Ideal Tax Evasion

We often pose decision making problems in either the real world or a logical world to exercise our minds in making logically correct decisions. But what about normal decisions that we all make? Consider the decision to pay taxes. The situation is described in the introduction of a paper, entitled ”Why Do People Pay Taxes?”:

”In recent years economists have devoted increasing attention to the study of individual tax evasion. Despite these efforts, however, our understanding of the reasons behind individual tax compliance behavior remains limited. In fact, the puzzle of tax compliance is that most people continue to pay their taxes.”

You might think the answer is simple. People pay taxes because they want to avoid the fines and other penalties that will befall them if they cheat. But if we pose the issue as a decision theory problem (regardless of morality–I will address that later), then one only needs to define a optimum method of cheating to maximize the expected return. That is, simply treat taxes like any business expense and seek to minimize them without regard to legality, but definitely considering the probability of being caught and the likely penalty.

When that is done, we find that most people over-pay their taxes in the sense of achieving a higher degree of compliance with the tax code than would be expected from a pure decision making approach. This is empirically true regardless of the level of enforcement.

To understand some of the reasons for this, consider a paper I recently found entitled Imperfect Decision-Making and the Tax Payer Puzzle.

It introduces the concept of ideal tax evasion. I rather like that. Since most people do not achieve ideal tax evasion, we can ask why. The answer takes a whole scientific paper, but one part of it is the C-D gap. That is, the Competence-Difficulty gap. In short, if the tax rules are just to complicated for your level of training, you punt and do the best you can without overly risking an excessive penalty. Most people are comfortable with strict compliance. For mega-corporations like General Electric, buying extra competence is not an issue regardless of the difficulty. The money they spend on tax avoidance is very small compared to their savings.

Perhaps the C-D gap also is one reason for the apparently stupid complexity of our tax laws. Creeping complexity is not just bowing to the desires of special interest groups who donate political funds to make favorable exceptions. The additional complexity is an end in itself to increase compliance cheaply. The more complex the tax code is; the higher the degree of compliance for simple-minded payers. Of course fat cats benefit dis-proportionately from increased complexity. For that reason, all tax simplification movements are either frauds from the get/go or they are quickly compromised by those who would benefit.

This applies to everyone including you and me. For instance, would you support eliminating the deduction for interest on home loans? What about medical deductions? Eliminating either would simplify the code.