Gareth Myles' Home Page

HMRC/HMT/ESRC Joint Resarch Programme

Tax Policy and Operations in the Context of Economic and Societal Change

Optimal Audit Policy for a Tax Evasion Network

Investigators

Principal investigator : Gareth Myles, University of Exeter and Institute for Fiscal Studies

Co-investigator : Nigar Hashimzade, University of Reading

Co-investigator : Matthew Rablen, Brunel University

International collaborator : Frank Page, Indiana University

Summary of Proposal

Tax evasion is important. HMRC estimate the tax gap to be in the region of £40 billion, which is about 8% of the total tax liability. The reduction of the gap is a Departmental Strategic Objective. Achieving a reduction requires an understanding of the processes at work so that the most effective auditing strategy can be implemented. Moreover, the possibility of a reduced settlement for the HMRC in the Comprehensive Spending Review increases the importance of better targeting of limited enforcement resources.

Standard economic theory presents the decision on whether to fully comply with tax regulations as a simple gamble. From the taxpayer's perspective the gamble is successful when the tax administration fails to detect a concealed taxable liability. It is unsuccessful if an audit reveals the true position and a penalty is consequently paid. The odds involved in this gamble are determined by the probability of being audited and the taxpayer uses these odds to determine the gain from concealment. This basic model has been used to determine optimal punishment and audit strategies for an independent tax administration.

The problem with the basic model is that it makes two central predictions that are inconsistent with empirical and experimental evidence. Firstly, it predicts much higher levels of evasion than are observed in practice. In fact, for realistic parameter values it predicts that all taxpayers should engage in concealment whenever they have an opportunity. Secondly, it predicts the level of evasion will fall when the tax rate rises. Empirical evidence also reveals that social factors, which are absent from the model, are important in the compliance decision.

The most promising solution to these shortcomings has been the application of behavioural economics to the study of compliance. Behavioural economics encompasses a range of methods that relax the traditional assumptions of economic theory. In the context of the compliance decision two types of departure have been considered. The first changes the way a taxpayer assesses the gains and losses that result from a decision to evade tax. This is in recognition of the inadequacy of the standard approach to gambling as a description of actual behaviour. The second modification introduces social factors into the compliance decision. These changes provide an improved explanation of taxpayer behaviour and are potentially important for understanding the effects of audit policy and for the refining the use of compliance tools.

Our proposed research will take the recent ideas from behavioural economics and use them to study the most effective way for a tax administration to encourage compliance. The analysis will be centred upon the effect of taxpayers possessing individual attributes and social connections that impact upon the compliance decision. We aim to accommodate differences in preferences, in attitudes toward compliance, and in opportunities for evasion. We also wish to model the formation of attitudes and beliefs as the outcome of social interaction, and opportunities as the outcome of occupational choice. To achieve these aims we will apply the theory of network formation to track the links between taxpayers and the transmission of attitudes and beliefs. This will be combined with agent-based modelling employing behavioural economics to describe individual choices.

The components we have outlined will provide a more compelling description of how taxpayers make compliance decisions. It will provide a rich framework in which we can pursue the question of how best a tax administration can conduct compliance operations. The fundamental idea is to explore how a tax administration can improve the efficiency of its operation by exploiting the structure of the network and the processes of attitude and belief formation. The outcome will be a set of practical recommendations for improved compliance policy.