Tax Gaps and Tax Rates: New Evidence from the Taxpayer Compliance Measurement Program

The reductions in the top marginal rates during the 1980's have renewed interest in the relationship between the underreporting of income and the marginal tax rates. Unfortunately, theory provides no clear answer to question of whether lower marginal tax rates reduce or increase the size of the underground economy as the substitution effect encourages evasion while the income effect discourages it. We explicitly recognize that income has both a direct effect on the size of under-reporting and an indirect effect through a change in the marginal tax rate. We present a method that separates the scale impact of income on under-reporting from the indirect effect income plays in the taxpayer response to changes in the marginal tax rate. We find a positive relationship between marginal tax rates and tax evasion.