Learning in experiments: Dynamic interaction of policy variables designed to deter tax evasion

While neoclassical economic theory sheds insight into the way that audit rates and penalty rates interact when individuals decide to declare income for taxation, it predicts far lower levels of compliance than observed levels of compliance. This paper analyses experimental responses to explore a dynamic interaction between audit and penalty rates as individuals learn how to comply with taxation. It compares the responses of subjects in experiments with responses that are predicted when individuals rely on an adaptive learning process (that offers information feedback about decision payoffs). This comparison suggests that learning is an important consideration when explaining differences between predicted and observed levels of tax compliance.     

Repeal of the Estate Tax and Its Impact on Philanthropy

The estate tax has many advocates and opponents. We present a review of the primary arguments and empirical evidence promulgated in support of continuation and for repeal. Overall, we find that there are plausible theories and strong, but not definitive, empirical evidence on both sides of the issue. Further research is needed that more clearly isolates differences between the income‐tax and estate‐tax (that is, the after‐tax cost or “price” of a donation or bequest) effects, the independent‐income and wealth effects (how having higher income or wealth has an effect on giving during life and at death), and married and single estate tax filers. These differences can be best isolated using longitudinal data. Data and analyses for both the short run and long run are necessary before society can reasonably predict the impact the repeal of the estate tax will have on both giving during life and charitable bequests.     

How does inequality aversion affect inequality and redistribution?

We investigate the effects of inequality aversion on equilibrium labor supply, tax revenue, income inequality, and median voter outcomes in a society where agents have heterogeneous skill levels. These outcomes are compared to those which result from the behavior of selfish agents. A variant of Fehr-Schmidt preferences is employed that allows the externality from agents who are “ahead” to differ in magnitude from the externality from those who are “behind” in the income distribution. We find first, that inequality-averse preferences yield distributional outcomes that are analogous to tax-transfer schemes with selfish agents, and may either increase or decrease average consumption. Second, in a society of inequality-averse agents, a linear income tax can be welfare-enhancing. Third, inequality-averse preferences can lead to less redistribution at any given tax, with low-wage agents receiving smaller net subsidies and/or high-wage individuals paying less in net taxes. Finally, an inequality-averse median voter may prefer higher redistribution even if it means less utility from own consumption and leisure.     

The 10% Flat Tax: Tithing and the Definition of Income

Developing a fair and widely accepted income definition presents one of the greatest challenges to tax reform. To arrive at a definition separate from the federal tax code, we surveyed 1200 Latter‐day Saints about their practice of tithing. Tithing is similar to a flat tax with no deductions, where individuals voluntarily contribute 10% of self‐defined income to the church. The results of our survey indicate that most respondents operate on a cash realization basis, which excludes savings and does not allow any deductions. Respondents' income concepts generally do not coincide with current tax laws or economists' views of comprehensive income.     

TEMPTATION‐DRIVEN BEHAVIOR AND TAXATION: A QUANTITATIVE ANALYSIS IN A LIFE‐CYCLE MODEL

This paper examines the impact of labor and capital income taxes in a stochastic overlapping generations (OLG) economy where agents face borrowing constraints and their behavior is temptation driven. We quantitatively establish that the existence of temptation in preferences may function as an opposing mechanism to modeling choices, such as liquidity constraints, life‐cycle structure, and idiosyncratic earnings risks, that are critical in delivering a positive capital income tax rate. We show that a sufficiently large measure of individuals having self‐control preferences, or alternatively, a sufficiently high cost of exercising self‐control, puts downward pressure on the optimal capital income tax rate. (JEL E21, E62, H55)     

Social norms and tax compliance: Framing the decision to pay tax

Observed levels of tax compliance are higher than predicted levels (when predictions are based on Allingham and Sandmo's neoclassical model of tax evasion). They are higher if social norms recognise the importance of compliance. But how do social norms frame decisions to pay tax? Can prospect theory be applied to shed insight into the way that social norms exert their influence? An analysis of questionnaire responses (from Italy and from the UK) suggests that they exert their influence by changing the reference points that individuals use when they code changes as ‘gains’, or ‘losses’. The evidence suggests that social norms frame the decision to pay tax by changing individuals’ perceptions of their entitlement to income. This consideration is important when designing policy to deter evasion.     

The changing face of private retirement plans

A rapidly growing public policy concern facing the United States is whether future generations of retired Americans, particularly those in the "baby boom" generation, will have adequate retirement incomes. One reason is that Social Security's projected long-term financial shortfall could result in a reduction in the current-law benefit promises made to future generations of retirees. Another reason is that many baby boomers will be retiring with employment-based defined contribution (DC) plans, as opposed to the "traditional" defined benefit (DB) plans that historically have been the predominant source of employer-provided retirement income. These factors are likely to reduce the amount of life annuity benefits that future retirees will receive relative to current retirees, raising questions as to whether other sources of retirement income--such as individual account plans (DC plans and individual retirement accounts, or IRAs)--will make up the difference. This Issue Brief highlights the changes in private pension plan participation for DB and DC plans and provides some possible explanations for these changes. Results are presented from the Employee Benefit Research Institute's (EBRI) Retirement Income Projection Model that quantify how much the importance of individual account plans is expected to increase because of these changes. This Issue Brief also discusses the risk of outliving one's assets, since a greater fraction of pension wealth is projected to come from "nonguaranteed" sources. Results of the model are compared by gender for cohorts born between 1936 and 1964 in order to estimate the percentage of retirees' retirement wealth that will be derived from DB plans versus DC plans and IRAs over the next three decades. Under the model's baseline assumptions, both males and females are found to have an appreciable drop in the percentage of private retirement income that is attributable to defined benefit plans (other than cash balance plans). In addition, results show a clear increase in the income retirees will receive that will have to be managed by the retiree. This makes the risk of longevity more central to retirees' expenditure decisions. The implications of these model results for retirees are significant. First, individuals--rather than the pension plan sponsor--increasingly will have to manage their retirement assets and bear the risk of investment losses. Second, since most retirees' non-Social Security retirement income will be distributed as a lump sum or in periodic payements (from a defined contribution plan or IRA) rather than as a regular paycheck for life (from a defined benefit plan), retirees will need either to purchase an annuity from an insurance company or carefully manage their individual rate of spending in order to avoid outliving their assets.     

State and Local Taxation of the Elderly

Using data from Massachusetts, this paper explores the impact of state and local taxes on the elderly. The combined tax burden from the state personal income and sales taxes and the local property tax are, on average, higher for the elderly than the nonelderly only for those with total incomes under $10,000 and over $75,000. High tax burdens on low-income elderly are primarily attributable to the property tax faced by homeowners. High-income elderly face high burdens because the state income tax rate on capital income is higher than the rate on earned income. Evidence suggests that public policies to reduce the property tax burdens on elderly homeowners have been largely ineffective.     

Decision heuristics and tax perception – An analysis of a tax-cut-cum-base-broadening policy

In this paper, both a conjoint analysis and a lab experiment are conducted to analyze the influence of changes in the tax rate and the tax base on the perceived tax burden. Our results show that the majority of individuals do not make rational tax decisions based on the actual tax burden but rather use simple decision heuristics. This leads to an irrationally high impact of changes in nominal tax rates on the perceived tax burden. Taxpayers favor tax options that apply a lower tax rate on their gross income over a higher tax rate applied on their net income despite the lower actual tax burden of the latter option. This result suggests that politicians could combine increasing fiscal revenues and decreasing subjects’ tax perception. Furthermore, overestimation of tax rate changes increases considerably when information on tax rate is considered first (framing effect).     

THE CREDIT‐CHANNEL TRANSMISSION MECHANISM AND THE NONLINEAR GROWTH AND WELFARE EFFECTS OF INFLATION AND TAXES

With the credit‐channel effect driven by the central bank's open market operations, this paper's model easily gives rise to the nonlinear inflation‐growth nexus, which is evidenced by a number of cross‐country empirical studies. The threshold level of the inflation rate is found to be lower when tax rates are higher. The presence of the credit‐channel effect also provides the rationale for setting positive (and smaller than 1) tax rates on consumption, labor income, and capital income. The optimal tax rates rise as the inflation target declines. Under a fiscal policy rule where labor and capital income taxes move proportionally to each other, the optimal capital income tax rate could be higher than the optimal labor income tax rate. Under a sufficiently large central bank balance sheet, the credit‐channel effect will be so weak that inflation and all kinds of taxes are growth and welfare repressing. This provides a rationale for central banks that have implemented quantitative easing policies to shrink their balance sheets. (JEL E58, E62, O42)     

Consumer Preferences and Demand for Annuities: Evidence From Hong Kong

Retirees without annuities in Hong Kong confront longevity and investment risks. Despite these risks, there is very limited uptake of annuities. This study identifies product and consumer characteristics that are associated with the demand for annuities in Hong Kong. We conduct a discrete choice experiment and distribute a consumer survey among two independent representative samples of workers aged between 40 and 64. Results suggest that a fixed monthly income and a 10-year guarantee period are two significant product characteristics, while a bequest motive, being married, and an understanding of the annuity are consumer characteristics that are associated with the demand for annuities. Being presented the optimal hypothetical annuity product, approximately one-third of middle-aged workers choose to annuitize their retirement savings. The findings and methods of this study can be applied for designing annuity products in other contexts.     

Dynamics of tax evasion with back auditing,social norm updating,and public goods provision – An agent-based simulation

Income tax evasion dynamics and social interactions are analyzed with an agent-based model in heterogeneous populations. One novelty is the combined analysis of back auditing and ageing, which allows for incorporating psychological findings with respect to social norm updating over a taxpayer’s life cycle. Another novelty concerns individual’s social behavior regarding a Pareto-optimal provision of public goods. Simulation results support the counterintuitive conclusion drawn elsewhere in the literature that income tax compliance may decrease with raising marginal per capita returns (MPCRs). Yet, back auditing seems to have by far the strongest impact on the dynamics of fiscal fraud and also can help to curb the extent of tax evasion (ETE).     

Does fairness matter in tax reporting behavior?

Experimental results show that taxpayers who receive no public transfer generally perceive their exchange equity with the government to be less equitable than taxpayers who receive a public transfer. Furthermore, the effect of the public transfer on reported income depends on the extent to which the taxpayers use the perception of equity in their tax reporting decisions. Subjects who perceive equity to be important in their tax reporting decisions report more income when they receive a public transfer, but report less income when they receive no public transfer, as predicted by equity theory. In contrast, subjects who perceive equity to be less important in their tax reporting decisions act directionally consistent with the economic effect. That is, taxpayers who receive no public transfer tend to report more income than those who receive a public transfer.     

Health care reform: managed competition and beyond

Since the election, the health care reform debate has focused on three broad features: implementation of managed competition, changes in the tax treatment of health insurance, and the imposition of budget caps or targets. The basic element of managed competition is the creation of sponsors who act as collective purchasing agents for large groups of individuals. One of the potentially most politically difficult issues in implementing any health care reform proposal is likely to be defining the minimum standard benefit package. It will determine the costs society bears, the income of providers, the health of many individuals, and the attributes of a workable health care reform package. Managed competition is intended to foster competition among health plans on the basis of cost and quality. The measures of quality actually employed in the health care system will determine in large part the incentives faced by insurers, providers, and consumers. The problem of adverse selection is potentially the most important issue in reforming the health insurance market. If individuals can opt not to purchase health benefits, poorer risks will be more likely to purchase health insurance than good risks, and at minimum the price of these benefits will be higher than would otherwise be the case. Managed competition requires that individuals share at least some of the financial consequences of their choices among health plans. As a result, most managed competition proposals change the tax code by limiting the exclusion of employer contributions to health insurance from worker's taxable income. Changing the health insurance market, mandating employer health benefits, and changing the tax code may have significant effects on the health care delivery system, but they are unlikely to reduce health care cost inflation in the near term. One of the proposals for restraining the growth in health care costs is the imposition of a budget on the amount spent on health care services. The combination of the constraints placed on federal governmental action by the budget and the significant political problems involved in reaching a consensus on the important elements of health care reform may limit the ability of the federal government to implement national health care reform in the near term. As a result, individual states may be encouraged by the federal government to continue to experiment with their own health reform programs.     

Taxing utility

In order to assess the efficiency of a tax, we should examine its effect on the behavior of individuals. In general, the less a tax affects behavior, the more efficient it is thought to be. The standard example of a non-distorting tax is a lump-sum tax, which does not change with the behavior of the taxpayer. However, this article demonstrates that behavioral distortions can and do arise from a change in even a lump-sum tax. The only truly non-distortionary tax would be one based on utility itself. Utility, which has been used as a norm for distributional analysis, is also the ideal base for efficiency analysis. In fact, any reasonable attempt to describe a minimally distortive basis of taxation will significantly resemble the notion of a tax on utility. Therefore, utility itself is the best basis for evaluation of the efficiency of a tax. Such a tax has many additional features which make it more useful for analytical purposes than lump-sum taxes.     

Inequality and education decisions in developing countries

In this paper we analyze the effect of inequality on school enrollment, preferred tax rate and expenditure per student in developing countries; when parents can choose between child labor, public schooling or private schooling. We present a model in which parents make schooling decisions for their children, weighing the utility benefit of having a child with formal public or private education versus the forgone income from child labor or household work. Parents vote over the preferred tax rate to finance freely provided public education. The utility benefit of an educated child is proportional to expenditure per student, so that there is congestion in public school. We find that when parents can send their children to work or to private school, high inequality leads to exit from public education at both ends of the income distribution. Thus high inequality reduces the support for public education, leading to a low tax rate and expenditure per student. Exit from public education results in both high child labor and a large fraction of students attending private school. In fact there is a threshold level of inequality above which there is no longer support for public education. In addition we explore the implications for the design of foreign aid. The results suggest that foreign aid policies should focus on promoting school attendance rather than increasing school resources, as the later policy might be offset by a reduction in the recipient country’s fiscal effort, with little impact on outcomes.      

Mental accounting of income tax and value added tax among self-employed business owners

Mental accounting describes a series of cognitive operations that help organize financial activities and facilitate money management. Self-employed taxpayers who make use of a separate mental account for future income tax payments or collected value added tax (VAT) might find it easier to declare their taxes correctly than taxpayers who do not. This study used a questionnaire to investigate whether self-employed taxpayers (N = 350) use mental accounting to manage their income tax and VAT obligations, whether mental accounting relates to tax knowledge, business and personality characteristics, and to what extent mental accounting is related to intended tax behavior. Our results reveal that some taxpayers mentally segregate taxes from turnover (segregators) while others do not (integrators). We found small differences in mental accounting between income taxes and VAT. Moreover, confirmatory factor analyses suggested that tax knowledge and mental accounting are distinct constructs. Segregation of taxes was related to lower impulsivity and more positive attitudes toward taxation. Individuals who stated they segregate taxes due from turnover more often claimed to run financially prosperous businesses. Mental accounting was not related to intentions of evading taxes, but individuals with higher mental accounting scores reported more pronounced levels of tax planning. While our research design does not allow drawing causal inferences, these findings could suggest that increasing self-employed taxpayers’ ability to organize their financial activities might be a promising strategy to strengthen the competitiveness of their businesses.     

IN-KIND VERSUS CASH TRANSFERS IN THE PRESENCE OF DISTORTIONARY TAXES

In-kind transfers can Pareto-dominate cash transfers as a means of income redistribution if in-kind transfers and leisure are Hicks substitutes and leisure is a normal good. The result holds when redistributive instruments also include a linear income tax. The paper proves that if the poor receive more in-kind transfers (and the rich less) than what they would choose for themselves then, compared to cash transfers, there will be a higher labor supply by the poor, a lower labor supply by the rich, and higher levels of aggregate pre-tax income and tax revenues.     

World Income Distribution and Tax Reform: What Tax Systems Do Low‐Income Countries Need?

This article develops a new method for assessing relative direct tax burdens across all countries, treating the world as a single economic entity and assuming identical preferences across countries. Empirical results show that the new direct tax burden indices are significantly high in low‐income countries in comparison with middle‐ and high‐income countries. This article argues in favour of narrowing the base of income and capital gains tax in low‐income countries and a long‐term convergence of the tax burden levels across countries. Future research into tax reforms in low‐income countries should focus simultaneously on economic growth, quality of life and the natural environment.     

The Impact of Uruguay's 2007 Tax Reform on Equity and Efficiency

In 2007, the Uruguayan government implemented a tax reform which introduced a new progressive labour income tax and a flat capital income tax, and reduced some indirect taxes, with the objective of improving fiscal balance, income distribution and economic growth. This article evaluates the impact of such tax reform on equity and efficiency on the basis of data derived from the Encuesta Continua de Hogares (ECH) for 2006 and 2009. Using a Difference‐in‐Differences technique, it shows that the new system reduced inequality by 2 Gini points without producing any discernible disincentive effect, suggesting that suitably designed reforms of direct taxation can simultaneously promote equity and efficiency.