How Tax Evasion and Avoidance Undermine a Good Tax System

September 22nd, 2014

In the United States, the overall noncompliance rate for all federal taxes and individual income taxes stands at about 14 percent. According to studies by the Taxpayer Compliance Research Program and the National Research Program, about 1 percent of wages and salaries are underreported and about 4 percent of taxable interest and dividends are misreported. A study of Germany found that the corporate tax base would have increased by 14% if no income-shifting had occurred. Developing countries lose about $900 billion in illicit outflows per year, which severely undermines these nations’ abilities to effectively raise revenue.

These activities are not merely an inconvenience for citizens and policymakers, but rather they undermine the very core of tax systems around the world. There are many things a good tax system should do, but all tax systems should have the three key goals: provide revenue, distribute costs fairly, and promote growth and efficiency. Tax evasion and avoidance, whether via an offshore tax haven or an anonymous corporation, undermine the world’s ability to achieve all of these goals.

Goal 1: Provide the appropriate level of revenue in a timely manner. The first and most obvious goal of any tax system should be generate revenue. Of course, the level of revenue produced by a tax system should not be arbitrary. The tax system should generate enough revenues to meet the needs of the nation with the appropriate level and in a timely manner.

Tax evasion and avoidance impede the ability of tax professionals to generate sufficient revenues. For example, the loophole that allows U.S. corporations to defer foreign earnings will cost the United States government $114 billion over ten years unless we close it. According to a report by Global Financial Integrity, between 2002 and 2006, developing countries lost an annual $100 billion in tax revenues from trade mispricing.

Goal 2: Distribute the cost of services fairly. A good tax system should not unduly burden one group of citizens over another. The burden of taxes should be distributed fairly—although not necessarily equally.

Yet tax evasion and avoidance undermine this goal because different people have different propensities to avoid and evade taxes. Opportunities and predilections for tax evasion, while related to income, are not systematically so. In fact, not everyone avoids taxes by the same proportional amount or by an amount strictly related to income. As a result, tax evasion creates inequities because equally well off people and businesses have different tax burdens.

Some corporations and businesses tend to avoid more taxes than others. For example, Google Inc. received a great deal of infamy when it avoided $2 billion in worldwide income taxes by sheltering $9.8 billion of its revenues. At 17 percent, the effective tax rate for the average Fortunate 500 Company is much lower than the tax rate for the average American family. At 2.3 percent, the effective tax rate for the largest 100 U.S. corporations is even lower than this standard.

Goal 3: Promote economic growth and efficiency. Economic efficiency is a relatively intangible concept, but it occurs when society maximizes the production of goods and services at the lowest possible per-unit cost. An economy is efficient when you can’t make someone better off without making someone else worse off.

Some taxes reduce economic efficiency, but in many ways taxation can promote economic efficiency. This often occurs, for example, when the government taxes activities that impose costs on the rest of society. Take a pollution tax, which can increase economic efficiency by ensuring that the polluting company must account for the cost it imposes on society through its pollution when it decides its level of production.

Tax evasion reduces economic efficiency. The most obvious reason for this is the costs it imposes on taxpayers as the government works to reduce non-compliance. There are other ways tax evasion can reduce efficiency, however. For example, to the extent that it is easier to avoid taxes on some activities and investments rather than others, tax evasion creates socially inefficient incentives for individuals and business to engage in those activities.

The patterns in tax avoidance and evasion are consistent with the saying that the “poor evade and the rich avoid.” which means that the rich tend to reduce their tax burdens through legal structures, such as tax shelters, and those with lower incomes attempt outright evasion. In a legal sense, tax evasion and avoidance are very different. From an economic perspective, however, the difference is much smaller. Both tax evasion and tax avoidance undermine a tax system’s ability to meet its three most important goals.

Written by Ann Hollingshead

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