Tax evasion and flat taxes

Tax evasion is an issue all round the world. Russia had for the years following the collapse of the Soviet Union large problems with tax evasion. In January 2001 it introduced a reformed personal income tax code. In fact it became the first large economy to adopt a flat tax. The new tax code replaced a conventional progressive rate structure with a flat tax rate of 13 percent. What were the effects of this?

A new NBER working paper looks at this question: Yuriy Gorodnichenko; Jorge Martinez-Vazquez; and Klara Sabirianova Peter, 2008. "Myth and Reality of Flat Tax Reform: Micro Estimates of Tax Evasion Response and Welfare Effects in Russia," NBER WP 13719.

In this paper it is argued that the flat tax reform was a major factor in decreasing tax evasion in Russia. It is also noted that greater fiscal revenues in 2001 and several years beyond can be linked to increased voluntary tax compliance and reporting. In addition it is found that there was a positive productivity effect on the real side of the economy albeit smaller than the tax evasion effect.

In a summary of their paper on VoxEU.org, Gorodnichenko, Martinez-Vazquez and Peter point out that

As income underreporting is not observable by definition, we use data on reported consumption and income to infer tax evasion. Under the permanent income hypothesis, current consumption should equal a share of permanent income. Assuming that consumption expenditures are fully reported, the discrepancy between consumption and income, which we call the consumption-income gap, indicates that households underreport a portion of their income.

The Russian tax reform decreased marginal tax rates for some groups of people only. Because of this it was possible to use the variation across time and taxpayers to identify and estimate the effects of the flat rate income tax reform.

The findings of the study indicate that, ceteris paribus, for the households who received the reduction in marginal tax rates the consumption-income gap decreased by 9 to 12% more than other households.

That is, the most significant reduction in tax evasion was for taxpayers that experienced a decrease in tax rates upon introduction of the flat tax.

The study also found that this decline in tax evasion was likely due to changes in voluntary compliance rather than being due to greater enforcement efforts by the tax authorities. The productivity effect which was measured by the relative increase in consumption for households that faced the lower tax rates post reform, was zero at the threshold and about 4% for those taxpayers that experienced the decrease in tax rates over a four-year period.

The research has a number of policy implications. If an economy is plagued by ubiquitous tax evasion, as was the case in Russia, then a flat rate income tax reform may lead to substantial revenue gains via increased voluntary compliance. But the strong evasion response suggests that the gains in efficiency from the Russian tax reform are perhaps smaller than it had been thought up to now.

Using observable responses of consumption and income to tax changes, we find that the tax-evasion-adjusted deadweight loss from the personal income tax is at least 30% smaller than the loss implied by the standard method based on the response of reported income to tax changes.

Thus, overall, it should be noted that while there are real efficiency gains from a flat tax, the most important result of reform appears to be the reduction of tax evasion.