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Tax evasion is the use of unlawful means by individuals and firms to reduce their taxes. It refers to taxpayers’ intentional actions that misrepresent or conceal the true state of their financial affairs to tax administrators. An example of tax evasion is taxpayers’ deliberate understatement of their income. Tax fraud is a kind of evasion that involves the falsification of records. In most countries tax evasion is a crime punishable by fines or imprisonment.
Tax avoidance is the use of lawful means by individuals and firms to decrease their taxes. In some countries a distinction is made between tax planning and avoidance. Acceptable tax planning satisfies both the wording and the intent of the tax law. Tax avoidance (abusive tax planning) is consistent with the letter but not the spirit of the law. It usually involves the exploitation of loopholes in tax legislation to the advantage of taxpayers. An example of tax avoidance is transforming highly taxed income into preferentially taxed capital gains. The boundary between tax planning and avoidance is sometimes fuzzy, and so is that between tax avoidance and evasion.
Under the self-interest and rationality assumptions, taxpayers would engage in evasion or avoidance so long as their incremental benefits from such activities exceed their incremental costs. However, many individuals and firms appear to be inherently honest and comply more fully than is anticipated by this approach. This suggests that taxpayers’ observed compliance levels depend not only on economic incentives but also on their sense of moral and social obligations. The determinants of tax evasion and avoidance broadly include:
Taxpayers’ sense of community association and perception of the tax system’s fairness;the tax rate (higher rates may induce evasion and avoidance, while the difference between personal and corporate rates encourages avoidance);opportunities to evade or avoid taxes (tax withholding and third-party reporting reduce evasion, while access to skilled tax practitioners increases avoidance);tax practitioners’ approach to reporting decisions;taxpayers’ compliance costs;tax administrators’ effectiveness (including detection, penalty, and enforcement).
In developing countries, entry into the formal economy may be blocked by legal, regulatory, and bureaucratic barriers. This blockage gives rise to tax evasion and avoidance.
The extent of tax evasion and avoidance can be approximated by the tax gap, which is the difference between the tax that is meant to be paid and that which is paid. The quantification of the tax gap, especially tax avoidance by businesses, is beset with both conceptual and empirical difficulties. Numerical estimates nevertheless suggest that tax evasion and avoidance are serious in industrialized countries. In the United States the federal tax gap (which includes tax evasion, unintentional errors, nonfiling, and tax underpayment) in 2005 was estimated by the U.S. Treasury to be 14 percent of the total federal tax revenue or $345 billion, most of which is attributable to underreporting of individual incomes (U.S. Treasury 2006). Studies of the black market economy suggest that, generally speaking, countries in the Organisation for Economic Co-operation and Development (OECD) face even higher relative tax gaps than the United States. Although there are no reliable estimates of tax gaps in industrializing countries, it seems plausible to argue that, compared with developed economies, developing nations suffer higher relative tax gaps because of their poorer tax administration and larger informal sectors.
Bibliography:
- Schneider, F. 2006. Shadow Economies of 145 Countries All over the World: What Do We Really Know? http://www.econ.jku.at/Schneider/ShadEconomyWorld145_2006.pdf.
- S. Department of the Treasury. 2006. A Comprehensive Strategy for Reducing the Tax Gap. http://www.ustreas.gov/press/releases/reports/otptaxgapstrategy%20final.pdf.
- Woellner, Robin H., Stephen Barkoczy, Shirley Murphy, and Chris Evans. 2006. Australian Taxation Law. Sydney: CCH.
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