Tax Rates and Tax Evasion

[A]s tax rates rise above the median level of 34 percent, the extent of evasion rises dramatically.

Higher tax rates provoke tax evasion. In Tax Rates and Tax Evasion: Evidence from 'Missing Imports' in China (NBER Working Paper No. 8551), Raymond Fisman and Shang-Jin Wei capture this phenomenon in some detail when they look at how importers in China responded to high tariff rates by engaging in a rash of evasive behaviors. They find the reaction in that country to be so intense that "tax increases may even produce a reduction rather than an increase in tax revenues."

Fisman and Wei were interested in fleshing out a widely-held notion --that higher tax rates will encourage greater evasion - with a study that could assess the magnitude of the effect. So they decided to examine detailed statistics on a range of goods exported from Hong Kong to China, paying specific attention to the value and quantity reported by Hong Kong versus what was reported by China.

In general, import taxes are based on the value and category code assigned to particular goods. (For example, an export category code might refer to a four-door passenger car, a certain type of steel, or a computer chip.) What Fisman and Wei document is that, in industries characterized by higher taxes and tariffs, importers fight back by fudging values and category codes for goods coming in from Hong Kong. "We conclude that there are widespread practices of underreporting unit value of the imports and mislabeling higher-taxed products as lower taxed products," they state.

Moreover, the extent of evasion that they document is very large. Using data from 1998, they find that on average a 1 percent increase in the tax rate results in a 3 percent increase in evasion. Fisman and Wei observe that importers in China are willing to tolerate "relatively low tax rates." But when rates reach a certain threshold, they rebel: "[a]s tax rates rise above the median level of 34 percent, the extent of evasion rises dramatically," the authors assert.

Fisman and Wei believe their approach to studying the relationship between tax increases and tax evasion - comparing export documentations to import declarations - "can be applied to other countries as well." In addition to providing hard data on the "behavior response of tax evasion to tax rates," they believe a multi-country study "could provide a more objective measure of the laxity of the rule of law across countries, in contrast to the subjective, perception-based measures of corruption and rule of law now popular in empirical studies."

-- Matthew Davis