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Stanford Law School conference on the tax gap

This past Saturday I was a commentator, at the Stanford Law School's tax gap conference, on a paper by Joe Bankman, Stuart Karlinsky, and Susan Morse concerning why cash businesses cheat (based on field interviews with people who spoke freely because it was confidential).

In my comments, I described the paper's chief finding as quite similar to that of a recent scientific study that addressed the question: Why do the female spiders in some species eat their mates?

As a news article on the study explains:

"[Previous s]tudies have suggested various complex evolutionary reasons involving costs and benefits to the species, sperm competition and esoteric sexual selection schemes.

"But it turns out that the motivation for this creepy cannibalism is much simpler. It's all about size. The males are much smaller. Big females eat their puny mates simply because a) they're hungry and b) they can."

That, in a nutshell, is the Bankman-Karlinsky-Morse finding. Cash businesses often cheat because (a) they're hungry (that is, they'd rather have more money than less) and (b) they can. It's not about deep feelings concerning the government, social reciprocity norms, etcetera.

Empirical evidence cited in the paper suggests that cash businesses, on average, pay tax on only half their income, versus 99% for employees. This is clearly a big efficiency problem as well as a revenue problem, amounting to a huge tax preference for one set of activities over another. Talk about excessive incentives for entrepeneurship. And while part of the under-reporting comes from hand-to-mouth small operators, it also extends well up the income scale.

Why hasn't enforcement been better? It's inherently hard to observe cash businesses' transactions, but not impossible, especially in the modern computer age. Political will and under-powered government incentives to find the revenue are important as well. Aggressive data mining operations, perhaps involving private firms that will be compensated by the Treasury based on how much their suggested approaches end up yielding, could do a lot to address the problem, and perhaps in the next few years we will see movement in this direction. Even if the reported income percentage from cash businesses were raised just a bit - say, from 50% to 60% to 70% - that would raise revenue while actually reducing economic distortion.

Once again, an economic downturn isn't the absolute best time to start doing this, but it might be an ideal time to lay the groundwork to start doing it in the next phase of the business cycle.

Full post as published by Start Making Sense on November 10, 2008 (boomark / email).