Thursday, July 28, 2005

Rules versus discretion

How to follow up on the highly publicized tax evasion cases in the Philippines? The traditional approach is to settle. Currently this administration is publicly pursuing criminal cases against tax evaders. However the option of settling is tempting, given the immediate cash flows this provides (stanching the urgent fiscal hemorrhage) compared to the prospects of protracted court trials.

This is the classic problem of "dynamic inconsistency", formalized by 2004 Nobel prize winners Finn Kydland and Edward Prescott. It may be the case that, after announcing a rule, there may be a short run benefit to reneging on it. Case in point: the dilemma of pursuing tax cases. Another example is patent protection, say for HIV medicines, for which society may benefit greatly if the intellectual property protection is rescinded. The problem with pursuing these short run benefits is that the entire framework of rule-setting is undermined. If it is widely known that patent protection is withdrawn whenever a great discovery is made, incentives to invest in making discoveries is dampened. In the case of tax collection, government sends a signal that it is wiling to settle tax evasion cases, then the incentive is to evade now (baka makalusot) and settle later; the possible savings in unpaid taxes is probably much larger than the surcharges and penalties anyway.

My recommendation? Well what is that program called? Run After Tax Evaders. Not after their money. And not just run - get the goods on them, and finish the job.

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