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    A Note On Income Tax Evasion: A Theoretical Analysis

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    nala
    This note analyzes a theoretical model of income tax evasion. It shows that when the fine is imposed on the evaded tax, rather than the undeclared income, there is no substitution effect as the tax rate increases. As the tax rate rises, the model predicts the amount of income evaded will decrease due to a pure income effect. This is because both the tax rate and penalty rate rise proportionally with an increase in the tax rate. The note also finds that as true income rises, declared income will rise by less than true income rises.

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    A Note On Income Tax Evasion: A Theoretical Analysis

    Uploaded by

    nala
    151 views2 pages
    This note analyzes a theoretical model of income tax evasion. It shows that when the fine is imposed on the evaded tax, rather than the undeclared income, there is no substitution effect as the tax rate increases. As the tax rate rises, the model predicts the amount of income evaded will decrease due to a pure income effect. This is because both the tax rate and penalty rate rise proportionally with an increase in the tax rate. The note also finds that as true income rises, declared income will rise by less than true income rises.

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    Tax Evasion

    Original Title

    Yitzhaki 1974

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    This note analyzes a theoretical model of income tax evasion. It shows that when the fine is imposed on the evaded tax, rather than the undeclared income, there is no substitution effect as the tax rate increases. As the tax rate rises, the model predicts the amount of income evaded will decrease due to a pure income effect. This is because both the tax rate and penalty rate rise proportionally with an increase in the tax rate. The note also finds that as true income rises, declared income will rise by less than true income rises.

    Copyright:

    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    151 views2 pages

    A Note On Income Tax Evasion: A Theoretical Analysis

    Uploaded by

    nala
    This note analyzes a theoretical model of income tax evasion. It shows that when the fine is imposed on the evaded tax, rather than the undeclared income, there is no substitution effect as the tax rate increases. As the tax rate rises, the model predicts the amount of income evaded will decrease due to a pure income effect. This is because both the tax rate and penalty rate rise proportionally with an increase in the tax rate. The note also finds that as true income rises, declared income will rise by less than true income rises.

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    © All Rights Reserved
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    of 2

    Journal of Public Economics 3 (1974) 201-202.

    0 North-Holland Publishing Company

    A note on
    INCOME TAX EVASION: A THEORETICAL ANALYSIS*

    Shlomo YITZHAKI+
    The Maurice Falk Institute for Economic Research in Israel, Jerusalem, Israel

    Received January 1974

    In the Allingham-Sandmo model the taxpayer should pay a penalty rate 7c on


    the undeclared income. This assumption leads to the conclusion that when the
    tax rate increases there will be two opposing effects, an income and a substitution
    effect.
    In this note I want to show that if the fine is imposed on the evaded tax, as it is
    under the American or Israeli tax laws, there are no contradictory effects.
    Assuming that the taxpayer has an absolute risk aversion which decreases with
    income, we can conclude that as the tax rate increases the income evaded
    decreases. In this case there is no substitution effect.
    To show this result, I use the same notation and equation numbers as Alling-
    ham and Sandmo (1972).
    The taxpayer will choose X so as to maximise
    E[U] = (1 -p)v(W-ex)+pU[W-8x-Fe(W-x)J, (l)*
    where F is the fine (F > 1),
    Y= W-ex,
    and
    2 = w-ex-Fe(w-X). m*
    The first-order condition is

    e[-(1 -p)U( Y)+p(F- l)U(Z)] = 0. (3)*


    The conditions for interior solution are

    w w> P@-1)
    U[ W( 1 - Fe)] <I-p

    pF< 1. (6)*
    These conditions are the same as in the Allingham-Sandmo model if F = x/e.
    *M.G. Allingham and A. Sandmo, 1972, Income tax evasion: A theoretical analysis,
    Journal of Public Economics 1,323-338.
    tl would like to thank Michael Bruno and Agnar Sandmo for their helpful comments.
    202 S. Yitzhaki, Note on Income tax evasion

    If we assume U(0) + co, FO > 1 will always lead to a positive income


    declaration.
    If we differentiate (3)* according to 8, we get

    ax
    -= -~(~-P)U(Y)~~[R,(Z)-~,(Y)I+W-W?A(Z)~, (14)*
    ae

    where D s @[(l -p)U( Y)+P(F- l)!U(Z)] and RA( Y) < RA(Z) leads to
    8X/% > 0. In this case both the ordinary tax rate and the penalty rate increase
    proportionally with 0. Therefore there is no substitution effect and we are left
    with a pure income effect.
    Differentiating (3)* with respect to W, we get

    ax Fe&m - [R4W- R4(VI


    -= (la*
    aw Fezt,(z)- ep,(z) - R~( r)] *
    From this equation we can see that RA(Z) > RA( Y) leads to 8X/a W < 1, so
    that declared income changes more slowly than true income.

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