The evasion of fiscal and labor regulations: Firm behavior and optimal tax policy

• Date: 01 February 2020
• Author: Steeve Mongrain,Katherine Cuff,Joanne Roberts
• Published date: 01 February 2020
• DOI: http://doi.org/10.1111/jpet.12394

J Public Econ Theory. 2020;22:69–97. wileyonlinelibrary.com/journal/jpet © 2019 Wiley Periodicals, Inc.

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69

Received: 3 July 2018

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Accepted: 31 July 2019

DOI: 10.1111/jpet.12394

ORIGINAL ARTICLE

The evasion of fiscal and labor regulations:

Firm behavior and optimal tax policy

Katherine Cuff

1

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Steeve Mongrain

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Joanne Roberts

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1

Department of Economics, McMaster

University, Hamilton, Ontario, Canada

2

Department of Economics, Simon Fraser

University, Burnaby, British Columbia,

Canada

3

Department of Social Sciences

(Economics), Yale‐NUS College,

Singapore, Singapore

Correspondence

Katherine Cuff, Department of

Economics, McMaster University, 1280

Main St. W., Hamilton, ON, Canada, L8S

4M4.

Email: cuffk@mcmaster.ca

Abstract

Firms face many fiscal and labor regulations, but they

may evade these legal requirements in several

different ways. We develop a model that captures

these two types of evasion decisions and unlike

existing literature assume firms can evade labor

regulations independently from income tax responsi-

bilities. We characterize firms’entry and evasion

behavior and find that the design of the tax system can

generate both positive and negative correlations

between evasion decisions consistent with what is

observed empirically. We then characterize optimal

government policies given the firms’decisions. We

obtain intuitive optimal tax rules that highlight the

trade‐offs the government faces when firms have

multiple margins on which to evade.

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INTRODUCTION

Governments impose many different forms of labor regulations and taxes on businesses.

Labor regulations stipulate that firms must pay payroll taxes, make social security

contributions, meet health, and safety standards in the workplace, and comply with

employment standards, including general holidays, vacations, working hours and minimum

wages. Business tax laws require firms to collect sales taxes on goods sold and pay taxes on

their income or profits. Empirically it has been documented that businesses may evade some

government regulations while complying with others. Termed “partial compliance,”

Kumler, Verhoogen, and Frías (2015) document that formally registered firms in Mexico

evade social security contributions and Carrillo, Pomeranz, and Singhal (2017) show that

there is widespread misreporting of both revenuesandcostsbyformalfirmsinEcuador.The

process of formalization itself can require registration at different levels of government

agencies for tax purposes and for a given number of paid workers there is variation in the

percentage of firms registering with different agencies (de Mel, McKenzie, & Woodruff,

2013). The existence of different margins along which firms can choose to evade or not

comply with government regulations can result in increased enforcement along one margin

changing firms’evasive behavior along another margin (Carrillo et al., 2017). Under-

standing firm behavior, when they can make evasion decisions along various margins, is

crucial to the design of an efficient and effective tax system.

Despite the empirical evidence of firms responding differentially to government labor

regulations and tax laws, much of the theoretical literature on firms’evasion decisions has

focused either solely on the evasion of business taxes

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or on the joint decision of firms to evade

all or none of the government‐mandated activities.

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This latter approach includes the large

literature on the formal versus the informal sector.

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By either ignoring the labor market

regulation evasion decision or assuming tax evasion implies labor regulation evasion, existing

models cannot capture these empirical observations and potentially lead to misguided policy

prescriptions.

In this paper, we allow firms to decide whether to evade labor regulation independently

from their decision to evade business income taxes and analyze optimal government policy

given firms’evasion decisions. Examining these two evasion decisions independently is of

practical relevance and critical to understanding how government should optimally

structure business taxes. Our paper contributes to a small literature that attempts to model

labor market regulation evasion decisions separately from income tax evasion decisions.

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Tonin (2011) considers minimum wage evasion, but only to the extent it influences personal

income tax evasion and Madzharova (2013) illustrates that the deductibility of wages in light

of a lowered corporate tax can give an incentive to under‐report wages (and pay less payroll

taxes) and thereby shift income from the payroll tax base to the corporate tax base. More

recently, Ulyssea (2018) considers firms who can choose whether to pay all of their income

taxesandhiresomeworkersinformallyortoevadealloftheirincometaxesandhireallof

their workers informally. Consequently, there is only an extensive margin with respect to

income tax evasion. We instead allow for both an extensive and intensive margin for firms’

income tax evasion decisions, thereby capturing the reality that some firms only evade or

avoid some of their income tax liability, and allow for an extensive margin decision for

firms’labor market regulation evasion behavior. We then characterize optimal policy in this

environment.

We adopt a simple model in which a set of heterogeneous entrepreneurs decide whether

to start up a firm or not. Each active firm opens a position, hires a single worker, and

produces output according to linear production technology. Firms differ in the amount of

1

The corporate tax evasion literature such as in Marrelli and Martina (1988), Crocker and Slemrod (2005), or Chen and Chu (2005) to mention a few, is not

really concerned with labor regulations. Likewise, Bayer and Cowell (2009), de Paula and Scheinkman (2010), or Lipatov (2012) are also only interested in

corporate or sales tax evasion.

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Rauch (1991), Fortin, Marceau, and Savard (1997), Fugazza and Jacques (2003), and de Paula and Scheinkman (2011) all model the choices of entrepreneurs to

operate either in the formal (where all regulations are respected) or the informal sector (where all regulations are evaded) based on factors like scale economies,

wage regulations, and taxes. Cuff, Marceau, Mongrain, and Roberts (2011), Djajic (1997), and Epstein and Heizler‐Cohen (2007) assume the decision to evade

one type of regulation implies evading all other regulations.

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Kanbur and Keen (2014) formalize the idea that the informal sector is heterogeneous, but they do not look at the interaction between the labor market and

fiscal policies.

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There is also literature looking at personal income tax evasion where taxpayers can evade taxes using different means. Alm (1988), Cremer and Gahvari (1994),

and Martinez‐Vazquez and Rider (2005) examine the substitutability of different forms of evasion/avoidance and highlight how it makes the comparative statics

and characterization of the optimal policies nontrivial.

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