Measuring income under-reporting by the self employed.

As I have discussed before, there is significant interest in attempting to quantify the tax gap (the difference between the taxes that should be paid and those that are paid). Many countries produce such measures, including the US, the UK, and the EU. Canada, however, has not yet jumped on this bandwagon so we have no official measures of the tax gap.

In order to get a sense of the tax gap, we need to know how much income goes unreported to the tax authority. A method that has been developed to measure income under-reporting is called the expenditure-based method, first popularized by Pissarides and Weber. The basic principle of this Expenditure-based method is that true household income can be imputed from expenditures. This is not that extreme of an assumption. After all, the income that is not reported for tax purposes must be used for something. Saving it can create to much of a paper trail for the tax authorities, whereas spending it can be harder to trace.

The basic premise of the method is that actual income can be imputed by comparing expenditure levels of household that under-report their income to expenditure levels of households that do not under-report their income. Of course, this is controlling for households characteristics to ensure that you are comparing like households with like household.

So how do you know if a household is under-reporting their income? You don’t. Instead you have to come up with an identifiable characteristic that is associated with the incentive and opportunity to engage in income under-reporting. One group that has both the incentive and opportunity to engage in income under-reporting for tax purposes due to the lack of third party reporting is the self-employed. Since the self-employed are readily identifiable, they make an interesting group to study for these purposes.

In practice, the method is implemented by estimating reliable expenditure functions (i.e. Engel curves) for households without self-employment income that are then inverted to estimate true income for the self-employed. This is what is shown in the diagram below:

CaptureThat is, the given expenditure level E is associated with an income of Y* in a household without self-employment income. That same expenditure level though is only associated with an income of Y in a household with self-employment income. Therefore, the household with self-employment income is under-reporting its income by the amount given by (Y*-Y).

In my work, I have taken this method and modified it to relax many of the assumptions and make the method more flexible. I applied it to Canadian data and found that

  • reported self-employment income is a poor measure of total household income
  • the gap between true and reported self-employment income is larger for households at the lower end of the reported self-employment income distribution.
  • the GST increased tax noncompliance by those with larger amounts of self-employment income and unaffected tax noncompliance by those with small amount of self-employment income.
  • Total amount of Income Under-Reporting (in real terms) by the self-employed more than doubled after the implementation of the GST
  • The average income under-reporting by self-employed households in Canada is about $14,000.

Of course, what this amounts to in terms of the tax gap depends on the households marginal tax rate. Using only federal statutory tax rates, it equates to between $2100 and $4060 in unpaid taxes. While on a per household basis, this does not seem like a lot, assuming 2.6 million self-employed households and the lowest federal statutory tax rates it amounts to $5.5 billion in unpaid taxes or about 5% of federal personal income tax revenues. Imagine the difference this money could make in terms of education, health, or other publicly provided services.



2 thoughts on “Measuring income under-reporting by the self employed.

  1. You wrote: “Imagine the difference this money could make in terms of education, health, or other publicly provided services.”.

    I think: “Imagine the difference it could make if the federal government (in particular) did not waste money on non-public-beneficial expenditures in the way and at the profligate rate that it does.”.

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