Tax progressivity, income distribution and tax non-compliance


This article examines the determinants of tax non-compliance when we recognise the existence of an imperfectly competitive “tax advice” industry supplying schemes which help taxpayers reduce their tax liability. We apply a traditional industrial organisation framework to model the behaviour of this industry. This tells us that an important factor determining the equilibrium price and hence, the level of non-compliance, is the convexity of the demand schedule. We show that in this context, this convexity is affected by the distribution of pre-tax income, the progressivity of the tax-schedule and the way in which monitoring and penalties vary with income. It is shown that lower pre-tax income inequality as well as a less progressive tax code may cause more tax minimisation activities. Therefore, the frequently advocated policy of reducing the highest tax rate may fail as a policy directed at improving tax discipline. One way of offsetting the possible harm to tax compliance from a less progressive tax could be an adjustment of the penalty and monitoring functions.

Tatiana Damjanovic & David Ulph

Research Highlight 2010

This research project examines the determinants of tax non-compliance when there is a "tax advice" industry supplying schemes which help taxpayers reduce their tax liability. Our approach is to apply a traditional industrial organisation framework to model the behaviour of this industry. This suggests that the level of non-compliance is affected by the distribution of pretax income, the progressivity of the tax-schedule and the way in which monitoring and penalties vary with income. We show that lower pre-tax income inequality, as well as a less progressive tax code, may cause more tax minimisation activities. It follows that the frequently-advocated policy of reducing the highest tax rate may fail as a policy directed at improving tax discipline. One way of offsetting the possible harm to tax compliance from a less progressive tax could be an adjustment of the penalty and monitoring functions.

David Ulph