Abstract - Economics Research Reports

 

Tax Evasion and Trust

By Ronald Wintrobe (University of Western Ontario)

June 4, 2001

Tax evasion has been a huge problem in Russia. Since the breakup of the Soviet Union there has been a steady decline in the share of Gross Domestic Product collected in revenue by the State at all levels, although in the last couple of years the problem has improved somewhat. The standard view of tax compliance in tax theory is that taxes are a “burden” or windfall harm, and that individuals pay only because they are forced to, i.e., that they believe that if they did not , they would be liable to prosecution by the state. On this view, it is essential that the probability of being discovered for tax evasion, and the size of the penalty if caught and convicted are sufficiently large to deter evasion. Once this view is accepted, the chief problem in normative taxation theory is to devise taxes which minimize the “excess burden” of a tax, ie, how to minimize the total burden of taxation.

One problem with the standard view is that for some taxes such as income taxes, it is hard to believe that the probability of being caught for evasion is very large. Another problem with the model is that it makes a very odd prediction–namely that an increase in the tax rate t actually leads to less tax evasion.

In this paper I take a “public choice” approach to the problem of tax evasion. Moreover, I assume that people will be more willing to pay their taxes when they trust the government more. Thus, we would expect that tax evasion would be lower, ceteris paribus, the more responsive governments are to their citizens’ wishes. Finally, since the level of tax evasion depends on the trust of citizens that other citizens pay their taxes, it follows that there are multiple equilibria, which can be broadly classified into two: one in which, broadly speaking, people assume that others are paying and so most of them also pay, and the other in which the opposite is true.

I propose four problems which are fundamental to the “bad” equilibrium and which should be addressed in order to improve the situation: (1) As long as people do not believe the government is responsive to their wishes, even if it may he honest, they will attempt to evade their taxes. (2) As long as people do not trust the government they will be unwilling to pay their taxes. Consequently one, obviously very difficult, line of reform is to take measures to increase trust in their government. (3) As long as people believe the tax code is fair, they will be more willing to pay their taxes. (4) As long as people assume other people are trying to evade taxes, they will attempt to evade themselves. This is in line with the solution to crime which has been widely adopted in a number of U.S. cities and is known as the “Fixing Broken Windows” approach. On this last line of thought, disorder and crime are contagious. The program to combat crime focused on minor rather than major problems and in some ways reversed the emphasis on “marginal deterrence” for bigger offenses which is characteristic of the individualistic approach. The application of the approach to tax evasion is straightforward: it suggests de-emphasizing going after big evaders such as Gazprom and raising the level of enforcement on small evaders instead. However, the points raised in #1, 2 and #3 above have to be kept in mind: the system must be seen to be fair, and the government has to be seen to be democratic and responsive to the people’s wishes.

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