The Analysis of Tax Evasion

Ever since Allingham and Sandmo (1972) created their model, many pieces of literature have come to view on the analysis of tax evasion. These works have explained the behavior of a single underreporting agent. However, many papers do not include the extent to which one takes part in tax evasion. Clotfelter (1983) stated that the extent to which one evades taxes is strongly correlated with the source of one's income. Other papers reveal that the opportunity for tax evasion differs among occupations and these differences affect the labor market behavior of the agent.

Other papers like that of the Watson (1985) model have included a two-sector model. In one sector, evasion is evadable while in the other evasion is non-evadable. In this paper, Yung strongly mimics Watson's two sector model. The only difference is that Yung proves that a rise in the tax rate increases the participation in the underground economy if and only if agents' preferences for risk-bearing exhibit increasing relative risk aversion (IRRA).

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This paper fits in to the topic area by looking at the different aspects of tax evasion. They use other pieces of literature including Allingham and Sandmo's model to make their analysis of how appealing tax evasion can be. As stated before, Yung strongly mimics the Watson model. He does this in order to demonstrate the fact that agents will maximize expected utility as given the government's use of a particular tax-collection technology. There is a constant tax rate on declared income as well as the probability of detection if declared income is less than the actual income.

The paper also includes Watsons two sectors for when an agent decides to evade. The only difference from Watson's model is the fact that if an agent is detected, the penalty is a multiple of the amount of tax evaded instead of a multiple of undeclared income. Yung also states that when the government changes their variables (t and p), relative attractiveness of the two sectors may change.

Agents will then move from sector to the other until pre-tax wages adjust. Once pre-tax wages adjust, the third equation or the indifference between the two sectors will hold once again. Yung denotes how these two sectors can be become more or less attractive. If there is an increase in the tax rate, the amount by which sure tax payments in the non-evadable sector exceeds expected tax payments in the evadable sector. This in turn increases the appeal of the evadable sector. Another thing is that the increase in the tax rate may alter an agents willingness to bear the risk. As a result, the tax sector will look less appealing. However, in the case of constant relative risk aversion, the effects off-set each other. In this case, a change in t will not alter the comparative appeal of the two sectors. The utility available in the non-evadable sector is altered by t as it is in the evadable sector.

The overall conclusion of this paper stems from the Slemrod and Yitzhaki model. They concluded that tax evasion introduces uncertainty into an agent's tax payments, which creates an excess burden. When there is an increase in the probability of detection however, evasion is reduced and the excess burden is then lessened. In this paper, tax evasion creates an excess burden in two ways The first way is Slemrod and Yitzhaki's model. The second comes from the fact that a the potential to evade distorts labor market decisions. This in turn will create differences in the pre-tax wages between the two sectors.

This paper might of used Allingham and Sandmo's paper as a simple road map to create their own model within the tax evasion literature. The Allingham and Sandmo model in Yung's view can be considered the overall base model. Yung then probably used this model as well as the models from other papers in the literature to create his own. This in turn caused an extension in the tax evasion literature overall.