Economists consider tax compliance to be an irrational behavior. That is, the penalties for tax evasion are not severe or certain enough for it to be an economically rational decision not to try to evade your taxes. And yet, to a great extent, people willingly cough up what the government tells them to. Why?
A few items on this theme have hit the web in recent weeks. For example, Tax Evasion: Cheating Rationally or Deciding Emotionally, a discussion paper from the Institute for the Study of Labor in Bonn, Germany. The authors summarize their paper as follows:
The economic models of tax compliance predict that individuals should evade taxes when the expected benefit of cheating is greater than its expected cost. When this condition is fulfilled, the high compliance however observed remains a puzzle. In this paper, we investigate the role of emotions as a possible explanation of tax compliance. Our laboratory experiment shows that emotional arousal, measured by Skin Conductance Responses, increases in the proportion of evaded taxes. The perspective of punishment after an audit, especially when the pictures of the evaders are publicly displayed, also raises emotions. We show that an audit policy that induces shame on the evaders favors compliance.
On The Becker-Posner Blog, the economics and law sages Gary Becker and Richard Posner consider the irrationality of taxpaying and try to figure out what’s up. Becker begins by explaining the math behind the assertion that tax evasion is rational:
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 0.93×$1000 − 0.07×$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.
Becker then tries out some answers:
- Some people accurately report their income because that information is already available to the government in other ways, and a mismatch would be likely to trigger an audit.
- People may fear being labeled a tax evader because this has implications of dishonesty that would interfere with their professional lives in areas in which ethics and integrity are valued.
- People tend to obey a law to a certain extent when there is a social norm to obey the law to that extent. This may be criticized as a tautology begging a bootstrap explanation, but there’s something to the observation that our species tends to fly in tight flocks when it comes to our customs, habits, and ethics.
But he concludes that “audits, punishments, and the other deterrence variables mentioned in the previous paragraphs do not fully explain why there is not much more tax evasion.” He thinks the answer is that “most people believe they have a duty, moral or otherwise, to report their taxable income more or less honestly.” But then he immediately adds the caveat: “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.”
Posner responds by saying he believes that feelings of duty are probably less important than Becker suggests, and rational economic judgment more important. For example:
- The civil penalties for tax evasion are more severe than in Becker’s calculation
- If you are charged, in addition to these penalties, you’ll likely “incur heavy legal and accounting expenses in defending against the charge”
- The audit rate may be low, but it doesn’t represent a randomly-distributed probability: instead, it “is higher for those taxpayers who are in the best position to evade taxes without being caught or whose tax returns raise a red flag because of unusually high deductions or other suspicious circumstances”
- If you’re audited once, your risk of a future audit (and its attendant expenses) rises
- Criminal prosecution is also a possibility
- Successful evasion of taxes is a skill that you must learn, and to learn this skill involves additional costs
Most people comply with most laws most of the time. I believe that in most cases they do this not because they feel any moral duty to comply with law, but because the potential payoff does not seem to exceed the costs, including the information costs that I have emphasized. The reason I doubt that there is much of a felt moral duty to comply with tax law is that there is a vast amount of illegal behavior by normally law-abiding citizens. The flouting of the traffic laws, the theft of employer property, the nonpayment of social security taxes on household help, illegal gambling, and the employment (both personal and commercial) of illegal immigrants are only the most obvious examples. These are cases in which law enforcement is so lax that the expected punishment costs for most violations hover close to zero, and there are distinct benefits from violation.
Then Posner takes an interesting tangent: why don’t governments make tax evasion less economically rational by increasing the odds of an audit? He argues that it may in fact be economically rational for the government not to do this:
Every dollar spent by the Internal Revenue Service on enforcement brings in several dollars in additional tax revenue, suggesting that an expansion in the IRS’s budget would be necessary to equate the marginal benefits of tax enforcement to its marginal costs. But this suggestion ignores the fact that the benefits are, as a first approximation, merely income transfers, whereas the marginal costs of tax enforcement are social costs. If taxes are evaded, the resulting shortfall in tax revenues is made up by increasing the tax rate, and there is no social loss unless the increase has worse misallocative effects than the evaded taxes would have had, had they not been evaded. One reason, therefore, that tax evasion is widespread is that it may be cheaper from an overall social standpoint to have slightly higher tax rates than to devote additional resources to law enforcement, though the first-best solution might be stiffer penalties, especially monetary penalties.