Economic Crime: Tax Offenses

Economists have made important strides in trying to understand tax evasion. Gary Becker's classic article on the economics of crime used economic theory to tackle normative questions such as how many resources should be spent on law enforcement of laws and what penalties the government should impose. Becker's theory about criminal behavior assumed that individuals evaluate the benefits and costs of various activities (including criminal activities like tax evasion) and choose those activities that provide the highest income (or expected utility), after taking into account the associated net costs.

Allingham and Sandmo apply Becker's general approach to issues of tax avoidance and evasion. Using similar assumptions about the rational maximizing behavior of individuals, Allingham and Sandmo posit a simple situation where individuals must decide whether to declare all of their income on a tax return or deliberately underreport the income to tax authorities. The rational individual evaluates the expected gains or losses associated with the decision and seeks to maximize the expected utility or income. The gain derived from underreporting is the expected value of the reduced taxes. The cost or loss associated with tax evasion is a function of the probability of detection and conviction and the penalties imposed.

This model of tax compliance is consistent with two intuitions. First, taxpayers will cheat if they think they can get away with it. Second, taxpayers voluntarily will improve their compliance when penalties increase or when the probability of getting caught goes up.

Allingham and Sandmo and others have attempted to estimate the impact of several factors on voluntary tax compliance. For example, commentators have examined the relationship of demographics and social factors to levels of noncompliance, the effectiveness of different penalty structures on increasing deterrence, and the deterrent effect of past audits on future compliance (Andreoni, Erard, and Feinstein).

Simple economic models cannot adequately capture the dynamics of tax evasion. Andreoni, Erard, and Feinstein offer three factors that may influence taxpayers' compliance decisions. These factors also explain why the level of tax compliance, at least in the United States, is higher than the economic models would predict. First is the role of guilt and shame. It is difficult to model these factors, but it is clear that many taxpayers will feel guilt about evading taxes and shame upon apprehension. Second, taxpayers' perception of fairness of their tax burden will influence compliance. There is substantial evidence that the existence, real or perceived, of an unfair tax system will allow taxpayers to rationalize cheating on their own tax returns. Finally, the degree of taxpayers' satisfaction with the performance of government will influence tax compliance. Taxpayers are more willing to comply with tax laws if they believe that their tax money is being well spent. All these factor play an important role in the level of tax compliance in the United States. These factors also help explain the high level of tax evasion in countries in Eastern Europe and the former Soviet Union.