Tax evasion with psychic costs and penalty renegotiation.

• Author: Cho, Joonmo

1. Introduction

   The Primary Issues

   Tax evasion is a constant source of fiscal concern for most governments. The United States Internal Revenue Service [19] for instance has estimated that the federal income tax liability not reported on timely filed tax returns for 1986 was on the order of $70.1 billion. In response, the U.S. has taken steps to address the problem, including implementation of the Taxpayers Compliance Measurement Program, which is designed to provide guidance in establishing audit procedures. A longstanding belief is that a sound auditing policy accompanied by a known penalty system is necessary to insure that individuals accurately report their incomes to the taxing authority. This belief indeed forms the basis for most models of tax compliance as for instance those of Reinganum and Wilde [24; 25] and Mookherjee and Png [23].

   The basic problem is this: When a taxpayer knows his own income but the revenue collector does not, the taxpayer may have an incentive to dissemble on his income report. In order to discourage this type of behavior and to insure that taxpayers comply with the tax laws, the revenue collector may selectively audit taxpayer reports and impose penalties when false reports are identified.(1) Auditing, however, is costly.

   This paper presents a positive theory of tax evasion through a formal analysis of the problem just described. One important feature of the examination includes how the optimal auditing policy changes as the willingness of the tax authority to renegotiate the penalty changes. While penalty renegotiation is an observed practice, this aspect of the tax compliance problem and its implications have not yet been investigated within a formal context.

   While false reporting that goes undetected increases net-of-tax consumable income for the dissembler, empirical evidence suggests that individuals suffer psychic costs from cheating [2; 16]. In this paper we show how auditing policy interacts with the individual taxpayer's perception of the psychic cost of cheating. The individuals in our model exhibit heterogenous psychic costs of dissembling which cannot be observed by the tax collector.(2) These psychic costs may be so high that some people would not cheat even if the expected marginal penalty if detected were zero.

   The tax revenue collector is typically not the political body which proposes and adopts the tax structure. The tax collector is however, typically empowered to implement the means for collection. For these reasons we restrict the revenue collector's problem to the selection of the penalty for cheating, and the audit policy employed, taking the tax structure as given. The tax collector may also be empowered to renegotiate the penalty for any individual who is discovered through an audit to have falsely reported her income. We grant this privilege to the tax collector in our model after first investigating the consequences of a policy of no renegotiation.

   Ex post renegotiation of the penalty has been an heretofore neglected aspect in the study of tax compliance and auditing policy. In practice, the actual penalty paid is often negotiated between the revenue collector and the audited dissembler. We specifically address the policy issue of whether penalty renegotiation is a tax revenue maximizing policy. Renegotiation is a feasible strategy for the tax collector when the net-of-penalty income of the dissembler is below her 'bankruptcy' threshold level and the tax collector will incur real costs in the process of seizing income to cover the tax and penalty liability. By reducing the penalty through negotiation the taxpayer avoids the stigma of bankruptcy and the tax authority avoids the seizure cost.(3) Thus, the revenue collector is able to raise net tax revenue. Of course, in order to induce a dissembler to accept the renegotiated penalty, the outcome must guarantee him a greater utility than his utility under bankruptcy. We examine the conditions under which ex post Pareto-improving renegotiation of the penalty is possible.(4)

   When there is information asymmetry between the taxpayer and the tax collector regarding the individual's bankruptcy threshold, a policy of penalty renegotiation may however not be a revenue maximizing strategy. Once the possibility of renegotiation becomes public knowledge, audited dissemblers have an incentive to claim (falsely) that the penalty will place them in bankruptcy, and hence that they will not be able to cover the tax and penalty liability out of income. If there is no way for the revenue collector to sort out the true bankruptcy claims from those that are false, then too much renegotiation will occur and expected net tax revenue will be smaller than if the tax collector had perfect knowledge of the bankruptcy status of individual taxpayers. Furthermore, if renegotiation of the penalty is recognized before taxpayers report their income, then they will estimate that the expected cost of dissembling is below what it otherwise would be. This inference follows from the prediction that the revenue collector will reduce the initial penalty whenever the dissembler claims that bankruptcy is imminent in order to save the costs of seizing income. Thus, even taxpayers with large psychic costs of cheating may be induced to dissemble. We show however that a tax recovery strategy which combines aspects of a renegotiation policy and an asset seizure policy can reduce false bankruptcy claims while allowing the tax collector to obtain some of the benefits of renegotiation.

   The tax collector also has the opportunity to select the penalty along with the optimal audit strategy. Two possible situations present themselves with respect to the choice of a penalty. First is the case of an arbitrary fixed penalty selected independently of the audit strategy. Second is the case of an optimally chosen penalty structure selected jointly with the audit strategy. In the latter case the penalty structure is not a priori restricted to any particular form. We begin our discussion by focusing on the optimal audit strategy, given a fixed, but arbitrarily selected, penalty. While on the surface, the notion of a fixed penalty of this sort is unappealing, it is not unusual to observe this type of penalty system in practice. The first part of the analysis therefore emphasizes only one dimension of the problem faced by the revenue collector, the optimal audit policy. We then turn to the issue of the optimal penalty structure.

   Related Literature and Distinguishing Features of the Model

   We borrow the concept of renegotiation from the recent literature on commitments as illustrated in Baron and Besanko [6] and Green and Laffont [17]. The focus of this literature has generally been on nonbinding agreements, not on Pareto-improving renegotiation moves. This paper introduces the idea of ex post Pareto-improving renegotiation within the context of tax evasion. The setting therefore combines the risk sharing and the renegotiation problems examined by Dewatripont [9] and Dewatripont and Maskin [10], Fudenberg and Tirole [13] and Ma [22]. There are important contextual differences however between our model and these others. In our model, the revenue collector is willing to renegotiate the penalty in order to maximize ex post net-of-seizure cost tax revenue.(5) Dissemblers are willing to accept the new offer because they can avoid the stigmatization associated with bankruptcy and income seizure. This stigmatization is potentially comprised of a social stigma, the stigma that follows the individual when seeking new employment opportunities, and the stigma that follows the individual when seeking new credit.(6)

   The model presented here also has the following new features as compared to the existing literature on tax evasion and auditing. First, in our model, the revenue authority maximizes expected net-of-cost tax revenue.(7) This objective function is in sharp contrast to the objective in Mookherjee and Png [23] but is similar to the objective examined in Reinganum and Wilde [24]. In Mookherjee and Png [23], the government chooses the auditing and tax structure in order to maximize social welfare. In Reinganum and Wilde [24] the government (here the tax authority) is identified as a net revenue maximizer who is also a net cost minimizer. Our results, however, differ from those obtained in Reinganum and Wilde [24]. Reinganum and Wilde show that in equilibrium, every taxpayer reports falsely by a constant portion of his true income.(8) This implies that a constant auditing policy by the revenue maximizer is optimal. Given this auditing policy, taxpayers are actually indifferent about whether they cheat or not, but the stability of the auditing policy is supported only when taxpayers cheat by a certain constant proportion of true income. In our model, some taxpayers are better off by cheating (are not indifferent) because they have relatively lower psychic costs of dissembling than do others. They cheat because their expected income gain is greater than their psychic cost.

   Second, our model incorporates the idea that personal psychic costs are incurred as a result of cheating. The first formal model to incorporate morality as a deterrent to tax evasion was presented by Gordon [14]. He introduces psychic costs into Allingham and Sandmo's [1] model of tax evasion to explain the empirical findings that some taxpayers never evade, that evasion increases with the tax rate, and that evasion decisions are independent. The emphasis of our paper is quite different from Gordon's. However, our model is rich enough to replicate some of his results.(9)

   Finally, unlike the previous literature, this paper assumes that taxpayers have heterogenous bankruptcy levels. The bankruptcy level is assumed to be private information ex ante, known only to the taxpayer. The ability of an identified dissembler to threaten to declare bankruptcy has important implications for the benefits to...