Tax Rascal

# Do the Fat Cats Always Cheat?

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According to a new study, yes: people earning \$500,000 to \$1 million understate their income by about 21%, compared to 8% for those earning \$50,000 to \$100,000. The first obvious response is outrage — how dare they lie, when they’re already so much better off? But a more practical question is to ask what we can do about this — and whether we should do anything at all.

To deal with tax evasion, you have to think like a tax evader. The first thing to do is to restate your term: the marginal tax rate isn’t a tax rate — it’s the return on dishonesty. Someone taxed at 15% gets fifteen cents for every dollar worth of lies; someone taxed at 35% gets a hefty \$.35 for every dollar of dishonesty.

Next, you have to ask what they’re thinking. First, stipulate that it’s not a moral question to the tax evader. It’s just a question of keeping as much money as possible. The decision to lie about income is just a practical question: what are the odds of getting caught, what is the punishment, and how much do you prefer certainty to risk?

For example, let’s say our unfriendly evader is looking into whether or not to hide \$10,000 in income. The return on hiding the money is 35% of that, or \$3,500. The evader thinks there’s a 10% chance of getting caught, and that if caught he’d pay triple damages, or \$10,500. So his expected return is 90% * \$3,500 minus 10% of \$10,500, or \$2,1000.

Whether or not the evader does this depends on whether or not he likes a risky \$2,100 (remember, there’s a 10% chance of a \$10,500 fine) more than a certain \$0. But this is the basic calculation. Ratcheting up the risk of getting caught changes things: with 30% odds of being busted, the new return is 70% * \$3500 minus 30% of \$10,500, or an expected loss of \$700.

But then we come to a new question: what if enforcement isn’t perfect? As the Forbes article explains:

Higher income folks receive more of their income from sources that are easier to hide, including self-employment earnings; income from rents, partnerships and S corporations; and capital gains.

“The distribution of noncompliance lines up pretty closely with who gets income that’s hard (for the IRS) to keep track of[.]”

This means that for certain highly productive activities — starting a new business partnership, owning a business, investing in other companies — there’s a higher chance of attention from the taxman, even if the unpaid taxes are completely legal. Increased enforcement could discourage these activities, lowering tax revenue, and forcing higher income tax rates (which, as discussed above, increase the incentive for cheating).

It’s easy to imagine a quick fix to some tax problems, but the quicker the fix, the larger the later ramifications. Instead of hoping to catch every last dollar of unreported income, it’s better to ask: at what point is enforcement no longer worth the cost? At what point do we give up and say that there’s a certain amount of cheating that we don’t like, don’t want, but can’t deny is cheaper than the alternative?

### 2 Responses to “Do the Fat Cats Always Cheat?”

1. The Wallet : Loose Change: 10/27/08 Says:

[…] Personal Finance: -Even though the Fed has cut interest rates, the savings aren’t being passed on to most credit card users. Grrr…[SmartMoney] -Clipping coupons is so nineties. Set down your scissors and reach for a new savings weapon — some gadget called a computer. [MarketWatch] -A study finds that those who earn \$500,000 to \$1 million understate their income by about 21%, compared to 8% for those earning \$50,000 to \$100,000. A blogger asks: why do fat cats cheat? [TaxRascal] […]

2. The Ten Best Tax Blog Posts: 2008 | Tax Rascal Says:

[…] If you’d ever wondered who cheats the most on their taxes, Don’t Mess With Taxes has the answer: the rich cheat more than anyone. Although it’s a little more complicated — the rich have an easier time cheating, and get ‘paid’ better for it. […]