Why so Little Tax Evasion? Becker

All the rich countries are successful in raising sizable amounts of revenue from taxes with only a rather little tax evasion. Tax avoidance is the use of legal means to reduce taxes, whereas tax evasion uses illegal means. The federal government of the US raises almost 20 percent of American GDP through taxes on personal and business income, capital gains, estates, and the sale of gasoline and some other goods. The estimates from the 2001 IRS National Research Program indicate that the percent of income not reported is quite low for wages and salaries, but rises to over 50 percent for farm income, and about 40 percent for business income. Income tax payments overall are under reported 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. The reason is that only about 7 percent of all tax returns are audited (over a 7 year period), and typically the penalty on under reported income is only about 20 percent of the taxes owed. Virtually no one is sent to jail simply for evading taxes unless that evasion is on a very large scale, or involves massive fraud. If a person were to evade $1,000 in taxes, his expected gain would be 0.93x$1000 -0.07x$200 (=$1000/5) = $916. On these considerations alone, he should not hesitate to evade paying the $1,000, and presumably much more. To be sure, the expected gain is not the right criterion since most taxpayers would be risk averse regarding audits and punishments, especially if there is some chance of much greater than the average punishment or likelihood of an audit. However, if the expected gain from evading $1,000 were $916, the degree of risk aversion would have to be huge, far higher than the risk aversion that is embodied in pricing of assets, for risk to explain why there is so little tax evasion. This is not to say that possible punishments have no affect on the amount of tax evasion. Compliance rates are much higher when governments have independent evidence on a person's income since then the probability of audit when he under reports his income is much higher than when they do not have 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 to independent consultants, whereas no one reports how much they paid in tips, or how much they bought from a local store. A PhD study in progress at the University of Chicago by Oscar Vela also shows that persons in occupations where integrity is a more important determinant of success, such as law or medicine, are less likely to evade taxes. Presumably, any publicity that an individual in these occupations was convicted of tax evasion would damage his reputation and earnings. Vela finds that considerations of reputation, along with more traditional variables in the tax evasion literature do help explain how much evasion occurs for different types of income. These variables include the likelihood of audits that varies for different classes of taxpayers, punishments for those audited, marital status (not surprisingly, married persons are less likely to evade taxes), the marginal tax rate, and the ease with which governments can match reported incomes with independent evidence on incomes, such as from 1040 and 1099 tax forms, Note that tax avoidance as well as tax evasion tends to rise as the marginal tax rate increases. That is, with higher tax rates, individuals and businesses are both more likely not to report some of their income to the tax authorities, and also to search harder for ways to reduce how much of their income they are obligated to report. This implies, for example, that flattening the income tax structure would increase the amount of personal income reported to tax authorities because both the amount of evasion and the avoidance of the personal income tax would be reduced. However, audits, punishments, and the other deterrence variables mentioned in the previous paragraphs do not fully explain why there is not much more tax evasion. I believe it is necessary to recognize that most people believe they have a duty, moral or otherwise, to report their taxable income more or less honestly. I intentionally say "more or less honestly" because a little cheating on taxes is usually considered to be ok, as long as it does not go too far. Individuals might not pay social security taxes on their payments to workers who clean their houses, and they might pay a mason in cash because he then gives them a lower price, but these same persons would be very reluctant to engage in large-scale tax evasion. Similarly, 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 when that entails inconvenience and cost to themselves. There would be considerably more crime if individuals only obeyed laws when the expected cost of being caught, adjusted for risk, exceeded the benefits from disobeying these laws. To some extent, people obey many laws, including tax laws, because most other persons are doing the same. If so, their behavior might change radically if they lost confidence that others would pay their taxes and obey other laws. Clearly, morality about obeying laws does not apply to all types of taxes, or all laws-people often cross a street when the light is red, do not stop at stop signs when riding their bikes, and do not report much of their tips. Moreover, in many countries of Latin America, Africa, and Russia and other parts of Eastern Europe, individuals do not even feel much obligation to pay ordinary income and other taxes. They evade except when they expect the chances of being caught are high, as with businesses paying value added taxes. These countries are unable to raise substantial amounts from taxes on personal incomes or businesses except when marginal tax rates are low. Instead they rely greatly on value added and other more difficult to evade taxes.

Comments

[ctw]

"morality about obeying laws does not apply to all types of taxes"Which raises an interesting question: since many (all?) libertarians consider some (much? all?) taxation to be "theft", are rates of evasion higher among them? Confessions from libertarians (under pseudonyms, of course)?

- Charles

[Jack]

Ha, ha! This statistic alone tells the simple story:

"The estimates from the 2001 IRS National Research Program indicate that the percent of income not reported is quite low for wages and salaries, but rises to over 50 percent for farm income, and about 40 percent for business income. Income tax payments overall are under reported by about 13 percent. What determines the degree of tax evasion?"

........... Those with W-2 income have very little opportunity to underreport while those in business including farming, have much better opps. Surely we don't want to conclude that wage earners are far more moral than farmers and other businessmen?

[ohwilleke]

Information reporting makes a huge difference. And, the fact that lawyers are subject to a more intense information reporting regime than any other comparable business person, probably accounts for their high level of compliance.

Audit risk likewise applies to Doctors. The vast majority of them have to retain staff to create detailed paper trails of income for insurance reimbursement purposes. This elevates the risk of being turned in by a whistle blower immensely. Also, as self-employed high income small business people, they have much higher audit rates than the general public.

The notion that the audit risk for wage earners is low belies how the audit system works. Audit risk is, in fact, very high for wage earners who report income less than on their attached and also independently transmitted W-2s.

Put more clearly, the issue is not, why is tax evasion rare, for it is very common when it is possible to do unilaterally, but why are tax evasion conspiracies rare? Tax evasion conspiracies, such as paying employees under the table, are far easier to accomplish without IRS deduction through audit than the unilateral tax evasion behavior.

[Paco]

Dear Professor Becker:

I'm not so certain that tax evasion is so rare. Of course, it all depends on how one defines "evasion" -- I would define evasion broadly to include the under-reporting of income. Also, although I am an academic and not a practicing attorney, my gut instinct tells me that doctors and lawyers massively under-report that portion of their income that they receive in cash or in-kind.

I agree more with Posner's skeptical attitude regarding the efficacy of "morality" alone (or mere internal constraints) in promoting cooperation. Instead, I would argue that different behaviors have different equilibrium points depending on the behavior of the population as a whole. I'm thinking here of the concept of "evolutionary stable strategies" -- that is, some behavarial strategies (evade taxes or defect) will be frequent or not depending on the behavior of other people.

[jeff]

I am not surprised by the stats. What is telling is that any increase in marginal tax rates will effectively increase the amount of tax avoidance and evasion that occurs. I don't know the correlation, but I would assume it is higher than .5; especially given the expected penalties.

The data on marginal rates would lead one to theorize that if you dropped marginal rates on corporations, they would pay more in taxes.
Thus the government would get more revenue because corporations would either recognize more revenue, or recognize more revenue in the US if the rates were better here compared to other countries.

The interesting thing to me is the reputation cost that occurs if you are audited, or found to be under reporting your income. (I never knew lawyers cared about ethics!;))

It is also very interesting to me that there is a similar reputation cost among people who default on loans in microfinancing. If the loan is not repaid, then the deadbeat is shunned.

Perhaps reputation cost can be statistically proven across humans, regardless of ethnicity etc.

[Doug Stewart]

I disagree with your first sentence. France is considered one of the rich countries, but tax evasion is extensive.

I've lived and worked in Canada, UK and France. All three have tax evasion (as does every country). However, in France it is commonplace.

To begin with, almost all tradesmen and small businesses avoid tax, not only in a small way but quite substantially. I can say this not only from discussions with other people but from having worked with many of them. An enormous amount of work is done in cash.

Even more substantial businesses do a lot of business in cash to avoid paying taxes.

Part of the explanation is that France has a very high tax burden and most people feel that the level is quite unfair. Furthermore, much of the tax is spent on a bloated bureaucracy (the highest in western Europe) and on social security (which it is widely felt is being misspent). So they do not feel a moral obligation to pay tax.

There are also cultural elements. Everyone has to balance conflicting requirements between family, work and the wider society. In France, the culture is generally to give a higher priority to family, relative to the other obligations, than one will find in most other western countries. Therefore, evading taxes provides more money for family (top priority), which is considered sufficient justification for the resulting implications to wider society.

Of course, to some extent, this is self-reinforcing. As you noted in your post, if confidence breaks down, so does the moral obligation. As it is well-known that substantial tax evasion is wide-spread, the moral obligation to pay one's taxes is reduced.

[Muxec]

I doubt the accuracy of the data reporting low avoidance rate. How did they measure it.

I lived in country with widespread avoidance, one of the advantages of such conditions is, that if everyone misreports, and everyone knows that, it prevents conflicts between people as serious conflicts may cause mutual destruction.

[Bob K]

Why not talking instead about the morality of taxes?. Let's talk about the morality of telling US citizens taxes are for their own good and then blowing the money in foreign adventures, pork projects, special interests and lobbies.

[sa]

Shouldn't your calculation of expected payoff be 0.93x$1000 -0.07x$1200 = $846?

[David Heigham]

Very few people's morality is completly independent of the behaviour of those about them (the best Judges may be exceptions, perhaps Posner will advise). Tax evasion is rather like painting graffitti. If it appears to be rare in a community, few will offend. If it appears commonplace, many will yield to the impulse. This is not, I think, primarily a matter of perceived risk; it is much more a question of perceived shared norms - like keeping your front garden in a reasonable state, or not leaving your rubbish in front of someone else's house.

This is a wooly hypothesis, but a prediction made on the basis of it came true. When ther British, under Mrs. Thatcher, introduced a municipal per capita poll tax, I predicted that it would be popular and paid at first. However, it was easy to drop off the tax register, and evasion would rise to levels which the social consensus in favor of paying would collapse. So it turned out; remarkably rapidly.

[Alexander]

Perhaps after seeing this article, tax evasion rates will increase among blog readers.

On a side note, those professions that make more money include individuals who may hold out hopes for a future career in either elected or appointed office. High profile lawyers, in particular, may dream one day of being appointed federal judges, and even your random wealthy businessman might hold out some dream of seeking political office. Given the vetting that goes into the tax situation of politicians and judges, it seems like this might at least account for a great deal of compliance among the upper classes.

[tucker]

What about the time cost of being audited? You say "If a person were to evade $1,000 in taxes, his expected gain would be 0.93x$1000 -0.07x$200 (=$1000/5) = $916." But if you lose hours to the auditing process you lose wages or valued leisure time as well. I don't actually know what the time costs of auditing are, but my impression, perhaps from a society that wants me to pay taxes, is that they are significant. If a one time evasion of $1000 leads to 5 lost leisure hours that I value at $50 an hour it changes the calculation. If that has the possibility of repeated auditing for the rest of my life it changes the calculation drastically.

[Rodger Malcolm Mitchell]

Chairman Greenspan was bad at his job. He believed cutting interest rates stimulates the economy and raising rates “cools” it. Neither has any historical backing, and it didn’t work for him, either.
The single most important and predictive variable affecting GDP growth is growth of Total Debt (federal, state, local, business and personal).
A growing economy requires a growing supply of money. Since all money is a form of debt, a growing economy requires a growing supply of debt.
A graph of Total Debt growth and GDP growth shows the two lines are essentially parallel since the 1920's.
Chairman Greenspan could have helped our economy by urging more tax cuts and more federal spending. This would have pumped money into the economy and boosted GDP.
The tax that should be cut first: FICA. This immediately would stimulate both the consumer and the business side of the economy, and be popular with voters.
Medicare and Social Security would be supported the same way the military and the other 400+ federal agencies are supported: By deficit spending.
And no, this type of action never has been shown to cause inflation.
You may read all about it at www.rodgermitchell.com

[jin]

I wonder how the auditing works. If it takes the form that once someone is found evading tax in one year the government will audit all the previous years, then it will be rational not to evade tax after evading it for a few years (because the marginal cost of doing so becomes increasingly higher.)

[Spincycle]

Dr. Becker,

You are kind of reformulating the Riker-Ordhaeshook voter theorem with the similar 'Duty' (Moral) number large enough to overwhelm cost-benefit analysis. I think this question can be empirically studied through survey and my guess is that it has a lot to do with perception of threat. Like Americans are willing to support billions of dollars of expenditure to mitigate negligible chance of terrorist attacks, I believe they use similar calculations in paying taxes especially with the mythology of IRS's audits.

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