DP12798 | Forensics, Elasticities and Benford's Law

Publication Date

03/20/2018

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Abstract

By its very nature, tax evasion is difficult to detect as the parties involved have an incentive to conceal their activities. This paper offers a setting where doing so is possible because of an exogenous shock to the tax rate. It contributes to the literature by proposing two new methods of detecting evasion in the context of border taxes. The first method is based on Benford's law, while the second relies on comparing price and trade cost elasticities of import demand. Both methods produce evidence consistent with an increase in tax evasion after the shock. The paper further shows that evasion induces a bias in the estimation of trade cost elasticity of import demand, leading to miscalculation of gains from trade based on standard welfare formulations. Finally, welfare predictions are derived from a simple Armington trade model that accounts for tax evasion.