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Optimal Tax Administration

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The first concerns the usefulness, or otherwise, of the concept of the ‘compliance gap:’ the difference between the amount of tax legally due and that actually collected. This is an intuitively appealing indicator of the effectiveness of a revenue administration—with clear advantages, for instance, over the simple comparison of cost-revenue ratios (i.e., administration (and/or compliance) costs relative to revenue raised) that has traditionally been a focus in assessing the performance of tax administrations.

The limitations of the compliance gap and other indicators in assessing the welfare impact of administrative actions point to a second and still more basic question: What do policy makers need to know about the costs and effectiveness of administrative interventions in order to set them optimally? The analogous question on the policy side has received considerable attention, with much of the recent literature focusing on the circumstances in which the elasticity of a reported tax base with respect to the net-of-tax statutory rate is a sufficient statistic for the choice of marginal tax rate. An extensive empirical literature focuses on estimating this elasticity, particularly for income taxes, in which setting it is known as the elasticity of taxable income.

Policy makers facing a need to raise more revenue have broadly two alternatives: to raise rates, or to devote more resources to improving tax compliance.

Rhetoric on this abounds, but theory has provided little guidance on this most basic of policy choices: Is it better to raise an additional dollar of revenue by raising statutory tax rates or by strengthening tax administration so as to improve compliance?

Closely related to this is the question of how constraints on one dimension of tax system design affect the optimal choice of the other: if, for instance, tax administration is weaker than would ideally be the case, does that call for higher tax rates than would otherwise be optimal, or for lower?

The key to the answers to these questions set out in this paper is the concept of the enforcement elasticity of tax revenue: the responsiveness of revenue collected to administrative interventions (one such elasticity, in principle, for each instrument of administration).

 This is the central contribution of the paper, and is the administration-side analogue to the elasticity of taxable income, acting, in the same way, as a sufficient statistic for the behavioral impact of administrative interventions that encompasses effects on the levels of both true and concealed activities.

The choice between policy and administrative measures turns on the balance between these two elasticities, along with an even simpler form of the cost-revenue ratio. The optimal compliance gap is characterized, in a benchmark case, by a simple inverse elasticity rule, the relevant elasticity in this case being that of evasion with respect to enforcement; more generally, the optimal gap also reflects the distinct reactions to administrative actions of both real earnings and (legal) avoidance.

The greatest obstacle to practical implementation, however, is the current state of empirical knowledge. An extensive and long-established literature has produced much information on compliance and, especially, administration costs, but has focused much more on their levels than on how they vary with alternative interventions, which is what matters for the efficient design of those interventions and their comparison with policy measures.

Most fundamental, however, is the lack of empirical information on enforcement elasticities. While tax administrations often recognize the importance of these elasticities in their budget submissions, they have received almost no direct attention in the academic literature, and the information that can be inferred indirectly is very limited. Looking forward, however, there are two reasons to be optimistic.

For one thing, the analysis developed here tells us exactly what empirical quantities to look for, a necessary but clearly insufficient condition for reaching the goal of an implementable guide to policy.

Second, a new wave of creative empirical researchers, often working in concert with enlightened tax administrations and armed with modern empirical research designs that promise compelling identification of causal impacts, are making clear progress.

The whole publication you can read: HERE!

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