Simply stated, people respond to incentives. When tax rates are punitive, folks earn and report less taxable income, and vice-versa.
In a previous post, I quoted an article from the International Monetary Fund, which unambiguously concluded that high tax burdens are the main reason people don’t fully comply with tax regimes.
Macroeconomic and microeconomic modeling studies based on data for several countries suggest that the major driving forces behind the size and growth of the shadow economy are an increasing burden of tax and social security payments… The bigger the difference between the total cost of labor in the official economy and the after-tax earnings from work, the greater the incentive for employers and employees to avoid this difference and participate in the shadow economy. …Several studies have found strong evidence that the tax regime influences the shadow economy.
Indeed, it’s worth noting that international studies find that the jurisdictions with the highest rates of tax compliance are the ones with reasonable tax systems, such as Hong Kong, Switzerland, and Singapore.