David Seim. Tax Rates, Tax Evasion and Cognitive Skills

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IIES, Stockholm University …

IIES, Stockholm University
October 2012

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  • 1. Tax Rates, Tax Evasion and Cognitive Skills David Seim IIES, Stockholm University October 2012D. Seim (IIES, Stockholm University) Tax Rates, Tax Evasion and Cognitive Skills October 2012
  • 2. Introduction Earnings responses to taxes: (i) Real substitution responses (ii) Reporting responses (legal and illegal) Tax system complex: ability to respond possibly affected by cognitive abilityD. Seim (IIES, Stockholm University) Tax Rates, Tax Evasion and Cognitive Skills October 2012
  • 3. This Paper Identify the effects of a tax change on substitution and evasion. Study whether the cognitively able are more likely to evade.D. Seim (IIES, Stockholm University) Tax Rates, Tax Evasion and Cognitive Skills October 2012
  • 4. Motivation Crucial to understand tax evasion for giving policy recommendations on how to reduce evasion. Need to know tax elasticity of both taxable net wealth and actual net wealth to determine optimal tax rate. If the ability to evade taxes differs across people: The tax incidence will fall disproportionally on the less able. Heterogenous effects on wealth inequality within skill groups.D. Seim (IIES, Stockholm University) Tax Rates, Tax Evasion and Cognitive Skills October 2012
  • 5. Contribution Provide an empirical measure of tax evasion. Find tax elasticities of evasion on the order of 1 - 3.5 in both a structural and reduced form framework. Use military enlistment data on cognitive skills to establish that cognitively able are more likely to evade the wealth tax.D. Seim (IIES, Stockholm University) Tax Rates, Tax Evasion and Cognitive Skills October 2012
  • 6. Roadmap I STRUCTURAL APPROACH Develop a model of savings and evasion. Estimate model using bunching at kink points. Administrative data on taxable net wealth for the Swedish population. II REDUCED FORM APPROACH Use new measure of tax evasion. Apply a D-in-D framework exploiting tax reforms.D. Seim (IIES, Stockholm University) Tax Rates, Tax Evasion and Cognitive Skills October 2012
  • 7. III BOUNDED RATIONALITY AND TAX RESPONSES Construct model of cognitive skills, savings and evasion building on Chetty et al. (2007). Use Swedish military enlistment data on cognitive skills to test the model’s predictions.D. Seim (IIES, Stockholm University) Tax Rates, Tax Evasion and Cognitive Skills October 2012
  • 8. Related Literature Optimal taxation: Feldstein (1999), Saez (2001), Chetty (2009). Tax evasion: Allingham and Sandmo (1972), Clotfelter (1983), Slemrod (1985), Slemrod (2001). Methodology: Saez (2010), Chetty et al. (2011). Cognitive costs: Chetty et al (2007), Liebman and Luttmer (2011).D. Seim (IIES, Stockholm University) Tax Rates, Tax Evasion and Cognitive Skills October 2012
  • 9. STRUCTURAL APPROACHD. Seim (IIES, Stockholm University) Tax Rates, Tax Evasion and Cognitive Skills October 2012
  • 10. Model Individuals have homothetic utility function 1−δ 1−δ c1,i c2,i ui (c1 , c2 ) = +β 1−δ 1−δ where c1,i is consumption today, c2,i is consumption tomorrow, β is the discount factor, 1 is the IES. δD. Seim (IIES, Stockholm University) Tax Rates, Tax Evasion and Cognitive Skills October 2012
  • 11. Agents’ budget constraints c1,i = yi − s c2,i = (1 + r ) ((1 − τ ) (s − e) + e − C (e, s)) where yi is income, distributed with continuous and differentiable CDF F (y ), s is savings, r is the deterministic interest rate, τ is tax on taxable savings. Agents can evade taxes τ by choosing e < s subject to a cost function C (e, s).D. Seim (IIES, Stockholm University) Tax Rates, Tax Evasion and Cognitive Skills October 2012
  • 12. Cost Function Builds on Slemrod (2001). e γ 1 C (e, s) = pe s 1+γ where p > τ and γ measures curvature of cost. 1 τ γ ei∗ = si∗ pD. Seim (IIES, Stockholm University) Tax Rates, Tax Evasion and Cognitive Skills October 2012
  • 13. Mean Evasion as Function of Net Wealth Evasion = max{Third Party Reported Net Wealth − Taxable Net Wealth, 0} 400000 300000 Evasion 200000 100000 0 1500000 2500000 3500000 4500000 Third Party Reported Net WealthD. Seim (IIES, Stockholm University) Tax Rates, Tax Evasion and Cognitive Skills October 2012
  • 14. Model In equilibrium, 1−δ 1 δ 1 1−δ τ γ γ β (1 + r ) δ δ 1−τ 1− p 1+γ si∗ = 1−δ yi 1 δ 1 1−δ τ γ γ 1 + β (1 + r ) δ δ 1−τ 1− p 1+γ and taxable net wealth becomes 1−δ 1 δ 1 1−δ γ τ γ β (1 + r ) δ δ 1−τ 1− p 1+γ 1 τ γ si∗ − ei∗ = 1−δ 1− yi 1 1−δ 1 δ p τ γ γ 1 + β (1 + r ) δ δ 1−τ 1− p 1+γD. Seim (IIES, Stockholm University) Tax Rates, Tax Evasion and Cognitive Skills October 2012
  • 15. Linear Tax Scheme, τ = τ0 After Tax Net Wealth, c2 = (s − e) − T (s − e) IC High IC Low Slope 1 − τ0 s −eD. Seim (IIES, Stockholm University) Tax Rates, Tax Evasion and Cognitive Skills October 2012
  • 16. Progressive Tax Scheme with τ = τ1 > τ0 for s − e >= z ∗ After Tax Net Wealth, c2 = (s − e) − T (s − e) IC High 1 IC Low IC High 2 Slope 1 − τ1 Slope 1 − τ0 s −e z∗ z ∗ + ∆zD. Seim (IIES, Stockholm University) Tax Rates, Tax Evasion and Cognitive Skills October 2012
  • 17. Simulated Savings Using Swedish Data on Income, τ = 0 6000 5000 4000 Frequency 3000 2000 1000 0 0 0.5 1 1.5 2 2.5 3 3.5 4 4.5 5 s−e 5 x 10D. Seim (IIES, Stockholm University) Tax Rates, Tax Evasion and Cognitive Skills October 2012
  • 18. Simulated Savings Using Swedish Data on Income,τ = 0.015 above SEK 150000 6000 5000 4000 Frequency 3000 2000 1000 0 0 0.5 1 1.5 2 2.5 3 3.5 4 4.5 5 s−e 5 x 10D. Seim (IIES, Stockholm University) Tax Rates, Tax Evasion and Cognitive Skills October 2012
  • 19. Agents with y ∈ f (τ0 ) , f (τ1 ) bunch at the kink point. (Where f (τ ) is given here .)D. Seim (IIES, Stockholm University) Tax Rates, Tax Evasion and Cognitive Skills October 2012
  • 20. Number of agents bunching: z ∗ +∆z B= h0 (s) ds z∗ h0 (z ∗ ) + h0 (z ∗ + ∆z) ≈ ∆z 2 ˜ ≈ ∆z h0 or, equivalently,  1−δ  1 δ 1 1−δ τ1 γ γ 1 + β R δ δ 1 − τ1 1− p 1+γ  B ≈ z∗  × ˜ h0 1 1−δ δ 1 + β δ R 1−δ 1 δ 1 − τ0 1− τ0 γ γ  p 1+γ 1−δ 1 δ 1 τ0 γ γ τ0 γ 1 − τ0 1− p 1+γ 1− p 1−δ 1 δ 1 τ1 γ γ τ1 γ 1 − τ1 1− p 1+γ 1− pD. Seim (IIES, Stockholm University) Tax Rates, Tax Evasion and Cognitive Skills October 2012
  • 21. Solve for structural parameter γ as a function of: (i) known parameters: z ∗ , τ0 , τ1 , B (ii) the excess bunching around the kink point: ˜ h0 , (iii) intertemporal parameter δ, discount factor β. (iv) cost p.D. Seim (IIES, Stockholm University) Tax Rates, Tax Evasion and Cognitive Skills October 2012
  • 22. Institutional Background and Data Figure: MTR since 1992 Marginal Tax Rate % 1.5 Taxable Net Wealth z∗D. Seim (IIES, Stockholm University) Tax Rates, Tax Evasion and Cognitive Skills October 2012
  • 23. Movement in Tax Bracket Cutoff Across Years SEK 1000 3500 Couples filing jointly 3000 2500 2000 1500 Singles 1000 1998 1999 2000 2001 2002 2003 2004 2005 2006 YearD. Seim (IIES, Stockholm University) Tax Rates, Tax Evasion and Cognitive Skills October 2012
  • 24. Declaring WealthD. Seim (IIES, Stockholm University) Tax Rates, Tax Evasion and Cognitive Skills October 2012
  • 25. Table: Perceptions of Tax Cheating in Sweden, in % Very Quite Not very Not at all Don’t common common common common know Federal inc. tax 8.6 26.6 32.5 8.8 22.1 Corporate tax 10.4 29.0 20.6 3.5 34.8 Inheritance tax 11.2 30.3 24.5 6.2 26.2 Wealth tax 18.7 37.2 15.6 3.8 23.5 Estate tax 4.7 17.3 35.2 16.6 24.8 Gas tax 2.7 9.6 31.4 25.0 29.8 Source: Survey by Hammar et al. 2006.D. Seim (IIES, Stockholm University) Tax Rates, Tax Evasion and Cognitive Skills October 2012
  • 26. Distribution of Third Party Reported Net Wealth,2002-2006 5000 4000 Frequency 3000 2000 1250000 1375000 1500000 1625000 1750000 Third Party Reported Net Wealth, SEK (2002−2006)D. Seim (IIES, Stockholm University) Tax Rates, Tax Evasion and Cognitive Skills October 2012
  • 27. Distribution of Taxable Net Wealth, 2002-2006 5000 4000 Frequency 3000 2000 1250000 1375000 1500000 1625000 1750000 Taxable Net Wealth, SEK (2002−2006)D. Seim (IIES, Stockholm University) Tax Rates, Tax Evasion and Cognitive Skills October 2012
  • 28. Estimating Excess Bunching I Follow previous literature Estimate the counterfactual as a polynomial excluding points around the kink. II Nonparametric way Compute the number of people tax liable using third party reported net wealth but not using taxable net wealth.D. Seim (IIES, Stockholm University) Tax Rates, Tax Evasion and Cognitive Skills October 2012
  • 29. Method I ˆ BN Cj 1 + I [j > 0] ∞ =µ0 + µ1 Zj + µ2 Zj2 + . . . + µ7 Zj7 + j=1 0 ρi I [Zj = i] + ε0 j i=−Rwhere Cj is number of people in net wealth bin j, Zj is taxable net wealthrelative to kink point in 5000 kronor intervals, R measures the lower boundof the bunching that is allowed (measured in 5000 kronor). B Estimator of b = h0 given by: 0 ˆ ˆ BN j=−R Cj − Cj0 = hˆ 0 ˆ Cj 0 j=−R R+1D. Seim (IIES, Stockholm University) Tax Rates, Tax Evasion and Cognitive Skills October 2012
  • 30. Empirical Results; Bunching 14000 12000 Frequency 10000 b=0.536 (0.0923) 8000 6000 −50 −40 −30 −20 −10 0 10 20 30 40 50 Taxable Net Wealth Relative to Tax Bracket Cutoff (SEK 5000)D. Seim (IIES, Stockholm University) Tax Rates, Tax Evasion and Cognitive Skills October 2012
  • 31. Bunching results, 2002-2006 5000 4000 Frequency b=0.6565 (0.0991) 3000 2000 −50 −40 −30 −20 −10 0 10 20 30 40 50 Taxable Net Wealth Relative to Tax Bracket Cutoff (SEK 5000)D. Seim (IIES, Stockholm University) Tax Rates, Tax Evasion and Cognitive Skills October 2012
  • 32. Does Bunching Track the Tax? Bunching in 2001: 1200 1000 Frequency 800 600 400 1000000 1250000 1500000 Taxable Net WealthD. Seim (IIES, Stockholm University) Tax Rates, Tax Evasion and Cognitive Skills October 2012
  • 33. Does Bunching Track the Tax? Bunching in 2002: 1500 1000 Frequency 500 0 1000000 12500000 1500000 Taxable Net Wealth Relative to Tax Bracket Cutoff (SEK 5000)D. Seim (IIES, Stockholm University) Tax Rates, Tax Evasion and Cognitive Skills October 2012
  • 34. Does Bunching Track the Tax? Bunching in 2001: 1200 2006 kink 1000 2001 kink infl. adj. 2001 kink inv− ested in stocks Frequency 2001 kink invested in riskfree interest rate 800 600 2001 kink 400 1000000 1250000 1500000 Taxable Net WealthD. Seim (IIES, Stockholm University) Tax Rates, Tax Evasion and Cognitive Skills October 2012
  • 35. Does Bunching Track the Tax? Bunching in 2006: 1400 1200 1000 Frequency 800 600 400 1000000 1250000 1500000 Taxable Net WealthD. Seim (IIES, Stockholm University) Tax Rates, Tax Evasion and Cognitive Skills October 2012
  • 36. Method II Estimator of B is given by: BN = N I [z ∗ − R < Zi < z ∗ & Si > z ∗ ]. ˆ i where Zi is taxable net wealth of i, Si is third-party reported net wealth, R is lower bound of allowed bunching. 0 ˆ i=−R Pi Estimator of h0 is given by: h0 = R+1 where Pi denotes the number of people in third party reported net wealth bin i. ˆ B = 1.009 (0.0189)D. Seim (IIES, Stockholm University) Tax Rates, Tax Evasion and Cognitive Skills October 2012
  • 37. Calibration and Results Elasticity of intertemporal substitution= 0.25 p ∈ [0.02, 1] β = 0.98, (1 + r ) = 1.04 ˆ B Bunching, h = 1.009 0 gives γ = [0.42, 0.93] and εe,τ = [2.37, 1.08]D. Seim (IIES, Stockholm University) Tax Rates, Tax Evasion and Cognitive Skills October 2012
  • 38. REDUCED FORMD. Seim (IIES, Stockholm University) Tax Rates, Tax Evasion and Cognitive Skills October 2012
  • 39. Define evasion as e = max{s − (s − e), 0}. Methodology (Gruber and Saez, 2002): Regress ∆ log evasion over X years on ∆ log net-of-tax rates (NTR). Instrument for ∆ log NTR using the simulated change from holding net wealth levels constant at base year levels. First stage strong: Coefficient= 0.690 and t = 350.D. Seim (IIES, Stockholm University) Tax Rates, Tax Evasion and Cognitive Skills October 2012
  • 40. Table: Elasticities Estimates from Variation in Tax Bracket Cutoff Dependent var: ∆ log Evasion 2y 2y 3y 3y ∆ log NTR -1.966*** -2.247*** -3.917*** -4.587*** (0.665) (0.664) (0.749) (0.747) Age Fixed Effects X X X X Year Fixed Effects X X X X Region Fixed Effects X X Wage spline X X Base Year Evasion spline X X X X Observations 1919253 1919253 1508141 1508141 Standard errors clustered at household level.D. Seim (IIES, Stockholm University) Tax Rates, Tax Evasion and Cognitive Skills October 2012
  • 41. BOUNDED RATIONALITYD. Seim (IIES, Stockholm University) Tax Rates, Tax Evasion and Cognitive Skills October 2012
  • 42. Let agents internalize θi ∈ [0, 1] of the tax in optimization. θHIQ > θLIQ . Perceived constraints: c1 = y − s e γ pe c2 = R (1 − θi τ ) (s − e) + e − s 1+γ Let first period consumption adjust c1 = y − s − τ R (1 − θi ) (s − e) .D. Seim (IIES, Stockholm University) Tax Rates, Tax Evasion and Cognitive Skills October 2012
  • 43. Predictions: (i) The amount of bunching increases with θ, i.e. highly skilled agents bunch more. (ii) Conditional on bunching, the distribution of taxable net wealth does not differ across cognitive skill-groups.D. Seim (IIES, Stockholm University) Tax Rates, Tax Evasion and Cognitive Skills October 2012
  • 44. Military Enlistment Data Enlistment mandatory for men at age 18. Two days of physical, cognitive and noncognitive tests. Cognitive test consists of: Logical skills Verbal skills Spatial skills Technical comprehensionD. Seim (IIES, Stockholm University) Tax Rates, Tax Evasion and Cognitive Skills October 2012
  • 45. Heterogenous Responses by Cognitive Skills .05 .15 Fraction of Bunchers 0 .1 Fraction of Bunchers, by Cognitive Skills 1000000 1500000 2000000 2500000 3000000 Pre wealth High Skilled Low SkilledD. Seim (IIES, Stockholm University) Tax Rates, Tax Evasion and Cognitive Skills October 2012
  • 46. Heterogenous Responses by Cognitive Skills .04 Fraction of Bunchers .02 .01 .03 0 2 4 6 8 10 Cognitive SkillsD. Seim (IIES, Stockholm University) Tax Rates, Tax Evasion and Cognitive Skills October 2012
  • 47. Table: Dependent var: indicator for evading the tax through bunching,logit-model (1) (2) (3) (4) Sample: All All 2002 − 2006 2002 − 2006 Cognitive Skills 0.015 0.063* 0.103*** 0.127*** (0.025) (0.034) (0.040) (0.044) Cognitive Skills Sq. -0.064*** -0.051* (0.023) (0.028) Third Party Rep. NW. X X Third P.R. NW. - spline X X Year Fixed Effects X X X X Age Fixed Effects X X X X Region Fixed Effects X X X X Family Fixed Effects X X X X Education Fixed Effects X X Observations 60800 60800 34265 34265 Standard errors clustered on the household level.D. Seim (IIES, Stockholm University) Tax Rates, Tax Evasion and Cognitive Skills October 2012
  • 48. Distribution of Taxable Net Wealth Among Bunchers,2002-2006 1500 1000 Frequency 500 0 500000 1000000 1500000 Taxable Net WealthD. Seim (IIES, Stockholm University) Tax Rates, Tax Evasion and Cognitive Skills October 2012
  • 49. Distribution of Taxable Net Wealth Among Bunchers, HighSkilled, 2002-2006 80 60 Frequency 40 20 0 500000 1000000 1500000 Taxable Net WealthD. Seim (IIES, Stockholm University) Tax Rates, Tax Evasion and Cognitive Skills October 2012
  • 50. Distribution of Taxable Net Wealth Among Bunchers, LowSkilled, 2002-2006 20 15 Frequency 105 0 500000 1000000 1500000 Taxable Net WealthD. Seim (IIES, Stockholm University) Tax Rates, Tax Evasion and Cognitive Skills October 2012
  • 51. Are people with high cognitive ability better at locating atthe kink? Define two skill groups (high and low cognitive skills): Mann-Whitney U test of equal distributions gives P-value for equality of distributions = 0.4064 Use discrete variable with nine cognitive skill groups: Kruskal-Wallis test gives P-value for equality of distributions = 0.4668D. Seim (IIES, Stockholm University) Tax Rates, Tax Evasion and Cognitive Skills October 2012
  • 52. Conclusion Approach tax evasion from three angles. Findings: Bunching identifies structural tax elasticity of evasion of 1 − 2.5. Reduced form estimates on the order of 2 − 4.5. Cognitive skills matter for the extent of evasion. Actual revenue from tax increase is 88 % of the mechanical revenue (ignoring real and evasion responses).D. Seim (IIES, Stockholm University) Tax Rates, Tax Evasion and Cognitive Skills October 2012
  • 53. Final Remarks STRUCTURAL APPROACH Functional form assumptions, relies on parameter values being correct. REDUCED FORM Identifying assumption: Changes in tax rates not correlated with base year net wealth.D. Seim (IIES, Stockholm University) Tax Rates, Tax Evasion and Cognitive Skills October 2012
  • 54. Appendix Agents with  1−δ  1 δ 1 1−δ τ0 γ z ∗ 1 + β R δ δ 1 − τ0 1− p γ 1+γ  y∈ 1−δ , 1 δ 1 1 1−δ τ0 γ γ τ0 γ β R δ δ 1 − τ0 1− p 1+γ 1− p  1−δ  1 δ 1 1−δ τ1 γ z ∗ 1 + β R δ δ 1 − τ1 1− p γ 1+γ  1−δ 1 δ 1 1 1−δ τ1 γ γ τ1 γ βδR δ 1 − τ1 1− p 1+γ 1− p BackD. Seim (IIES, Stockholm University) Tax Rates, Tax Evasion and Cognitive Skills October 2012