The dynamic effects of fiscal reforms and tax competition on tax compliance and migration

• Published date: 01 August 2018
• Date: 01 August 2018
• Author: Fabio Lamantia,Mario Pezzino
• DOI: http://doi.org/10.1111/roie.12318

SPECIAL ISSUE PAPER

The dynamic effects of fiscal reforms and tax

competition on tax compliance and migration

Fabio Lamantia

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Mario Pezzino

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University of Calabria, Rende, Italyand

University of Manchester, Manchester,

UK

2

School of Social Sciences, University of

Manchester, Manchester, UK

Correspondence

Fabio Lamantia, Department of

Economics, Statistics and Finance

(DESF), University of Calabria,

Via P. Bucci 1/C, Rende (CS), Italy.

Email: fabio.lamantia@unical.it

Funding Information

E.U. COST Action IS1104 “The EU in

the new economic complex geography:

models, tools and policy evaluation”

Abstract

We study the dynamic effects of fiscal reforms on migration

and tax evasion in an international context with two asym-

metric countries. Given an initial international distribution of

honest and dishonest taxpayers, the tax system (e.g., tax

rates and degrees of progressivity) and the salary in each

country, individuals decide where to reside and how much

time to spend working. The model allows us to study in a

dynamic setting how the distribution of honest and dishonest

earners is geographically affected by fiscal reforms (e.g.,

variations in tax rates) and auditing efforts (e.g., probability

of auditing and fines) of different countries. We show that

various dynamic long term scenarios can be generated. The

particular convergence of the model depends crucially on

the initial geographic distribution of dishonest agents. This

implies that tax reforms that have been successful in reduc-

ing tax evasion in one country may produce very different

results in others, if initial conditions are significantly differ-

ent. Chaotic cyclical behavior may also arise if individual

propensity to migrate is sufficiently high.

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INTRODUCTION

All around the world the wealth of economic agents is taxed by local and central governments to

finance expenditure in services to the population. Fiscal policy makers, in general, have to face the fact

that taxes may influence individuals’economic behavior and, in many situations, they are a very

important factor affecting the financial decisions of households and firms.

A particularly important issue connected to taxation is the possibility that some individuals may

decide to report smaller earning or not pay taxes at all; in other words, they may decide to engage in

forms of tax evasion. Tax evasion is a common and widespread problem that fiscal policy makers face

around the world. The traditional view in the economic literature originates from the economics of

crime (Becker, 1968) and is based on the idea that no individual, if allowed, would want to pay taxes.

Indeed tax evasion has often been described as a gamble.

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C2017 JohnWiley & Sons Ltd wileyonlinelibrary.com/journal/roie Rev IntEcon. 2018;2 6:672–690.

DOI: 10.1111/roie.12318

The economic literature has also started considering the fact that some individuals in the society

may be inherently honest and, to some extent, may also obtain a positive utility from paying taxes.

Because of the existence of some form of intrinsic motivation among taxpayers,

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some individuals

may believe that paying taxes is a citizenship duty and a way to contribute to society’s welfare. Of

course, individuals’tax morale, that is, their propensity to be intrinsically motivated toward honestly

paying taxes, may be significantly affected by the way they see the actions of their governments.

Indeed, in those countries in which governments are considered particularly corrupted or inefficient,

the intrinsic motivation of individuals to pay taxes may be very low.

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Importantly, the inclination of taxpayers to honestly report their earnings may also be affected by

various aspects of a tax system. For instance, a tax system that includes strict auditing and harsh fines

may be seen as greedy and oppressive by the average taxpayer.

In an international context, fiscal policy makers have to consider the possibility that economic

agents may rationally decide to reside in countries in which the tax system has features that match their

preferences. Indeed, the economic literature has shown significant interest in understanding the rela-

tionship between tax competition and migration. Such a relationship is a two-way one. On one hand,

differences in national tax systems may induce migration of economic agents; on the other, changes in

other factors that affect migration (such as costs of migration or skill differentials) may influence, in

turn, the way optimal taxes should be defined. The relationship between tax competition and migration

has been studied in various papers—Mirrlees (1971) and (1982), Borjas (1999), Razin, Sadka, and

Swagel (2002), Bucovetsky (2003), Simula and Trannoy (2010)—looking for forms of optimal taxa-

tion when economic agents are allowed to migrate. Our paper contributes to the literature studying

another important and, to our knowledge, scarcely explored relationship: the evolutionary connection

between tax/auditing systems, tax evasion and migration. In other words, we study in a dynamic setting

the way different taxation and auditing systems may affect the migration decisions of individuals who

intend to commit tax evasion. Specifically, we consider a two-country framework and assume that

each country employs a different tax system (i.e., different rates and different degrees of progressiv-

ity).

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In addition, we assume that economic agents can decide how much effort to invest in economic

activities and whether to migrate to a country with a more favorable tax system. An evolutionary

model, in which the fraction of dishonest payers residing in each country is endogenized and updated

according to expected utilities, provides the dynamics that we are going to discuss.

We show that various dynamic long term scenarios can be generated, including equilibria in which

all dishonest individuals converge to one of the countries as well as equilibria where dishonest individu-

als are distributed in both countries. In addition, the stability of the equilibria may be affected by over-

shooting; in particular, instability (chaotic cyclical behavior) may arise if individuals’propensity to

migrate is sufficiently high. The particular convergence of the evolutionary process often depends cru-

cially on the initial geographic distribution of dishonest agents. This provides an important caveat to fis-

cal policymakers who may be considering to adopt fiscal reforms that have been successful in other

countries. The model shows that tax reforms that have been successful in reducing tax evasion in one

country may produce very different results in another, if initial levels of tax evasion are significantly dif-

ferent. Finally, we show that the particular evolutionary trajectory of tax evasion and migration that a

country can experience critically depends on the level of progressivity of a tax system. In particular, we

show that the progressivity of tax regime influence s individuals’choices in terms of effort and migration

and this, in turn, has consequences on the ability of a country to generate tax revenues. Our analysis

shows that a tendency to a flat rate system m ay have positive effects on the tax revenues of a coun try.

The remainder of the paper is organized as follows. Section 2 describes the basic model. Section 3

introduces the evolutionary dynamics. Section 4 discusses the results and provides examples. Section 5

concludes.

LAMANTIA AND PEZZINO

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