Income Tax Evasion: A Theoretical Analysis.

Conceptual Clarification

The concept of tax evasion is pervasive in all countries, and this is a reality that present tax administrative structures are skewed by(Lymer & Oats2010).Given this, therefore, there is an obvious need to modify the standard taxation models to factor in this reality.Conceptually,it is essential to distinguish between tax evasion and tax avoidance. Pedantically,tax evasion refers to the illegal evasionof tax by individuals and corporations, whereas tax avoidance is the reduced utilization of tax law jurisprudence to reduce one’s tax burden.Tax evasion intimates the deliberate illegal misrepresentation of tax records by individuals and corporations to secure liabilityfrom (reduce or completely evade) remission of requisite taxes.It should be noted that tax evasion is not exclusive to just nonpayment of taxes but also inclusive of underpayment of taxes.

Perhaps the traditional boundary was delineated by Oliver Wendell Holmes. He posited that “when the law draws a line, a case is on one side of it or the other, and if on the safe side is none the worse legally that a party availed himself to the full of what the law permits and when an act is condemned as evasion what is meant is that it is on the wrong side of the law”(Yitzhaki1974)Therefore while there may be many grey areas between the concept of tax avoidance and tax evasion, the last distinctive element is the illegality of tax evasion.Put simply, and tax evasion is the failure to “declare taxable activity,” whereas tax avoidance is merely the reorganization of one’s economics to lower the value of the tax paid.Under the current Australian jurisprudence,the offenses occasioning prosecution for tax evasion are contained in Sections 134 and 135 of the Criminal Code Act 1995.

Brief Theoretical Background

Statistically, tax evasion constitutes significantly to the total economic activity, and this demonstratesthe underlying need to develop a comprehensive theory of tax evasion, which can be used to design tax administrative systems that curtail tax evasion. The magnanimity of tax evasion in economics can be shown by the statistics from the Internal Revenue Service of the U.S in 2017, which depicts that only 0.5% of individual tax returns were audited in that year (Internal Revenue Service 2018).In attempting to address the problem of tax evasion, various theories have been proposed.Under the economic theory of tax evasion, corporations and individuals remit taxes merely because they are compelled to do so by the state through the use of sanctions (Schneider & Enste 2013). This theory views charges as encumbrances and overburden.However, Torgler (2007) proposed that payment of taxes is a “pro-social” behavior and that there is a willingness from taxpayers to remit taxes conditionally subject to the industrial action of others.They suggest an index tax morale system within where people will be more willing to remit taxes if they believe other people are doing the same.

There has also been suggested a public choice theory which establishes a connection between taxation and government services(Mueller 1989).This theory suggests that citizens of democratic political jurisdictions have developed a substantial nexus between their remission of taxes and the delivery of essential public services by the government.The theory views taxes as a principal unrequited payment remitted to the government and a primary source of revenue through which the government avails essential services to its citizenry. Accordingly, therefore citizens strive to pay their taxes to ensure access to these services.This theory has been furthered by Cowell and Gordon (1988), whoestablished that whether the public is underprovided or over provided withcertain public goods inextricably determines tax evasion.However, the authors find the result of this study counterintuitive, being that the relationship between the government and the public is multidimensional and exceeds more than just the provision of public goods.Further other scholars such as Griffith(2004) have established an inextricable link between human happiness and the existence of a progressive tax structure

MODES OF TAX EVASION

Becker (1968) theorized the economics of crime, which provided the premise upon whicheconomic models of tax evasion were established. The theoretical scope of tax evasion and its effects have enormously widened since its maiden systematic analysis by Allingham and Sandmo (1972). They applied the economics of crime models in analyzing tax compliance. Modern tax administrative structures have evolved into multi-pronged systems with complex multiplicities. With this evolution of the tax system, there has been a simultaneous evolution of tax evasion methods, which has been aided by intricacies of tax administrative systems, which have made it challenging to observe tax evasion. Perpetration of tax evasion is done through, among other things, overstatement of expenditure or “generation of income to declare a low profit, thereby translating to lower taxes payable” (Balafoutas& Sutter 2015).Further,evaders may also shift income to countries with lenient tax policies or even no taxation at all.This has been facilitated by the emergence of underground cash economies, which assist in the circumvention of administrative tax regulations imposed by the state.

PRESENT EFFECTS OF TAX EVASION

Generally, tax revenue is a universal tool used by governments to amass revenue for economic growth through the actualization of macro-economic objectives in areas of fiscal policy.Tax evasion impairs the macro-economic objectives of taxation.It imputes the performance of the government’s obligation to provide essential services to its citizenry.It impairs the state’s ability to operate due to a lack of adequate revenue.For example, in the US, a study from Demos conducted in 2011 showed that the country lost approximately 3.09 trillion dollars between 2000-2011.In Australia, the Australian Taxation Office lost over 11 billion dollars between 2015 and 2016, with approximately 7.1 billion dollars lost through the ‘black economy.’

Therefore, the ravaging effects of evasion are directly felt by governments as their ability to provide essential services is greatly inhibited by evasion.Eventually, this is bound to have a direct effect on the citizens as the government will be forced to implement stringent measures such as implementing higher tax rates to respond to the widening tax gap.Richardson (2006) observed that income level is a fundamental determinant of tax evasion, with middle-income earners found to be more compliant with tax laws as compared to low or high-income earners.Similarly, Sumino (2016) adopts an institutionalist view of taxation, which reveal attitudinal differences in taxationamong different income groups.If this observation is valid, then tax evasion alsocompromises the horizontal and vertical equity of administrative tax structures.

Tax evasion has a significant adverse effect on revenue collection.It is detrimental because it heavily inflates the burden of taxation since some of the costs attached to it are real source costs and not just mere transfers.In elucidating this concept, Bayer (2006) posits that a real resource cost emerges when taxpayers conceal evasion and tax administrative authorities try to detect evasion.Further tax evasion generates investment distortion through the purchase of assets exempted from taxation . Also, Toby (1983) observes that tax evasion leads to erosion of moral values and leads to inflationary pressures.When individuals and corporations gain excess money through tax evasion, there is an increase in the quantity of money in circulation. At the same time, there remains a corresponding stagnation in the production of goods and services, therebyresulting in inflationary market trends characterized by few goods and more money.Hamel (2015) in explaining the heavy reliance of efficient capitalist economies on business competition posits that business corporations evading taxes gain an economic advantage over companies with efficient business practices and this is detrimental to the economy as it may result in the adverse situation where tax-evading corporations outlast companies with efficient tax practices.Therefore,tax evasion is detrimental and opposed to the economy not only because of the effects discussed above but also because of its adverse effects on the efficient interaction within the underlying market.

LEGISLATION AS A REMEDY

Over the past, governments have enacted new laws to curb tax evasion.The USA government has enacted the Bank Secrecy Act (BSA),also known as the Currency and Foreign Transactions Reporting Act,which requires financial institutions to assist the government in the prevention of money laundering by keeping records of transactions which exceed the daily limit of 10000 dollars.The institutions are also required to report any suspicious activities that informal criminal activities such as tax evasion and money laundering.Shortly after its enactment in the USA, several activist groups moved to court to challenge its constitutionality because it violated the Fourth Amendment Rights. The Supreme Court determined in California Bankers Assn. v Schultz (1974) that the Act was valid and obliged financial institutions to comply with its provisions.

Currently, in Australia, the Senate Economics Legislation Committee deliberated upon the Currency (Restriction of Use of Cash) Bill 2019and recommended it.This bill (which will be subsequently referred to as just the Currency Bill in this paper) is similar to the BSA and has been recommended on the premise that it will assist in curbing the ‘black economy’ by illegalizing cash transactions of over 10000 dollars. To analyze the effects of such legislation, it is important to examine the ramifications of the BSA in the USA as well as to compare with the Australian rationale behind the proposition of its new law.

EFFECTS OF THE LEGISLATION

Other than the rather obvious ramification of a shift towards a cashless economy, the new legislation will undoubtedly trigger a paradigm shift in the realm of taxation.The rationale behind the drafting of the Currency Bill was to protect the integrity of the tax administrative structure and to prevent tax evasion. The legislation is aimed at curbing the use of cash by individuals and corporations to avoid the scrutiny of tax administrative authorities. Once enacted, the new laws will, essentially, limit all cash transactions to a maximum value of 10000 dollars except those that meet the prerequisites stipulated. The new laws should be read in tandem with the Anti-Money Laundering and Counter-Terrorism Finance Act 2006, which similarly imposes cash limits on transactions to curtail money laundering. To this extent, it should be noted that money laundering is predicated on tax evasion.

The Currency Bill was introduced in furtherance of recommendations by the Black Economy Taskforce in 2017 to crack down on the black economy, particularly concerning small businesses that are responsible for a huge chunk of the Australian tax gap. The new law will reduce tax evasion, especially by the small businesses notorious for transacting using the black economy. The intendment of the new law is to limit unrecorded transactions, which has, in the past, provided an avenue for tax evasion.The law will axiomatically inhibit the use of cash by individuals and state corporations to further evasion of tax.By criminalizing cash payments of over 10000 dollars and imposing sanctions, which include a 25000-dollar fine and imprisonment, the new laws will deter small business owners from operating on the black economy.The new law will only apply to payments made to businessesthat have an Australian Business Number for trading goods and services as opposed to transactions between individuals.

There have been various concerns raised about the ramifications of the new laws. Business operators have cited the cost of shifting to electronic transactions as being a point of concern. In contrast, other citizens have raised concerns about the new laws being an infringement on their financial freedom to use their money as they may please. Further, a report from the Treasury in America which intimated that the BSA had brought only minimal impact in curbing tax evasion has been another indictment on the new laws.

CONCLUSION

Generally, it remains to be seen whether or not the new laws on transactions will revamp the existing tax administrative structures and prove useful in curbing the tax revenue lost through the black economy. However, inevitably, tax evasion modes will equally evolve to circumvent the new laws.

BIBLIOGRAPHY

List of Cases

California Bankers Assn. v Schultz (1974)416 U.S. 21

 

BOOKS AND ARTICLES

Allingham, M.G., and Sandmo, A. (1972). Income tax evasion: A theoretical analysis. Journal of Public Economics,1,323

Bayer, R.C., (2006). A Contest with the taxman-the impact of tax rates on tax evasion and wastefully invested resources. European Economic Review, 50,1071-1104

Becker, G.S., (1968). Crime and Punishment: An Economic Approach. Journal of Political Economy,76, 169-217

Cowell, F.A., and Gordon, J.P.F.,1988. Unwillingness to pay. Journal of Public Economics,39, 305

Griffith, T.D., (2004).Progressive Taxation and Happiness. Boston College Law Review, 45,1363-1398

Hamel, G., (2015). How Does Taxation Affect the Economy? Available at www.ehow.com/how-does_4744227_tax-evasion-affect-economy.html

Internal Revenue Service, (2018). Internal Revenue Service Data Book. Washington: Internal Revenue Service

Lymer, A., and Oats, L., (2010). Taxation: Policy and Practice. 17th ed. Fiscal Publication.

Mueller, D., (1989). Public Choice II.  New York: Cambridge University Press

Richardson, G., (2006). Determinants of Tax Evasion: A Cross-Country Investigation. Journal of International Accounting Auditing & Taxation, 15,150-169

Schneider, F., and Enste, D.H., (2013). The Shadow Economy: Theoretical Approaches, Empirical Studies, and Political Implications. 2nd ed. Cambridge: Cambridge University Press

Sumino, T., (2016). Level or concentration? A Cross-National Analysis of Public Attitudes towards Taxation Policies. Soc Indics Res, 129,1115-1134

Toby, R., (1983). The Theory and Practice of Income Tax. Macmillan Press Ltd

Torgler, B., (2007). Tax Compliance and Tax Morale. Edgar Elgar

Yitzhaki, S., (1974). Income Tax Evasion: A Theoretical Analysis. Journal of Public Economics, 3,201

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