Spatiality and persistence in U.S. individual income tax compliance.

INTRODUCTION

The individual income tax system in the United States operates on a self-assessment basis, in which individuals annually determine their tax liability and pay what they deem due. Over time, a taxpayer learns more about the tax system, so that reports today may depend in part on reports in the past. An individual can also communicate with or be influenced by other fliers in choosing how much to report, so that her/his reporting decision may depend in part on the decisions of others. Put differently, insofar as a taxpayer may recall his or her own past filing experience and may communicate in some ways with other taxpayers, these issues help shape the taxpayer's current report. Thus, two phenomena emerge from past reporting experience and from the exchange of information and experiences with other filers, one relating to dynamic effects (or persistence) in the taxpayer's reporting decision and the other relating to spatial dependence (or interdependence) across all taxpayers.

Dynamic effects suggest that this year's evasion decision is affected by past evasion experience. There is, therefore, an element of persistence in individual income tax evasion decisions. As suggested by Dubin (2007), this may also be due to the delayed audit completion cycle. He argues that "... taxpayers may adjust their reported taxes based on a mixture of taxes reported in the previous year and the optimal level

There are several possible explanations for spatial dependence in tax evasion. Individuals typically exchange their experiences with others, so they influence and are influenced by the tax evasion behavior of other taxpayers. (1) Further, if one taxpayer successfully evades because he or she is not audited, then (given the audit resources available to the tax administration) this may increase the probability that another taxpayer will be audited. Still another explanation may be due to a "social norm" of compliance. A social norm can be distinguished by the feature that it is process-oriented, unlike the outcome-orientation of individual rationality (Elster, 1989). A social norm represents a pattern of behavior that is judged in a similar way by others and that, therefore, is sustained in part by social approval or disapproval: if others behave according to some socially accepted mode of behavior, then the individual will also behave appropriately, but if others do not so behave, then the individual will respond in kind. Consequently, an individual will comply as long as he or she believes that compliance is the social norm; if noncompliance becomes pervasive, then the social norm of compliance disappears. (2) Manski (1991) and McFadden (2006) suggest still another, related explanation for interdependence. Both argue that individuals faced with dynamic stochastic decision problems that pose immense computational challenges may look to others to infer satisfactory policies, so that interdependence may come simply from imitating others, perhaps through social networks.

These twin issues of persistence and spatial dependence are seldom raised in the theoretical or empirical analyses of tax evasion, at least not in tandem. This is our purpose in this paper. We first extend the original Allingham and Sandmo (1972) model of income tax evasion by incorporating both issues. We then test their empirical validity in the context of the U.S. federal individual income tax evasion. We use state-level, time-series, cross-section data for the years 1979 to 1997, collected from a variety of sources, to estimate the factors that affect annual per return evasion in the individual income tax. The estimation methods use several econometric models that incorporate both spatial dependence and dynamic considerations and that also consider the potential endogeneity of the audit rate. When estimation methods appropriately consider these issues, the empirical results indicate strong and robust support for both spatiality and persistence in tax evasion. The results also show a large deterrent effect from higher audit rates. (3)

In the next section we briefly review past empirical studies conducted on individual income tax compliance. We then extend the Allingham and Sandmo (1972) model by incorporating persistence and spatiality. The following section deals with data and related methodological issues, including the methods employed in the empirical work, analytical issues related to the construction of variables, and descriptive statistics. We then present our estimation results, first examining the spatiality and persistence issues separately and then suggesting and implementing a way to combine them. In the final section we summarize our findings and discuss their implications.

SOME PREVIOUS EMPIRICAL STUDIES