The effect of policies, specifically tax policies, on evasion is a subject of considerable policy interest and has been studied extensively. An early theoretical treatment is due to Allingham and Sandmo (1972), who show that the sign of the elasticity of tax evasion with respect to tax rates is ambiguous, depending on taxpayers’ risk aversion and the punishment for evasion: increases in tax rates make evasion more attractive (substitution effect) but also reduce taxpayers’ wealth (income effect). Empirical results have also varied considerably because of the difficulty of disentangling substitution and income effects and the difficulty of measuring evasion. One setting in which it is possible to observe and measure evasion of taxes is in the case of customs duties. Bhagwati (1964) in an early innovative contribution suggests that the discrepancies between a country’s reported imports and the corresponding exports reported by its trading partners may be explained by undervaluing or misclassifying imports at the border in order to reduce the tariff burden. A noteworthy recent empirical study by Fisman and Wei (2004) measures evasion of import taxes by these reporting discrepancies to examine the impact of tariff rates on duty evasion in the context of imports from Hong Kong to China.
Relatively less attention, however, has been paid in the empirical literature to the effect of, what might be called enforcement on evasion and especially on the elasticity of evasion with respect to tax rates. This is not surprising because it is much more difficult to quantify and isolate the enforcement effect. An outcome such as evasion or corruption can be thought of as resulting from the interaction of demand and supply factors. The demand for evasion is linked to tax policies: higher the tax rate, larger is the benefit that economic agents can derive from evasion and hence greater the demand for it. But agents’ willingness to engage in evasion also depends on how likely it is that evasion will be detected and/or the ease with which customs officials can be bribed. These latter, can be thought of as the supply or enforcement side, which too have a bearing on evasion. Besides the level effect that the enforcement regime can have on evasion, Slemrod (1994) and Slemrod and Kopczuk (2002) point to a conceptually separate impact that enforcement improvements may have on the slope of evasion. They argue that the enforcement regime can shape the behavioral response of agents to changes in tax rates and thus may be an important policy tool. But isolating the enforcement effect and measuring its contribution to evasion and the elasticity of evasion with respect to taxes is a challenge as we will discuss below.
This paper is a modest attempt at taking on this challenge. The opportunity to do so is afforded by the Indian tariff reform of the 1990s. In August 1991, in the aftermath of a balance-of-payments crisis, India launched a dramatic unilateral trade liberalization as part of an IMF adjustment program. As Panels A and B in Figure 1 show, there was a decline in the level and the variation of tariffs beginning in the late 1980s, a process that was accelerated after the macroeconomic crisis of 1991 (see Topalova, 2004 for details). Average tariffs declined from nearly 100 percent in 1987 to 80 percent in 1991 followed by a further decline to about 25 percent at the turn of the century. Similarly, the standard deviation of tariffs declined from 50 percent to 40 percent and to about 10 percent over the same period. This rich variation in tariffs over time and across product groups offers a crucible for evaluating the impact of tax rates on evasion.
That these changes may have had a role to play in evasion, is graphically illustrated in Figure 2, which shows that despite the surge in India’s imports after the trade reform, seizures made by Indian Customs declined dramatically from nearly 70,000 cases in 1990 to about 45,000 in 2004 (Figure 2a). Relatedly, so did the magnitude of evasion (Figures 2b, 2c, 2d and 2e). For example, in Figure 2c, evasion hovers around 120 percent for the late 1980s and early 1990s, but starts declining consistently, reaching about 85 percent in 2002-2003. Thus, there seems to be a declining trend in both tariffs and evasion. Whether the developments in Figures 1 and 2 can be formally shown to be related and how forms the core of the paper.
This paper makes two contributions. First, it builds on the existing literature in testing the impact of tariff policies on evasion and, arguably, refining the estimated effects. Fisman and Wei (2004) quantify this effect for trade between China and Hong Kong by examining whether variation in tariffs across 1600 imported goods at 6-digit level was systematically correlated with the evasion across these products. Their main finding is that there is such a correlation, with a one percentage point increase in the tax (sum of the tariff and VAT on imports) rate associated with a two-three percent increase in evasion.
In this paper, we exploit two sources of variation to identify the effect of tariffs on evasion: variation across products (as in Fisman and Wei, 2004) but also across time. Using both sources of variation confers some important advantages over a strategy that exploits across-product variation alone. If tariffs are systematically correlated with some other aspect of the product (say ease of enforcement) that also affects evasion, then the latter approach would conflate both these effects. Because we exploit variation over time, we are able to control for such product-specific or other characteristics, and hence isolate better the impact of tariffs on evasion. Indeed, our identification will rely on exploiting the variation in tariffs within 6-digit products over time and is hence a very demanding and general specification.
