Tax evasion

• 1. Introduction

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  Tax evasion is a financial crime with a reach that extends from small business owners skimming cash to the wealthiest individuals on earth hiding fortunes in offshore accounts. At its core, it is a deliberate lie: telling the tax authority you earned less than you did, or that your expenses were higher than they were. But the scale of that lie, multiplied across millions of actors, amounts to staggering losses. The IRS estimated the 2006 tax gap at $450 billion in the United States alone. A study of the 2008 gap put unreported income at roughly $2 trillion. How does so much money disappear from public coffers? Who is doing the evading, and why? And what happens when governments try to fight back?

• 2. The Economics of Cheating

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  In 1968, Nobel laureate economist Gary Becker first theorized the economics of crime. Building on that foundation, economists Michael G. Allingham and Agnar Sandmo published an economic model of tax evasion in 1972. Their model focused on income tax, the main source of revenue in developed countries. It frames evasion as a rational calculation: a risk-averse person weighing the probability of being caught against the size of the punishment.

  Later research complicated that clean picture. Subsequent studies found that people are also more likely to pay taxes when they believe the money is spent well and when they feel they have a voice in public decisions. That second finding matters because it shifts the focus from punishment to legitimacy.

  Empirical work has since found that income tax evasion rises with the tax rate, the unemployment rate, the level of income, and dissatisfaction with government. The U.S. Tax Reform Act of 1986 appears to have reduced evasion in the United States, suggesting that policy design is not irrelevant. One motive researchers describe is Wallschutzky's exchange relationship hypothesis: taxpayers evade when they feel the exchange between their taxes and the public services they receive is unbalanced. The logic, bluntly stated, is that evading and paying a fine can be more economical than paying accumulated taxes over years.

  A 2017 study by Alstadsæter and colleagues drew on random stratified audits and leaked data to reach a stark conclusion. The probability of tax evasion rises sharply with wealth, and the top 0.01% of earners are about ten times more likely than average people to evade. That same group evades as much as 25% of their taxes.

• 3. Customs, VAT, and Smugglers

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  Customs duties are an important source of revenue in developing countries, and importers have developed several methods to avoid them. Under-invoicing reduces the declared value of goods when duty is calculated as a percentage of that value. When duty is charged per unit rather than per dollar, importers misdeclare quantities. Changing a product's description to match a Harmonized System code with a lower duty rate is another route.

  Smuggling takes evasion a step further by removing the transaction from official records entirely. No customs declaration is made, so no duty is assessed. The transport is covert by design.

  Value-added tax, which emerged as a major form of consumption tax in the second half of the 20th century, introduced its own evasion patterns. Producers who collect VAT from consumers can under-report their sales. The United States has no broad-based federal consumption tax, but its states levy sales taxes that create cross-border evasion when shoppers buy in lower-taxed jurisdictions. Canada operates both a federal VAT called the Goods and Services Tax and provincial sales taxes, and some provinces combine both into a single levy.

  In liberal democracies, enforcing local sales tax on low-value goods crossing internal borders is rarely cost-effective. There are few border controls between jurisdictions by design. Sub-national governments typically focus enforcement on high-value items such as cars, where the tax at stake justifies the effort.

• 4. Governments Push Back

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  HMRC, the United Kingdom's tax collection agency, launched a voluntary amnesty program in 2010 targeting middle-class professionals. It raised £500 million. The following year, HMRC stated it would continue pressing, with a goal of collecting £18 billion in revenue before 2015.

  In 2013, the UK's Coalition government created a new criminal offence for aiding tax evasion. It also removed the requirement for investigators to prove intent to evade before prosecuting. In 2015, Chancellor of the Exchequer George Osborne announced new powers for HMRC to target people with offshore bank accounts. The number of prosecutions for tax evasion doubled in the 2014-15 year, reaching 1,258.

  HMRC estimated that in the tax year 2016-17, pure tax evasion cost the government £5.3 billion. The wider tax gap that year, covering all forms of non-compliance, stood at £33 billion, representing 5.7% of liabilities. Tax avoidance separately accounted for an estimated £1.7 billion.

  In the United States, the IRS has identified small businesses and sole proprietors as the largest contributors to the tax gap. Cash-based businesses are difficult to audit without mounting significant investigations. The most common method identified in U.S. data was overstating charitable contributions, particularly church donations. The Corporate Transparency Act addressed a separate vulnerability by requiring companies to disclose their beneficial owners to the Financial Crimes Enforcement Network, targeting shell companies that had long been used to conceal assets.

• 5. Tax Farming and Privatized Enforcement

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  Professor Christopher Hood first suggested privatizing tax enforcement as a way to collect revenue more efficiently than a government department. Bangladesh partly privatized its customs administration in 1991. By August 2005, Bangladesh had hired four pre-shipment inspection companies, including Cotecna Inspection SA, SGS (Bangladesh) Limited, Bureau Veritas BIVAC (Bangladesh) Limited, and INtertek Testing Limited, to certify the price, quality, and quantity of imported goods for three years.

  The arrangement went wrong. In March 2008, Bangladesh's National Board of Revenue cancelled Cotecna's certificate for serious irregularities. Bangladeshi authorities found the company guilty of complicity with importers in evading customs duties on a large scale. Complaints about the other three companies mounted as well. Bangladesh then planned to train its own customs officials in WTO valuation, trade policy, and the ASYCUDA system to take back the inspections.

  Cotecna's problems extended beyond Bangladesh. The company was also found to have bribed Pakistan's prime minister Benazir Bhutto to secure a pre-shipment inspection contract with Pakistani importers. She and her husband were sentenced in both Pakistan and Switzerland.

  The older form of privatized collection, tax farming, has a longer and more dramatic history. Under tax farming, governments received a lump sum in advance from a private entity, which then collected revenue from taxpayers and kept the proceeds. Abuses by tax farmers, combined with a tax system that exempted the French aristocracy, were a primary cause of the French Revolution that overthrew Louis XVI.

• 6. Leaks, Wealth, and Offshore Havens

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  Studies suggest that 8% of global financial wealth sits in offshore accounts. Wealthy individuals are substantially more likely to hold unreported accounts, and the probability of appearing in a major leak rises sharply among the top 0.01% of the wealth distribution. A paper using data from HSBC Switzerland, known as the Swiss Leaks, and from Mossack Fonseca, the Panama Papers, found that about 3% of personal taxes are evaded on average in Scandinavia. Among the top 0.01% of that region's wealth distribution, the figure rises to about 30%.

  The same study found that after tax amnesties reduced evasion, wealthy taxpayers did not shift to legal avoidance at higher rates. That finding suggests that enforcement can capture real revenue rather than simply pushing behavior into different channels.

  In early October 2021, the International Consortium of Investigative Journalists released the Pandora Papers: 11.9 million leaked financial records totaling 2.9 terabytes of data. The documents exposed secret offshore accounts of around 35 world leaders. Sheikh Mohammed bin Rashid al-Maktoum, the ruler of Dubai and prime minister of the United Arab Emirates, was identified as a shareholder in three firms registered in the Bahamas and British Virgin Islands. Those entities were connected through an Emirati company partially owned by Dubai Holding and Axiom Limited. The leaked records showed the Dubai ruler held extensive upmarket real estate across Europe through those offshore structures.

  The Pandora Papers also cited Dominique Strauss-Kahn, former Managing Director of the IMF and former French finance minister, as having been permitted to establish a consulting firm in the United Arab Emirates in 2018 after the tax exemptions on his Moroccan company expired. That structure allowed him to receive millions of dollars in consulting fees free of tax. A network of banks, stock traders, and lawyers separately obtained billions from European treasuries through suspected fraud involving dividend taxes; the five hardest-hit countries lost at least $62.9 billion combined, with Germany alone losing around €31 billion.