Measuring Illegal Activity and the Effects of Regulatory Innovation: A Study of Diesel Fuel Tax Evasion

Abstract

The taxation of diesel fuel varies by use. Consumers using diesel fuel on-road must pay state and federal highway taxes while diesel fuel consumed for residential heating, industrial use, farming or off-road travel do not pay taxes. Variation in the taxation of diesel fuel creates the incentive for firms and individuals to evade on-road diesel taxes by purchasing untaxed diesel fuel and then using or reselling it for on-road use. This paper studies the incentives for tax evasion and the effects of regulatory changes meant to limit evasion of on-road diesel taxes. We propose a model of fuel tax evasion in which firms choose to purchase quantities of taxed and untaxed diesel fuel based on a heterogenous cost of evading and an endogenously set level of regulatory enforcement. We use this model to propose an empirical test for evasion requiring only data on observed taxed quantities, not the potentially unobserved evaded quantities. We then empirically study the effects of regulatory innovation in October 1993, including the addition of dye to untaxed diesel fuel, which increase the costs of evasion and lower the costs of regulatory enforcement. We estimate the effect of the regulatory changes on state-level sales of diesel fuel and untaxed heating oil. We find that sales of diesel fuel rose 29 percent following the regulatory change while sales of untaxed heating oil fell by a similar amount. This suggests that the regulatory changes substantially limited the amount of diesel fuel tax evasion. The increase in diesel consumption was higher in states with higher tax rates and in states with more legitimate home heating oil use.