Tax Rates and Tax Evasion: Evidence from “Missing Imports” in China Raymond Fisman Columbia University Shang-Jin Wei IMF 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 punishment is 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 MethodApproach/ Examples Problems Inference from obs. quantities 1.M Demand 2.I – C -based on dubious assumptions -measures evasion level (not sensitivity) U.S. TCMPIntensive 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 Exports i – China-Reported Imports i = ‘Evasion Gap’ i + Noise i =  i +  *(Tax Rate) i +  I H 0 :  > 0

Predictions: Types of Evasion Smuggling that bypasses Hong Kong: Not detected by analyses Under-reporting prices Under-reporting quantities ‘Mislabeling’ goods

Summary of Predictions Type of EvasionPredictions 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’ goodsTax 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: Examples

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 3 rd 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

VariableMeanStd. Dev. Gap_Value Gap_Qty Tax Rate (Tariff+VAT) Direct Export Ratio Summary Statistics

Specification log(Export k ) - log(Import k ) = α + β Tax k + ε k Import* k = Import k + Misclassified Indirect Import k But observed imports (Import*) are imperfectly recorded:

Modeling Assumption: Misclassified Indirect Import k = k  k Import k Recall: Tax Rates are Identical for Direct & Indirect Imports Tax rate uncorrelated with Misclassified Imports

Import* k = Import k + Misclassified Indirect Import k = (1+ k  k ) Import k log(Export k ) - log(Import* k )= α* + β Tax k + e k Hence: Combining with previous equations, we estimate: Evasion Gap

Summary of Predictions Sign In Value Regression Sign In Qty Regression TaxAvg(Tax)TaxAvg(Tax) Underreported Prices +000 Underreported Quantities +0+0 Relabeling +–+– Type of Evasion

Tax Rates and Tax Evasion Motivation & Basic Methodology Data Specification Results and Interpretations Extensions

Table 2: Tax Rate and Evasion

Table 3: Aggregation by Tax Rates

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_Value k = α + β 1 *Tax k + β 2 *Avg(Tax_o) + υ k If mis-labeling exists: β 2 < 0

Table 4: Evidence of Mis-labeling

Table 5: Evidence on Quantities

Robustness Checks 1.Controlling for Exemptions 2.Exclude ‘indirect export dominated’ industries Results: Qualitatively unchanged

Table 6: Controlling for Exemptions

Table 7: First Differences

Flexible Functional Form

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?