Fairness in tax compliance: A political competition model

• Author: Ángel Solano‐Garcia
• DOI: http://doi.org/10.1111/jpet.12232
• Date: 01 October 2017
• Published date: 01 October 2017

Received: 12 June 2016 Accepted: 24 July 2016

DOI: 10.1111/jpet.12232

ARTICLE

Fairness in tax compliance: A political

competition model

Ángel Solano-Garcia

Universityof Granada

ÁngelSolano-Garcia, Departamento de Teorí e

HistoriaEconómica, Universidad de Granada,

18011Granada, Spain (asolano@ugr.es).

Iwould like to thank Enriqueta Aragonès, Hum-

bertoLlavador, Santiago Sanchez-Pages, Socorro

Puy,and Ascension Andina for their helpful com-

ments.I acknowledge financial support from

SpanishMinistery of Economy and Competitive-

ness,grant numbers ECO2013-44879-R and ECO

2014-57673-REDT.The usual caveat applies.

This paper analyzes the political economy of income redistribution

when voters are concerned about fairness in tax compliance. We

consider a two-stage model where there is a two-party competition

overthe tax rate and over the intensity of the tax enforcement policy

in the first stage, and voters decide about their level of tax compli-

ance in the second stage. We find that if the concern about fairness

in tax compliance is high enough, a liberal middle-income majority of

voters may block any income redistribution policy.Alternatively, we

find an equilibrium in which the preferences of the median voter are

ignored in favor of a coalition formed by a group of relatively poor

voters and the richest voters. In this equilibrium income redistribu-

tion prevails with no tax enforcement.

“I'll bet a million dollars against any member of the Forbes400 who challenges me that the average (federal tax

rate including income and payroll taxes)for the Forbes 400 will be less than the average of their receptionists.”–

WarrenBuffett, 20071

1INTRODUCTION

In the midst of the recent debt crisis, tax compliance has been a hot issue in many parliaments of developedcountries.

For instance, Mitt Romney's case of tax avoidanceintroduced another dimension into the debate about income taxes

in the 2012 U.S. elections. The importance of tax compliance in politics is even more intense in European countries

with financing problems in such countries as Greece, Portugal, Ireland, Spain, and Italy. While millions of citizens are

required by their governments to bear the burden of heavy tax hikes, recent news reports have unveiledimportant

cases of tax evasion, tax avoidance, and tax fraud by politicians and large fortunes in these countries (see the case of

the Barcenas scandal,2Lagarde's list, or the Spanish tax amnesty for some examples). This misbehavior affects public

opinion on society's tax morale which may result in voters'shiftingtheir preferences for income redistribution.

The aim of this paper is to study the political economy of income redistribution when voters are concerned about

fairness in tax compliance. We consider a two-stage model where there is two-party competition overthe tax rate and

1Forthe full interview with Warren Buffett see http://www.cnbc.com/id/21553857

2Forsome reviews of the case see http://www.nytimes.com/2013/02/01/world/europe/prime-minister-of-spain-accused-of-receiving-payouts.html?_r=0

Journal of Public Economic Theory.2017;19:1026–1041. wileyonlinelibrary.com/journal/jpet c

2017 Wiley Periodicals,Inc. 1026

SOLANO-GARCIA 1027

over the levelof tax enforcement in the first stage, and voters decide about their level of tax compliance in the second

stage. Regarding tax noncompliance, we focus on tax evasion rather than on tax avoidance since tax evaderswho are

detected have to pay a penalty.3Inour framework, the possibility of tax evasion adds a way of redistributing income

from the poor to the rich that is opposite to traditional taxation models. These two opposing ways of redistributing

income turn middle-income voters into the highest net contributors to welfare policies: They are subsidizing both the

poor by the traditional redistributive channel, and the rich by the channel associated with tax evasion. Wefind that if

fairness concern in tax compliance is large enough, a majority of middle-income voters may block any income redis-

tribution policy. Alternatively,a coalition of the poorest and the richest voters in favor of income redistribution but

against any tax enforcement policy can also be a feasible equilibrium.

There is vast literature on tax compliance (for excellent surveys,see Andreoni, Brian, & Feinstein, 1998; Slemrod,

2007; Slemrod & Yitzhaki, 2002). Most of the studies in the literature are based on the frameworkproposed by Alling-

ham and Sandmo (1972) in which taxpayers maximize their expected utility under the probability of a penalty if they

are caught underreporting their taxable income. This deterrence theory has been criticized by many authors because

it predicts a much lower compliance rate than what we actually observe (see Alm, McClelland, & Schulze, 1992; Feld&

Frey,2002; Graetz & Wild, 1985).

Behavioralmodels that assume some tax morale in taxpayers try to solve this empirical problem. For instance, Erard

and Feinstein(1994) proposed a model in which tax noncompliance produces feelings of guilt and shame that are incor-

porated exogenouslyin taxpayers'utility function. Gordon (1989) addressed the topic of fairness and tax compliance.

He made the psychic cost of tax evasionendogenous in a dynamic model in which this psychic cost varies inversely with

the number of individuals evading in the previous period. A similar approach was suggested in Bordignon (1993), who

considered that individuals'decisions about tax compliance depend on what they consider is fair,which in turn would

depend on their conjectures about the aggregated level of tax compliance. More recently,Taxler (2010) incorporated

tax morale into the Allingham and Sandmo (1972) model. His study underlined the role of beliefs about others'levelof

tax compliance in shaping the relationship between tax enforcement and tax evasion.

Other papers have focused on the effect of corruption and waste of resources by the government on tax compli-

ance. Pommerehne, Hart, and Frey (1994) presented a dynamic model in which taxpayer compliance decreases with

deviation between the individual's optimal choice of public good provision and the one implemented, noncompliance

by other taxpayers,and the level of government waste in the previous period.

Empirically, Spicer and Becker (1980) supported the premise that fairness is important for tax compliance. They

experimentally found that individuals'decisions about tax evasion depend on the relative comparison between their

payments and others'payments. Other more recent empirical papers such as Cummings, Martinez-Vazquez,McKee,

and Torgler(2009), Frey and Torgler(2007), and Torgler (2002 and 2005) found a significant relationship between tax

compliance, tax morale, and trust in public institutions.

Followingthe approach of these behavioral models and empirical results, we assume that individuals are concerned

about fairness in tax compliance. More precisely,we assume that taxpayers suffer a psychic cost of deviating from the

expected averagelevel of tax compliance. Our main findings are as follows.

We find that voters'preferences on both policy instruments heavily depend on their sensitivity to the social cost

of tax evasion, as well as their perception about the wasting of public funds. Regardless of the analysis of other cases,

throughout the paper we focus on the scenario in which the latter voters'characteristicsare important enough. In this

context, we obtain that preferences for income redistribution are nonmonotonic in taxpayers'income, with middle-

income voters being against income redistribution and votersin the extremes of the income distribution being in favor.

This result contrasts with the classical result that preferences for income redistribution are decreasing in income

(see Meltzer & Richard, 1981). Introducing the possibility of tax evasion changes the way income is redistributed

through income tax with respect to the traditional models. In traditional taxation models, poor voters prefer a high

income tax in order to extract income from the rich. Including the possibility of tax evasion makes the poor prefer a

3Weare aware that the distinction between tax evasion and tax avoidance sometimes becomes blurred, especially when dealing with individuals at the topof

theincome redistribution.