The Pedagogy of Tax Evasion: Its Extent and Its Determinants
Cebula, Richard, Paul, Chris, International Advances in Economic Research
CHRIS PAUL [*]
This pedagogical note develops a model of individual choice and a comprehensible and functionally realistic framework that explains how the size of the underground economy or the extent of aggregate income tax evasion can be estimated. It also describes three models for estimating the size of the underground economy for the U.S. and provides a formal but easily understood analytical model of determinants of the extent of aggregate income tax evasion. The latter model is useful in serving as the basis for empirical estimates of determinants of income tax evasion and is useful in enhancing student understanding economic behavior through student projects. (JEL A23, H26)
Income tax evasion presents several characteristics that make it an effective subject for teaching economic concepts and tools. First, it offers the opportunity to apply marginal analysis and demonstrate the use of the equimarginal principle in the choice calculus of economic agents. Second, the illegal nature of tax evasion allows the incorporation of risk and ethical considerations into the individual's choice calculus. Third, income tax evasion is illegal and by its very nature leaves no directly observable data. Thus, its magnitude must be inferred, that is, estimated from secondary sources. This means that alternative methods of measurement may be applied and their results compared. This exercise exposes the student to techniques of national income accounting and deductive logic. Fourth, it demonstrates the use of empirical methods and results of estimating income tax evasion by applying methods of measurement.
There is extensive literature addressing the determinants of tax evasion behavior or, alternatively stated, the size of the underground economy. Aside from a variety of principally theoretical models of tax evasion behavior (see, for example, Falkinger , Allingham and Sandmo , Klepper et al. , Das-Gupta , and Pestieau et al. ), there are a number of studies on such behavior using questionnaires or experiments [Spicer and Lundstedt, 1976; Friedland, 1982; Spicer and Thomas, 1982; Benjamini and Maital, 1985; Alm et al., 1992; Baldry, 1987; De Juan, 1989; Thurman, 1991] or, in a few cases, what De Juan et al.  refer to as official data [Clotfelter, 1983; Slemrod, 1985; Pommerehne and Weck-Hannemann, 1989; Erard and Feinstein, 1994] such as audit and income tax data. Indeed, the issue of the size of the underground economy as measured by the extent of income tax evasion, which consists essentially of economic transactions that are not reported or are underreported to the gover nment tax collection authority, was the subject of an entire issue of Public Finance/Finances Publiques .
In order to comprehensively cover the economic issues associated with tax evasion, the first section of this study presents an individual choice model of income tax evasion which incorporates expected net monetary value of avoiding taxes, risk preferences, and guilt as arguments in the choice function. The second section offers a model of aggregate income tax evasion. The third section discusses the three primary methods used to estimate the extent of income tax evasion and presents selected estimates of tax evasion applying each model. The fourth section provides concluding remarks.
A Choice Model of Tax Evasion
Here, a simple analytical model is developed to explain the choice to evade income taxes. It should be emphasized to the student that the choice of reporting or not reporting income is subject to the same principles as other economic choices. Individuals make decisions based on the relationship between marginal benefits and marginal costs. Consequently, the methodology developed here is applicable in general form to a vast array of other individual choice issues. Students may be assigned the task of identifying and modeling other choice behaviors, such as the decisions to vote or to migrate. …