The Taxman Cometh

Friday, April 18, 2008

All rich countries manage to raise sizable amounts of tax revenue with relatively little tax evasion. (Tax evasion uses illegal means to reduce taxes, whereas tax avoidance uses legal means.) The U.S. federal government raises almost 20 percent of GDP through taxes on personal and business income, capital gains, estates, and the sale of gasoline and other goods. Estimates from the 2001 IRS National Research Program indicate that the percentage of unreported income is low for wages and salaries but rises to more than 50 percent for farm income and about 40 percent for business income. Overall, income tax payments are underreported by about 13 percent. What determines the degree of tax evasion?

If taxpayers responded only to the expected cost of evading taxes, evasion would be far more widespread. Why? Only about 7 percent of all tax returns are audited (over a seven-year period), and typically the penalty on underreported income is about 20 percent of the taxes owed, a moderate amount. Few are sent to jail simply for evading taxes unless that evasion is on a huge scale or involves massive fraud. If a person were to evade $1,000 in taxes, his expected gain can be calculated as 0.93 times $1,000, minus 0.07 times $200—or $916. On those considerations alone, he should not hesitate to evade paying the $1,000 and presumably much more.

To be sure, expected gain is not the sole criterion. Most taxpayers would be risk-averse regarding audits and punishments, especially if the likelihood of punishment or an audit would be much greater than average. If the expected gain from evading $1,000 were $916, however, the degree of risk aversion would have to be huge, far higher than the risk aversion that is embodied in pricing assets, for risk to explain why there is so little tax evasion.

Possible punishments do have an effect on the amount of tax evasion. Compliance rates are much higher when governments have independent evidence of a person’s income, because the probability of an audit when she underreports her income is much higher than when the monitors lack this information. For example, income from independent consulting to companies is better reported than tips on earnings, or than the incomes of farmers and other small business owners, because employers report how much they paid independent consultants. No one reports how much he paid in tips, however, or how much he bought from a local store.

A study in progress at the University of Chicago by doctoral candidate Oscar Vela also shows that people in occupations in which integrity is an important determinant of success—such as law or medicine—are less likely to evade taxes than other earners. Presumably, a professional convicted of tax evasion would probably suffer damage to her reputation and earnings. Vela finds that considerations of reputation (along with more traditional variables in the tax-evasion literature) help explain how much evasion occurs for different types of income. The traditional variables include the likelihood of audits, which varies for different classes of taxpayers; punishments for those audited; marital status (married persons are less likely to evade taxes); the marginal tax rate; and the ability of governments to match reported incomes with independent evidence such as 1040 and 1099 tax forms.

Only about 7 percent of all tax returns are audited (over a seven-year period). Virtually no one is sent to jail simply for evading taxes unless it’s evasion on a grand or fraudulent scale.

Tax avoidance, as well as tax evasion, tends to rise as the marginal tax rate increases. That is, with higher tax rates, both individuals and businesses are more likely to underreport their income to the tax authorities and to search harder for ways to reduce the amount they are obligated to report. This implies that flattening the income tax structure would increase the amount of reported personal income.

But audits, punishments, and the other deterrence variables mentioned above still do not fully explain why there is so little tax evasion. I think that most people believe they have a duty, moral or otherwise, to report their taxable income more or less honestly. I say “more or less honestly” because most people consider a little cheating on their taxes to be OK as long as it does not go too far. Thus people might fail to pay Social Security taxes when they hire a worker to clean the house or pay a mason in cash to get a lower price, but they would be very reluctant to engage in large-scale tax evasion.

Most people do not believe it is moral to steal money even when there is little chance they will be found out, and they feel obligated to obey many other laws, even inconvenient and costly ones. Crime would be much more widespread if individuals obeyed laws only when the expected cost of being caught, adjusted for risk, exceeded the benefits from disobeying those laws. To some extent, people obey laws, including tax laws, because most other people are doing the same. Their behavior might change radically if they lost confidence that others would pay their taxes and obey other laws.

Most people believe they have a duty, moral or otherwise, to report their taxable income more or less honestly.

Clearly, morality about obeying laws does not apply to all types of taxes, all laws, or all places. People often cross a street when the light is red, fail to stop at stop signs when riding their bikes, and fail to report their tips. Moreover, in many Latin American and African countries, as well as in Russia and Eastern Europe, people do not feel much obligation to pay even ordinary income and other taxes. They evade taxes except when the chances of being caught are high, as with businesses paying value-added taxes. In those countries, governments are unable to raise substantial amounts from income or business taxes except when marginal tax rates are low; thus they come to rely on harder-to-escape instruments like value-added taxes.