Quantifying Deadweight Loss of Taxation with Evasion and

Avoidance: Evidence from Trade Taxes in Iran

Kowsar Yousefi1,2

Hanifa Pilvar3

April. 2018

Abstract: The impact of Illegal trade (evasion) on welfare is vastly investigated in different theoretical
models. We add to this literature by introducing exempt-tariff imports, called as tariff avoidance and obtain
welfare implications of tariff raise with evasion and avoidance. Our model assumes a small open economy
with endowed households who can choose between three methods of importing: legally with paying full
tariffs, exempted imports, and illegal trading. Those agents who seek for exemptions or illegal methods
burden with opportunity cost, and illegal trading is associated with an additional penalty. We solve the
model for equilibriums with and without the two types of tariff noncompliance (i.e., exemption and illegal
trade), and obtain sufficient statistics for welfare analysis. Results indicate that in equilibrium without
illegal trade (evasion), the elasticity of tariff-paid import is sufficient to calculate welfare loss associated
with tariff raise. Same statistics is sufficient if the economy burdens with exemption. However, with illegal
trade, the statistics depends on a weighted average of tariff-paid imports, exempted imports and aggregate
imports. Weights are determined by the resource cost associated with the noncompliance. Results indicate
that in an equilibrium where evasion and avoidance exists, there are three welfare reducing mechanisms:
consuming lower amount of foreign products due to higher relative prices, diversion of formal imports into
informal sector, and increase in request for exemptions. Therefore, welfare implications of tariff raise is
larger in an environment with evasion and avoidance.

Key words: Import Tariffs, Illegal Import, Smuggling, Evasion, Avoidance, Welfare.

1
Assistant Professor of Economics, Institute for Management and Planning Studies, Tehran, Iran. Email:
k.yousefi@imps.ac.ir or yousefi.kowsar@gmail.com,
2
We gratefully acknowledge comments by Professor Friedrich Schneider, Amir Kermani, Mohammad Vesal, Seyed
Ali Madanizadeh, Mostafa Beshkar, Mohammad Hosseini, and seminar participants in UECE Game Theory Lisbon
Meetings, Lisbon, Portugal (2016) and weekly meetings at School of Economics, Sharif University (2017). Moreover,
we are thankful to Iran Custom and IMPS research deputy for providing dataset of this study. All mistakes are ours.
This study is funded by (deceased) Dr Kazemi Ashtiyani grant (Iranian National Elite Foundation).
3
Graduate of Economics (MS level), Sharif University.

1
1. Introduction

The elasticity of taxable income is known as the sufficient statistics to derive the deadweight loss
associated with increasing income tax (Feldstein, 1999). However, this statistics is not sufficient
when tax evasion and tax avoidance exist, and they are associated with auditing cost, or
externalities to the society. In such an economy, the excess burden of taxation “depends on a
weighted average of the taxable income and total earned income elasticities, with the weight determined
by the resource cost of sheltering income from taxation.” (Chetty, 2009) Thus, in the context of income
taxes, quantifying the excess burden of taxation with evasion and avoidance is not possible since
total incomes are endogenously sheltered and not observable by data collectors.

The main contribution of the current study is to introduce a framework for measuring the
deadweight loss of taxation. We consider trade taxes, for which both types of non-compliance (i.e.,
evasion and avoidance) are well established in the literature. We quantify welfare changes of
raising import taxes, in line with a theoretical general equilibrium model. In this setup, evasion
corresponds to illegal imports and avoidance denotes exemptions. We solve a general equilibrium
model for a small open economy, in which the level of evasion and avoidance are chosen
endogenously by optimizer agents. Further, we derive welfare statistics and empirically estimate
it using disaggregated trade data.

Details of the model are as following. There are two types of home and foreign goods and a
representative household who optimizes their level of consumptions. Moreover, the household has
three choices for importing the foreign goods that she is going to consume: legal importation with
fully paid tariffs, exempted legal imports (avoidance), and illegal import4 (evasion). The two latter
cases are considered as nonconformity manners, for which she has to bear an opportunity costs.
Moreover, illegal importing is associated with penalties enforced by the government. The penalty
is in the form of a transfer to the society (equivalent to public goods provision by the government).
The results of our model indicate that smuggling diverts formal import to informal sector until the
marginal cost of illegal import is equalized to the (import) tax rate. Also, the level of seeking for

4
We use these words interchangeably: smuggling, illegal imports, and evasion. Also, Tariff exemption is equivalent
to tariff avoidance. There are scholars who denote smuugling as trading forbidden goods (i.e., Fisman and Wei,
2004) and other ones who use this word for the manner of illegal importing. (Lovely an Nelson, 1995). In Iran,
government and media follow the latter.

2
exemptions is endogenized in the same way. Generally speaking, households compare the
expected marginal cost of disobedience with the tax rates. Theoretical findings indicate that in an
equilibrium with corner solution of zero evasion, the elasticity of taxable5 import is sufficient
statistics for welfare assessment. Nevertheless, in an equilibrium with non-zero level of evasion
this welfare formula needs to be adjusted to a weighted sum of aggregate imports, legal imports
and taxable imports. This finding is consistent with the Chetty (2009).

The equilibrium condition of the economy depends on the parameters of the model. For example,
if the marginal costs of evasion is too large, there would not be any illegal importation at the
equilibrium. Different equilibrium solutions are as following: 1. full compliance (no evasion or
avoidance exist at equilibrium), 2. An equilibrium with taxable and exempted imports, 3.
Equilibrium with taxable imports and illegal imports, 4. Equilibrium with all three types of
importing (taxable, exempted and evaded import).

Welfare changes in equilibriums 1 and 2 (with no illegal imports) are obtained by the standard
𝜏𝜕𝑇𝐼
sufficient statistics ( ), where 𝜏 is the import tax rate and 𝑇𝐼 is the fraction of legal imports
𝜕𝜏

which pays full tariffs (called as taxable income in the tax literature). All the same, if the economy
is at equilibrium number 3 or number 4 and smuggling is non-zero, the above formula is not
sufficient; mainly due to the externality associated with the transfers to the society. In equilibrium
with evasion, the society’s total welfare becomes less sensitive to tax raise. Further, increasing
anti-smuggling auditing reduces welfare sensitivity to tax raise.

The empirical contribution of this study is to quantify welfare changes using disaggregated dataset
of a developing country. The dataset is from Iran’s custom administration. There are many
evidences in the data and official reports which confirm that the level of exemptions and illegal
importing are non-zero in Iran. Thus, to pursue the empirics, we employ theoretical equilibrium of
number 4, in which the level of evasion and avoidance are non-zero.

The units of observations are 6 digits of HS codes and exporting countries. Exports are regarding
from each of these countries to Iran. We select 20 top trade partners of Iran. For each specific
good, the value of exports by a country are taken as the aggregate import to Iran. The legal imports
is taken from the reported imports by the Iran’s custom. Finally, taxable import is the share of legal

5
Share of import which pays full taxes (=tariff+value adde tax).

3
imports which pays full taxes. Import tax contains tariffs and value added taxes, which is good–
specific. Data is from 2004 to 2011.

We use a fixed effect panel model to estimate the elasticity of aggregate imports, legal imports,
and taxable imports w.r.t import taxes. The aggregate imports shows the least response to tariffs,
albeit negative (-0.014). This can be interpreted as the lower consumption of foreign good as its
price goes up. Next comes the elasticity of legal imports which is negative but larger in magnitude
(-0.15). This elasticity is derived by two mechanisms: increase in expenses of foreign purchase
plus and diversion of formal importation into informal sector. Last by not least is the elasticity of
taxable imports, which has the largest absolute value (-0.5). Three mechanisms are causing such a
large elasticity: rising price of foreign good, diversion of some of legal imports to illegal section,
and seeking for exemptions. Back to the statistics, if one uses the standard sufficient statistics
𝜕𝑇𝐼
(𝜏 ) to quantify deadweight loss of tax raise while the evasion exists, the estimate would be
𝜕𝜏

upward biased (in magnitude).

We are not the first to investigate the noncompliance in the trade literature. Many notable studies
address the impacts of smuggling on welfare. Even though the trade theories imply that optimal
tariffs are zero in a small economy with a competitive market, zero tariffs are rare in practice. In
such a situation where the government is not ruling optimally, it is ambiguous whether evading a
nonoptimal rule is welfare decreasing or not. Current response to this concern is mostly theoretical
and depends on the model’s assumptions. Some scholars assume that smuggling is competitive
and requires no resource cost, and formal trade is just a cover for informal activities; as a result,
illegal import is equivalent to tariff reduction and increases total welfare. (Pitt, 1981; Thursby et
al, 1991) Other studies (O’Connell, 1992; Daubrée, 1995) assume an increasing marginal cost for
smuggling which diverts current trade rather than creating a new one.

Our model could be extended in variety of aspects. On theoretical side, assume a general
equilibrium model. Potential mechanisms through which smuggling improves welfare could be
categorized as 1. reducing price levels and 2. increasing production frontier; 3. Neutralizing a
nonoptimal policy of tariffication when exporters are inelastic with respect to domestic prices (in
which, full tariffs pass through domestic prices rather than reducing exporters pricing). Though,
the welfare reducing channels are 4. diversion of formal imports to exempt-seeking and illegal
imports which lowers government income; 5. resource waste of noncompliance activities. Our

4
model mutes the first two mechanisms by assuming numeraire pricing for the home product; also,
foreign goods are priced exogenous to the home country. Moreover, production frontier is
determined by the endowment of the economy and not affected by smuggling. Notwithstanding,
the two aforementioned welfare reducing channels are active in our model, in addition to the
channel 3 which is an escape from non-optimal government policies. The welfare analysis of such
a general equilibrium model can be obtained using Envelope Theorem. An extension of this
framework can be employed for a trade model with all four mechanisms implemented in it.

One of the challenging aspects of the trade literature is the smallness of welfare impact of
liberalization. The influential paper by Arkolakis et al. (2008) shows that the welfare margin is
negligible in a standard new trade model. Notably, introducing noncompliance solves part of this
puzzle. A notable study by Sequeira (2016) reports that in an African economy, the elastic bribery
system neutralizes the effect of liberalization. Our paper contributes to this literature by adding
avoidance and evasion to a theoretical model of a small open economy. Our framework can be
extended to the new trade theories with monopolistic competitions.

The rest of the paper is organized as follows. The model is described in section (2). Section (3)
and (4) are respectively introducing the dataset and empirical results. Robustness checks are in
section (5) and conclusion comes in the last section.

2. Literature on Models of Smuggling

Different aspects of informal trade are widely studied in the literature. Some scholars use the word
smuggling for trade of the forbidden goods (human trade, ancient goods) and the word illegal trade
for the manner of illegally trading (Fisman and Wei, 2004, 2005; Mishrea et. al., 2008). However,
there are other scholars who call the illegal manner of trading as smuggling (Bhagwati and Hansen,
1973, Lovely and Nelson, 1995; and many others). Golub (2015) provides a notable survey on
different categorizations and their examples in Africa. In this study, smuggling and illegal trade
are interchangeably used for the manner of illegal trading6.

6
In the formal reports provided by the Iranian agencies, smuggling is used for either the manner of illegal trading or
trading forbidden goods, i.e. heroin.

5
There are many studies on the welfare impacts of smuggling. The main questions of this literature
are: who provides resources for smugglers? Does smuggling create new trade or divert the current
one? What is the welfare implication if one assumes smuggling as a way to free trade? Which
channels link smuggling with welfare? We follow the literature review by focusing on different
approaches taken by scholars in these three questions.

Bhagwati and Hansen (1973), one of the first studies in this literature, assume that smugglers use
foreign resources and burden no resource cost on the home economy. On the other hand, different
studies by Sheikh (1974) and Lovely and Nelson (1995) are assuming a more reasonable
assumption that smuggling is an activity within the economy, which uses the economy’s resources.
There are scholars who are making an extreme case assumption of no resource cost associated with
smuggling, besides the assumption that legal activities exist because they are used as a cover for
illegalities (Pitt, 1981; Thursby et al., 1991).

Lovely and Nelson (1995) measure the short-run impacts from tariff increase, and strengthening
anti-smuggling efforts. In the former case, if resources are reabsorbed to formal sector, a positive
impact on welfare occurs. Otherwise the impact is negative. Strengthening auditing efforts activate
two channels: reduction in smuggling with a positive effect, and increasing domestic prices with a
negative impact. The overall impact is ambiguous. Our study focuses on the short-run, too. We
reasonably make simplistic assumptions on the price level (numeraire for home and exogenous for
the world) and employ Envelope Theorem to obtain welfare statistics.

On the long-run horizon, some scholars compare the two static equilibriums of no smuggling, and
tariff-run economy with smuggling. In that set up, they discuss whether smuggling causes domestic
prices to fall (and adds to consumer surplus); and if lost government income is neutralized by
additional consumer surplus. Different assumptions on marginal cost of smuggling (increasing,
decreasing, and flat) is pivotal in obtaining results 7 . All these models assume a competitive
domestic marker.

7
For more details, see the survey by Golub, 2015.

6
4. Model and Results
Consider a small open economy, which consists of households (with endowment y 8 ) and a
government with a balanced budget. The household utility encounters consumption of domestic
and foreign products. Importing foreign goods is taxed by the government at rate 𝜏. However, the
households may shelter her actual consumption from the custom agencies. Sheltering could be
either in the form of evasion or avoidance. Avoidance is a legal act of pursuing exemption and
requires opportunity costs; this can be interpreted as the time needed for acquiring trade licenses.

Evasion undergoes with two types of costs: resources and penalty. The former is the opportunity
costs of looking for informal means of import. The latter is the penalty of illegal act of evasion,
which is collected by the government. The government then uses this source of income to balance
his budget (i.e., to provide public goods). There are different models which can be employed for
the penalty; i.e. Allingham and Sandmo (1972) or Chetty (2009a). These scholars assume that
individuals are audited with probability prob(e), where e is the amount of evasion, and prob(.) is
an increasing function of e; that is, higher evasion increases the chance of being caught. In that
case, the evader must pay her tax bill plus an extra fine, which depends on the tax rate 𝜏 and the
amount of evasion e: F(e, τ). The expected penalty of evasion is shown by 𝑧(𝑒, 𝜏) and is equal to
𝑝𝑟𝑜𝑏(𝑒)(𝜏𝑒 + 𝐹(𝑒, 𝜏)). Our main results are robust to different functional forms of the penalty
deterrence function.

We assume a log-linear function for the household utility. The consumption of home product
shows up in a linear form; while the foreign product is in a logarithmic form. Therefore, there is
no risk associated with the consumption of home products while the risk aversion associated with
the consumption of foreign good assures that its equilibrium level is nonzero. This form of utility
eases solving the model. Also, a general case is discussed in the appendix.

The household maximizes his utility, subject to the budget constraint:

max. u(cd , cf , a, e) = cd + ln(cf ) − g(e, a)

s. t. cd + (1 + τ)(pcf − a − e) = y − a − e − z(e, τ) ∶ 𝜆
𝑎≥0 ∶𝛾
𝑒≥0 ∶𝜂

8
Alternatively, one can assume that households own labor endowment (l) and production technology f(.). Our
results are robust to this assumption.

7
where, 𝑐𝑑 is the consumption of domestic products, 𝑐𝑓 is the consumption of foreign products, y is
the endowment given to the household, e and a stand for evasion and avoidance, respectively; and
𝜏 is the ad-valorem statutory tariff rate9. The agent is risk neutral on domestic consumption (which
is more abundantly available) and risk averse on foreign goods (thus, the two goods are not
complete substitutes). Home product is numeraire, while the price of foreign product is noted by
𝑝. The country is considered as a small market with no impact on the world price (p). Therefore,
p is exogenously determined in this model. The shadow price of constraints are indicated by 𝜆, 𝜂
and 𝛾.

As mentioned earlier, three categories are distinguishable in our model. Aggregate Imports (AI) is
denoted by pcf , Legal Imports (LI) is equal to aggregate import minus evasion (pcf − e), and
Taxable Imports (TI) is pcf − a − e. Illegal import is the difference between AI and LI; and
exempted import is the difference between LI and TI.

Equilibrium: At equilibrium, the international market clears: 𝑝𝑐𝑓 = 𝑋; where, 𝑋 is the value of
exports. In the home market, market clearing for the domestic products indicates: 𝑋 + 𝑐𝑑 = 𝑦.

The government budget constraint is balanced at equilibrium: 𝑝𝑢𝑏𝑙𝑖𝑐 𝑔𝑜𝑜𝑑𝑠 = 𝜏(𝑝𝑐𝑓 − 𝑎 − 𝑒 ) +

𝑍(𝐸, 𝜏), where, Z is the total penalty paid by the society and 𝐸 is the aggregate amount of evasion.
At equilibrium, the consistency between society’s and individual’s action holds and requires that
𝑧 = 𝑍 and 𝑒 = 𝐸.

It is important to understand which mechanisms are driving the results. Overall, four mechanisms
can be identified as the impact of tariffs noncompliance on the welfare: price reduction due to not
paying tariffs, shifting the production possibility frontier due to accommodating imports of
intermediate goods, neutralizing nonoptimal tariff policy, diversion of formal imports into
informal sector (which requires higher opportunity costs), and resource wastes due to more
requests for exemptions and use of loopholes. In our model, the first two mechanisms are mute.
Here, the price level is independent of smuggling: The domestic prices are numeraire, and the
foreign price p is exogenous to the home country (because it is relatively small). Thus, here there

9
The budget constraint is a re-written form of 𝑐𝑑 + (1 + 𝜏) ⏟
(𝑝𝑐𝑓 − 𝑎 − 𝑒) + 𝑎 + 𝑒 = 𝑦 − 𝑧(𝑒, 𝜏)
𝑖𝑚𝑝𝑜𝑟𝑡𝑠 𝑤ℎ𝑖𝑐ℎ 𝑖𝑠
𝑙𝑒𝑔𝑎𝑙 𝑎𝑛𝑑 𝑡𝑎𝑥−𝑝𝑎𝑖𝑑

8
is no mechanism through which the smuggling reduces prices. Moreover, the production frontier
is not affected by smuggling. It is determined by the households’ endowment. Therefore, the only
welfare improving channel which is activated by noncompliance is the escape out of non-optimal
tariffication (remind that optimal import tax is zero for a small economy). Moreover, two welfare
reducing forces are working: smuggling causes formal imports to divert into informal sector; and
increases the resource waste due to the penalty which may be imposed to evaders.

In our model, there is no trade creation due to non-compliance. The first order conditions w.r.t 𝑐𝑑
1
implies that 𝜆 = 1 and = 𝜆(1 + 𝜏). Thus, the value of imported foreign goods is a reverse
𝑝𝑐𝑓

function of tariff rates. Similarly, the consumption of home product is independent of

noncompliance. The value of domestic production is obtained using equilibrium equation: 𝑐𝑑 =
𝑦 − 𝑋. If we substitute X with the balance trade, we have 𝑐𝑑 = 𝑦 − 𝑝𝑐𝑓 . Therefore, introducing
evasion and avoidance doesn’t change the equilibrium amount of domestic and foreign
consumptions.

The F.O.C with regards to evasion is – 𝑔𝑒 + 𝜆(1 + 𝜏) − 𝜆 − 𝜆𝑧𝑒 + 𝜂 = 0; where, 𝑔𝑒 and 𝑧𝑒 are
respectively the marginal opportunity costs and marginal penalty associated with the evasion. By
substituting 𝜆 = 1 we obtain 𝜂 = 𝑔𝑒 + 𝑧𝑒 − τ. The optimal level of evasion is zero when its
shadow price is positive, or, 𝜂 > 0 which is equivalent to 𝑧𝑒 + 𝑔𝑒 > 𝜏 . If we do the same
procedure for the avoidance, we obtain a condition 𝑔𝑎 > 𝜏 which holds if the optimal level of
avoidance is equal to zero. These two conditions (𝑧𝑒 + 𝑔𝑒 > 𝜏 and 𝑔𝑎 > 𝜏) hold when 𝜏 is small
or the noncompliance costs are negligible. Apart from those corner equilibriums, the household
chooses avoidance and evasion such that: 𝑧𝑒 + 𝑔𝑒 = 𝜏 and 𝑔𝑎 = 𝜏.

One may assume that 𝑔𝑒 , 𝑔𝑎 and 𝑧𝑒 are structural parameters of the economy showing how the
housholds’ oppurtunities are distributed or how the government reacts to rent seeking activities.

Welfare implications: The social welfare function is defined as the sum of individual’s utility and
the government revenue (tax + transfer costs)10,11:

10
The terms denoting people income (wL+d) is constant with respect to change in tariffs: given the perfect
competition in domestic market, the dividend is zero.
11
To close the model, one needs to assume balanced trade.

9
 W(τ) = {y − a − e − z(e, τ) − (1 + τ)(pcf − a − e) + ln(cf ) − g(a, e)} + τ(pcf − a − e)
+ z(e, τ)
Using envelop theorem for the agents’ optimized variables (i.e., consumption, labor, avoidance
and evasion), the marginal excess burden of tariffs could be obtained as follows:

dW ∂z ∂(pcf − a − e) ∂z ∂z ∂e
= − − (pcf − a − e) + (pcf − a − e) + τ + +
dτ ∂τ ∂τ ∂τ ∂e ∂τ
∂(pcf − a − e) ∂z ∂e ∂TI ∂z ∂e
=τ + = τ( ) +
∂τ ∂e ∂τ ∂τ ∂e ∂τ
where, 𝑇𝐼 = pcf − a − e (total foreign purchase minus sheltered amount). We know from the
agent’s optimization problem that the amount of evasion and avoidance are endogenously chosen
such that the marginal cost of complying with tariffs is equal to the marginal benefit of
∂g ∂z ∂g
noncompliance; in other words we have = τ and ∂e + ∂e = τ. Thus, with a simple algebra,12
∂a

we can drive the marginal excess burden of taxation in terms of the derivatives of imports:

dW ∂AI ∂LI ∂TI

= τ[(1 − μ) ( ∂τ ) − (1 − μ) ( ∂τ ) + ] (1)
dτ ∂τ

where, AI or the aggregate import is an alternate notation for 𝑝𝑐𝑓 , LI or legal imports corresponds
∂g ∂g
∂e ∂e
to 𝑝𝑐𝑓 − 𝑒 and TI stands for pcf − a − e. We define μ = = ∂g ∂z , which represents the ratio
τ +
∂e ∂e

of marginal resource cost of evasion to the tax rate, or the share of marginal resource cost of total
marginal cost of evasion. This parameter (𝜇) is between 0 and 1, with zero corresponding to
infinite marginal auditing deterrence and 𝜇 = 1 corresponding to no penalty. Now equation (1)
can be rewritten as following:

dW ∂AI ∂(AI−LI) ∂(LI−TI)

=𝜏 − 𝜏𝜇 ( )−𝜏( ) (1a)
dτ ∂τ ∂τ ∂τ

This form is useful in distinguishing three different deriving forces of tariff raise: increase in
∂AI ∂(AI−LI)
relative prices ( 𝜏 ), diversion into informal sector ( 𝜏𝜇 ( ) ) and more request for
∂τ ∂τ
∂(LI−TI)
exemption ( ). With an increase in tariffs, higher relative price of foreign product reduces
∂τ

aggregate imports; similarly, legal and tariff-paid imports are affected by this force. The second

12 𝜕𝑇𝐼 𝜕𝑧 𝜕𝑒 𝜕(𝐴𝐼−𝑒−𝑎) 𝜕𝑧 𝜕𝑒 𝜕𝐴𝐼 𝜕𝑒 𝜕𝑎 𝜕𝑧 𝜕𝑒 𝜕𝐴𝐼 𝜕𝑎 𝜕𝑒 𝜕𝑧 𝜕𝐴𝐼

𝜏( )+ = 𝜏( )+ = 𝜏( )−𝜏 −𝜏 + = 𝜏( )−𝜏 + ( − 𝜏) = 𝜏 ( )−
𝜕𝜏 𝜕𝑒 𝜕𝜏 𝜕𝜏 𝜕𝑒 𝜕𝜏 𝜕𝜏 𝜕𝜏 𝜕𝜏 𝜕𝑒 𝜕𝜏 𝜕𝜏 𝜕𝜏 𝜕𝜏 𝜕𝑒 𝜕𝜏
𝜕𝑎 𝜕𝑔 𝜕𝑒 𝜕𝐴𝐼 𝜕𝑎 𝜕𝑒 𝜕𝐴𝐼 𝜕(𝐿𝐼−𝑇𝐼) 𝜕(𝐴𝐼−𝐿𝐼) 𝜕𝐴𝐼 𝜕𝐿𝐼 𝜕𝑇𝐼
𝜏 − ( ) = 𝜏[ − − 𝜇 ( )] = 𝜏 [ − −𝜇 ] = 𝜏[(1 − 𝜇) ( ) − (1 − 𝜇) ( )+ ]
𝜕𝜏 𝜕𝑒 𝜕𝜏 𝜕𝜏 𝜕𝜏 𝜕𝜏 𝜕𝜏 𝜕𝜏 𝜕𝜏 𝜕𝜏 𝜕𝜏 𝜕𝜏

10
mechanism which is the diversion of formal imports into informal sector has no impact on
aggregate imports; however, it causes an additional reduction in legal and tariff-paid imports. The
last deriving force, which is more exemption requests, is only effective on the tariff-paid imports
(TI). In other words, two deriving forces which cause changes in LI are higher relative prices and
diversion of formal trade into informal sector. Both these mechanisms are welfare reducing.
Changes in TI are derived by all three possible mechanisms: higher relative prices, diversion into
informal sector and higher level of exemption. We expect that importers seek for more exemption
when tariffs are higher. Thus, all these mechanism are having same direction and we have:

∂TI ∂LI ∂AI

< < <0 (2)
∂τ ∂τ ∂τ

We continue by assessing different equilibriums which may occur based on model parameters.

1. Equilibrium with no evasion and no avoidance: assume 𝑧𝑒 + 𝑔𝑒 > 𝜏 and 𝑔𝑎 > 𝜏. Thus, the
∂W ∂AI ∂TI
benefit of noncompliance is less than its cost and equation (1a) becomes: =𝜏 =𝜏
∂τ ∂τ ∂τ

(noting that AI=LI=TI). This result is similar to what is known as sufficient statistics in the tax
literature. Which is defined as the “taxable income formula for deadweight loss.” (Chetty, 2009) Here,
the only mechanism which is in effect is the reduction of foreign goods consumption due to higher
1
relative prices (𝑝𝑐𝑓 = 1+𝜏)

Equilibriums with non-compliance: now assume that 𝜏 increases till at least one of the
inequalities (𝑧𝑒 + 𝑔𝑒 > 𝜏 and 𝑔𝑎 > 𝜏) are violated. As a result, three different states might occur:

2. Equilibrium with a>0 and e=0; we have AI=LI (no evasion) and TI<LI (avoidance is non-
∂W ∂AI ∂(AI−TI) ∂TI
zero). Thus, equation (1a) becomes =τ −𝜏( )=τ . Similar to an
∂τ ∂τ ∂τ ∂τ

equilibrium with no evasion and avoidance, here, derivative of taxable import is sufficient
statistics to quantify the deadweight loss. Two deriving forces are lower consumption due to
higher relative prices and more request for exemption.

11
3. Equilibrium with a=0 and e>0. Illegal import exists (AI>LI) and seeking for exemption is
∂AI ∂(AI−LI) ∂AI
not optimal; therefore: TI=LI. Equation (1a) becomes 𝜏 − 𝜏𝜇 ( )= ⏟ −
∂τ ∂τ ∂τ
−
𝑖𝑙𝑙𝑒𝑔𝑎𝑙
⏞
∂(AI−LI )
𝜏𝜇 ( ).
∂τ
⏟
+

In this environment, an increase in tariffs activates two mechanisms: reduction in aggregate

imports due to higher relative price of foreign products, and increase in illegal imports. Both
∂TI
mechanisms are welfare reducing. Here, 𝜏 is not a sufficient statistics any more.
∂τ

4. Equilibrium with a>0 and e>0. This is the general case. As shown in equation (1a), the
∂AI ∂(AI−LI) ∂(LI−TI)
deadweight loss of taxation is 𝜏 − 𝜏𝜇 ( )−𝜏( ). Again, changes in AI is
∂τ ∂τ ∂τ
∂(AI−LI)
derived by higher relative prices. The second term ( ) indicates changes in illegal
∂τ
∂(LI−TI)
imports, which is expected to be positive; and the third term, corresponds to changes
∂τ

in avoidance.

5. Data Description

Our data13 is coming from two main sources: UNCOMTRADE and Iran Custom Administrative.
We use UNCOMTRADE database to obtain exports of other countries to Iran, in 6 digits of HS
Code. Iran used HS2002 version until 2009 and 2007 version afterward; we adjusted the data of
COMTRADE accordingly. We restrict our study to top trading partners, which account for 75%
of total import (in 2013), plus countries which have a preferential trade agreement 14 with Iran; In
our final dataset, there are 23 countries from 2004 to 2011. It is notable that our study is to measure
“elasticities,” therefore not having all the countries in the sample wouldn’t cause any bias.

13
The data of this study is similar to the Yousefi, Vesal and Pilvar (2018).
14
Bosnia and Herzegovina, Cuba, Kyrgyzstan, Pakistan, Tunisia, Turkey

12
Official imports are obtained from Iran’s Custom Administrative. This dataset encompasses
import values (in Rial and US Dollar), paid tariffs15 and exporting countries. The Custom data is
disaggregated into 8 digits of HS codes. However, we have to aggregate it to HS6 to be compatible
with UNCOMTRADE.

We adjust for the difference between calendar year of the two dataset. The Iran’s custom data is
in Hijri calendar, while the UNCOMTRADE is in Gregory. We use a simple algebraic transform
as following: Year in Hijri calendar= Year in Gregory calendar -621, followed by transforming
variable16:

10 2
Variableyear in Hijri = 12 Variableyear in Gregory + 12 Variableyear in Gregory+1.

Our final dataset is based on Hijri calendar; however, we report the equivalent Gregorian year
because it is more familiar with the general audiences. Our final dataset is a panel of products-
partner, in HS 6 digit, from 2004 (Hijri: 1383) to 2011 (Hijri: 1390).

Exports by producer country are given as the aggregate import 17 (AI). Legal imports (LI) is the
imports recognized by the Iranian custom; and finally, taxable import (TI) is a share of LI with
Custom revenue
fully paid statutory tariffs: TI = .
statutory tariffs

We follow Fisman and Wei (2004) to measure a proxy of illegal import, which equals to the
discrepancy between reported export of partners and the reported import of Iran (similar to Fisman
and Wei, 2004).

We merge different data sources; therefore, any year-country with no official reporting is dropped
in the final dataset (i.e., Kyrgyzstan 2012-2013). Moreover, due to use of logarithmic forms, goods
with zero import are also excluded. Even-though these cleaning ends up with loosing 25% of the
original trade dataset, we are not concerned whether it biases the findings; because, non-reporting

15
Paid tariff might be different from statutory rate. This gap is used as a proxy for exemptions, which is legally
assigned if the importer is qualified. There are several qualification restrictions, including import of capital goods
for the purpose of production, road-building equipment, home devices for residents of foreign countries, etc.
16
Each Gregorian year starts in 12th of Dey, which is the 10th month of the Hijri calendar.
17
There might be some products which are illegally exported, and illegally imported. Those products never be
observed in our dataset.

13
has no correlation with tariff rates. Similar issue exists in the literature, such as, Fisman and Wei
(2004), Mishra et. al. (2008).

Statutory tariffs are obtained from the Handbook of Custom Regulations. It publishes annually by
the Ministry of Industry and Trade, and contains all the import regulations 18. Iran has started
collecting VAT since 2008, with a rate of 3% for the eligible goods in the introductory year, and
increased it to 4, 5, and 6% in 2011, 2012, and 2013. We used the sum of statutory tariff and value
added tax as the total trade tax implemented on goods.

There are total of 16,450 observations with tariff anomalies (7.7% of data) which are dropped. The
implemented tariffs of these observations were higher than statutory rate ( 𝜏𝑖𝑚𝑝𝑙𝑚𝑒𝑛𝑒𝑡𝑒𝑑 >
(1 + 0.05) × 𝜏𝑠𝑡𝑎𝑡𝑢𝑡𝑜𝑟𝑦 ). These observations could be due to data errors or change in statutory
tariffs in the middle of the year 19 . Either way it is not identifiable by us; therefore those
observations are dropped out of the final dataset.

We make the following corrections in order to obtain an accurate and compatible data set. First,
after the imposition of international sanctions against Iran in 2011, Iran’s Ministry of Industry,
Mine and Trade introduced 10 different categories, known as priorities (olavieyat). According to
this categorization, different multipliers were imposed on goods. For example, import of
commodities subject to the 10th priority prohibited in the second half of 2011 (following exchange
rate crisis). By the presidential election and change of cabinet in the following year, the prohibition
removed but the tariff rates were doubled. Since our data is annual, we are not able to identify
changes in the middle of the year. Therefore, we exclude years>2010 in the final dataset.

Iran has several preferential trade agreements (PTA) with countries like Pakistan, Cuba, Bosnia
and Kyrgyzstan. These PTAs include a limited list of goods for which reduced tariff rates are
implementing. Preferential tariffs are obtained from the appendix of “Iran’s Import and Export
Regulation Hand Book, 2015 (1394)”. For countries with a preferential trade agreement with Iran,
we exclude the list of goods with such preferential discount

18
In 2012, tariffs doubled for certain goods due to exchange crisis, which were not been mentioned in the book. We
have the list of goods with doubled tariffs, called as priority=10.
19
Although the Trade Law verifies that any changes in tariffs must be executable only at the beginning of the
following year, some exceptions could be find.

14
 Finally, some minor issues still remain in our data. First, in some partner-HS code observations,
reported export of the partner (AI) is less than Iran’s reported import (LI) which seems as if there
is a negative amount of evasion or over measurement of import. In these cases either the
measurement error or the misinvoicing are playing the main role. We rely on fixed effect estimator
to control the impact of these issues on the estimated correlations.

Table 1 shows data statistics. The average tariff is about 20% (ad valorem), while the average
actual tariff rate is 18%.

Table 1: Data Statistics

Mean SD Min Max P50 P75
Total Exports by Iran’s partners, called as 1.595 11.948 0.00 911.71 0.083 0.503
Aggregate Imports(AI), in Million Dollars

Custom imports by Iran, called as Legal Import 1.093 8.643 0.00 857.29 0.051 0.341
(LI), Million Dollars

Fraction of Custom imports with full 𝜏𝑠 , called 1.072 8.399 0.00 857.29 0.080 0.394
as Taxable Import (TI), Million Dollars
Log(illegal imports) 0.173 2.351 -16.38 12.08 0.226 1.427
Log(tax) 2.647 0.880 1.39 5.01 2.708 3.350
Government oil income, in Billion Dollars 3.172 0.405 2.77 3.95 3.027 3.738
𝑓𝑟𝑒𝑒 𝑋 𝑟𝑎𝑡𝑒 − 𝑜𝑓𝑓𝑖𝑐𝑖𝑎𝑙 𝑟𝑎𝑡𝑒 3.7% 7.6% 0.2% 23.8% 0.8% 2.5%
× 100
𝑜𝑓𝑓𝑖𝑐𝑖𝑎𝑙 𝑋 𝑟𝑎𝑡𝑒
Observations 145,001
Note: Table displays statistics of the data; each unit of observation is specified by a 6digits HS code and partner.
Partners are 20 top exporting countries to Iran. Nominal values are in US dollar, constant 2005. The tax variable
denotes tariffs plus VAT taxes. Government custom revenue refers to government trade income.

15
Figure 1: Exports by Partners, Legal Imports, and Taxable Imports, 2004-
2013

Aggregate Legal Imports Taxable Imports

Year
Imports (AI) (LI) (TI)
2004 19435 14948 11632
2005 22401 18542 14300
2006 24907 17929 15250
2007 30013 19970 15844
2008 31188 21545 18630
2009 30063 20650 17035
2010 34729 21440 17827
2011 38597 23524 18909
Note: The figure shows total exports by partners or Aggregate Imports, custom reported imports or the Legal
Imports and Taxable Imports. Values are reported in the table. All nominal values are in million US$, constant 2005.

Figure 1 shows exports by partners (20 top exporting countries to Iran), imports reported by Iranian
custom, and imports which are paid full taxes. As mentioned before, we call those values as AI,
LI and TI, respectively. The discrepancy between AI and LI has widened till 2011. In 2012, when
sanctions caused an exchange crisis in Iran, aggregate import has dropped (not shown in the
figure); in the same year, the gap between illegal and taxable import is widen. The difference

16
between AI and LI is a proxy for illegal imports, while the LI-TI gap encounters exempt imports.
Indeed, both gaps may contain measurement errors.

The discrepancy rises to its largest amount in 2010 and 2011 (about 15 billion US$-2005). It is
about 20% of total imports of the country. Following the international sanctions and exchange rate
crisis in Iran, total imports declined (from 50 to about 40 billion US$-2005 base year).
Simultaneously, the measured discrepancy (proxy of illegal imports) also declined. We exclude
years>2010 due to many different forces in act. (i.e., sanctions, anti sanction activities, currency
depreciation, presidential election)

6. Empirical Results
Table 2 presents elasticities of aggregate import (column 1), legal import (column 2) and taxable
imports (column 3) with respect to tariffs. AI represents total exports reported by exporting
countries; equivalently, it is sum of legal and illegal imports. The measured elasticity of AI (𝜀̂𝐴𝐼 =
−1.4%) shows a low responsiveness in regard to tariffs. Theoretically, it is showing behavioral
impact: consumption of foreign goods decreases when relative prices go up.

The elasticities of LI and TI are estimated equal to -.15 and -.50, respectively. The 𝜀̂𝐿𝐼 encounters
two different forces: more expensive foreign good and diversion of legal imports to illegal section.
The two effects (more expenses+evasion) adds up in 𝜀̂𝐿𝐼 ; which makes the magnitude of 𝜀̂𝐿𝐼 larger
than 𝜀̂𝐴𝐼 (15%>1%).

Taxable Imports (TI) is a fraction of legal imports which pays full taxes. Therefore, the elasticity
of taxable import (𝜀̂𝑇𝐼 ) is consist of three forces: more expenses, evasion and avoidance, and it is
the largest in magnitude (𝜀̂𝑇𝐼 = 50% > 𝜀̂𝐿𝐼 = 15% > 𝜀̂𝐴𝐼 = 1%).

Table 2: Welfare Implications of Tariff Changes, 2004-2011

Panel A: FE Estimations Results-All Data
All observations
(1) (2) (3)
Log(AI) Log(LI) Log(TI)
Log(tax) -0.0140** -0.149*** -0.500***
(-2.02) (-6.56) (-21.35)

17
 Mislabeling -0.00671 0.0284 0.00457
(-0.74) (1.06) (0.17)
Log(Government oil revenue) 0.0771*** 0.290*** 0.465***
(9.77) (12.10) (18.91)
𝑓𝑟𝑒𝑒 𝑋 𝑟𝑎𝑡𝑒 − 𝑜𝑓𝑓𝑖𝑐𝑖𝑎𝑙 𝑟𝑎𝑡𝑒 -0.0207 -0.0887 -0.168**
𝑜𝑓𝑓𝑖𝑐𝑖𝑎𝑙 𝑋 𝑟𝑎𝑡𝑒 (-0.73) (-1.09) (-2.07)
N 120689 120689 118626
Note: Table shows changes in Aggregate Imports (AI), Legal Imports (LI) and Taxable Imports (TI) with respect to
percentage change in tax rate (=tariff + value added tax rate). In all columns we use fixed effect panel regressions,
where units are partner-good (in 6 digits HS code). All models include the following variables: 10 different dummies
for AI splines in 2004, a dummy variable for commodities more vulnerable to mislabeling (this dummy takes the value
1 when the difference between minimum and maximum of tariff rate in the HS 4-digit group is more 10 percentage
point or more), logarithm of government oil revenue (representative as government other incomes), logarithm of
government oil revenue (as a proxy for government’s incomes), ratio of black market premium to official exchange
rate, year dummies and constant term. Fixed effects for each exporting country-HS code (6 digit) are excluded using
FE estimator. Values are in million US$, constant 2005-base year. Robust t-statistics are in parentheses. *, ** and
*** represent, p < 0.1, p < 0.05 and p < 0.01, respectively.

A set of covariates is used to capture aggregate shocks. Official exchange rates and government
oil revenue (as the main source of government income) are obtained from the Central Bank. We
expect tow mechanisms in force when government oil income goes up: less pressure on custom
income induced by the government, and more custom imports due to more abundant resources.
While the former is a negative force, the latter is positive. The net effect is positive and significant
as the coefficient of log(Government oil income) suggests.

We also control for the discrepancy between free market and the official exchange rates (black
market premium). The coefficient has no specific sign; however, it is necessary to be included
because it captures macro disorders in the exchange market.

We define dummy variables for each decile of AI in the base year 2004 (1383) to control for the
impact of high value imports on policy making20. Generally speaking, the custom administration
may intend to extract more revenue from products with larger import value. Nominal dollar values
are deflated into US$-2005, using US GDP deflator (obtained from WDI).

In order to calculate the welfare impact of change in tariff rates, we use the theoretical results
dW
shown in equation (2): = [(1 − μ)𝜀𝐴𝐼 𝐴𝐼 − (1 − μ)εLI LI + εTI TI].
dτ

20
Gruber and Saez (2002) use deciles to control for initial income in their tax investigations.

18
The average values for AI, LI, and TI in our data are 1.7, 1.2 and 0.99 Million US$ (2005 base
year), respectively (Table 1). It means that, the average official import within each of the 6 digit
HS categories and from each of the selective trade partners is equal to 13 hundred thousand dollars,
while about one hundred thousand out of it is exempted (we don’t observe any paid tariffs for
them), and, it is also accompanied by about five hundred thousand illegally imported goods, all in
2005 constant US$. We are not able to measure 𝜇 in our data, however, it ranges from 0 to 1.
Therefore, the welfare implications of tariff changes can be calculated as a function of 𝜇. Panel
𝑑𝑊
(B) of Table (6) shows the resulting diagram. The vertical axis is , measured in million US$,
𝑑𝜏

and the horizontal axis is 𝜇, which is unitless.

It is worth mentioning that, moving along the horizontal axis is meaningless for the purpose of
inference. 𝜇 (=the ratio of marginal resource costs to sum of marginal resource and transfer costs)
is a structural parameter in our model; it is mainly determined by how much the society is
pressuring on rent seekers and illegal importers. Therefore, if one moves along horizontal axis
(changes in 𝜇), the estimated coefficients would change; and the Lucas critique tells us that we
cannot anymore use the current estimated amounts. Therefore, we can find an interval for the
welfare implications of tariff changes: $-115k to $-100k.

Figure 2 : Welfare Implications

19
Note: The figure shows changes in welfare with respect to change in tariff rate in different values of μ. Calculations
dW
are based on equation (2): = [(1 − μ)εAI AI − (1 − μ)εLI LI + εTI TI], and empirical coefficients are estimated in
dτ
Panel A, columns 1-3.

dW
Going back to the derived equation for the , in an economy with μ = 1, sufficient statistics
dτ
δTI
(τ ) is sufficient to drive welfare implications of tariff change. The corner value of -114k US$
δτ

is obtained if one uses such statistics. When the externality of transfer adds to the model, based on
its largeness, the responsiveness of welfare changes reduces. In our model, where optimal tax is
zero, it makes sense that evading tariffs adds to the total welfare. However, in an environment with
non-competitive domestic market, or international bargaining power (where classical terms of
trade works), this finding might change.

20
5. Robustness
A set of robustness tests is shown in Table 3. Main results (Table 2, column 1-3) are copied in
panel A to simplify comparison. Panel B excludes observations with top 90% and low 10% tax
rates. Panel C uses no control variable, except for year dummies, and Panel D uses a log-linear
specification. As the table shows, results are robust qualitatively and quantitavely. The coeffificent
on aggregate imports (AI) indicate the lowest sensitivity w.r.t taxes; while the remaining others
are more elastic.

Table 3: Robustness
(1) (2) (3)
Specification Variable of Interest Log(AI) Log(LI) Log(TI)
Log(tax) -0.0140** -0.149*** -0.500***
Main Model
A (-2.02) (-6.56) (-21.35)
(Table 2)
Excluding observations on Log(tax) -0.0117* -0.0883*** -0.435***
B
top 90% and low 10% of tax (-1.66) (-3.71) (-17.76)
rates
Log(tax) -0.0217 -0.154*** -0.505***
No Controls except for year
C
dummies (-1.00) (-6.59) (-20.95)
Tax -0.000467 -0.0125*** -0.0265***
D Log-Linear (-0.93) (-10.69) (-21.10)

Note: Table shows robustness of results. Panel A is the main results (copied here for simple comparison). Panel B
excludes observations with top 90% and low 10% tax rates. Panel C uses no control variable, except for year dummies,
and Panel D uses a log-linear specification. Columns 1, 2 and 3 show changes in Aggregate Imports (AI), Legal
Imports (LI) and Taxable Imports (TI) with respect to percentage change in tax rate (=tariff + value added tax rate).
In all columns we use fixed effect panel regressions, where units are partner-good (in 6 digits HS code). All models
include the following variables: 10 different dummies for AI splines in 2004, a dummy variable for commodities more
vulnerable to mislabeling (this dummy takes the value 1 when the difference between minimum and maximum of
tariff rate in the HS 4-digit group is more 10 percentage point or more), logarithm of government oil revenue
(representative as government other incomes), logarithm of government oil revenue (as a proxy for government’s
incomes), ratio of black market premium to official exchange rate, year dummies and constant term. Fixed effects for
each exporting country-HS code (6 digit) are excluded using FE estimator. Values are in million US$, constant 2005-
base year. Robust t-statistics are in parentheses. *, ** and *** represent, p < 0.1, p < 0.05 and p < 0.01, respectively.

21
 6. Conclusion

In this article we introduce a model of small open economy in which two types of noncompliance
exist: evasion and avoidance. We obtain deadweight loss of tariff raise in any set of equilibrium
of this economy. The closet paper to ours is the Chetty (2009) who studies sufficient statistics in
the income tax literature.

In the theoretical environment, agents pay resource costs to avoid or evade taxes. Further, they are
subject to potential fines if they evade. Results indicate that adjusted formulas are needed to drive
the marginal burden of taxation in an economy with evasion. Otherwise the estimates would be
upward biased (in magnitude). Our approach to employ taxation in an open economy enables us
to quantify the deadweight loss of taxation, while it is impossible to quantify it in other frameworks
where the actual amount of income is sheltered and not observed.

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23
24
 Appendix B: Model General Case

Consider the case where the utility of the agent is increasing and concave and taxation and auditing is
costly i.e. a proportion of 𝜆 < 1 of tax and fine returns to the government

max. u(cd , cf , a, e) = ψ(cd ) + ϕ(cf ) − g(e, a)

s. t. cd + (1 + τ)(pcf − a − e) = y − a − e − z(e, τ)

W(τ) = {ψ(y − a − e − z(e, τ) − (1 + τ)(pcf − a − e)) + ϕ(cf ) − g(a, e)} + λ(τ(pcf − a − e)

+ z(e, τ))
dW ∂z ∂ψ ∂ψ ∂(pcf − a − e) ∂z
=− − (pcf − a − e) + λ(pcf − a − e) + λτ +λ
dτ ∂τ ∂z ∂τ(pcf − 𝑎 − 𝑒) ∂τ ∂τ
∂z ∂e
+λ
∂e ∂τ
∂AI 𝜕𝑎 𝜕𝑒 𝜕𝑧 ∂ψ ∂ψ ∂z ∂e
= λτ − 𝜆𝜏 − 𝜆𝜏 + (𝜆 − ) + (𝑝𝑐𝑓 − 𝑎 − 𝑒) (𝜆 − )+λ
∂τ 𝜕𝜏 𝜕𝜏 𝜕𝜏 ∂z ∂τ(pcf − 𝑎 − 𝑒) ∂e ∂τ
∂g ∂ψ ∂z ∂ψ ∂g
From the utility maximization of the agent we know that ∂a = τ ∂τ(pc −𝑎−𝑒) and ∂e ∂z + ∂e =
f
∂ψ
τ ∂τ(pc −𝑎−𝑒)
f

∂AI 𝜕𝑎 ∂z ∂e 𝜕𝑧 ∂ψ ∂ψ
λτ − 𝜆𝜏 + (λ − 𝜆𝜏) + (𝜆 − ) + (𝑝𝑐𝑓 − 𝑎 − 𝑒) (𝜆 − )=
∂τ 𝜕𝜏 ∂e ∂τ 𝜕𝜏 ∂z ∂τ(pcf − 𝑎 − 𝑒)

∂AI 𝜕𝑎 ∂e 𝜕𝑧 ∂ψ ∂ψ
𝜆𝜏 [ − + 𝜇 ] + (𝜆 − ) + (𝑝𝑐𝑓 − 𝑎 − 𝑒) (𝜆 − )=
∂τ 𝜕𝜏 ∂τ 𝜕𝜏 ∂z ∂τ(pcf − 𝑎 − 𝑒)

𝜕𝐴𝐼 𝜕𝐿𝐼 𝜕𝑇𝐼 𝜕𝑧 ∂ψ ∂ψ

𝜆𝜏[(1 − 𝜇) ( ) − (1 − 𝜇) ( ) + ] + (𝜆 − ) + (𝑝𝑐𝑓 − 𝑎 − 𝑒) (𝜆 − )
𝜕𝜏 𝜕𝜏 𝜕𝜏 𝜕𝜏 ∂z ∂τ(pcf − 𝑎 − 𝑒)

Weighted average of AI, LI and TI Direct cost of subjecting the agent to

more risk when 𝜏 is increased

∂g
∂ψ
∂z − ∂e
𝜏
∂τ (pc − 𝑎 − 𝑒 )
𝜇 = ∂e − 1 = f
−1
𝜏 ∂ψ
∂z

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