The article describes an experiment that examines the effect of three audit schemes on taxpayers' joint or related decisions about the level of labor to be supplied and the amount of income to underreport in the United States. Individuals failed to report between $70 and $79 billion in federal taxes due on legal income received in 1986. This amount is equivalent to approximately 20 percent of federal income taxes due and 40 percent of the federal deficit in that year. This problem can be countered by auditing self-reported income; An audit scheme is the approach by which a taxing authority chooses the self-reports to be audited. The three audit schemes differ principally in the information used by the taxing authority to determine which self-reports of income to audit: no information is used--reports are chosen strictly at random; reported income is the basis for choosing the reports to be audited; an estimate of true income is used in addition to reported income to select audit cases. The taxpayer's labor response to the tax system may not be determined solely by the direct effect of tax rates.

[Individuals failed to report between 70 and 79 billion in federal taxes due on legal income received in 1986. This amount is equivalent to approximately 20 percent of federal income taxes due and 40 percent of the federal deficit in that year. Including underreporting of organizations and of those who receive illegal income likely pushes the annual amount of taxes due, but not paid, above the $100 billion mark (Roth et al. 1989, 1). Thus, reporting income for tax purposes may be characterized by a high degree of inaccurate self-reporting with an immediate economic impact. This problem can be countered by auditing self-reported income. An audit scheme is the approach by which a taxing authority chooses the self-reports to be audited. This paper describes an experiment that examines the effect of three audit schemes on taxpayers' joint or related decisions about the level of labor to be supplied and the amount of income (if any) to underreport. The three audit schemes differ principally in the information used by the taxing authority to determine which self-reports of income to audit: (a) no information is used-reports are chosen strictly at random; (b) reported income is the basis for choosing the reports to be audited; (c) an estimate of true income is used in addition to reported income to select audit cases. Also examined is the impact of alternative tax rates and penalty levels on earned and underreported income. Traditional theoretical work shows that income taxes alter the amount of labor supplied (e.g., Flanagan et al. 1984, 143-5). However, predictions regarding the direction of the change in labor supply are ambiguous: the labor supplied may increase as the taxpayer tries to compensate for the income lost to taxes by working more (the income effect), or the amount of labor may drop as alternatives to work become more economically attractive (the substitution effect). Swenson (1988) experimentally examined labor supply in response to varying marginal tax rates, and the overall results are consistent with the substitution effect dominating the income effect. The taxpayer's labor response to the tax system may not be determined solely by the direct effect of tax rates. Once a tax system is imposed, those electing to underreport their actual earned income may also elect to increase their labor supply as a result of a diminished tax substitution effect in the presence of underreporting. If the reporting decision directly affects the labor supply decision, then any tax system parameter (e.g., penalty and audit) affecting the reporting decision will also impact the labor supply decision. Consistent with the reasoning above, Pencavel (1979) analytically portrays the taxpayer's response to the tax system (i.e., rates, penalty, and probability of audit) as a joint or related decision about labor supply and the income reported. In a similar vein, Atkinson and Stiglitz (1980, 27-8) refer to the impact of taxation (and evasion opportunities) on labor supply in terms of income, substitution, and "financial" effects. They explain that financial effects arise when "the same real activity can correspond to several different forms of payment, which are taxed at different rates." The most extreme example offered of the financial effect on labor supply is the underground or "hidden" economy. Taxpayers may restructure their activities or transactions so as to operate in an economic environment free of taxation. Recognition of the jointness of the labor and reporting decisions suggests that it is reasonable to incorporate both variable in empirical studies to test how the taxpayer responds to the tax environment. In another study, Collins et al. (1990) found evidence that a positive relationship exists between work effort and noncompliance opportunities. In general, subjects with a noncompliance opportunity worked harder than those without an underreporting opportunity. The effects of the tax environment (i.e., audit schemes, tax rates, and penalty levels) on income earned and underreporting of income are tested in a laboratory setting because well controlled real world setting counterparts are not available. The experimental design consists of three audit schemes and two levels of tax rate and penalty resulting in 12 between-subject conditions. The subject's task is a computerized letter decoding task. During the experiment, each subject participated in a practice work session and four five-minute actual work sessions. At the end of each work session, subjects self-reported the income earned and corresponding tax liability. One of the three audit schemes was followed to select reports to verify. The reports denoting whether audit selection had occurred were returned privately to the subjects before the beginning of the next work session. Subjects were compensated based on the actual income earned less the taxes self-reported and possible penalties (proportional to the tax deficiency) imposed as a result of the audit. The subjects' underreports of income and work effort are analyzed for each work session separately and across work sessions two through four together using a multivariate analysis of covariance (MANCOVA). The number of letters decoded by each subject in the practice work session is included as the covariate. This measure serves as a surrogate for ability. Subsequent analyses of covariance (ANCOVAs) and mean comparisons are performed for each dependent variable. Verification schemes that incorporate the preliminary information signal sent by the taxpayer are more successful overall in curbing underreporting than purely random audit models. Also, underreporting is generally greater when tax rates are high and penalty levels are rather low. Finally, underreporting and effort are positively related. Those subjects electing to underreport also produce significantly more income.]

Preferred Stocks, Foreign Tax Credits, Tax Reform Act, Tax burden

Although firms account for entity-level taxes, they do not account for shareholder-level capital gains and dividend taxes. To account for these proprietary-level taxes, we add them to a residual-income equity valuation model. Empirical analysis supports the model's predictions. First, both capital gains and dividend taxes reduce investors' implicit valuation of the reinvested portion of earnings. Second, dividend taxes reduce the valuation of the portion of earnings distributed as dividends, but capital gains taxes do not. Third, dividend taxes reduce the valuation of retained earnings equity, but again, capital gains taxes do not. These findings suggest that investors implicitly extend entity-level accounting to the proprietary level when they value the firm. The findings also suggest that when fully accounting for the effects of implicit dividend taxes, reinvested earnings appear to be subject to three levels of taxation—corporate, dividend, and capital gains taxes. Paying earnings out as dividends eliminates the capital gains layer of tax and may provide a net wealth benefit for shareholders, rather than a tax penalty as commonly assumed.

We exploit a unique experimental setting within the life insurance industry to examine the effects of taxes, regulation, earnings, and organizational form on life insurers' investment portfolio realizations. A unique equity tax levied on mutual life insurers, as well as the statutory rate variation that occurred during our sample period, allow us to disentangle the effects of taxes from earnings or profitability. Consistent with some policymakers' claims, we find mutual insurers' capital gain realizations are affected by company-specific equity tax rate variation. In addition, we find capital regulation and earnings considerations affect both stocks' and mutuals' realizations.

Banking, Regulatory capital, Financial reporting, Tax incentives