Measuring Illegal Activity and the Effects of Regulatory Innovation: A Study of Diesel Fuel Tax Evasion

The taxation of diesel fuel varies by use. Consumers using diesel fuel on-road must pay state and federal highway taxes while diesel fuel consumed for residential heating, industrial use, farming or off-road travel do not pay taxes. Variation in the taxation of diesel fuel creates the incentive for firms and individuals to evade on-road diesel taxes. Firms evading on-road diesel taxes purchase untaxed diesel fuel and then use or resell it for on-road use. This paper studies the incentives for tax evasion and the effects of regulatory changes meant to limit evasion of on-road diesel taxes. We propose a model of fuel tax evasion in which firms choose to purchase quantities of taxed and untaxed diesel fuel based on a heterogenous cost of evading and an endogenously set level of regulatory enforcement. In addition, we empirically study the effects of regulatory innovation in October 1993, including the addition of dye to untaxed diesel fuel, which increase the costs of evasion and lower the costs of regulatory enforcement. We estimate the effect of the regulatory changes on statelevel sales of diesel fuel and untaxed heating oil. We find that sales of diesel fuel rose 35 percent following the regulatory change while sales of untaxed heating oil fell by a similar amount. This suggests that the regulatory changes substantially limited the amount of diesel fuel tax evasion. In addition, we exploit differences in state-level on-road diesel taxes as a source of variation in the incentive for evasion. We find evidence consistent with the comparative statics of our model the change in the sales of diesel fuel following the regulations were greater in areas with higher state on-road diesel taxes. ∗The authors thank Christopher Synder for helpful comments and conversations. †University of California at Santa Cruz. [email protected] ‡John F. Kennedy School of Government, Harvard University. Erich [email protected].