Jonathan W. Benowitz, CPA
Loyola University Chicago School of Law, JD 2019
It is commonly accepted that lowering tax rates increases tax compliance and high tax rates encourage tax evasion. The recent U.S. tax reform bill, the Tax Cuts and Jobs Act of 2017, was enacted partly due to assumptions that lowered tax rates would increase tax compliance and recover lost revenue. Here, I examine the theoretical basis for the claim that lowering income taxes increases compliance, as well as the external evidence regarding the extent of increased compliance due to lowering tax rates.
Tax non-compliance encompasses not only willful tax evasion, but also misreporting through inadvertence or lack of knowledge as well as aggressive manipulation of the tax law. The IRS estimates that the average annual gross tax gap in federal corporate income tax for the period 2008-2010, the most recent period that was studied, is $44 billion. The IRS defines the gross tax gap as the amount of true tax liability that is not paid voluntarily and timely. It is not clear to what extent aggressive tax manipulation is included in the estimate. “Base erosion,” whereby corporations manipulate the amount of income subject to tax by such means as aggressive transfer pricing with foreign affiliates in low tax jurisdictions, is thought by many to be the cause of large foreign caches of cash. U.S. companies are reported to be hoarding $2.5 trillion overseas.
When would tax cuts lead to increased revenues: The Laffer Curve
The notion that tax cuts may lead to increased revenues is forever linked to American economist and Reagan policy advisor, Arthur Laffer. The Laffer curve is a hypothesis about how the rates of taxation result in varying levels of government revenue. Specifically, the hypothesis is that, starting from a tax rate of zero, revenues rise with increases in the tax rate to a certain point, after which increasing tax rates will result in reduced revenues. Revenue is theorized to be reduced when taxes get too high due to non-compliance, as well as legal tax avoidance and less effective tax enforcement. Revenue may also decrease due to the effect of high taxes discouraging people from working by making the activity less rewarding.
The Laffer curve is typically postulated as follows: at zero percent taxes, the government would earn no revenue; at one hundred percent taxes, the government would also earn no revenue (since no one would work, or if they did, they would refuse to pay taxes). At some point in-between zero and one hundred percent taxes, revenue is maximized.
The Laffer curve has been invoked to explain the increase in revenue after tax cuts during the Reagan administration. Most recently Arthur Laffer has worked for Kansas governor Sam Brownback, who cut Kansas taxes that topped out at 6.45 percent, leading to a Kansas to move from a budget surplus to a substantial deficit. Most economists question whether the Laffer curve has any relevance to the U.S. economy today when taxes are far below 50 percent.
The effect of tax cuts on tax compliance: theoretical models
The Laffer curve does not break out the effect of non-compliance from the effect of discouraging work and other income-producing activity, but some theoretical treatments of the Laffer curve do attempt to isolate the effect of lowering taxes on tax compliance. In January of 2008, a working paper was prepared for the IMF that reported on a general equilibrium economic model that the authors believed demonstrates how tax rate cuts could increase revenues by improving tax compliance. Due to the manner that penalties for tax evasion relate to taxes evaded, gains from tax evasion drop faster than the potential cost of tax evasion as the tax rate decreases. The model’s authors intuitively assume that tax evaders tie down revenue authorities’ enforcement capacity as audits of evaders are more time consuming due to the need for prosecution, so that a reduction of evasion has the spillover effect of increasing enforcement capacity. Therefore, the authors maintain that relatively small tax cuts, by decreasing incentives to evade, increase revenues through spillovers, creating Laffer effects.
The authors of the working paper and others have cited the case of Russia’s 2001 adoption of a moderate flat tax to replace a progressive structure as an example consistent with the results of their model. However, since the intent of tax evasion is to conceal the true amount of income, non-compliance must be inferred by indirect means such as analyzing the discrepancy between reported income and (presumably) fully reported consumption.
Theoretical models showing compliance gains when taxes are lower assume that enforcement activity remains steady as tax rates change. Recent cuts to the IRS budget curb enforcement activity, effectively reducing compliance irrespective of any change in tax rates.
Does lowering business taxes increase compliance?
Much of the empirical research and theoretic models below have focused on the behavior of taxpayers who are individuals, although there may be an implicit assumption that the same behavior would hold true for business organizations.
Experimental evidence is harder to come by for the effect of lowering taxes on corporate behavior. The largest cut in the tax reform act is the permanent decrease of the corporate tax rate to 21 percent. India, which has suffered high rates of tax non-compliance by both businesses as well as individuals, is one of the countries that has been recently looking to increase tax compliance by lowering tax rates on businesses. India’s finance minister proposed cutting India’s corporate rate from 30 percent to 25 percent. However, India also will be increasing compliance efforts, such as increasing penalties for tax evasion. Increasing penalties increases the cost of non-compliance, which in and of itself may increase tax compliance, so it is not only unclear whether India’s experiment will increase tax revenue in the long term, assuming it is implemented, but even if it does, to what extent the lowered tax rate is a factor.
Conclusion: tax cuts may (or may not) increase compliance
The notion that tax cuts will increase compliance is linked heavily to the broader idea of the Laffer curve. If there is an ideal tax rate from where further tax increases reduce revenue, part of the expected growth in revenue from tax cut is expected to come from increased compliance. The increased compliance resulting from reducing the cost of compliance seems intuitive, but then so do many other intuitive ideas that have not born out in practice. Few economists actually agree that tax cuts would actually lead to increased U.S. tax revenues, and historical examples of tax cuts leading to increased compliance may not be generalizable to the situation in America. Without a conclusive answer to the question, the only way to know what effect the tax cuts may have on tax compliance may be to wait and see.