Measuring illegal activity and the effects of regulatory innovation

This paper examines tax evasion in the context of the diesel fuel market and the response of evaders to regulatory innovation. Diesel fuel used for on-road purposes is taxed, while other uses are untaxed, creating an incentive for firms and individuals to evade on-road diesel taxes by purchasing untaxed diesel fuel and then using or reselling it for on-road use. We examine the effects of a federal regulatory innovation in October 1993, the addition of red dye to un-taxed diesel fuel at the point of distribution, which significantly lowered the cost of regulatory enforcement. We propose a model of the evasion decision that predicts that evasion increases as taxes rise and monitoring costs fall. Testing the predictions of the model, we find that sales of diesel fuel rose 26 percent following the regulatory change while sales of heating oil, which is an untaxed perfect substitute, fell by a similar amount. The effect on sales was higher in states with higher tax rates and in states likely to have higher audit costs. Heating oil sales are also found to be much less responsive to demand factors such as temperature and season prior to the dye program, indicating that a significant fraction of sales prior to dyeing was illegitimate. In addition, we find evidence that tax evaders found new methods of evading fuel dye regulations. We find that sales of kerosene and jet fuel, two undyed alternatives to untaxed diesel fuel, rose following the introduction of fuel dye. Furthermore, we find a pattern of price and tax elasticities consistent with innovation in new evasion techniques subsequent to the regulatory change. Finally, we examine the extent to which tax increases are incorporated into tax revenues, using the estimated tax and price elasticities to describe how this is affected by evasion. We estimate that the elasticity of tax revenues with respect to the tax rate was 0.60 prior to the dye program, yet would have been 0.85 in the absence of evasion.