Income Tax Evasion Revisited: The Impact of Interest Rate Yields on Tax-Free Municipal Bonds

Abstract

1. IntroductionIncome tax evasion remains a timely issue, as evidenced by recently published studies (e.g., see Feige 1989, 1994; Alm, Jackson, and McKee 1992; Pestieau, Possen, and Slutsky 1994; Cebula 1997, 2001; Alm, McClelland, and Schulze 1999; Atkins 1999; Panteghini 2000; Ali, Cecil, and Knoblett 2001; Saltz 2001). In an effort to provide further insight into the determinants of tax evasion, this study hypothesizes that the tax-evasion decision may include an assessment of the tax-free interest rate yield on, say, high-grade municipal bonds relative to the taxable interest rate yield on alternative high-quality bond issues, such as 10-year Treasury notes. Presumably, the higher the interest rate yield on high-grade municipals (whose interest is legally exempt from federal income taxation) relative to the taxable interest rate yield on 10-year Treasury notes, the more attractive those municipals become, ceteris paribus. In effect, the interest paid on tax-free bonds, especially for households in higher tax brackets, may offer an attractive legal alternative (income tax avoidance) to illegal income tax evasion.1 Thus, it is hypothesized that the higher the tax-free interest rate yield on high-grade municipals relative to the taxable yield on 10-year Treasury notes (or equivalent taxable issues), the less the incentive for and, hence, the less the degree of income tax evasion.This study investigates empirically whether higher yields on tax-free municipals (relative to the taxable yields on 10-year Treasury notes) reduce the degree of aggregate federal personal income tax evasion. Section 2 provides the model, which includes a variety of variables already established in the literature to affect tax evasion. Section 3 describes the data. Sections 4 and 5 provide the empirical findings and concluding remarks.2. The ModelThe economy consists of agents who generate economic value that is reflected in the form of income and choose whether to report none, some, or all of their income to the Internal Revenue Service (IRS).The probability that the representative economic agent will not report taxable income, pnr, is treated as an increasing function of the expected gross benefits to the agent of not reporting income, eb, and a decreasing function of the expected gross costs to the agent of not reporting income, ec:(Formula Omitted. See article image.)The expected gross benefits from not reporting income to the IRS are hypothesized to be an increasing function of income tax rates. Unlike previous studies, this study focuses on both the average effective federal personal income tax rate (AEPT) and the maximum marginal federal personal income tax rate (MAX), such that(Formula Omitted. See article image.)Furthermore, as suggested by Feige (1994) and Cebula (2001), the higher the level of public dissatisfaction (DIS) with the perceived performance of government employees and elected government officials, the greater the subjective benefit taxpayers derive from tax evasion. Accordingly, becomes(Formula Omitted. See article image.)Finally, as explained in section 1, it is hypothesized in this study that the higher the tax-free interest rate yield on high-grade municipal bonds (TF) relative to the taxable interest rate yield on 10-year Treasury notes (TEN), the greater the incentive to engage in legal tax avoidance and the lower the incentive to engage in tax evasion. Thus, becomes(Formula Omitted. See article image.)The expected gross costs of not reporting income to the IRS are hypothesized to be an increasing function of the expected risks thereof. In this study, to the representative economic agent, the expected penalty from not reporting taxable income to the IRS, if said activity is detected by the IRS, is measured in part by the total pecuniary penalties (including both penalties per se and interest) previously assessed by the IRS on audited tax returns (PEN). …