Fiscal and Regulatory Enforcement

Topic 10

An Example: Tax CollectionThe basic problem :

Individuals know how much tax they owe.The Inland revenue does not = Asymmetric Information.

The Policy Questions:

• Should the Inland Revenue audit every tax return?• If not how much effort should be put into

enforcement?• What is the right mix of monitoring and penalties?• How do these policies affect the amount of tax

evasion?

Outline 1. A model of polluter behaviour with random

enforcement.

2. The consequences for policy• Balance between audit frequency and

penalties.• Effects on pollution abatement.

3. Enforcement and administration costs.

4. Enforcement and information gathering.

1. A Model of Polluter BehaviourWe will consider a polluter/criminal/tax evader to

make rational decisions in the light of the costs and benefits of the actions they can take.

e.g. Becker and crime.

1. A Model of Polluter BehaviourSome Modelling Issues:

Is violation (a) a discrete choice? You either: pollute or comply.(b) a continuous choice? Levels of violation can chosen.

This is a technological and a modelling issue.

Are Polluters:(a)Risk neutral? I.e. large entities like firms who do

not care too much about risk.(b)Risk averse? Individuals facing large punishment

costs if detected violating.

A Discrete Choice: Comply or Pollute

If you comply:• there is no risk of a penalty = certainty.• but there is also no gain.

If you pollute• You save on abatement costs.• Generate external damage.• Risk detection (may not be immediate).• If detected there is a penalty.

The Optimal Decision

Let

A = Abatement Costs.p = Probability of detection.F = Penalty/Fine if detected.

A risk neutral polluter would pollute iff A > pF.

A risk averse polluter would require A+c > pF(where c>0 is its risk premium.)

Notice there is a trade off

To deter pollution needA< pF

Need(1) Low abatement costs (i.e. not onerous to comply).Or(2) pF large. Either: (a) very large fines with small

probability of detection or, (b) high probability of detection with smaller fines.

For risk neutral polluters both (a) and (b) equivalent.For a risk averse polluter (a) is much worse than (b).For a risk loving (criminal) (b) is worse than (a).

Continuous Choice: How much pollution?

The quantity of pollution emitted depends on:(1)The threshold that determines whether a

violation has been committed or not.(2)How the probability of detection varies with the

amount of pollution.(3)How the size of the fine varies with the amount

of pollution.(4)How pollution affects costs and benefits.

Continuous Choice: How much pollution?

e = amount of emissions.e*=threshold of violation.

Optimal level of emissions maximizes:

(e) -A(e) - p(e-e*)F(e-e*)

Let us consider the case where p does not depend on e, because a random audit will always detect it.

e*=0 and F(e) = F x e the fine is proportional to the size of the violation (i.e. the fine is the price of a violation).

Then:

Risk Neutral Polluter

Emissions

Marginal Abatement Costs = Slope of (e)-A(e)=MAC

Risk Neutral Polluter

Emissions

pFMarginal cost of enforcement=pF

Risk Neutral Polluter: Optimal Choice

Emissions

Marginal Abatement Costs = Slope of (e)-A(e)

pFMarginal cost of enforcement

A Regulatory Standard that has an effect

Emissions

MAC

pFMarginal cost of enforcement

Regulatory Standard

A Regulatory Standard that has no effect

Emissions

MAC

pFMarginal cost of enforcement

Regulatory Standard

Some CommentsEnforcement operates exactly like a Pigouvian Tax (as in

the Stern Report) when firms are risk neutral.

The higher the MAC the higher the amount of emissions.

If firms have very different MAC’s, it will result in very different compliance levels.

If firms are risk neutral this can result in an efficient amount of emissions provided pF is chosen correctly.

The regulatory standard means that firms below it have no incentive to make further reductions in emissions.

Audit frequency and Fine Size

From the perspective of the firm pF is the only thing that matters. But,

- increasing p (likelihood of audit) can be very expensive for the government.

- Increasing F is free!

Cheapest effective policy is: p -> 0 and F-> ∞(Shoot any violator.)

Audit frequency and Fine Size

Cheapest effective policy is: p -> 0 and F-> ∞(Shoot any violator.)

But:(1) Bankruptcy makes imposing such penalties practically impossible.(2) Does not have a good marginal effect, if you are going to be shot may as well be shot for a big gain not a small one.(3) This is very costly to those who are risk averse. A small chance of being killed is very welfare reducing!(4) Courts may not implement the policy.

Why do firms comply?

Actually the expected penalties for non-compliance with pollution control are very low, still many firms comply.

Voluntary Compliance=> Firms are not maximizing profits.=> Firms may lose relative to their

competitors.

Why do firms comply?1) Market Penalties: Most of the penalty is in terms

of lost ‘reputation’. (Estimated at 86% of costs of detection by Badrinath & Bolster Journal or Regulation Economics 1996).

2) Misjudgement: firms don’t understand the risks or the size of the penalties.

3) Type 1 errors: Polluters over comply to avoid the risks of being wrongly identified as violators.

4) Penalty Leverage: There are long run costs from violation: higher future audit frequency, heightened regulatory attention.

5) Bargaining: This is a concession granted in exchange for policy maker approval of other projects.

Different Kinds of Audit Errors

Firm BehaviourCompliant Non-Compliant

Compliant OK Type 2 ErrorAudit Outcome

Non-compliant Type 1 OKError

Why these matter

These errors tend to occur if either: the regulator has poor information or monitoring ability.the firm as poor control over its processes.

Type 2 Errors:These tend to reduce the incentives to abate emissions as they reduce the probability that the polluter is detected.

Type 1 Errors:These tend to increase incentives to abate.

Enforcement Costs and Pollution Abatement

If the costs of enforcing a given level of abatement are taken into account how does this affect the choice of abatement level?

MAC = Marginal Abatement Costs

MDC = Marginal Deterrent Costs

Without Enforcement Costs

Marginal Abatement Costs =MAC

Marginal Deterrent Cost

Amount of Pollution

Enforcement Costs

We expect these to decrease as higher levels of pollution (or lower levels of abatement) are tolerated.

Marginal enforcement cost = additional enforcement cost of one more total unit of abatement.

This increases as pollution reduces.

Enforcement Costs

Marginal Abatement Costs =MAC

Marginal Deterrent Cost

Amount of Pollution

Marginal Enforcement Cost

Without Enforcement Costs

MAC + MEC

Marginal Deterrent Cost

Amount of Pollution

Marginal Enforcement Cost

Self ReportingSelf reporting has benefits:

- May eliminate asymmetric information problem.- Gives policy makers more leverage in imposing penalties (i.e. more severe penalties may be possible if report lies).- Can give individuals incentives to report truthfully.- Societal benefits – better info about the scale of problems and how to remedy spills etc.

Self ReportingSelf reporting Has Problems

- Incentives for truthful reporting will be costly in terms of lost efficiency.- Everyone has to report => reporting burden on individuals.- Investment in avoidance behaviour.- Devising a good measure to report difficult.

Heyes “Cutting Pollution Penalties to protect the environment” JPubEcon 1996

Here we consider a world where pollution is persistent but can be cleaned up if it is detected.

Polluters have imperfect control over the amount of pollution they produce.

Sometimes they pollute by accident.

Firms must choose: (1) How little to polluteAnd (2) Whether to admit a spill.

Heyes 1996

Penalties do 2 things

(1)Makes a high planned level of pollution costly.(2)Make polluters reluctant to admit a spill when it

occurs by mistake.

Policy is a compromise. Penalty is too high – don’t want to admit accidents

when they happen but do not plan to pollute much.Penalty is lower – firms prepared to admit accidents

but do not put in much effort at pollution abatement.

Other Conclusions

If pollution is not persistent => clean ups not so important tend to want higher penalties.

If pollution is very persistent want to reduce penalties to encourage firms to report and allow cleanups.

Kaplow and Shavell Optimal Law Enforcement…. JPE 1994

Introduces the possibility that self reporting of violations reduces the penalty that individuals face if the violation were detected by audit.(Kind of like –turning yourself in in the hope that you will be treated leniently.)

What happens if you raise the probability of audit?- More people just turn themselves in => reduced marginal deterrent cost.- Number of non-violators increases => marginal deterrent cost is higher (more people to audit).