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Welcome to the sixth edition of the Oxy Economics Newsletter! For those of you who participated last year, welcome back. For those of you who are new, we hope that you'll make the newsletter an annual habit. Where else can you hear about current events in the department, keep up to date with old classmates, and make new connections with economics majors from other eras?

The most exciting news from 2004-05 is the extremely successful search we conducted for two new tenure track faculty in the department. We hired two outstanding teaching economists from an applicant pool of over 350 applicants! All of the faculty in the department as well as all of the students who participated in the search process are simply thrilled that both have chosen Occidental. Bevin Ashenmiller received her A.B. degree from Princeton and her Ph.D. for UC Santa Barbara. She also taught at CMC for several years prior to coming to Oxy. Her fields of special interest include environmental and resource economics, applied microeconomics, and labor economics. Lesley Chiou received her B.A. from UC Berkeley and her Ph.D. from MIT. Her fields of interest are industrial organization, applied econometrics, and labor economics. We would especially like to thank the many Economics majors here at Oxy who helped with the search. Two students actually traveled to Philadelphia and helped the faculty interview the finalists at the American Economic Association Meetings.

The other big news is that the entire Economics Department has moved! We now reside in Fowler Hall on the second floor. The College did an outstanding job of remodeling Fowler. We always encourage our alums to come back and visit, but now you have an additional reason -- check out the new Fowler Hall.

So, if you're ever in the area, please don't hesitate to stop by and say hello. Perhaps the best part of teaching is hearing from former students. If you can't visit, drop us an e-mail and let us know what you're up and how you're doing.

Best regards,

Robby Moore

What do Al Capone, Mickey Cohen, Chuck Berry, Spiro Agnew, Leona Helmsley, Robert Huttenback, Harry Reems, and Pete Rose have in common? They were all convicted of a tax crime. This list might go on and on and deliberately spans many decades of tax enforcement. In this respect, there is nothing new under the sun when it comes to tax evasion. (Note that violation of criminal tax statutes goes hand and hand with non-tax crimes and is the more notorious cousin of good old-fashioned tax evasion). While civil and criminal tax evasion seem endemic to our tax system, the ability of the Internal Revenue Service (IRS) to deter these crimes has sputtered from badly ill to nearly moribund. First consider some troubling facts.

The annual tax gap (i.e., the difference between taxes owed and taxes paid) is estimated to be $200 billion, or about 10 percent of what is collected each year from individuals and businesses. The IRS estimates that three-quarters of this tax gap is attributable to individual taxpayers. At that rate, individuals currently represent $150 billion of the tax gap, which is more than double the level estimated in 1985.  While the tax gap has grown, the IRS’ ability to audit and enforce the tax code has diminished. For instance, in 2002, the IRS had roughly 13,000 revenue and tax agents devoted to examination. This number is down from the 18,000 revenue and tax agents employed in 1995. Meanwhile, the Criminal Investigations Division of the IRS (CI) is considerably smaller. In 1970, CI had approximately 2,500 agents. By 1998, the number of CI agents had increased to only 3,000 agents.

There has also been a staggering decline in the individual audit rate. During the period from 1977 through 1986 the individual audit rate declined from about two and one-half percent to just over one percent. This decline in the audit rate through 1986 was followed by the bottom falling out: the individual audit rate reached 0.6 percent in 1991 and was only 0.15 percent by 2001. At the same time, individual returns filed per capita has grown steadily over the last twenty-five years by nearly 20 percent.

Seemingly, the decline in audits and the decline in CI has been the natural consequence of budget policies applied to the IRS during this period. Additionally, the IRS appeared to adopt a policy of substituting third-party information reporting, document matching, and correspondence audits (audits conducted by mail) for traditional face-to-face exams. Due to the increases in the tax gap, it is critical to reassess the role played by examination in taxpayers’ voluntary compliance and to ascertain what effect CI investigations play in general deterrence.

Using dynamic panel econometric techniques applied to historical time-series cross-section data, I have investigated the effects of audit rates on taxpayer compliance and most recently the specific and general deterrence effects of CI activities. Although the general deterrence effects provided by audits have been widely acknowledged, the IRS has not quantified the “spillover” benefits provided by audits. Spillover benefits are the increase in collections from taxpayers, whether or not they are audited, who report more taxes in response to an increased likelihood of an audit. The principal innovation, in my empirical investigations, has been to directly estimate taxes due, rather than first attempting to construct a noncompliance measure and then extrapolating from noncompliance to revenue.

My most recent study attempts to answer several basic questions focused primarily on CI. First, does CI have a measurable effect on voluntary compliance, which includes both civil and criminal tax laws? Second, if CI does have a measurable effect on voluntary compliance, what mix of CI investigations has the greatest influence on voluntary compliance? (CI investigates two broad categories of cases: tax violations and money laundering violations.) A subsidiary inquiry is whether either or both types of cases have an effect on voluntary compliance with the tax laws. Third, does media attention and publicity on CI investigations increase the compliance effect? Fourth, do convictions that result in prison sentences affect compliance differently from cases that result in probation?

II. Criminal Investigation

One of CI’s functions is to investigate alleged violations of the tax and money laundering statutes. CI has focused its activities for some time on narrowing the tax gap. Tax gap investigations include both tax and money laundering cases that involve tax issues. Tax gap investigations normally do not include illegal activity associated with narcotics investigations. Tax-related investigations encompass all Title 26 violations (tax evasion, failure to file, filing of false returns, fraudulent returns, or aiding or providing assistance to fraudulent returns) as well as tax violations that fall under Title 18 USC §286, 287, 371 (conspiracy to defraud the government or commit offense or false claims). CI also has jurisdiction over Title 31 cases (currency reporting violations). CI tax investigations are so-called legal source tax crimes because they encompass all cases involving tax violations where income is derived from legal activity, including questionable refund schemes, return preparer cases, excise tax cases, employment tax cases, and frivolous filers and nonfilers. CI also investigates illegal source financial crimes and narcotics-related financial crimes.

case might be referred to the CI for criminal investigation. However, audits are not the sole source for tax-related cases. CI may investigate a tax case initiated by a special agent in the field, a referral from another agency (FBI, Customs, or the US Attorney or DOJ), informants, as part of the Grand Jury process, or as a result of refund fraud-related activity. While the IRS can investigate and audit tax returns and recommend civil penalties, CI has the exclusive responsibility and authority to investigate tax fraud and to recommend prosecution for willful and egregious tax code violations.

Money laundering activity and tax activity can be closely related. Money laundering activity (i.e., activity involving illegal income sources) is often a precursor to tax evasion. As such, it is sometimes difficult to determine whether a specific investigation is primarily tax related or not. CI has been able to classify its cases in terms of whether they are primarily tax related or money laundering related. CI has further classified cases according to whether they are both tax and money laundering cases, tax cases only, money laundering cases only, or neither.

III. Data, Empirical Analysis, and Simulations

My analysis is based on two models that were both estimated using a state-level time-series cross-section. One model specified reported taxes per return filed as a function of audit rates and a variety of socioeconomic explanatory variables. The other model specified returns filed per capita as a function of the same variables. The data employed is a compilation of annual tax enforcement, criminal investigation, socioeconomic, and political statistics for each U.S. state from 1977 to 2001. The tax collections and examination variables rely on data reported in the Annual Report of the Commissioner of Internal Revenue, IRS Data Book, and IRS Statistics of Income Bulletin. My econometric analysis relates reported taxes per return and returns filed per capita to tax rates, the percent of adult population over 65 year old or with a high school education, per capita income, the percent employed in service or manufacturing, the percent on welfare, and other measurable factors. Further, the econometric models include explanatory factors for IRS activities (including audit and CI enforcement) which are treated endogenously. The econometric models were used to perform several simulations.

IV. Policy Implications

I now further summarize my results and answer the basic questions that were above. First, I found that CI activities have a measurable effect on voluntary compliance. I found statistically significant results from my measure of CI sentenced cases on general tax deterrence. Second, I conclude that the mix of sentenced cases (tax and money laundering) is not a significant determinant of tax compliance (perhaps because the mix has been already optimally set). Third, changes in media attention, at the margin, were not found to be statistically significant determinants of compliance outcomes. However, the time period available to study media effects does not allow me to precisely measure these effects. Given the large general deterrence effect found for CI activities, there is indirect evidence of a large media effect, even if the econometric model did not have sufficient data to isolate this result. Finally, I have found that incarceration and probation (rather than fines) have the most influence on taxpayers. It would seem that an emphasis on prison and probation time should be encouraged based on these results.

In 1991, the IRS reported a unit cost of $1,298 per audit and a unit cost of $103,064 per CI conviction. These are $1,597 and $126,801 in 2001 after adjusting for inflation. In the same year, there were approximately 202,244 individual audits performed and roughly 2000 tax and money laundering sentences. Doubling tax and money laundering sentences would cost $254 million (at these unit cost estimates), while doubling the audit rate would cost $323 million. However, doubling the audit rates is predicted to lead to an $18.71 billion increase in per annum reported collections, while doubling tax and money laundering cases is predicted to increase reported tax collection by $16.68 billion per annum. Hence, an additional dollar allocated to audit would return $58 in general deterrence, while an additional dollar allocated to CI would result in $66.

An increase in the IRS budget of $25 million allocated to CI for additional investigations, prosecutions, and sentencing would not appear to push the envelope of historical experience. Such an amount might be used to increase tax and money laundering cases by roughly 200 per year and would necessitate roughly 250 additional tax agents. This represents a roughly 10 percent increase in tax and money laundering cases at 2001 levels. But, more importantly, this increase is within the range of historical CI experience. According to the simulations, general deterrence could rise by over one billion dollars as a result of the $25 million allocation to cases processed by CI.

V. Conclusions

For tax evaders, money launderers, and those involved in fraudulent tax schemes these are heady times indeed. Even for the average taxpayer there is perhaps no better time to play the tax lottery than today. The odds of getting away with low levels of tax cheating are better now than ever. Of course, this is not a recommendation for tax non-compliance. The worry is that our tax system is quite fragile because such a significant portion of taxes paid are paid by taxpayers who voluntarily comply with the tax laws. Could the situation get worse? In all likelihood the answer is yes. Taxpayer non-compliance can continue to grow if taxpayers feel that the system is simply unfair or if they are undeterred by the threat of audit or penalty.

And yet it’s possible that the “times they are a-changing”. The IRS has recently introduced its National Research Program which replaces the defunct Taxpayer Compliance Measurement Program (gone for the last 13 years). The NRP and TCMP are both designed to randomly audit a representative sample of taxpayers and turn them upside down in a detailed and excruciating line-by-line review of their tax records. The purpose of these specialized audits is to develop detailed information which allows calibration of formulas (“scoring rules”) to predict tax cheating from observable characteristics in the population at large.  A change in political administration might also resurrect the IRS enforcement programs. Republicans are generally believed to prefer lower levels of enforcement for all forms of regulation and consequently are not known for advocating increased IRS funding (note that IRS budgets and enforcement levels have, nonetheless, dropped through decades of mixed ideology). My prescription is not a popular one. However, with more tax enforcement and requisite budget increases, I remain convinced that the IRS can go from “Lost” to “Survivor”.

Notes:

    1. Jeffrey A. Dubin is Visiting Professor of Economics on leave from the California Institute of Technology. This article is based on research recently completed for the IRS CI division. The complete study is available from http://www.irs.gov/pub/irs-soi/04dubin.pdf. Dubin requests that no one kill the messenger.

    2. Let dALR denote the change in assessed liability per return for a change in the audit rate of dIAR. Similarly, let dRTR denote the change in reported tax liability per return for the same change in audit rate dIAR. The change dALR is the total revenue effect (since it includes both reported amounts and additional taxes and penalties) and dRTR is the indirect effect. The direct effect of audits is defined as dALR-dRTR. Since ALR-RTR is a measure of additional taxes and penalties, dALR-dRTR is simply the change in additional tax and penalties resulting from the audit change. Consequently, it is the direct effect. The spillover measure is the ratio dRTR/dALR since it measures the percentage of the total change that occurs from general deterrence as a result of the change in the audit rate. 

Bevin Ashenmiller is a new faculty  member in the Economics Department who received her PhD from the University of California is 2005.  She is teaching Principles of Economics I and Environmental Economics.  Her primary areas of research are Environmental Economics and Labor Economics.  In her dissertation she studied the labor market effects of subsidizing recycling through consumer deposit-refund programs. 

Lesley Chiou is a new faculty member who recently received her Ph.D. from M.I.T. Her dissertation examined how a store's format and distance affect consumers' shopping patterns. This fall she is teaching Intermediate Microeconomics, and in the spring, she will be teaching Industrial Organization and Applied Econometrics.

Jeffrey A. Dubin begins his first term at Oxy this Fall. He is teaching Contemporary Economic Problems (Economics 395). This course is an analytical investigation of the economic aspects of certain social issues and policies. The course covers aspects of law and economics including intellectual property and trade-mark infringement, as well as aspects of business theory, including modern marketing theories and applications of econometrics to business decision making.
    Dr. Dubin is currently Professor of Economics at the California Institute of Technology where he has been a faculty member since 1982. He is currently enjoying his leave of absence by visiting and teaching outside of Pasadena (even if Oxy is just on the outskirts!). This last Winter, he visited at the University of California, Santa Barbara where he taught a second-year Ph.D. field course in time-series econometrics. He returns to U.C.S.B this Winter quarter to teach econometrics again and to offer a course on demand analysis for energy and environmental problems at the Bren School.
    Dr. Dubin earned his undergraduate degree in Economics with highest honors and great distinction from the University of California, Berkeley, and received a Ph.D. in Economics from the Massachusetts Institute of Technology. Dr. Dubin 's research focuses on microeconomic modeling with particular emphasis in applied  econometrics.  His current research concerns discrete choice econometrics, energy economics, and tax  compliance. One of his recently completed studies concerned the effect of criminal enforcement on taxpayer compliance.
    Dr. Dubin is the author of numerous publications, including Consumer Durable Choice and the Demand for Electricity: Elsevier North-Holland, 1985, Studies in Consumer Demand-Econometric Methods Applied to Market Data, Kluwer Academic Publishers, 1998, Empirical Studies in Applied Economics, Kluwer Academic Publishers, 2001, and The California Energy Crisis: What, Why, and What’s Next, Springer-Kluwer Academic Publishers, 2004. He received the Econometric Society Frisch Medal in 1986 with Professor Daniel McFadden.
    Dr. Dubin  is also co-founding member and Director of Statistical and Economic Analysis at Pacific  Economics Group in Pasadena. He frequently provides expert testimony and consults in matters of statistics and applied economics. He was a recent expert witness on behalf of the Oakland Raiders in a jury trial in Sacramento.
    He and his wife, Jackie, live in Pasadena. They are parents of two boys. One is in his Junior year at Polytechnic High School and the other is currently a sophomore at U.C. Berkeley where he is planning on majoring in history and or economics.

John "Doc" Karayan is looking forward to another great year. This past one was exciting, with a host of scandals throughout the world spicing up accounting and financial analysis (the topic of ECON 233, which he teaches). It also made even more interesting the expert witnessing on taxation and accounting which Doc occasionally does in complex business litigation. Along with preparing for classes and grading, he kept current by presenting papers and publishing articles, as well as co-authoring a treatise last year on Stock Market Analysis. More importantly, Doc's son just left for his senior year as a chemistry major at Duke (where he is President of a co-ed fraternity), and his daughter is now back at Washington University in St. Louis for her sophomore year majoring in Classics.

Mary Lopez is a new faculty member who received her Ph.D. from the University of Notre Dame in 2003. This fall she is teaching Principles of Economics II and Economics of Immigration. In the spring she will teach Principles of Economics II and Economics of Race and Gender. Her dissertation focuses on the impact high-skill immigrants have on the U.S. economy.

Jerry McIntyre starts his fifth year at Oxy after spending the summer at the International Monetary Fund in Washington , D.C. where he continued his research on economic growth, macro- and international economics. He looks forward to a great year teaching Econ 251 - Intermediate Macro, Econ 495 - International Macroeconomics: Theory and Policy, and Econ 311 - International Economics. He extends an invitation to everyone to drop by his new office in Fowler 224 for an espresso and some econ whenever they are free.

Robby Moore served as Chair of the Department for the Spring semester and will be continued in this capacity for three years. Along with recently retired Professor Halstead, he will be presenting a poster session at the AEA meetings in Philadelphia on "Predicting the Effects of Macroeconomic Shocks and the Self-Correction Mechanism: A 'Hands-On,' Collaborative Approach for the Principles Course". He also is serving as the new director for the Center for Teaching Excellence.

Sita Nataraj is looking forward to her sabbatical in 2005-06. She has several research projects lined up, including one on the provision of public goods through markets versus the political process. In the fall of 2004, she taught a new Game Theory course and had fun planning class games designed to illustrate many of the concepts. This past summer, she worked on another Social Security related research project. Together with co-author John Shoven, she studied the risk Social Security participants face as a result of law changes designed to compensate for funding imbalances. They have a third Social Security project planned for next summer. In December 2004, Sita married Slavi Slavov, who teaches economics at Pomona College.

Giorgio Secondi taught in the Core program again, and again he found it a lot of fun (and a lot of work). During the year he participated in a “faculty learning community” about coffee cultivation in Costa Rica. Eleven Oxy professors from different departments participated in this learning community, which revolved around the ecological, economic, political, and social significance of coffee cultivation in the history of Costa Rica. The experience culminated in a wonderful two-week trip to Costa Rica in May. Highlights included visiting two Guaymi indigenous communities in a remote location on the border with Panama and learning about their economic and political struggles; and attending a lecture on carbon cycle and global warming at the La Selva Biological Station, in the tropical wet forest of northern Costa Rica. After Costa Rica Giorgio traveled briefly to Italy and then went back to New Hampshire, to teach again in the Summer School at Phillips Exeter Academy. He’s on sabbatical leave this fall and looking forward to focusing on his scholarly work.

Carolyn Sissoko is returning to Oxy for her third year as an adjunct professor. She spent much of the summer abroad travelling in Europe and West Africa and presented a paper, Short-Term Credit: A Monetary Channel Linkng Finance to Growth, at the Society for the Advancement of Economic Theory Conference in Vigo, Spain. She is currently working on a paper that extends her analysis to include fiat money. This year she will be teaching two courses: Econ 495 in the fall and Econ 315 in the Spring. Econ 495 is a senior seminar which takes a close look at the historical role of financial institutions in the economy and tries to figure out why the Great Depression took place -- a rather elusive goal. Econ 315, the Economics of Financial Markets, studies the same issues, but with a focus on the present day U.S. economy. She is looking forward to seeing everyone again at the start of the semester.

Woody Studenmund is delighted to have completed the fifth edition of his best-selling textbook, "Using Econometrics," and he thinks that the new edition is the best ever!  He continues to love teaching his econometrics and managerial economics courses, but he has stopped his administrative work, most recently stepping down after six years as the College's Director of Institutional Planning.  He encourages all alums to visit the campus to see the department's new offices on the second floor of Fowler Hall.

Mike Tamada continued as the Director of Institutional Research. His projects included working with Kenyon Chan on a faculty database, helping with assessment of the success of Oxy's diversity efforts, and studying the causes of differential GPAs. He advises the men's and women's Ultimate Frisbee Clubs and annually travels to Potlatch, a large coed Ultimate tournament in Seattle, to play with the Oxy reunion team.  Last summer he hiked up Mt. Whitney.

Jim Whitney had fun teaching a new frosh seminar, "Investigating the global economy," in Fall 2004. He also taught Principles of Economics (Econ101) for the first time since 1998; it brought back fond memories about what a great opportunity it is to expose students to the economic way of thinking. Jim and his wife Linda (who works in Oxy's Center for Academic Excellence) took off for Argentina over winter break to visit their daughter Cami, who was spending her junior year abroad in Buenos Aires. At the end of the academic year, Jim started a two-year stint as President of Faculty Council.