R. Fishman & S-J. Wei

Journal of Political Economy, Vol. 112, No.2 (2004) pp. 471-96

Principal Research Question and Key Result Does tax evasion increase with the tax rate, and how responsive is this relationship?
Theory Increasing tax rates on imports may reduce collections by reducing imports. This can happen in two ways:

  1. Increasing tax rates reduce true imports
  2. Increasing tax rates reduces the true fraction of imports reported to the Chinese authorities.
Motivation Markets alone may lead to an underprovision of goods such as education, infrastructure and health services. States may step in to correct those market failures with public good provision. This will generally need to be financed out of taxes. However, it may be the case that unless taxes can be efficiently collected, simply increasing tax rates will not result in greater revenue collection due to evasion. In such a situation it would be important to know the responsiveness of evasion to tax rates such that holding enforcement mechanisms constant, tax rates could be set at or below the point where marginal revenues collected is equal to marginal revenues lost through evasion. It would not be desirable to set rates above this level as increasing the tax rate would actually decrease the amount of revenue collected. Past theoretical work has produced inconclusive results, as they are heavily dependent upon the modeling assumptions, whereas empirical work has typically suffered from an inability to precisely measure evasion and hence identify causal mechanisms.


The design of the study allows them to examine three types of evasion: a) an underreporting of unit value b) underreporting of taxable quantities c) mislabeling of higher-taxed products as lower taxed products.


Data Data are trade flow data from WITS and COMTRADE at 6 HS digit level 2,043 products in 1998.

Tax evasion is measured for China as log(export_value) – log(import_value). Export values are for goods exported from Hong Kong to China as reported by Hong Kong. Import values is the value of goods reported as being shipped from Hong Kong to China as reported to Chinese customs.  A similar technique is used to measure the quantity gap as opposed to the value gap.


Strategy They compare the (HK) reported exports from HK to China, with the (China) reported imports from HK to China, and postulate that any difference in the reported numbers is due to evasion. They then run the following regression to examine how evasion changes with tax rates:


log(exportk) – log(importk) = a + Btaxk + Ek



There is a likely problem of measurement error in the dependent variable. This is due to the fact that Hong Kong reports both direct and indirect exports to China (indirect, being from another source nation, going via HK). China reports only what it considers to be direct imports from HK, but it cannot always determine which imports are direct, and which are indirect which leads then to sometimes report indirect trades, as direct trades. This will tend to understate the evasion gap. Whilst this will not bias the estimates (if the error is not correlated with the regressor), it will decrease the precision of the estimates. In order to counter the problem, they exclude product categories for which there is generally a high proportion of indirect trade.


In order to examine the possibility that products are misclassified in order to avoid higher rates, then include a variable called average(tax) which is the average tax rate for products in the same 4 digit category (it is relatively easy to misclassify within 4 digits as the descriptions are quite similar). If misclassification is prevalent there should be a negative coefficient on the variable, as increasing the average tax rate of a category makes evasion less attractive (holding constant the tax rate of the product concerned).

  • Results of the baseline specification are 2.93, and this is significant, although with an R^2 of only 0.02 the model only explains 2% of the observed variation (possibly due to noise from the misclassified indirect imports), although the r^2 is improved somewhat when the data are aggregated into 42 tax rates and averaged.
  • The average(tax) coefficient is negative and significant and also its inclusion drastically increases the coefficient on the TAX variable.
  • For the quantities specification the results indicate that misreporting quantities is not as prevalent or significant as misreporting classification and value.


  • Robust to the exclusion of large outliers.
  • They try to remedy the measurement error (see below), and vary the amount of excluded observation pursuant to this strategy.
  • They interact a dummy for a product being tax exempt with the TAX variable and find it is negative and not significant (i.e. there is no incentive to cheat when the product is exempt from tax).
  • They do a difference estimation using data from 1997 and 1998 in order to control for fixed product characteristics omitted from the main specification that may still be driving results. The results are similar, although reduced in magnitude and significance as much of the variation has been differenced away.
  • They allow the functional form to be varied by estimating the main specification for 4 tax rate quartiles. They find low effects are low rates, and this increases, and then tapers out as rates get particular high.
Problems It is not totally clear that the reported import/export numbers should match, as HK may impose export tax in which case there would be incentives for exporters to underreport. It is also not clear that the Chinese would then rely on HK values, rather than making their own assessments.


If some products are more likely to be misclassified than others then we have an omitted variable problem or a problem of non-random measurement error (as error is now correlated with the regressor). If the proper classification of a shipment as direct or indirect is some function of the amount of effort put in by Chinese customs officials, and EFFORT is a variable that reflects this, it seems plausible that effort may be increasing with tax rates. This could be because a more valuable potential cargo in terms of tax revenue may attract more attention in customs. Likewise EFFORT will be correlated with the gap measure, as EFFORT determines to a certain degree the recorded value of imports. Thus EFFORT is correlated both with the independent variable and the error term, and will therefore bias the results. The direction of the bias is known: at low tariff levels low amounts of effort are put in so there is over reporting of imports due to classifying some indirect imports as direct. This will tend to mask any evasion. At higher levels of taxation more effort is taken, so misclassification is reduced exposing the full extent of evasion. Thus evasion will tend to appear greater at higher levels of taxation, and this will bias the estimates of the TAX variable upwards.


In order to identify evasion by misclassification, they include a variable of average tax across similar products defined as those with the same 4 digit HS codes. What is not clear is the extent to which there is significant variation in tariff levels for products within the same 4 digit code. Whilst the frequency distribution graph 2b does show variation in tariff levels within 4 digit categories, most of this variation is at the low end, between 1-4%. Thus it is not clear that a product imported to china would have tariff significantly different from the average tax rate for that 4 digit category. This means the tax variable and the average tax variable could be quite strongly collinear. This makes it difficult to separately identify evasion by misclassification.


To identify evasion by misreporting of quantity they use a different dependent variable that measures quantities rather than values. This measure should be subject to all the same problems associated with the value measure. It is curious that they find no effect of evasion by quantity manipulation, especially since it seems obvious that in the presence of evasion by misclassification recorded export import quantities should not match as some imports have been fraudulently labeled as different products.


Implications The estimates suggest that the average Chinese tax rate (36%) is already on the wrong side of the Laffer curve. In other words increasing tax rates will actually decrease tax receipts.


Developing countries frequently rely on border measures as a means of raising revenues. This is because with incomes low, and consumption taxes unpopular, they are often left with few options to effectively raise revenue. The evidence supplied by this paper indicate that to the extent that such measures are relied upon, care needs to be taken to set rates such that the maximum revenues are collected and not lost to evasion (assuming that enforcement measures cannot be readily improved due to corruption/lack of capacity).



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