More Ideal Tax Cheats

In my previous post about ideal tax cheats, we considered the puzzle of why there is such a high compliance rate for paying taxes when a purely business (i.e. logical) analysis indicates that one can maximize lifetime income by paying less tax than what is owed. The odds are that any given tax payer will not get audited, or if so, then a settlement can likely be negotiated. After all, the IRS (or your local tax authority) wants to maximize its income. Putting you in jail where you are not earning more money to feed the system is counter-productive. We can assume an enlightened tax agency that was given free rein by the politicians would implement security measures to maximize income. Too strong enforcement costs money, while too lax results in unacceptable non-compliance. Some severe punishment must happen occasionally simply to keep the game honest, but that cannot be a goal in a rational world.

To understand why most of us (myself included) honestly pay taxes, we need to consider more than the simple Bayesian decision theory applied to tax compliance. For those of you who want to explore further, I again refer you to “Imperfect Decision-Making and the Tax Payer Puzzle.”

One of the elements to consider is your own risk-aversion. Some people seek out risks and do things like scuba diving into unknown underwater caves. That seems just plain silly to me, but as a young man, I happily jumped out of perfectly good airplanes to have the joy of freefall. Many people consider that just plain silly. In the same way, I am averse to skimming on income tax, but have started several risky business ventures. The payoff for skimming taxes is most likely a few percent on your income, and working a bit harder seems like a better gamble to me.

Another element that I find perplexing is the moral one. Paying taxes is everyone’s obligation. No problem with that, but when you feel other people are not paying their fair share, how do you respond? A recent article in our local newspaper reported that residents of the posh Helmsley Building in New York paid an average of 14.7% on income while janitors and security guards paid almost 24%. Regardless of the reasons for this discrepancy, (some will argue there are perfectly good reasons for it), how does it make you feel? Do you feel it is morally right? How you answer might not change your actions, but how most of the population answers will determine the average compliance.

All this is similar to a project I worked on for some attorneys who wanted to be able to advise their clients on what courses to take in a dispute. Litigation costs money and the outcome is unknown. Should an attorney advise mediation or arbitration or go to court? What should the negotiating positions be? How can simple decision theory help guide a client? That is the problem they were working. The problem I was working was whether this effort could lead to a salable product for me. The jury is still out on my question.