The Underground Economy in the U.S.A: Preliminary New Evidence on the Impact of Income Tax Rates (and Other Factors)on Aggregate Tax Evasion, 1975-2008

This empirical study seeks to identify determinants of the underground economy in the U.S. in the form of aggregate federal personal income tax evasion over the period 1975-2008, with a specific focus upon the net impact of higher federal income tax rates on personal income tax evasion. In this study, we use the most recent data available on aggregate personal income tax evasion, data that are derived from the General Currency Ratio Model and measured in the form of the ratio of unreported AGI to reported AGI. Most other studies of federal income tax evasion for the U.S. do not use data this current. It is found that the impact of increases in the federal income tax rate on aggregate personal income tax evasion may, on balance, be ambiguous, possibly suggesting that the income effect is negative and outweighs the positive substitution effect for the representative taxpayer. It is also found that the degree of aggregate federal personal income tax evasion may be an increasing function of the percentage of federal personal income tax returns characterized by itemized deductions and a decreasing function of the Tax Reform Act of 1986 (during the first two years of implementation), the ratio of the tax free interest rate yield on high grade municipals to the interest rate yield on ten year Treasury notes, and higher audit rates of filed federal income tax returns (as a measure of risk from tax evasion) by IRS personnel. Finally, unpopular wars may provide a secondary benefit for and therefore act as an inducement for greater tax evasion.