Tax Rates and Tax Evasion: Evidence from “Missing Imports” in China

Raymond FismanColumbia University

Shang-Jin WeiIMF and NBER

Plan of the Presentation

• Motivation & Basic Methodology

• Data

• Basic Results

• Economic Interpretation

• Robustness Checks and Extensions

• Conclusions

Public Finance Theory: The Role of Evasion

• Often, collection assumed to be perfect

• Correlates of evasion:-punishment (cost)-tax rate (benefit)

• How important is this effect?

Theory: Rate-Evasion Relationship may be Counterintuitive

Model: Allingham & Sandmo (1972)Predicted Relationship: Depends on U’’’(w)

Model: Yitzhaki (1972)Predicted Relationship: Positive if punishmentis a function of evaded taxes

How much evasion is there? Measuring what we cannot observe

1. Discrepancy in Macro-variables-Difference between national income and product accounts-Ratio of currency to M2

2. U.S. Taxpayer Compliance Measurement Program (TCMP)

Measuring Evasion: Previous Work

Method Approach/

Examples

Problems

Inference from obs. quantities

1. M Demand

2. I – C

-based on dubious assumptions

-measures evasion level (not sensitivity)

U.S. TCMP Intensive Audit

-Rate-Evasion relationship not separable from income effect

Our Approach

Without Evasion (and measurement error):

Exports from Hong Kong to China

Imports from China to Hong Kong

In reality…

Noise

Evasion

HK-Reported Exports to China

China-reported Imports from HK

Does Tax Rate Affect Evasion?

HK-Reported Exportsi – China-Reported Importsi

= ‘Evasion Gap’i + Noisei

= i + *(Tax Rate)i + I

H0: > 0

Predictions: Types of Evasion

• Smuggling that bypasses Hong Kong: Not detected by analyses

• Under-reporting prices

• Under-reporting quantities

• ‘Mislabeling’ goods

Summary of PredictionsType of Evasion Predictions

Under-reporting per unit value

Tax rate positively correlated with evasion gap in values

Under-reporting quantities

Tax rate positively correlated with evasion gap in values and quantities

‘Mislabeling’ goods Tax rate of closely related goods negatively correlated with evasion gap in values and quantities

Plan of the Presentation

• Motivation & Basic Methodology

• Data

• Basic Results

• Economic Interpretation

• Robustness Checks and Extensions

• Conclusions

Trade Flow Data: WITS(World Integrated Trade Solutions)

• Derived from UN Comtrade

• 6-digit Harmonized Commodity Description and Coding System (HS)

• Available since 1996

• Data Utilized: 1998 (little year-to-year variation in tax rates) (and later also 1997)

• Both Value and Quantity data available

Industry-level data: Examples540210 High tenacity yarn of nylon or other polyamides540220 High tenacity yarn of polyesters540231 Textured yarn :-- Of nylon or other polyamides, measuring per single yarn not more than 50 tex540232 Textured yarn :-- Of nylon or other polyamides, measuring per single yarn more than 50 tex540233 Textured yarn :-- Of polyesters540239 Textured yarn :-- Other

291211 Acyclic aldehydes without other oxygen function :-- Methanal (formaldehyde)291212 Acyclic aldehydes without other oxygen function :-- Ethanal (acetaldehyde)291213 Acyclic aldehydes without other oxygen function :-- Butanal (butyraldehyde, normal isomer)291219 Acyclic aldehydes without other oxygen function :-- Other291221 Cyclic aldehydes without other oxygen function :-- Benzaldehyde291229 Cyclic aldehydes without other oxygen function :-- Other

010111 Horses :-- Pure-bred breeding animals010119 Horses :-- Other010120 Asses, mules and hinnies

Tax Rate on Product k

• = Tariff rate on Product k + VAT on k

• In 1998, across 8 digit categories

• Mean = 36, min=13 and max =135

• standard deviation = 10.34

Direct vs. Indirect Imports/Exports

• Entry point for many 3rd country exports

• Indirect exports reported separately

HK Reported Exports

• In theory, Chinese reported imports reflect country of origin

• Not always successfully separated (esp. Taiwan)

China Reported Imports

Key Fact: Tax Rates are Identical for Direct & Indirect Imports

Evasion Gap Defined

Gap_Value = log(Export_Value) - log(Import_Value)

Gap_Qty = log(Export_Qty) - log(Import_Qty)

*All Export Figures reflect Direct Exports only

Tax Rate Data: WITS

• Derived from UNCTAD TRAINS (Trade Analysis and Information System) Database

• Tariff and VAT rates at the 8-digit level• No within-variation for almost all 6-digit

industries: analysis restricted to this subsample• TAX = Tariff + VAT• Taxes on similar goods: Tax rate of all other

goods in 4-digit class

Variable Mean Std. Dev.

Gap_Value -0.62 2.43

Gap_Qty -1.06 2.56

Tax Rate (Tariff+VAT)

36.09 10.34

Direct Export Ratio

0.17 0.23

Summary Statistics

Specification

log(Exportk ) - log(Importk )

= α + β Taxk + εk

Import*k = Importk + Misclassified Indirect Importk

But observed imports (Import*) are imperfectly recorded:

Modeling Assumption:

Misclassified Indirect Importk = k k Importk

Recall: Tax Rates are Identical for Direct & Indirect Imports

Tax rate uncorrelated with Misclassified Imports

Import*k = Importk + Misclassified Indirect Importk

= (1+ k k ) Importk

log(Exportk ) - log(Import*k )= α* + β Taxk + ek

Hence:

Combining with previous equations, we estimate:

Evasion Gap

Summary of Predictions

Sign In Value Regression

Sign In Qty Regression

Tax Avg(Tax) Tax Avg(Tax)

Underreported Prices

+ 0 0 0

Underreported Quantities

+ 0 + 0

Relabeling + – + –

Typ

e of

Eva

sion

Tax Rates and Tax Evasion

• Motivation & Basic Methodology

• Data

• Specification

• Results and Interpretations

• Extensions

Table 2: Tax Rate and Evasion

Dep.var.=evasion (1) (7)

Tax rate 2.82 (0.78) 3.44 (1.02)

Excluding outliers no yes

Excluding obs.Lacking quantities

no yes

Excluding obs.Lacking similar products.

no yes

#obs./ adj. R2 2043 / 0.015 1165 / 0.025

Table 3: Aggregation by Tax Rates

Dep.var.=Evasion (1) (2)

Tax Rate 3.10 3.47

(0.99) (0.98)

Method of aggregation mean median

Weighted OLS yes yes

#obs./ adj. R2 44/0.26 44/0.34

Economic Interpretation of the Estimate

• Let M = reported imports; X= true imports.

• M = X - Evasion

• Evasion = constant + Tax rate + noise

• dlog(M)/d Tax = dlog(X)/dTax -

• | dlog(M) / d Tax | > 3

Economic Interpretation (continued)

• Any tax rate above 33.3% is on the wrong side of the Laffer curve: a reduction in rate can result in an increase, rather than decrease, in revenue collection.

• The avg. tax rate in China was 36% (in 1998).• So many rates were too high even from a revenue

point of view.

Effect of mis-labeling: increasing taxes on similar goods

reduces evasion

Gap_Valuek = α + β1*Taxk

+ β2*Avg(Tax_o) + υk

If mis-labeling exists: β2 < 0

Table 4: Evidence of Mis-labeling

Dep. Var.=Evasion (2) (7)

Own Tax rate 6.32 (1.77) 7.20(1.39)

Tax Rate on ‘Similar’Products

-3.57 (1.70) -4.09 (1.47)

Excluding outliers? no yes

Excluding productsW/o Quan. Info.?

no yes

#obs. / adj. R2 1760 / 0.016 1165 / 0.029

Table 5: Evidence on Quantities

Dep. Var.=Evasion in Quantity

(5) (6)

Own Tax rate 7.59 (2.08) 8.11(1.62)

Tax Rate on ‘Similar’Products

-7.40 (2.07) -8.13 (3.50)

Excluding outliers? no yes

Excluding productsW/o Quan. Info.?

yes yes

#obs. / adj. R2 1191 / 0.011 1145 / 0.017

Robustness Checks

1. Controlling for Exemptions

2. Exclude ‘indirect export dominated’ industries

Results: Qualitatively unchanged

Table 6: Controlling for Exemptions

Evasion in value Evasion in Quantity

Own Tax Rate 6.03 (1.84) 6.97 (2.06)

Tax Rate onSimilar Products

-3.04 (1.77) -6.57 (2.09)

Exemption Ratio -0.72 (0.26) -1.02 (0.32)

# obs. / adj. R2 1639 / 0.028 1104 / 0.026

Table 7: First Differences 1997-98

Change inevasion invalue

Change inevasion inquantity

Change in own tax 3.90 (1.92) 5.43 (2.77)

Change in tax on similarproducts

-1.89 (2.01) 3.12 (3.08)

#obs. / adj R2 1574 / 0.006 1045 / 0.004

Flexible Functional Form

Tax –1st quartile -0.97 (3.56) -0.10 (4.96)

Tax –2nd quartile 0.77(4.47) -5.26 (4.72)

Tax –3rd quartile 7.41(3.04) 10.50 (3.98)

Tax –4th quartile 1.59 (1.20) 5.51 (2.65)

Tax on “similar” -3.69 (1.79)

#obs / adj. R2 2043 / 0.017 1760 / 0.022

Conclusions

• Evasion is highly correlated with tax rate• ‘Above average’ tax rates cause most

evasion• Evasion correlated with tax rates is

primarily:- under-reporting the unit value

• - mis-reporting goods as lower-taxed types

Future Work

• Apply the same technique to a broader set of countries

• -How does tariff dispersion affect evasion?

• -Is this an objective measure of corruption?