The Effects of Tax Rates and Enforcement Policies on Taxpayer Compliance: A Study of Self-Employed Taxpayers

Article excerpt

MUKHTAR M. ALI [*]

H. WAYNE CECIL [**]

JAMES A. KNOBLETT [*]

This paper presents an econometric analysis of taxpayer compliance, exploring its relationship with audit rates, penalties detected, tax rate schedule, income level, and sources of self-employment income. Using data drawn from the Annual Report of the Commissioner of Internal Revenue Service [IRS, various] and the Data Book [IRS, various] for 1980 to 1995, the audit rate and penalty rate are both effective deterrents to noncompliance. The effectiveness of these two policy instruments depends upon the individual's level of income. It seems the higher the income level, the more effective these instruments are. In general, compliance increases with the level of income but at a decreasing rate. It is also found that individuals tend to comply less as the marginal tax rate rises. Again, such tendency is more pronounced for high-income taxpayers than for low-income taxpayers. (JEL H20, H24, H26)

Introduction

Noncompliance is a major problem for federal tax authorities. The Internal Revenue Service (IRS) estimates the federal income tax gap for individual taxpayers at more than $93 billion for 1992 [IRS, 1996]. Further, the IRS estimates that revenue loss as a result of noncompliance increased at an alarming annual rate of 14 percent in the 1973-81 period. While dated, this finding begs research for deterrents. Accordingly, authorities are looking for effective policies to reduce noncompliance. U.S. Congress enacted compliance legislation in 1981, 1982, and 1984 and completely overhauled the federal income tax laws in 1986. Besides the changes in tax laws, these enactments added a wide variety of new penalties for noncompliance. Unfortunately, all this action has taken place in the absence of any solid knowledge about the responsiveness of tax compliance to such policy tools as audit rates, penalty rates, and tax rate schedule [Graetz and Wilde, 1985]. Without such knowledge, it would be difficult to judge the ef fectiveness of policies instituted during 1980s or to formulate an effective policy in the future.

This paper provides evidence concerning the possible effects of tax enforcement strategies and tax rate schedule for Schedule C and Schedule F filers on tax compliance by analyzing the annual time series data for 1980 to 1995 published in the Annual Report of the Commissioner of Internal Revenue Service [IRS, various] and the Data Book [IRS, various]. The audit rate and penalty rate both serve as effective deterrents to noncompliance. The effectiveness of these two policy instruments depends upon the individual's level of income. It seems the higher the income level, the more effective these instruments are. In general, compliance increases with the level of income but at a decreasing rate. It is also found that individuals tend to comply less as the marginal tax rate rises. Again, such tendency is more pronounced for high-income taxpayers than for low-income taxpayers.

The plan for this study is as follows. The second section reviews the existing theoretical and empirical literature on tax compliance. The third section develops an econometric model for tax compliance. The fourth section reports the estimated model and presents new empirical evidence on how audit rates, penalty rates and tax rates affect compliance. Some concluding remarks are presented in the fifth section.

Previous Research

The basic theoretical model of tax compliance is an extension of the classic economic analysis of crime by Becker [1968]. The model is a straightforward application of individual choice under uncertainty. The formal analysis was pioneered by Ailingham and Sandmo [1972] and Srinivasan [1973]. In this model, the taxpayer's actual income is exogenously given and he chooses a combination of riskless assets (reported income) and risky assets (unreported income). A constant proportional tax is applied to the reported income. …