A Tax Evasion-Bribery Game: Experimental Evidence from Ukraine

Abstract This paper examines the issue of tax evasion by enterprises through underreporting activity. We develop a view of this phenomenon as an equilibrium of the game between a businessman and an imperfectly monitored supervising official, in which a businessman can hide part of his profit and offer bribe to official. We determine conditions under which such tax evasion and bribery become wide-spread in the society, resulting in shadow economy. The game is put into an experimental setting in Kiev, Ukraine, with the emphasis of spreading of the tax evasion and bribery activity in the laboratory setting. We find that once it becomes known that substantial share of subjects playing the role of supervising officials agree to accept bribes from subjects playing the role of businessmen, the latter offer bribes more aggressively. Yet, this in turn does not affect the behavior of subjects playing the role of supervising officials. JEL Classification: C91, D73, H26, H32 Keywords: Tax Evasion, Bribery, Experiment, Learning in Games (ProQuest Information and Learning: ... denotes formulae omitted.) 1. Introduction The extent and persistence of the underground economic activities in many developing and transition countries suggest some fundamental problems. Schneider and Enste (2000), providing the most recent thorough assessment of the extent of shadow economy throughout the world suggest the following numbers in 1994-1995 as percentage of GDP: 39% in developing countries, 35% in countries of the former Soviet Union, and 20.9% in Eastern Europe. One most commonly used definition of the term 'shadow economy', according to Schneider and Enste (2000, p. 78), is 'all economic activities that contribute to the officially calculated (or observed) gross national product but are currently unregistered'. Shadow or underground economic activities in general can be divided into illegal activities and unreported legal activities. The major point that distinguishes shadow economy in developing and transition countries from that in the developed world is that the unreported and/or underreported legal activities appear much more wide-spread in the former group of countries, as documented (for transition countries) by Johnson et al. (1997, 1998). The generally accepted reason for emergence and sustainability of such underreporting in developing and transition countries is avoiding high taxes. The prohibitively high tax rates are claimed to force firms to hide their activity 'in the shadow'. Johnson et al. (1999) also suggest the following causes for unreported activity: predatory behavior of government officials; escaping extortion by criminal gangs; and inadequacy of institutional environment (i.e., weak contract enforcement). In either case, businesses are mostly viewed as victims of government officials or criminal structures, acting at their discretion. This paper develops a different view at underreporting as a Nash equilibrium of a game played between a government official and a businessman. The game itself resembles the traditional tax evasion game. The payoff structure is developed taking into account certain widely recognized institutional features of developing and transition economies, such as low compensation and imperfect monitoring of the government officials. Analysis of the model suggests a possibility that businesses may choose to underreport their profit and offer bribes to the government official because the official's best response to such action is accepting the bribe. Further analysis of the model suggests that underreporting will most easily spread across the society when share of officials willing to accept bribes reaches certain level, after which share of businessmen hiding profit will start increasing. The model was put in the experimental setting. The experiment was run in Kiev, Ukraine, in November of 2004. In order to add an element of learning to the experiment, the number of subjects playing the role of officials willing to accept bribes in the preceding round was periodically announced. …