July 22, 2008 - Phil Hodgen

The tax system is biased to encourage evasion

There is a lot going on in the offshore tax evasion world these days. I’ll start commenting a bit more on that in the upcoming days. After all, we deal daily with offshore trusts, money in Switzerland, and all that fun stuff.

Hidden agendas?

It seems to me that a lot of the commentary about the “rich” (definitions vary) and taxation have a hidden agenda. That agenda is “us vs. them” with a thin veneer over a lake of resentment.

Why do we tax?

The objective of a tax system is to gather money so the government can spend it. Moral outrage is misplaced.

Why do people cheat on their taxes?

If you’re wondering why people hide money and don’t pay tax, think about these points:

1. A small percentage of people will always cheat and lie.

Bell curve, people! Just like a few people will break into cars and steal your stereo, there will be a few people who will hide money and lie about it to not pay taxes. It’s there. Live with it. Set up appropriate systems but you’re going to have that background noise as long as humans are involved.

2. Tax systems can encourage cheating and lying.

How?? A couple of ways. One is with penalties. If you (metaphorically speaking) have the death penalty for all crimes from parking violations to murder, well, you’ve decreased the incentive to pay attention to penalties.

We do international tax stuff for humans and companies. In this arena the compliance (translation = paperwork and forms you have to file) is so complex–and the penalties so draconian–that you’re essentially at the mercy of a tax auditor who can club you to death for accidental errors.

In other words, the pain differential between lying and trying to do the right thing?? It’s shrinking. At the margin this increases the number of people who are willing to throw up their hands and not try to do the right thing.

3. Tax rates encourage lying and cheating.

The higher the rates, the more likely you are to see scheming and tax evasion. It is here that I see the Outrage and Wailing by commentators. This is where I’m going to have to back up my hunches with reality, but here goes.

I’m guessing that it is a decision made at the margin. Is it cheaper to pay the tax and sleep well at night?? Or is it cheaper to lie and live with the anxiety?

If this kind of marginal utility thinking is right, then a lower tax rate would encourage more people to live in the light rather than in the darkness.

Anecdotally I see that kind of thinking, particularly because of the capital gains tax rates. People can–and do–say “Meh, I’m just going to sell and pay the tax because the rate is 15%.” In California you have the 9.3% State income tax as well, so it pushes the cost closer to 25%. People pay that. I’m not sure they would think that way if the combined hit started to exceed 30%. But that’s guessing.

Statement of bias

I favor vastly simpler tax systems, even though it would cost me most of my livelihood.

I favor much lower tax rates. MUCH lower. No carve-outs for people to take tax deductions here or get credits there. Use the tax system to collect revenue only. Don’t use the tax system as a method to promote specific types of economic behavior, and don’t use the tax system to engage in moral judgments (hint: if the word “should” is in a sentence, you’re in bad shape).

A quick aside

Here’s the TaxProf’s post on this topic. It triggered today’s post from me.

It has some statistics in it. The statistics are claimed to be true, and the facts suggest a certain conclusion. In fact the conclusion fairly well shouts out at you.

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