The Psychic Cost of Tax Evasion

INTRODUCTIONThere is untold wealth in America-especially at income tax time.-AnonymousFor many individuals, cheating on one's taxes is perfectly rational.1 The overall odds of being audited are quite low2 and the penalty for un- derreporting is typically just a fraction of the tax owed.3 It should come as no surprise, then, that many taxpayers cheat. But this creates an expensive problem. Individual tax evasion costs the government over $250 billion in lost revenue per year, before taking into account revenue lost by corporate tax shelters or legal tax loopholes.4 This is troubling in any economy, but is particularly problematic in light of the current budget deficit.Why, then, does the government not invest more resources in cracking down on individual tax evasion? Standard deterrence theory indicates that tax compliance can be improved by raising the expected monetary cost of evasion to taxpayers. This expected cost is a simple function of the probability of detection and the fine for evasion: If the government makes it more likely that an individual will be caught cheating or more expensive if that individual is caught, then she should be less likely to cheat. For example, a rational actor would not evade $100 of taxes if she had a fifty percent chance of incurring a $400 penalty (expected penalty of $200) or a five percent chance of incurring a $4,000 penalty (same).5 Thus, according to deter rence theory, policymakers should be able to reduce tax evasion by raising the audit rate, increasing tax penalties, or some combination of both.At first blush, it is puzzling why the government has not employed this seemingly obvious strategy. The answer, in large part, is because it is not necessarily cost-effective from the government's perspective. Audits can require relatively large amounts of time and financial resources,6 and raising the audit rate beyond its current level is generally seen as politically infeasible. Increasing tax penalties imposes more subtle costs, but many scholars have argued that increasing penalties much beyond their current levels is cost prohibitive due to both high administrative costs (such as increased litigation) and the potential "crowding out" of voluntary compliance.7But there is another cost to tax evasion incurred by taxpayers, which may provide a more promising means by which the government can improve tax compliance. Apart from the potential monetary costs, individuals may also experience some form of psychological discomfort when they are dishonest, which may deter them from cheating. This discomfort-we might think of it as guilt-imposes an additional utility cost not accounted for by the standard deterrence model. I refer to this cost as the "psychic cost" of tax evasion, and argue that it should be factored into our understanding of the taxpayer's cost-benefit analysis along with the monetary costs.The idea that guilt might deter people from cheating is not new. The tax literature has long recognized that individual ethics play some role in tax compliance. But past scholarship has portrayed honesty as a fixed personal characteristic, generally assuming that individuals are either inherently honest or dishonest. Recent empirical studies by psychologists and behavioral economists, however, have demonstrated that individual honesty is actually a malleable trait, influenced heavily by environmental factors. While a minority of individuals are completely honest in all circumstances (even if it would be economically advantageous to lie), and a minority of individuals are dishonest whenever it financially benefits them, most fall somewhere in the middle of the spectrum and may or may not cheat depending on the circumstances.8Notably, the level of expected monetary gain derived from cheating is not the sole factor in the decision to be honest (contrary to what deterrence theory would predict), nor is it the most influential. Rather, researchers have identified several non-economic factors that influence the decision to be honest. …