Taxpayers' Behavioural Responses and Measures of Tax Compliance ‘Gaps’: A Critique and a New Measure

The work of Feldstein (1995 and 1999) has stimulated substantial conceptual and empirical advances in economists' approaches to analysing taxpayers' behavioural responses to changes in tax rates. Meanwhile, a largely independent literature proposing and applying alternative measures of tax compliance has also developed in recent years, which has sought to provide tax agencies with tools to identify the extent of tax non‐compliance as a first step to designing policies to improve compliance. In this context, measures of ‘tax gaps’ – the difference between actual tax collected and the potential tax collection under full compliance with the tax code – have become the primary measures of tax non‐compliance via (legal) avoidance and/or (illegal) evasion. In this paper, we argue that the tax gap as conventionally defined is conceptually flawed because it fails to incorporate behavioural responses by taxpayers. We show that conventional tax gap measures, which ignore the presence of behavioural responses, exaggerate the degree of non‐compliance. This potentially applies both to indirect taxes (such as the ‘VAT gap’) and direct (income) taxes. Further, where these conventional tax gap measures motivate reforms designed to increase the tax compliance rate, they will likely have a tax‐base‐reducing effect and hence generate a smaller increase in realised tax revenues than would be anticipated from the tax gap estimate.     

The Effective Tax Burden of Companies and of Highly Skilled Manpower: Tax Policy Strategies in a Globalised Economy*

Company taxes and taxes on highly skilled labour both influence the attractiveness of a particular region as a location for investment. We measure the effective tax burden on capital investment and on highly qualified labour in 33 locations across Europe and the United States. We then correlate both types of tax burden in order to study the different tax policy strategies applied in different countries. We find that effective tax rates on companies and on highly skilled employees are closely correlated for a number of countries. Ireland and most new EU Member States impose relatively lower taxes on capital investment than on highly skilled manpower. Conversely, in the US, companies are taxed heavily but the effective tax rate on highly skilled employees is moderate.     

Capital structure and international debt shifting

This paper presents a model of a multinational firm's optimal debt policy that incorporates international taxation factors. The model yields the prediction that a multinational firm's indebtedness in a country depends on a weighted average of national tax rates and differences between national and foreign tax rates. These differences matter as multinationals have an incentive to shift debt to high-tax countries. The predictions of the model are tested using a novel firm-level dataset for European multinationals and their subsidiaries, combined with newly collected data on the international tax treatment of dividend and interest streams. Our empirical results show that a foreign subsidiary's capital structure reflects local corporate tax rates as well as tax rate differences vis-à-vis the parent firm and other foreign subsidiaries, although the overall economic effect of taxes on leverage appears to be small. Ignoring the international debt shifting arising from differences in national tax rates would understate the impact of national taxes on debt policies by about 25%.     

Exploring the role Delaware plays as a domestic tax haven

We examine whether Delaware is a domestic tax haven. We find that taxes play an economically important role in determining whether U.S. firms locate subsidiaries in Delaware and that a Delaware-based state tax avoidance strategy lowers state effective tax rates by between 0.7 and 1.1 percentage points, on average. The tax savings represent a 15–24% decrease in the state income tax burden and translate to an increase in net income of 1.04–1.47%. However, we find that the tax benefits of Delaware tax strategies are diminishing over time in response to initiatives by state governments to limit multistate tax avoidance.     

The capitalization of taxes in bond prices: Evidence from the market for Government of Canada bonds

This paper provides estimates of the extent to which corporate and personal income taxes are capitalized in bond prices. The methodology yields estimates of the degree of tax capitalization, rather than an implied tax rate. This makes it straightforward to identify the marginal investor and test for changes in tax capitalization. The empirical approach also makes it unnecessary to jointly estimate the degree of tax capitalization and the entire yield curve. Corporate taxes are found to have been fully capitalized in pre-tax Government of Canada bond yields during the period 1986–1993. Since 1994, taxes have not been capitalized in yields. These results are consistent with the existence of a marginal investor, but the identity of the marginal investor changed from a financial sector firm to a non-taxed entity in the early 1990s.     

Sharing Risk with the Government: How Taxes Affect Corporate Risk Taking

Using 113 staggered changes in corporate income tax rates across U.S. states, we provide evidence on how taxes affect corporate risk‐taking decisions. Higher taxes reduce expected profits more for risky projects than for safe ones, as the government shares in a firm's upside but not in its downside. Consistent with this prediction, we find that risk taking is sensitive to taxes, albeit asymmetrically: the average firm reduces risk in response to a tax increase (primarily by changing its operating cycle and reducing R&D risk) but does not respond to a tax cut. We trace the asymmetry back to constraints on risk taking imposed by creditors. Finally, tax loss‐offset rules moderate firms’ sensitivity to taxes by allowing firms to partly share downside risk with the government.     

Why hasn’t tax competition triggered a race to the bottom? Some quantitative lessons from the EU

The integration of European financial markets in the early 1980s created an environment of near-perfect capital mobility across countries that had harmonized indirect taxes but maintained large differences in factor taxes. The years that followed witnessed several rounds of competition in capital taxes with puzzling results. Instead of the dreaded “race to the bottom” in capital taxes, the UK lowered its capital tax to a rate closer to those of France, Germany and Italy, while capital taxes changed slightly in these countries. The UK increased its labor tax marginally, but the other countries increased theirs sharply. This paper shows that these results are consistent with the quantitative predictions of a dynamic, Neoclassical general equilibrium model of tax competition that incorporates the key international externalities of tax policy operating via relative prices, wealth distribution and fiscal solvency. Tax competition is modeled as a one-shot game over time-invariant capital taxes with dynamic payoffs relative to a status quo calibrated to European data. The calibration is preceded by an empirical analysis that shows that the relationship linking taxes to labor supply and the investment rate in the model are in line with empirical evidence and that domestic taxes seem to respond to foreign taxes. The solutions of the games show that when countries compete over capital taxes adjusting labor taxes to maintain fiscal solvency, there is no race to the bottom and the Nash equilibrium is close to observed taxes. In contrast, if consumption taxes adjust to maintain fiscal solvency, competition over capital taxes triggers a “race to the bottom,” but this outcome entails large welfare gains. Surprisingly, the gains from coordination are small in all of these experiments.     

Indirect tax reform and the role of exemptions

This paper examines the question of whether indirect tax rates should be uniform, using four different modelling strategies. First, marginal tax reform is examined. This is concerned with the optimal direction of small changes in effective indirect tax rates and requires considerably less information than the calculation of optimal rates. Second, the welfare effects of a partial shift from the current indirect tax system in Australia towards a goods and services tax (GST) are considered, with particular emphasis on differences between household types and the role of exemptions. Third, in view of the stress on a distributional role for exemptions of certain goods from a GST, the potential limits to such redistribution are considered. The fourth approach examines the extent of horizontal inequity and reranking that can arise when there are non‐uniform tax rates. These inequities arise essentially because of preference heterogeneity.     

On the optimal timing of capital taxes

For many kinds of capital, depreciation rates change systematically with the age of the capital. Consider an example that captures essential aspects of human capital, both regarding its accumulation and its depreciation: a worker obtains knowledge in period 0, then uses this knowledge in production in periods 1 and 2, and thereafter retires. Here, depreciation accelerates: it occurs at a 100% rate after period 2, and at a lower (perhaps zero) rate before that. The present paper analyzes the implications of non-constant depreciation rates for the optimal timing of taxes on capital income. The main finding is that under natural assumptions, the path of tax rates over time must be oscillatory. Oscillatory tax rates are optimal when depreciation rates accelerate with the age of the capital (as in the above example), and provided that the government can commit to the path of future tax rates but cannot apply different tax rates in a given year to different vintages of capital.     

Land Tax Changes and Full Capitalisation

We use a unique data set to examine the extent to which changes in the Danish land tax are capitalised into house prices. The Danish local government reform in 2007, which caused tax increases in some municipalities and tax decreases in others, provides plenty of exogenous variation, thus eliminating endogeneity problems. The results imply full capitalisation of the present value of future taxes under reasonable assumptions about discount rates. Consequently, the paper gives an empirical confirmation of two striking consequences of a land tax. First, it does not distort economic decisions because it does not distort the user cost of land. Second, the full incidence of a permanent land tax change lies on the owner at the time of the (announcement of the) tax change; future owners, even though they officially pay the recurrent taxes, are not affected as they are fully compensated via a corresponding change in the acquisition price of the asset.     

Destination taxation and evasion: Evidence from U.S. inter-state commodity flows

Tax evasion has been an important issue in the accounting literature for several decades, but the focus has been on corporate income taxes. We develop a new way to examine tax evasion that focuses on corporate transactions, rather than corporate profits. Specifically, we examine how commodity flows respond to destination sales taxes, allowing for tax evasion as a function of distance between trade partners. After accounting for transportation costs, we find that the effect of taxes decreases as distance increases. This is consistent with the notion that longer distances between trade partners hinder government oversight and increase the likelihood of successful tax evasion. Our results are robust with respect to outliers, strategic neighbor effects, information sharing agreements and other re-specifications. These results are important to policymakers because they evidence the difficulty of enforcing destination taxation in open economies such as U.S. states and the European Union.     

Bank Taxes,Leverage, and Risk

We use staggered changes in the taxation of banks by U.S. states to show how banks adjust their capital structure in response to taxes. A one percentage point increase in the income tax rate leads to a decrease in the ratio of equity to total assets of 15 basis points. The effect is symmetric for tax increases and decreases but heterogeneous in that small and strongly capitalized banks react more. In response to taxes, banks also adjust their assets consistent with regulatory arbitrage activities intended to keep down regulatory risk measures, thereby keeping regulatory ratios at acceptable levels despite increasing leverage. Finally, higher taxes may decrease banks’ ability to survive crises.     

House Prices and Local Taxes in the UK

In this paper, estimates of the effects of local domestic property taxes (rates) on local house prices are presented, and the effect of local taxes on owner-occupied dwelling prices is calculated for a number of English cities for the period up to 1990. The methods used enable estimation to be made of the effect of the introduction, during 1990, of the Community Charge or poll tax in England, when the local tax base was moved from housing consumption onto individual residency. It is estimated that the reform could have increased house prices by around 15 per cent and contributed substantially to house price inflation.     

Distributional Implications of Environmental Taxation in Denmark

Environmental taxes have been introduced in many countries. However, few countries have reached the level of environmental taxation that is seen in Denmark today. This paper analyses the individual taxes as well as the combination of all these taxes and duties related to environmental concerns, including taxes on heating, transport fuels, electricity, water, waste, plastic bags, registration of cars, annual car use and pesticides. The distributional effect of taxes is examined in relation to household income, socio‐economic class, residential location and family status. The shifting of the tax structure from high marginal income tax to consumption‐based taxes, especially environmental taxes, might have distributional impacts that have not been considered part of the tax policy. The results suggest that in Denmark taxes on petrol and registration duties for cars are progressive, whereas most other environmental taxes are regressive, especially the green taxes on water, retail containers and CO2 emissions.     

Prospects for Agricultural Land Taxation in Developing Countries

Countries that collect tax revenue from the agricultural sectorthrough export taxes, marketing boards, and overvalued domesticcurrencies are often loath to abandon these distorting policiesbecause of the consequent revenue loss. One potential alternativeis to replace these distortionary taxes with a land tax, whichwould not depress output prices or discourage foreign exchangeearnings and which could be, in theory, a highly progressivetax. The advantages and disadvantages of a land tax are examinedtheoretically and using the specific experiences of Bangladesh,Argentina, and Uruguay. It is concluded that the land tax isnot necessarily more efficient than other types of taxes; theAchilles Heel of land taxation is administration; progressivetax rates based on land holdings are nearly impossible to administer;land taxes have been ineffective at promoting nonrevenue goals;political support by farmers is necessary to implement the tax;and the most promising prospects for a moderate land tax systemare in financing local, rather than central, government expenditures.     

What do firms do when dividend tax rates change? An examination of alternative payout responses

This paper investigates whether investor-level taxes affect corporate payout policy decisions. We predict and find a surge of special dividends in the final months of 2010 and 2012, immediately before individual-level dividend tax rates were expected to increase. We also find evidence that immediately before the expected tax increases, firms altered the timing of their regular dividend payments by shifting what would normally be January regular dividend payments into the preceding December. To our knowledge this is the first evidence in the literature about changes in the timing of regular dividend payments in response to tax law changes. For both actions (specials and shifting), we find that it was more likely for a firm to respond to individual-level tax rates if insiders owned a relatively large amount of the firm. Overall, our paper provides evidence that managers consider individual-level taxes in making corporate payout decisions.     

Optimal tax-timing and asset allocation when tax rebates on capital losses are limited

This article studies the portfolio problem with realization-based capital gain taxation when limited amounts of losses qualify for tax rebate payments, as is the case under current US tax law. When the tax rate applicable to realized losses exceeds that on realized capital gains, it can be optimal to realize capital gains immediately and pay capital gain taxes to regain the option to use potential future losses against a higher tax rate. This incentive adds an entirely new and as yet unstudied dimension to the portfolio problem. It causes risk averse investors to hold more equity and attain higher welfare levels than is the case when trading under a tax system that seeks to collect the same amount of taxes, but does not allow for tax rebate payments. This is because the benefit to these investors from having their losses subsidized is greater than the suffering from having profits taxed at a higher rate.     

Redistributive impact of indirect tax reforms: Greece, 1988–2002

This paper assesses the distributional impact of indirect taxes among Greek households between 1988 and 2002, a period that coincides with the introduction of significant reforms in the tax system due to EU membership. The highly differentiated indirect tax structure prevailing at the beginning of the period had distributional benefits over the more simplified 2002 tax structure. The overall inequality of the after‐tax welfare distribution has increased by 6–12½ per cent and changes in the indirect tax system seem to explain about half of this increase. The paper also applies a recent method of measuring the distributional impact of relative price changes caused by changes in tax rates of commodities (Newbery, 1995) and establishes that indirect tax reforms introduced since 1988 had an adverse impact on the distribution of purchasing power, which nevertheless seems to be very small.     

After the death of inflation: will fiscal drag survive?

Declining inflation rates might have negative consequences for tax revenues. Phenomena such as the inflationary bracket creep in a progressive income tax system do not work any longer. With this background, the paper analyses the extent of fiscal drag for OECD countries since 1965. Some consideration of the role of money illusion and indexation in this context lays the theoretical base. A framework is presented that allows for the classification of fiscal structures with regard to the type of fiscal drag. The subsequent econometric panel analysis is performed for total and disaggregated government revenues. The results back theoretical considerations of inflation's impact on different kinds of taxes, which tends to be positive for individual income taxes and social security contributions and is negative for corporate income taxation. The paper concludes that both declining inflation and changing tax structures limit the potential for future fiscal drag.     

The Stability of Tax Elasticities over the Business Cycle in European Countries

We estimate short‐ and long‐run tax elasticities that capture the relationship between changes in national income and tax revenue. We show that the short‐run tax elasticity changes according to the business cycle. We estimate a two‐state Markov‐switching regression on a novel data set of tax policy reforms in 15 European countries from 1980 to 2013, showing that the elasticities during booms and recessions are statistically (and often economically) different. The elasticities of personal income taxes, corporate income taxes, indirect taxes and social contributions tend to be larger during recessions. Estimates of long‐run elasticities are in line with existing literature.