Friends for Myles: Social networks and tax compliance

One reason why people pay their taxes is that they’re afraid of being caught, and fined, if they cheat.

In the simplest possible model of tax evasion, people only comply with the tax code if the benefits of evasion – the savings in taxes paid -  are less than the costs – the probability of getting caught times the penalty if caught.

The major problem with this simple model (and more sophisticated variants of it) is that it doesn’t fit the facts. Far fewer people evade taxes than one might expect, given that the probability of audit is fairly low (not that IRS, CRA or any other revenue agency will reveal the actual number), and the penalties for small-scale avoidance are not all that high.

Why doesn’t the simple model work? One hypothesis is that people pay taxes because they believe others are paying taxes: they contribute because it’s fair. Another hypothesis is that people are really lousy at estimating the probability getting audited.

Gareth Myles at University of Exeter is doing some fascinating research, along with co-author Nigar Hashimzade,  on the effects of social networks on tax evasion.  They hypothesize that people form estimates of the probability of being audited based on their own experience, and the experience of their co-workers, friends and neighbours. If I don’t know anyone who has been audited, then I will believe that the probability of being audited is low. On the other hand, if I get audited, or if my friend, neighbour or co-worker is audited, then suddenly my own perception of the probability of being audited will shoot up.

It seems to me that this research has a fairly obvious policy implication: revenue agencies should audit people who have lots of friends, and who will tell all of them that they are being audited. The more people know about an audit, the more effective it will be as a deterrent to others.

But how can a revenue agency know how many friends a person has?

The Canadian Community Health Survey asks respondents the following question:

About how many close friends and close relatives do you have, that is, people you feel at ease with and can talk to about what is on your mind?

It turns out that the size of a person’s social network is significantly related to a number of readily observable economic and demographic factors.  The complete results of my analysis using the 2009-10 CCHS are available here; the associated stata .do file is here. 

If tax collection agencies want to audit people with large social networks, they should begin by auditing males. I was surprised at the gender effect, but it's quite strong, and persists after controlling for a variety of factors. The average male between 20 and 64 in the CCHS sample has 8.5 close friends and family; the average female has 7.6. Now it could be that, even though women have fewer friends, those friends are closer, but simply looking at the reported number of friends, men have more.

What else? Predictably, higher income people tend to have larger social networks, as do people whose main source of income is employment or self-employment. (Unfortunately since evaders by definition are those who are underreporting their income, targeting high income individuals has some limitations as an audit strategy.) Married people have more friends and family than people living common-law, or singles.

The number of close friends and family a person reports declines with age until people are in their 40s, then picks up again a little, but never approaches the size of the social networks people have in their 20s. Auditing people young, when they will share the experience with many friends - hopefully via Facebook or Twitter - would be a good strategy for a revenue agency aiming to increase people's perceptions of the probability of being audited.

Immigrants, and especially recent immigrants, tend to have significantly smaller social networks. I would suspect, though I can't test it with the data, that people who move within a country also tend to have smaller social networks than those who stay put. Hence targeting stayers rather than movers might be a good strategy for a revenue agency looking to audit people with lots of social contacts.

Of course all of this presumes that the experience of being audited leads to greater tax compliance. If people's reaction to being audited is "it was no problem, the revenue agency didn't work out that I earned $20,000 in cash last year and didn't report it", then the experience of being audited might tend to decrease compliance - and the more people who know the auditing is unlikely to lead to seriously averse consequences, the more serious the tax compliance problem is likely to become. 

Comments

[Patrick]

Don't a small majority of people (60% IIRC) get refunds? So many people feel like they're getting paid to file (of course they aren't).

In my twenties I don't think I ever had many credits to claim. If I did, likely they were readily verifiable i.e required someone else to file something with the tax man. CRA knew everything already. Granted, there were WAY fewer boutique deductions back in the day (e.g. transit passes). Seems unlikely to be that scary an experience.

I would imagine that for the twentysomething crowd, a bigger problem than cheating would be simply not filing at all. Perhaps if they tossed a few more university students in jail for that they'd all be scared straight for life.

[Bob Smith]

I think the reality is that for most people (i.e., people whose only income is employment income), the opportunity for tax evasion is pretty limited, since all their income is reported to the CRA by their employer anyways (through T4s). Indeed, as Patrick observes, for most of those people filing a tax return is often a lucrative exercise, because their employers will have withheld more tax than they actually owe.

Moreover for those people non-compliance is pretty easy to detect - the computers can compare T4 information against tax return information. The same would be true of much investment income (from T5 slips on dividends or interest payments or T3s on trust distributions). Typically the people issuing the information slips have no real incentive to under-report your income (a not insubstantial chunk of my practice involves advising clients on how to comply with these rules). If you failed to report this income, the CRA wouldn't need an audit to pick it up, it would just be flagged by the computer and they'd reassess you.

That really leaves two limited areas for tax evasion. For most of us, we might try to claim deductions/credits we're not entitled to. But the reality is that there are very few deductions available for employees, and the significant credits/deductions (think child care, disability tax credit, charitable donations, tuition tax credit require third party authentication. People do try to play this game (note the recent conviction of a number of tax preparers for engaging in phony donation/deduction schemes), but generally only the truly gullible/stupid believe that they'll work.

The other area for evasion is in the remaining part of the economy which isn't criss-crossed with third party reporting obligations, namely the self-employed, the owner manager businesses or offshore investments (although, increasingly that last one is being closed down as Canada enters into tax information exchange agreements with the usual tax haven jurisdictions). I have no doubt that many dark things are done in this area, from under-reporting revenue (the big issue has been te use of electronic "zappers" to delete sales - the last budget imposed hefty criminal sanctions for the possession or use of such software), claiming fake or questionable expenses ("my trip to Disney WAS a business expense), or hiding money offshore. But this isn't an option for most taxpayers. And even here tax evasion can impose costs. If you're self-employed, under-reporting your income may save you some taxes, but it'll also make it harder for you to get a mortgage (since banks will look at tax return to verify your income). Ditto, under-reporting income may reduce the taxes of the owner manager business, but it makes it harder to sell).

I suspect tax evasion is relatively uncommon because for most people, its self-evident that the likelihood of being caught is very high - you know the government has the same information you do. Its actually kind of creepy how much our tax system depends on Canadians ratting one another out. Its almost Orwellian

[Frances Woolley]

Bob, the talk I went to by Gareth Myles was precisely on this issue - that people in some occupations have more opportunity for evasion/avoidance than others. As an aside, it always makes me laugh when someone makes a claim along the lines of "personal income taxes don't discourage entrepreneurship - look how many self-employed people Canada (or similar country) has." Perhaps one reason why self-employment has steadily risen over the years is that it allows more opportunities for avoidance/evasion (especially on the deductions side and also in terms of "income sprinkling") than employment.

So, clearly, yes, if a revenue agency wants to develop an audit strategy that targets individuals with the greatest opportunities for evasion, it should use any information that it has on the source of income, and the individual's occupational/employment/self-employment status.

The social network thing is a relatively minor - but hopefully somewhat entertaining - side issue.

[Russil Wvong]

"Why doesn’t the simple model work?"

The political scientist Hans Morgenthau talks about how norms (statements like "Thou shalt not steal", or in this case, "You shouldn't cheat on your income taxes") have two parts: the prescribed behavior, and more importantly, the sanction which occurs if you violate the norm! The sanction may be legal: the risk of being arrested and punished. It may be social: the risk of social condemnation and ostracism. Or it may be ethical: the guilt imposed by one's own conscience. Christoph Frei sums up: "'Thou shalt not steal' can be a command of ethics, mores, or the law. It is the sanction that differentiates these three types of rules of conduct."

The simple model (in which the individual decides whether to cheat solely based on the risk of being audited) is of course only considering the legal sanction. Tocqueville suggests that mores are more important than laws--if the norms you're trying to impose aren't already supported by social mores, passing laws isn't going to help much. (Chapter 17 of Democracy in America, Book 1.)

Looking at the December 2011 working paper by Myles and his co-authors, it talks about more sophisticated models which consider psychic costs (the ethical sanction) and social costs (the social sanction).

[Frances Woolley]

Russil - one of the other papers at this tax evasion workshop talked about the slippery slope - that is, there are two possible types of equilibria. One is a high trust/high compliance equilibrium, where everyone pays their fair share, and everyone complies because everyone figures everyone else is paying their fair share. The other is a low trust/low compliance equilibrium, where no one wants to pay because they don't believe others are paying.

It's not difficult to get from the high trust/high compliance regime to the low trust/low compliance regime - some corruption, bad governance, etc. Getting from the low trust/low compliance regime to the high trust/high compliance regime is a bit more of a challenge. Effective enforcement is part of the story, but by no means all of it.

[Peter T]

Right-wing parties in the US and UK have been trying to move to a low-trust, low-compliance (for their people) environment for the last 30 years. It turns out to be quite difficult, because the social capital built up over a few centuries of going the other way is pretty large. People persist in paying taxes, parking between the lines and helping the elderly across the street. And they persist in thinking the government can mostly be trusted to enforce reasonable rules. There's an enormous amount of inertia involved. Give them another couple of decades at least.

I have worked in revenue agencies (in Australia). The general view is that a tax that doesn't collect itself over 90% of the time is a wrong tax. A lot of time is spent making it easy for people to comply. And the Tax Office here is quite creative in finding ways to warn people about non-compliance (they run info campaigns warning of crack-downs, with a focus on those most likely to pay attention and warn their clients, such as tax agents, accountants and advisers), pick cases that will make the news and concentrate on one or two sectors at a time rather than scatter their effort - which gets the news around faster.

[Bob Smith]

"And the Tax Office here is quite creative in finding ways to warn people about non-compliance (they run info campaigns warning of crack-downs, with a focus on those most likely to pay attention and warn their clients, such as tax agents, accountants and advisers), pick cases that will make the news and concentrate on one or two sectors at a time rather than scatter their effort - which gets the news around faster.

Here in Canada, they're often aided and abetted by tax professionals who make a living out of helping taxpayers "fix" their problems. In Toronto, there's one particular law firm that's made a name for itself (not neccesarily a good one) running ominous-sounding ads warning of the "tax man" (usually portraying the "tax man" as either a "men-in-black"-type character with dark sunglass, or a sultry woman surrounded by a group of slobbering accoutants - suggesting that your accountant isin the thrall of the CRA and won't fight for you. I don't say they were good ads), and how he's going to come, shut down your business, take your house, pry your jewelery off your dying fingers, etc., unless you talk to that law firm and they help you square things up with the CRA through its "voluntary disclosure" program (which, if available, generally waives penalties and some interest on unpaid taxes). The end result is to scare people (often people who might not otherwise have been detected), increasing both the Fisc's revenue and that law firms.

[Bob Smith]

Fair enough.

"Perhaps one reason why self-employment has steadily risen over the years is that it allows more opportunities for avoidance/evasion (especially on the deductions side and also in terms of "income sprinkling") than employment."

Could be. I think the more typical form of tax-motivated "self-employment" is when businesses try to characterize their employees as "independent contractors" to avoid EI/CPP contributions (you see a lot of those cases in front of the tax court). That's tax-driven, but not by the "self-employed" taxpayer (who are often oblivious to the distinction). Interestingly, the handful of occasions where I've seen the "employees" instigate that type of tax planning they invariably end up paying more taxes (because, as "consultants", they aren't entitled to the favourable tax treatment afforded to employee stock options).

[Frances Woolley]

Bob - "That's tax-driven, but not by the "self-employed" taxpayer (who are often oblivious to the distinction)."

Haven't there been a couple of somewhat high-profile Canadian cases along these lines - when the "self-employed" individual was laid off and went down to local Service Canada office to collect benefits, only to discover that he/she wasn't entitled to benefits, because he/she was an "independent contractor"?

It's true that there are some cases like this, but I strongly suspect there are others where the employee is quite happy to have the contract structured this way.

[Bob Smith]

"Haven't there been a couple of somewhat high-profile Canadian cases along these lines - when the "self-employed" individual was laid off and went down to local Service Canada office to collect benefits, only to discover that he/she wasn't entitled to benefits, because he/she was an "independent contractor"?"

That's my recollection as well, and I said, there's a steady flow of these sorts of cases in the tax court.

"It's true that there are some cases like this, but I strongly suspect there are others where the employee is quite happy to have the contract structured this way."

Really? Would you be eager to renegotiate your contract with the university to take on a series of short-term contracts at the end of which you could be replaced without severance in order to be able to deduct your intenet bill? Don't tell your Chair! :)

I think the problem is that the economic reality of a "self-employment" relationship that is legally tenable is very different from the economic reality of your typical employee relationship. One of the key legal tests for distinguishing between the two types of legal relationships is whether there is an opportunity for profit or a risk of loss. I suspect that most people, being relatively risk adverse, aren't inclined to take on the economic risk associated with being a true independent contractor for the tax benefits (and if they're not taking on any risk, they probably aren't an independent contractor). Admitedly, people do make economically irrational decision in pursuit of tax reductions, but I suspect that if people are happy about being "independent contractors" for the tax savings, it's because they're either not actually independent contractors (so they, or more likely, their employer, can expect a knock from the Tax Man some day) or they're oblivious to the other legal implications of that status (i.e., no severance, no EI, no job security, limited legal protections, more onerous tax filing obligations) and become decidedly less pleased by their new status when those implications are revealed (as in the news stories you mentioned).

I suppose where the distinction is murkier is between between an independent contractor and a temporary worker (and, again, many dark things get done in that realm). So perhaps, in that context, one migh prefer to characterize oneself as a business and provide services to "employers" on that basis (hey, if you're taking on the risk of being a contractor anyhow, you might as well be able to deduct your cell bill). Still, even then, I suspect the tax-advantages of self-employment are at best a consolation prize, and would be given-up in a second if those "contractor" got a full-time job offer (which I think is generally consistent with the view that "self-employment" is, for most people - obviously, some people enjoy running their own business - a second-best option).

[Frances Woolley]

Bob - "Would you be eager to renegotiate your contract with the university to take on a series of short-term contracts"

There are two issues. One is the total before-tax value of the compensation package. The other is the way this compensation package is structured for tax purposes.

All else being equal, I would think that typically self-employment (and variants thereof) is a more attractive structure for tax purposes - I don't, for example, see doctors clambering for the privilege of being OHIP employees, instead of independent contractors billing OHIP. It sounds like you agree, but your point is that, generally speaking, all else is not equal.

There is some evidence to back up your position. I remember seeing papers that argued that, when employment started to pick up in the late 1990s/early 2000s, a fair few "management consultants" packed up their shingles and took jobs as employees.

[Bob Smith]

"It sounds like you agree, but your point is that, generally speaking, all else is not equal."

I think that's fair.

[Bob Smith]

Coming back to your original post. You do see some good examples of network effects in tax evasion. Although, I think the examples I'm thinking of go more towards explaining why people DO engage in tax evasion, not why they don't.

A lot of these tax avoidance schemes havea lot in common with Ponzi schemes - in particular in the way they prey on affinity groups or social networks. People are sold something that's too good to be true and they buy it, not because Charles Ponzi or Bernie Madoff are particularly trustworthy or because the taxpayers are particularly stupid (they often aren't). Instead, taxpayers buy it because their cousin Luigi, their neighbour Ethel, or their former classmate from dental school, Lou, have bought in, and they trust them.

I hadn't thought about it before, but the dynamics are the same as Ponzi schemes, the earlier joiners get in, their "success" validates their experience and they lure in others. Ultimately, the bigger the scheme gets, the more likely it is to implode (as participants show up on the CRA's radar screen), the CRA unwinds the social network up to the promoter (in tax disputes the CRA has almost unlimited power to obtain information from taxpayers) and the whole thing implodes.

For example, one of the biggest headaches for tax authorities over the past few years have been the so-called "de-taxer" movement. I won't go into details, but the gist of it is theory that people organize their affairs properly they can just opt-out of the tax system (anyone interested, can read a recent decision of the Alberta Court in Meads v. Meads, which (a) beautifully describes the MO of the detaxer and related movements, and (b) clearly establishes that they're so much nonsense).

In any event, the theory was promoted by a number of entrepeneurs who offered to teach their "clients" about their system (often for a cut of the taxes "saved"). For obvious reasons, this isn't something you advertise in the Globe and Mail, so peer networks seem to have played a big role in bringing in "clients". They get one sucker, and once he's convinced, he brings in his family and friends, and so on. Although the scheme is self-evidently moronic (and a number of the promoters, and clients, are now spending lengthy periods - at least by Canadian standards - in prison and are facing crippling fines, penalties and, of course, tax liabilities), if you have faith in your family and friends, you might buy into it. Judging by the caselaw, it seems that a number of dentists got involved in the scheme, presumably on the early recommendation of one of their peers. (I hate to slur the profession, but according to a friend of mine in dental school, dentists are notorious suckers for various tax and investment-related schemes - almost as bad as lawyers. UofT dental school apparently now offers courses during orientation to try to impart a bit of financial common sense on its graduates).

You saw the same thing in various charitable donation schemes (some illegal, some just unsucessful). Again, friends and family plays a key role in marketing these types of schemes. You hear about it from a friend or a co-worker, your financial planner (who many people trust, perhaps wrongly) etc., their experience validates the scheme, and you go along. Often people continue to fight with the CRA long after its clear (or should be clear) that they can't win because they feel so strongly that the particular scheme works (you see the same thing with Ponzi schemes, as people try to reproduce whatever investment strategy they were told was the basis for their illicit gains).

[Patrick]

That Mead v. Mead thing is really something. What a bunch of nuts.

I wonder if perhaps moderately wealthy evaders get sucked-in to schemes because it makes them feel like high rollers. Certainly, being a e.g dentist (BTW my grandfather was dentist) is fairly well remunerated but not very exciting or glamorous. Same could be said for quite a few well paid jobs. Even being a relatively wealthy business owner can ultimately be pretty mundane (sales meetings, staff problems, accountants). Lots of businesses do pretty boring stuff. Drive through your local industrial/commercial park. I see stuff like machine parts, plastic bottles, pneumatic tools, bearings, pipe, concrete septic tanks, lab services etc. My last employer made thermostats. So perhaps messing around with shell corporations and banks accounts in Panama fills a psychological need. If nothing else it gives you something to talk about at dinner parties that doesn't make people's eyes glaze over.

OT: Some years ago, I worked for a famous big firm that had the EI/CPP evasion thing going. Probably still do. 'Employees' where hired by a recruiter and were encouraged to incorporate with stories of big savings on taxes (total BS of course). If they didn't incorporate they would officially work for the recruiting firm, even though they were in fact staff of the famous big firm. I believe they had had some uncomfortable dealings with CRA over the matter.

[Bob Smith]

Patrick: "I wonder if perhaps moderately wealthy evaders get sucked-in to schemes because it makes them feel like high rollers."

I suspect that's part of the story. I also suspect that part of the problem is that people with the skill-set to be good dentists, doctors or ... ahem ... lawyers, aren't neccesarily equipped with the skillset to be saavy business owners. (I was picking on dentists earlier, but not a week without reading about a story about some lawyer who was duped by some sort of real-estate fraud or fake debt collection check scheme - I've received fraudster emails for the latter variety of scheme and they're so obviously fake, you have to wonder about the wit of anyone who falls for them). They may be smart, but they're not neccesarily wise.

[Jacques René Giguère]

Professions who require high self confidence will attract people with a God complex. They are the surgeons ( far worse than dentists), the pilots, the lawyers, the managers who hold people's lives and fortunes in their hands. Most are meta-cognizant enough to avoid trouble, the way most cops are ok guys. But there is a substantial minority in these avocations who are fubb,fubar and cgf enough to make it a fertile hunting ground for scammers. About 20 years ago, my father ,manager of a big hospital, asked my advice on a real estate deal that was popular among his colleagues. Ran the numbers, didn't really add up and told him it wasn't for him. A couple of years later , he called and thanked me. His colleagues, accustomed to give orders all day and have people obey them, had all lost a large amount.

[Difei]

This was a very interesting topic, and it reminded me of an article I read about UK's new Behaviour Insight's Team (aka the "Nudge Unit"). Their goal was also to help the government recoup tax revenues from late filers. One of the most brilliant idea was to print that "97% of doctors have filed all their tax returns for the last four years" on the reminder letters to encourage people to pay taxes by playing to their social norms. The result was an increase in response rate of around 35%! Just thought I'd share, and I think Canada deserves a "nudge team" on our side too! [source: http://tinyurl.com/njzdkdm]