Taxes as losses

Nobody likes to pay taxes. Yet, we all do it. Or at least most of us. 

When looked at from a behavioural finance perspective, taxes are a form of loss of the income we earned. And because we are all loss averse, we try to minimise the taxes we pay. And this where things get interesting. 

In a recent series of lab experiments, people were asked to report their taxes on income. They were told that they could underreport their income but would face a possibility that they would be audited, in which case their tax evasion will be discovered and they have to pay fines. The chart below shows what percentage of their labour income people were reporting to the tax authorities for realistic parameters of being audited (in reality somewhere between 1% and 5%, and 3% in the experiment) and the fines they would have to pay (in the experiment they would have to pay unpaid taxes plus a fine of the same amount).

Two observations stand out. First, even for very low income tax rates of 5% people significantly underreported their income. Second, as income tax rates increased, underreporting (i.e. tax evasion) increased but eventually saturated. There wasn’t much more tax evasion for an income tax rate of 60% compared to an income tax rate of 30%.

Share of labour income reported

Source: Dhami and Hajimoladarvish (2002).

This shows that people do indeed look at taxes as a form of a loss that needs to be avoided. If the chances of being caught for tax evasion are reasonably low, loss aversion dominates our behaviour and we try to pay as little taxes as possible. Yet, once the losses are big enough, it doesn’t make much of a difference anymore if we “lose” 50% or 60% of our income, so tax evasion experiences a saturation effect. Furthermore, even if people faced no fines or costs to tax evasion at all, they still reported about 31% of their income on average. If this sounds weird (why would people voluntarily pay taxes even if there is no cost to tax evasion?), you haven’t understood human beings as social animals. Because if we are found out as tax evaders, there isn’t just the financial cost of paying back taxes and fines, there is the moral cost of having to look into the mirror and knowing that you have cheated. And to avoid that cost to yourself, it is better to pay a symbolic amount of taxes so you can still say you paid your fair share. Arguably, for some people that fair share may be as low as $750, but for most, it is apparently somewhere around one third of our earned income taxed at 30% – or roughly 10% of our true earned income.

But in real life, we have to face real costs if we engage in tax evasion. But these costs are uncertain because not everyone gets audited each year. In a sense, tax evasion is like playing a lottery with the authorities where you have a pretty high chance of not losing anything and a small chance of losing a lot. More risk-averse people should thus be more reluctant to evade taxes, which is exactly what the study finds. If the probability of being audited is increased, the amount of income reported increases (i.e. tax evasion becomes less prevalent). But for risk-averse people, it increases more than for risk-loving people. This indicates that people and corporations who are overall more aggressive in their investments and tax declarations are also more likely to engage in illegal tax evasion. In other words, it indicates that aggressive tax accounting by companies should be a warning flag for investors. While most of these companies are not engaged in illegal tax evasion, the prevalence of tax evasion amongst these firms is likely higher than average.