causes a higher tax elasticity and a lower welfare cost, as an exception to Ramsey logic that may be important for public nance, for example to extensions to models of heterogeneous agents diering by both leisure preference and goods productivity. The paper discusses developing country tax evidence, at tax reform, government spending multipliers and US tax reform since the 1980s in terms of how tax evasion may factor into consideration of tax base broadening and tax rate reduction. Given rising productivity over time, the papers analysis suggests a scenario by which future tax law would see falling income tax rates, increasingly less tax evasion, and possibly stable tax revenue as a share of output, such as in the US experience of a 7:7% average from 1947-2018 (Fig.1, Sect.3). 2 Related Literature Kopczuk (2005, p. 2094) focuses on base broadening, the tax elasticity and its role in welfare loss. "This elasticity is the key parameter necessary to evaluate the deadweight loss of the income tax" and "that it is not a structural parameter depending only on underlying preferences and technology, but instead it depends on a non-rate aspect of the tax system (tax base) that can be manipulated by policy makers." Here the paper lays out the tax elasticity and welfare in a at tax framework, with base broadening resulting from decreasing the tax rate itself and from goods sector productivity advance that both decrease evasion, the tax elasticity magnitude and the welfare cost of the tax. Weisbach (2003, p. 9) stresses the importance of a welfare cost approach to analyz3 ing tax avoidance and evasion: "The task is to determine how to classify and treat the various responses to taxation based directly on the welfare consequences."7 He emphasizes that avoidance and evasion are related in economic consequences, with the former legal and the latter illegal. "There is also nothing sacred about a division of the world between evasion and avoidance." Weisbach (p. 12) analyses the eect of tax shelters on the elasticity of taxable income while noting that "It is easy to imagine how the avoidance/evasion type regime we have arises from this analysis." This paper provides both the avoidance through what Weisbach (p.14, footnote 1) calls the "labor/leisure distortion of an income tax" and evasion through the bank intermediary. The entanglement of legal evasion through tax expenditures and illegal evasion is left unwound in this paper in which the intermediation production of evasion implicitly allows for taking advantage of tax expenditures or shelters. See also Weisbach (2002, 2006) on tax expenditures and shelters. Saez et al. (2012) discuss how taxable income changes with tax rates, in the sense that with lower tax rates the income base can rise if there is a rising price elasticity of taxable income relative to the tax rate as the price. This paper builds upon the insight that for the tax base to rise signicantly, as some evidence after the 1981 and 1986 tax acts suggests (Saez et al.), then tax evasion could be decreasing as the tax rate falls. This paper models such optimal competitive equilibrium tax evasion, resulting in a greater elasticity of taxed income relative to the tax rate and a lower amount of evasion when the tax rate decreases. Sandmo (2005) reviews the literature on modeling tax evasion, including the approach of deciding how much income one is to report at the time that the decision needs to be made; this paper follows this concept by also deciding how much income to report. Sandmo further allows for a probability of detection of evasion, and possible penalties, a common feature of this literature (for example, Becker, 1968, and Ehrlich, 1973, 1996). Here, this paper considers the probability of detection and being penalized all in terms of resulting in some average, economy-wide, productivity of avoiding/evading the taxes. For example, in utilizing "tax expenditures" in a way that constitutes a type of avoidance 7Weisbach (2003, p. 9) expands on the welfare approach to avoidance and evasion: "To put the problem in a welfarist framework, we cannot assume pre-existing denitions of tax avoidance and evasion. Instead, we must determine which responses to taxation will be treated in various fashions based directly on the welfare consequences of such treatment". 4 behavior, there may be little uncertainty involved in the process of legally decreasing taxable income yet there can be signicant cost due to setting up various legal and accounting extensions. For tax avoidance/evasion, the paper here stipulates through an intermediation production process some average cost of avoiding and evading taxes, taking into account all of the probabilistic outcomes. This is a "certainty-equivalence" approach used in macroeconomics, an abstraction by which these factors are embedded into the productivity parameter of the intermediation sector (Gillman and Kejak 2014). Gale and Brown (2013) emphasize the importance of "broadening the income tax base". They oer ways to eliminate special tax deductions and consider how a value added tax works to raise taxes internationally. The paper here uses only a at income tax to show base broadening through less tax evasion. While a myriad of tax expenditures are reviewed by Gale and Brown, this paper abstracts also from the complex structuring of taxable income, through legal, accounting and investment banking fees, as being a part of the intermediation costs of evasion that are modeled; these costs can be thought of as including both the legal tax expenditures and illegal tax evasion that limit the income tax base. A broad literature on reaction to specic tax law exists. For example, Alstadster et al. (2019b) show how tax avoidance is aected through shelters that are enhanced by social networks, using a study of a 2006 Norwegian tax reform. US tax law has stimulated a broad literature focused on tax expenditures and incentives. Kopczuk (2005) analyzes the 1986 US tax act in terms of base broadening; Poterba (2011) reviews tax expenditures; and Slemrod (2018) also considers the base broadening aspects of recent tax legislation. Cummins et al. (1994) discuss the incentive effect of tax reform with a focus on investment and Auerback (2002) considers the eect of tax reform on revenues in a dynamic context. Studies also consider how changing the labor tax eects government revenue while including human capital; for example, Holter et al. (2019) examine US Laer curves with a at income tax. Piketty et al. (2018) cover a rich literature in estimating the eects of income level on effective tax rates, although their "estimates of incomes at the top of the distribution are based on tax data, and hence disregard tax evasion" (p. 556). The paper here displays a Laer curve as a result of evasion. 5 Section 3 examines some evidence on the US tax revenue to output ratio. Section 4 presents the model with a focus on the tax elasticity of income and the welfare cost of the tax. Section 5 provides examples with low and high productivity economies. Using the examples of Section 5, Sensitivity analysis is illustrated in Section 6 for the tax elasticity and welfare cost with respect to leisure preference and goods productivity. Discussion of the results is presented in Section 7, and the conclusion follows in Section

8 Conclusion

The paper presents a model of tax evasion based on a microeconomic, financial intermediation, technology that is based in the banking literature and that produces the evasion service. With a tax on labor income, the analysis studies the elasticity of reported income with respect to the tax as well as the welfare cost of the tax. It is shown how tax evasion increases the tax elasticity of reported income and increases the welfare cost of such taxation. Examples of tax elasticities and welfare cost estimates are provided for less and more productive economies. A stable share of income tax revenue in output while goods productivity trends higher is shown to imply a certain trend downwards in the tax rate. This gives a perspective on the direction in which tax law may evolve and how this may affect its welfare cost internationally.