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    Journal of Public Economics 66 (1997) 173197

    Tax evasion in an open economy:Value-added vs. income taxation

    a b ,*Roger H. Gordon , Soren Bo Nielsena

    Department of Economics, University of Michigan, Ann Arbor, MI 48109-1220, USAbEconomic Policy Research Unit, Copenhagen Business School, Nansensgade 19,5, DK-1366

    Copenhagen K, Denmark

    Received 1 January 1996; received in revised form 1 October 1996; accepted 22 October 1996

    Abstract

    Ignoring tax evasion possibilities, a value-added and a cash-flow income tax have similar

    behavioral and distributional consequences. Yet the available means of tax evasion under

    each can be very different. Under a VAT, avoidance occurs through cross-border shopping,whereas under an income tax it can occur through shifting taxable income abroad. Given

    evasion, we show that a country would make use of both taxes in order to minimize the

    efficiency costs of evasion activity, relying relatively more on whichever tax is harder to

    evade. We then make use of aggregate Danish tax and accounting data from 1992 to

    measure the amount of evasion that occurred under the two taxes. While the estimates of

    evasion activity are small, the figures imply that Denmark could reduce the real costs of

    evasion activity by relying more on value-added taxes. 1997 Elsevier Science S.A.

    Keywords: Tax evasion; Value-added tax; Income tax

    JEL classification: H21; H26; F23

    1. Introduction

    Given the increasing economic interdependence among developed countries, tax

    competition between countries is a growing concern. Multinationals can quickly

    shift substantial amounts of taxable income out of countries with high corporate

    *Corresponding author. E-mail: sbn/eco@cbs.dk

    0047-2727/97/$17.00 1997 Elsevier Science S.A. All rights reserved.

    P I I S 0 0 4 7 - 2 7 2 7 ( 9 7 ) 0 0 0 4 4 - 3

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    174 R.H. Gordon, S.B. Nielsen / Journal of Public Economics 66 (1997) 173197

    tax rates into countries with low rates, while individuals can readily escape

    domestic taxation of their income from financial assets through shifting their

    savings abroad into countries providing them anonymity and low tax rates.

    Given these pressures from transfer pricing and capital flight, countries have anincentive to lower their income tax rates relative to those in competing countries

    so that taxable income is shifted into rather than out of their jurisdiction. The extra

    tax base they attract by lowering their tax rates, however, will in large part result

    from a relocation of reported earnings, causing a drop in the tax base abroad and

    thereby generating a fiscal externality and inducing destructive tax competition

    among countries. The lower effective tax rate on foreign-source activity also

    creates costly distortions to the financial structure of firms and the portfolio choice

    of individuals. What options do countries face to lessen the efficiency costs

    generated by tax evasion in an open economy?

    In theory there do exist tax systems that are free of these locational distortions

    and fiscal externalities. As noted for example by Razin and Sadka (1991a) or1

    Mintz and Tulkens (1996), if individuals are immobile across countries then

    residence-based income taxes in a small open economy do not impose externalities

    on other countries that use the same type of tax, and the Nash equilibrium2

    residence-based tax rates cannot be improved on through tax coordination.

    However, in practice, such pure residence-based taxes have not been feasible. The

    basic problem is the difficulty of monitoring earnings and expenditures of

    domestic residents that occur abroad. While a government has the power to collect

    information from domestic firms and domestic financial intermediaries in order toenforce taxes on the earnings and expenditures of domestic residents, it has no

    ability to collect comparable information from foreign sources. Even if a country

    by statute has a residence-based tax, foreign-source earnings and expenditures will3

    as a result frequently escape tax, resulting in a very different tax structure in

    practice.

    Taxes on the return to capital income are particularly vulnerable to avoidance

    and evasion, given financial arbitrage, transfer pricing, and capital flight. Razin

    and Sadka (1991b), for example, forecast that these combined threats will lower

    effective capital income tax rates to zero in equilibrium. In fact, Gordon and

    Slemrod (1988) find that the U.S. loses tax revenue on net from its attempt to tax4the return to capital. But if capital income taxes both lose revenue and generate

    1When individuals are mobile, only benefit taxes are not vulnerable to tax competition, as argued by

    Buchanan and Goetz (1972).2When countries are large enough to affect the international rate of interest, further complications

    arise. See, e.g., Huizinga and Nielsen (1996).3Hines and Hubbard (1990), for example, document that U.S. multinationals pay little or no U.S.

    taxes on their foreign-source earnings.4Sorensen (1988) reports similar findings for Denmark. The loss of revenue results only in part from

    income shifting across borders domestic portfolio arbitrage also generates substantial revenue losses,

    as high income investors borrow heavily from tax exempt entities to invest in lightly taxed assets,

    generating tax losses in the process.

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    R.H. Gordon, S.B. Nielsen / Journal of Public Economics 66 (1997) 173197 175

    particularly large efficiency losses, then they have lost their role as an effective tax

    instrument. In this paper, we instead examine the degree to which taxes on income

    from labor are also vulnerable to evasion in an open economy.

    What opportunities for tax evasion remain if new real investments by domesticfirms can be expensed and the returns to financial assets and liabilities are made

    tax exempt, thereby eliminating any distortions to capital investments? The cash

    flow of foreign subsidiaries of Danish multinationals should in theory be subject to

    the same cash-flow tax, but monitoring their cash-flow remains very difficult.

    Given these difficulties, Denmark has instead in many bilateral treaties exempted

    the earnings of the foreign subsidiaries of Danish firms from domestic taxation.

    This approach is equivalent to a cash-flow tax treatment in present value only if

    the income of foreign subsidiaries simply reflects a normal return to funds invested

    abroad. The results in Gordon and Slemrod (1988), however, suggest that reported

    corporate income is far too high to represent the normal return to past real capital

    investments. The most plausible explanation for the observed excess profits is5

    that they represent the return to entrepreneurial effort and imagination. Exempting

    the income of foreign subsidiaries from tax therefore exempts the return earned

    abroad on the ideas and efforts of domestic entrepreneurs. Through use of transfer6

    pricing, they can avoid tax as well on domestic-source earnings.

    Given the difficulties governments face in taxing foreign-source earnings, tax

    evasion is an inherent part of an income tax system in an open economy, even if

    capital income is exempt from tax. One alternative approach to taxing labor

    income, however, is to tax the income when it is spent rather than when it isearned, as occurs with a value-added tax. Ignoring evasion, a cash-flow tax has the7

    same economic incidence and efficiency cost as a value-added tax. Once evasion

    is taken into account, however, the incidence and efficiency consequences of the

    two taxes can be very different. A governments inability to monitor transfer

    pricing used by multinationals has no effect on the value-added tax base, since the

    only price that matters for the value-added tax is the price paid by the final

    consumer. Similarly the inability to monitor foreign-source earnings is of no

    consequence for a VAT as long as the government can monitor consumption

    5Apparently, entrepreneurs, in part for tax reasons, choose to leave much of their earnings within thefirm rather than paying it out as wages and salaries, thereby paying tax primarily at corporate rather

    than personal tax rates on this income. See Gordon and MacKie-Mason (forthcoming) and Leamer

    (1996) for further discussion.6While the income earned abroad, or shifted abroad through transfer pricing, could be subject to

    corporate taxes in the host country, multinationals seem to be quite effective at shifting their taxable

    earnings to tax havens where they escape taxation entirely. See, e.g. Hines and Rice (1990) for

    evidence for U.S. multinationals.7A cash-flow tax is equivalent to an origin-based value-added tax, while a European-style value-

    added tax is destination-based. While the timing of tax payments differs under origin-based and

    destination-based VATs, at constant and identical rates the present value of the revenue they collect

    differs only to the extent that the present values of imports and exports differ. This difference simply

    equals the initial foreign asset position of the country, which for Denmark in 1992 equaled 35% of

    GDP.

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    176 R.H. Gordon, S.B. Nielsen / Journal of Public Economics 66 (1997) 173197

    expenditures. Monitoring consumption expenditures, however, generates its own

    and very different e