Tax (Non)-Compliance Research: A New Zealand Perspective

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Sibyl Amber Simmons
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1 Tax (Non)-Compliance Research: A New Zealand Perspective Norman Gemmell Chair in Public Finance Victoria University of Wellington Cash & Hidden Economy International Revenue Conference Auckland, April

2 Introduction Question: What do we know (and not know!) about taxpayers compliance responses to changes in tax policy and compliance efforts? Three research areas: 1. Taxpayers responses to taxation 2. Taxpayers responses to audits 3. Lessons for tax gap measures

3 1. Taxpayers responses to taxation

4 Taxpayers responses to taxation An (Australian) illustration: Australian vehicle fringe benefit tax (FBT) applies to private kms. travelled using company-provided vehicle. Till 2011, tax rate applied to kms travelled at three different tax rates: lower tax rate if travel more (above 3 annual kms travelled thresholds) Some facts : (Henry Review (2009) data for ) Total of around 15,000 cars (reported for FBT) On average FBT payers say they travel 22,000 (private) kms/year. Some as low as 3,000 kms., some over 40,000 kms. Question: In absence of tax, what pattern of kms. travelled would we expect? Perhaps a Normal Distribution around the average (22,000kms)?

5 1,000 3,000 5,000 7,000 9,000 11,000 13,000 15,000 17,000 19,000 21,000 23,000 25,000 27,000 29,000 31,000 33,000 35,000 37,000 39,000 41,000 Behavioural responses: Australian Vehicle FBT Perhaps something like this? Number of cars 1, Number of vehicles by kilometers travelled Total no. of cars 15,000 Number of cars 1, Annualised distance travelled in the FBT year (km)

6 1,000 3,000 5,000 7,000 9,000 11,000 13,000 15,000 17,000 19,000 21,000 23,000 25,000 27,000 29,000 31,000 33,000 35,000 37,000 39,000 Actually observe this Three thresholds: Number of cars 2,500 Number of vehicles by kilometers travelled Total no. of cars 15,000 25k Number of cars 2,500 2,000 15k 40k 2,000 1,500 1,500 1,000 1, Annualised distance travelled in the FBT year (km) Lesson: Our ability to enforce compliance depends on tax policy design

7 Measuring taxpayers response elasticities Economic researchers measure responses formally by the: elasticity of taxable income (ETI) = percentage change in taxable income in response to a 1% change in the net-of-tax rate (1 t) e.g. if top income tax rate: t = 0.5 then (1 t) = 0.5 At t = 0.5: ETI = 1 implies: a 10% decrease in t, increases taxable income by 10% [t: 0.50 to 0.45 ; (1- t): 0.50 to 0.55] ETI = 0.5 implies: a 10% decrease in t, increases taxable income by 5% ETI values are specific to each tax structure - depend on policy settings, legal regime, compliance effort etc. International estimates of ETI 0.1 to >1.0. Generally around What about New Zealand s ETI values?

8 Measuring NZ income tax responses NZ income tax: top rate raised in 2001 from 33% to 39% for incomes > $60k ( 10% fall in (1 t): 67% to 61%) Introduction of 39% rate: Estimate ETIs for top income decile & percentile ETIs are higher in the short-run (95% confidence interval in brackets)

9 Measuring NZ income tax responses NZ income tax: top rate raised in 2001 from 33% to 39% for incomes > $60k ( 10% fall in (1 t): 67% to 61%) Introduction of 39% rate: Estimate ETIs for top income decile & percentile ETIs are higher in the short-run Recent ETI regression estimates: Average across all taxpayers 0.68 Taxpayers with non-w&s income 0.51 Taxpayers without non-w&s income 0.19 Taxpayers with non-w&s income: All taxable income 0.22 Non-W&S income 2.84

10 20,000 23,000 26,000 29,000 32,000 35,000 38,000 41,000 44,000 47,000 50,000 53,000 56,000 59,000 62,000 65,000 68,000 71,000 74,000 77,000 80,000 83,000 86,000 89,000 92,000 95,000 98, , , , , , , , , , , , , , , , , ,000 Measuring NZ income tax responses Other evidence of responses to tax rate/threshold changes: Spikes in the income distribution Aggregate taxable income ($m) 1,600 1,400 1,200 1, Taxable Income Band ($)

11 $20,000 $25,000 $30,000 $35,000 $40,000 $45,000 $50,000 $55,000 $60,000 $65,000 $70,000 $75,000 $80,000 $85,000 $90,000 $95,000 $100,000 $105,000 $110,000 $115,000 $120,000 $125,000 $130,000 $135,000 $140,000 $145,000 $150,000 Measuring NZ income tax responses Other evidence of responses to tax rate/threshold changes: Spikes in the income distribution Total taxable income ($m) 2,500 2, , , taxable income band

12 Measuring NZ income tax responses Other evidence of responses to 2001 top rate change: The growth rate of top incomes & trusts after 2001 (Tax Working Group, 2009) Trustee income rises faster after 39% tax rate applies to beneficiary income (33% for trustees)

13 Measuring NZ income tax responses Other evidence of responses to 2001 top rate change: The growth rate of top incomes & trusts after 2001 (Tax Working Group, 2009)

14 2. Taxpayers responses to audits

15 Taxpayers responses to audits Audits are designed to raise more revenue! Well-targeted audits should do just that! But with random audits? more compliant taxpayers likely to be audited When audits reach a verdict of compliant, how do those taxpayers respond after the audit? What if: The audit fails to find avoidance/evasion? The audit is only partially successful identifies just some evasion? The audit process & the extent of audit success conveys information to compliant and non-compliant taxpayers Examine evidence from UK self-assessment income tax audits

16 Taxpayers responses to audits We expect different reactions to audits depending on: whether audit verdict is compliant or non-compliant random audits are conducted with/without replacement Gemmell & Ratto (2012): Examined: effect of random audits in 2000 on before/after declared incomes [ to ] Compare audited treatment group with control group of non-audited. Examine medium & small businesses, and personal taxpayers Estimate preventive yield : additional revenue (+ or -) resulting from audit.

17 Taxpayers responses to audits We expect different reactions to audits depending on: whether audit verdict is compliant or non-compliant random audits are conducted with/without replacement

18 Taxpayers responses to audits

19 Taxpayers responses to audits

20 3. Lessons for tax gap measures

21 Tax gap measures Tax gap measures capture differences between tax paid and theoretical tax liability. G = T * T = t(b * B) where B * (B) is the theoretical (observed) tax base; T = tax revenue B = qb * where q is the fraction declared for tax [(1 q) is hidden ] effective tax rate T = tqb * and G = t(1 q)b * Conventional tax gap measures based on answering question: If q is increased to 1, how much missing revenue would be raised? But crucially assumes B * remains unchanged by changes in q

22 Tobacco Excise Example 1 $3 Sales $3 million Tax Revenue $1 million ½ million $2 Missing Tax Revenue $ ½ million Tax gap $½ million 33% (0.5/1.5). But: Many cigarettes purchased illegally at $2 will no longer be bought when successful compliance effort pushes up the price to $3. i.e. Anyone who values cigarettes between $2 and $3 will smoke less If smuggled cigarette sales cut in half when extra $1 tax applied to all (& formerly legal cigarettes unaffected): True tax gap = $250,000. i.e. only half of conventional tax gap depends on which taxpayers respond to changes in compliance effort.

23 Tax gap measures Observed/declared tax D (when q = 0.5); Total tax C (= H )

24 Tax gap measures Tax (base) gap = G (= HF) ; declared base = q 1 B * ; hidden base = (1 - q 1 )B *

25 Tax gap measures A higher effective tax rate (due to higher q) reduces the tax base from H to E. Raising q reduces both tax gap measures to zero (at H or E) but quite different revenues

26 Tax gap measures With a sufficiently large response, the tax base may be lower when q = 1 (E below F)

27 Tax gap measures A form of ETI C E = change in tax base in response to a change in the compliance rate

28 Amending conventional tax gap measures Where does this leave us? Are taxpayer responses to changes in q like their responses to changes in t? Evidence from audit responses etc. may help If so, ETI estimates &/or observed audit responses may give some clues to the potential loss of total tax base when full compliance achieved. Conventional tax gap: compliance ETI = zero. Surely this is wrong? For some taxes this clearly not true: smuggled goods (tobacco, alcohol), corporate tax? Corporate tax: do some governments turn a blind eye to tax avoidance (e.g. profit-shifting) because otherwise the total tax base would be lower?

The consequences of these behavioural responses can be quite different depending on: Are they real (changed economic activity) or apparent (

29 Conclusions 1. Research has now identified a variety of taxpayer behavioural responses to tax policy (e.g. tax rates) and compliance enforcement 2. Compliance enforcement, not just tax policy, should take these into account 3. The consequences of these behavioural responses can be quite different depending on: Are they real (changed economic activity) or apparent ( rearranged activity)? Is avoided tax paid under a different (lower rate) tax? 4. Measuring tax gaps: finding hidden economic activity may reduce total economic activity (as well as the hidden share)

30 Questions?

Estimating the Distortionary Costs of Income Taxation in New Zealand

Estimating the Distortionary Costs of Income Taxation in New Zealand Background paper for Session 5 of the Victoria University of Wellington Tax Working Group October 2009 Prepared by the New Zealand Treasury