Evidence from a Tax Audit Experiment in Denmark

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[Announcing high probabilities of future audits generated] substantial future tax revenue through behavioral responses to a higher perceived probability of detection.

In Unwilling or Unable to Cheat? Evidence From a Randomized Tax Audit Experiment in Denmark (NBER Working Paper No. 15769), co-authors Henrik Kleven, Martin Knudsen, Claus Kreiner, Soren Pedersen, and Emmanuel Saez conclude that the low overall rate of tax evasion enjoyed by advanced economies has more to do with an information environment in which third-party reporting makes it difficult to cheat than it does with any moral reluctance to cheat on the part of taxpayers.

Observing the behavior of a random sample of 42,784 Danish taxpayers in 2007 and 2008, they find that income categories in which both taxpayers and third parties report payments have evasion rates that fall "between 0.2 percent and 0.9 percent" of each type of income. Income categories that are self-reported and not subject to third-party reporting have evasion rates of roughly 37 percent. Although self-reported income constitutes only about 5 percent of total income among the sample in this study, it is responsible for 87 percent of the detected tax evasion.

The authors also report on the results of an experiment in which taxpayers were randomly divided into two groups, one group in which all were audited and the other in which none were audited. The people in the 100-percent-audit group had comprehensive unannounced tax audits of their 2007 tax returns. None of the returns of the other (zero-percent-audit) group were audited. The following year, people from each group were randomly selected into three sub-groups with different audit probabilities (zero, 50 percent, and 100 percent, respectively) and informed in advance about the probability that their 2008 returns would be audited.

The combination of pre- and post-audit data makes it possible for the authors to examine taxpayer behavioral responses to actual audits and to the threat of audits, and to study the effect of high marginal tax rates on tax evasion decisions. The results show that audits had a strong and significant effect on subsequent reporting of self-reported income and it is concluded that audits generate "substantial future tax revenue through behavioral responses to a higher perceived probability of detection." Similarly, audit threats led to upward adjustments in self-reported income.

Many Danish taxpayers bunch at the kink points of the income tax schedule where marginal tax rates jump from 49 percent to 62 percent, which is evidence of behavioral responses to marginal tax rates. However, the audits show that the vast majority of those bunching taxpayers do not evade taxes. This implies that behavioral responses to marginal tax rates are due mostly to labor supply or tax avoidance rather than tax evasion. Overall, this evidence shows that broadening information reporting requirements can have a substantial impact on tax compliance.

-- Linda Gorman