Tax evasion and competition

Date01 November 2011
AuthorMarco Runkel,Laszlo Goerke
DOIhttp://doi.org/10.1111/j.1467-9485.2011.00565.x
Published date01 November 2011
TAX EVASION AND COMPETITION
Laszlo Goerke*
,
**
,
*** and Marco Runkel***
,
****
ABSTRACT
Using a Cournot oligopoly model with an endogenous number of firms and eva-
sion of indirect taxes, we show that more intense competition may have the neg-
ative side effect of increasing tax evasion, thereby, lowering public revenues and
welfare. This will be the case if market entry costs decrease. A similar result will
hold if marginal production costs fall and demand is either weakly concave, or
convex and inelastic. The result of more competition, less evasion and higher
public revenues will be obtained if (a) marginal production costs fall and
demand is convex and elastic or (b) the demand elasticity increases. As a policy
implication, we prove that tax enforcement should be intensified if there is a neg-
ative trade-off between competition and evasion.
II
NTRODUCTION
Competition policy is an important component of economic policy. The Euro-
pean Commission, for example, runs a branch concerned with antitrust and
liberalization, and every member state of the European Union has its own
national competition authority. Such institutions usually aim at reducing mar-
ket power and intensifying the degree of competition. For instance, the Euro-
pean Commission states that
[c]ompetition is a basic mechanism of the market economy and
encourages companies to provide consumers products that con-
sumers want. It encourages innovation, and pushes down
prices. In order to be effective, competition needs suppliers who
are independent of each other, each subject to the competitive
pressure exerted by the others.
1
Opening markets and thereby intensifying competition was also one of the
goals of introducing a common market in Europe. Similarly, in the United
States, the ‘Federal Trade Commission’s Bureau of Competition champions
*School of Business and Economics, Eberhard Karls Universita
¨tTu
¨bingen
**IZA (Bonn)
***CESifo (Munich)
****School of Economics and Management, Berlin University of Technology, Berlin
1
See http://ec.europa.eu/competition/antitrust/overview_en.html; accessed January 12, 2011.
Scottish Journal of Political Economy, Vol. 58,No. 5, November 2011
©2011 The Authors. Scottish Journal of Political Economy ©2011 Scottish Economic Society. Published by Blackwell
Publishing Ltd, 9600 Garsington Road, Oxford, OX4 2DQ, UK and 350 Main St, Malden, MA, 02148,U SA
711
the rights of American consumers by promoting and protecting free and vig-
orous competition’.
2
The key point of this paper is that competition policies
may have negative side effects that undermine the positive impact of increas-
ing competition. In our paper, these by-products are triggered by tax evasion.
We show that reducing market power may induce firms to intensify tax eva-
sion activities, thus eroding public revenues and possibly contributing to a
decline in social welfare. In such cases, competition policy should be accompa-
nied by a greater effort to fight tax evasion.
To develop these insights, we focus on the evasion of sales taxes.
3
Such
taxes have become increasingly important. For example, in countries belong-
ing to the Organization for Economic Cooperation and Development
(OECD), revenues from taxes on general consumption as a percentage of total
tax revenues increased from 13.6% in 1965 to 18.9% in 2006, with the over-
whelming fraction resulting from the VAT (OECD, 2008). In the United
States, general sales taxes accounted for about 31% of state government tax
collections in 2008.
4
Moreover, it is by now well established that a substantial
part of potential revenues is lost through tax evasion (Keen and Smith, 2006).
In a recent study published by the European Commission (2009), the gap
between the theoretical VAT liability and actual receipts in 2006 was
estimated at about 13% of VAT revenues. The Commission believes that a
considerable portion of this gap is due to tax evasion. Furthermore, for the
United Kingdom, the Institute for Fiscal Studies (2007) calculated that VAT
revenue losses resulting from evasion activities amounted to 17% of actual
receipts in the fiscal year 20052006. Therefore, the evasion of sales taxes and
of the VAT, in particular, has a substantial impact on tax revenues and
market outcomes, even in highly industrialized countries.
On the basis of this evidence, we develop a Cournot oligopoly model with
evasion of sales taxes. In our model, market entry is endogenous. The num-
ber of firms is determined by a zero-profit condition, stating that expected
net profits equal market entry costs. Those firms entering the market produce
a homogeneous good at constant marginal costs. Firms have to pay an ad
valorem sales tax, but may evade part of their tax duty. The degree of tax
evasion is measured either by the absolute amount of tax evaded successfully
or the tax evasion ratio, that is, the amount of tax evaded relative to tax
revenues in the absence of evasion. If a firm is detected evading taxes, it will
have to pay a fine. Public revenues comprise tax revenues (net of evaded
taxes) and fine payments. We measure the degree of market power by the
Lerner index, which reflects the price-cost mark-up, that is, the difference
between a firm’s (after-tax) output price and marginal production costs,
expressed as a percentage of the (after-tax) output price (see, e.g. Martin,
2001).
2
See http://www.ftc.gov/bc/index.shtml; accessed January 12, 2011.
3
Our basic results intuitively apply to other kinds of corporate taxes as well.
4
See http://www.census.gov/govs/statetax/0800usstax.html; accessed January 12, 2011.
712 LASZLO GOERKE AND MARCO RUNKEL
Scottish Journal of Political Economy
©2011 The Authors. Scottish Journal of Political Economy ©2011 Scottish Economic Society

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