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Government Failure

Government Failure

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In the literature about taxes, references to the terms ‘‘tax avoid-
ance’’ and ‘‘tax evasion’’ are frequent. Arthur Seldon dealt with
this problem by combining the two words to create the new word
‘‘avoision,’’whichisinthetitleofthischapter.Thischapterdevelops
the implications of that new term, which captures in one word both
tax avoidance and tax evasion as methods of reducing one’s total
tax payment. Roughly speaking, tax avoidance is taking measures
to reduce tax liability that are perfectly legal. Tax evasion, on the
other hand, refers to the use of illegal means to lower one’s tax
liability. Both have implications for resource allocations for society
and the choice of taxpayers. We will consider them one at a time,
beginning with tax avoidance.

The Home Mortgage Deduction

Consider the following simple example of tax avoidance under
U.S. tax law. Homeowners who have mortgages may deduct the
interest on the mortgage from their taxable income. The mortgage
deduction,thelargestloopholeintheU.S.taxcode,works forpeople
in all tax brackets. Although it now has immense political support,
it originally got into the income tax laws more or less by accident.
The reason that this example of tax avoidance leads to inefficiency
can perhaps best be shown by considering my own situation. I am
a bachelor and, for the past 15 years, I have owned either the house
or apartment in which I lived subject to as large a mortgage as I
can talk bankers into lending me. If I rented a house or apartment,
I would not be able to avoid taxes because I would not be paying
interest; rent on a house is not deductible.
I save a great deal of money that would have been paid in taxes
through this provision, even though a person who moves as often
as I might be equally satisfied with rental housing.1

The same is true

1

A newspaper article noted ‘‘a fast growing breed of professionals nationwide
who, fed up with the high cost and low return of home ownership, are choosing to
rent apartments.’’ K. B1umenthal, ‘‘Luxury-Apartment Rentals Are Booming,’’ Wall
Street Journal
, 22 September 1995, p. B1.

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for many people. Americans do move a good deal, but even those
who do not move frequently tended to rent their quarters until the
Second World War, when income tax rates rose enough to make the
saving significant from the interest deduction on a mortgage.
Selling one property and buying another when moving from one
place to another if you have to is undoubtedly much less convenient
than just dropping one lease and entering another. It is also expen-
sive for the middle class. As a consequence the avoidance of taxes,
which I reiterate is purely legal in this example, does inflict a cost
on society.

The Cost of Loopholes

The reader may feel that the home mortgage interest deduction
is not a gigantic inefficiency inflicted upon the economy. The total
reduction in taxes from this loophole is probably sizable. Some
would further argue that, after all, ‘‘if you give the money to the
government it will only waste it.’’ Any major cost imposed by this
loophole comes from people’s modifying their behavior (buying
houses rather than renting them) to avoid taxes. When we turn to
theillegalevasionmethodslaterinthischapter,youwillfindthatthe
same question can be asked, but that it results in a different answer.
Let us examine the possible costs of these loopholes. The first
obvious effect is that if the taxes are left at the same level as they
would be without the loophole, the government would have less to
spend. In spite of my earlier remark about government waste, this
reduction in tax revenues may lead to underfinancing of genuinely
valuable programs. Of course, it may also lead to underfinancing
of programs that we would be better off without.
Another possibility is a more likely outcome. The government
response to an income tax loophole that removes $50 million annu-
allyfromtaxrevenuesmaysimplybetoraisethebasictaxratesothat
the tax system with this loophole produces the same tax revenues as
ithadbefore.Thegovernmentwouldprovidethesamesetofservices
as before: the difference is mainly that the cost of the loophole is
distributed in a different way among taxpayers through the tax
system. In cases where the government is both setting the base tax
rate and producing this loophole, there is no reason to believe that
either accepting the loophole or raising other taxes to compensate
for its loss would be more efficient. In practice, however, what

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probably happens is a compromise in which both useful and value-
less programs are cut back.
The cost of such loopholes is difficult to calculate. Most people
find them annoying in terms of their effects and the difficulty of
understanding them. Until a few years ago the U.S. tax code con-
tained 17 pages devoted to the raising of racehorses.2

This seemed
to most people simply a detailed discussion of a particular industry.
However, when this section was repealed the effect was significant.
The value of breeding stock fell, by more than 50 percent in some
cases. In other words, these 17 pages had the effect of reducing the
cost of raising racehorses verysharply, attracting new investors, and
increasing the price of breeding stock as capital.
We can find many other cases of this sort in which the economy
is distorted by the existence of tax advantages. One element of the
tax code that affects wealthy people more than any other is simply
taking long vacations. On a vacation I would not be earning money,
but I would presumably be getting as much pleasure out of my
vacation as from the income I would otherwise earn. If this assump-
tion were not true, I would not take the vacation. Because leisure
is not taxed, I avoid taxes by taking vacations. Given a choice
between an income of $500,000 per year with the traditional two-
week vacation or an income of $450,000 with seven weeks of vaca-
tion, I might choose the $500,000. However, if there is a 50 percent
tax rate on earnings above $100,000, the net income after taxes is
$300,000 versus $275,000.3

As a consequence, I might choose the job
with the longer vacation. High-income earners, whether executives
or television stars, are likely to allocate their time between work
and leisure so this allocation causes a social loss.
The cost to society of the incentives of the tax code is presumably
the product that I would have made had I worked full-time. That
people will take more vacations under a higher tax system than with
lower taxes is clear. Another outcome may be that people simply
do not work as hard. The net effect is to reduce society’s income.

2

The U.S. tax code and the regulations issued to interpret it are sufficiently lengthy
that I doubt anyone has read all the way through them.

3

These numbers are arbitrary but not too different from the U.S. tax code.

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GOVERNMENT FAILURE

Special Services for the Tax Industry

Let us consider another outcome of tax avoision: a very large
number of industries (other than producing racehorses) exist solely
for the purpose of providing tax exemptions. Medical doctors and
other professionals frequently attend conferences in quite pleasant
and expensive resorts, sometimes even on luxury ocean liners. As
longas theconferenceprogramgives theappearancethatsomething
is learned or some economic gain is made, the individual’s cost of
attending such conferences is deductible from income taxes. This
tax policy means that conferences cost the person attending a good
deal less than they otherwise would and that people will take more
ofthesesemi-vacationsthantheywouldiftheirincomewerereduced
by the full cost.

Corporate Structure as a Response to the Tax System

There are many other examples of the effects of the tax code on
individual behavior. The author is involved with a family-owned
company in Iowa. Though the company is small, it has a most
elaborate corporate structure, designed for us by a tax accountant,
which does indeed reduce our taxes. However, it is clearly less
efficient than a simple corporate structure because resources are
invested in meeting the taxprovisions that might otherwise produce
higher returns in another investment.
Another problem related to corporate income taxes is that if the
corporation is financed with common stock, the income of the own-
ers is taxed at corporate rates. But if the corporation is financed by
selling bonds, the interest on the bonds is deductible as a business
expense. This dichotomy encourages most corporations to finance
a larger proportion of their investments by selling bonds than is
desirable from the standpoint of economic efficiency.
No doubt one could continue listing these distortions resulting
from the tax code. In most cases the reduction in economic efficiency
and the taxes avoided by the individual or corporation are compara-
tively small. Nevertheless, the economy is clearly less efficient than
it would be in the absence of these incentives for tax avoision. The
efficiencylossimplieseitherthatthegovernmentwouldcollectfewer
tax revenues, which by itself would pressure bureaucrats to be more

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efficient, or that a government would use a tax system such as a
value-added tax without exemptions that permit tax avoision.4

Tax Evasion

The second element in this chapter on tax avoision is the simple,
straightforward evasion of taxes. Let us begin with some rather
obvious cases of evasion. Tax evasion is often thought of as simply
underreporting of income to tax authorities. The income may be
obtained legally or from illegal activities such as the sale of drugs,
certaintypes ofgambling, sexualservices,or stolengoods.5

Theterm
‘‘black’’ or ‘‘underground’’ economy describes the activities used
bypeopletoevadetaxes.Peoplewhoengageintheseillegalactivities
obviously do not pay income tax in most cases. In the United States
some members of the mafia who are very well off pay income tax
for the purpose of explaining to the Internal Revenue Service why
they havean obviously highstandard of living. Normallythey claim
theirincomeisbasedonlegalformsofgamblingsuchashorseracing.

The Cost of the Underground Economy

That this kind of tax avoision on the whole is undesirable is
obvious, but the undesirability of concealing income from criminal
activities is less important than the criminal activities themselves.
Nevertheless, in the United States a significant amount of income
likely is derived from such illegal activities that is not taxed. The
underground economy is believed to be as large as 5–10 percent of
the U.S. gross disposable product ($300 billion to $600 billion for
1993).6

Needless to say, I object not to the tax avoision aspects of
such activities, but to the activities themselves. If they were taxed,
the profits from such illegal activities would be lower and hence
fewer people would enter the ‘‘industry.’’
Although taxing this form of tax avoision would add to the
national budget, the amount is not gigantic. However, in some other
form it is likely to be much larger. A former minister of finance in

4

No such systems exist in the real world.

5

Strictly speaking, evasion would also include activities to avoid state excise taxes
on liquor and cigarettes by buying large quantities in states with low excise taxes.

6

For a survey of the size of black economies see Friedrich Schneider and Dominik
H. Enste, ‘‘Shadow Economies: Sizes, Causes and Consequences,’’ Journal of Economic
Literature
38, no. 1 (March 2000): 77–114.

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Italy once suggested to me that Italy probably had as high a living
standardasWestGermany,eventhoughtheirstatisticsdidnotshow
it. He explained that the difference was the black economy, which
at that time would have to have been almost 50 percent of total
economic activity in order to balance the national income numbers.
This theory is not impossible, as anyone who has visited Italy can
attest, although I think perhaps he was being a bit too optimistic
about Italian prosperity.
The existence of tax avoision from the black economy raises a
number of philosophical problems. Suppose I need some minor
repairs around my house. Although I am unskilled in making
repairs, I could do some things, although it would take me more
time and the results would probably not be as good as if I had hired
someone. Under the U.S. tax code, if I perform the repairs myself
there is no tax to be paid, but this action could to some extent reduce
my income from my regular employment since such repair work is
not rest and recreation for most of us. Another possibility is that I
hire a repairman, but he conceals the matter from the government
in order to evade paying taxes.
Fromthestandpointofourowninterest,thelastexampleisclearly
the best. The repairman is undoubtedly better at doing the job than
I am, and he will no doubt perform the work for less money since
he has chosen to conceal the income from the IRS. Is there any real
reasonwhyweshouldobjecttothisformoftaxavoision?Theanswer
tothisquestionmaydependonwhetheryoubelievethegovernment
needs the money. If you feel it does not, you might argue that
changing the tax structure would be better so that the government
gets less and this kind of avoision is eliminated.
Nevertheless,this kind ofavoisionis alarge-scale activityinmuch
of the world. I understand that even Sweden has a great deal of it.
Tax avoision is so common that I am not clear in my mind whether
I encourage it or not. For example, I have a cleaning lady who comes
once a week, and periodically I hire someone for minor repairs. The
amounts are small enough so that under the U.S. tax code, I am not
requiredtoreportthepayments,althoughifthelawwerecarriedout,
the recipients would report them as income.7

I have never inquired

whether they do so.

7

Failure to pay social security taxes on the wages of domestic employees became
an issue in the appointment of several political officials. The adverse publicity was
sufficient to complicate and in some cases derail the appointment.

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Tax ‘‘Avoision’’

A Social Cost of Avoision

Which of the scenarios previously discussed is socially desirable
is very difficult to determine because one would have to know what
the government would do if the law were strictly carried out and
the additional taxes were collected and made available for expendi-
tures. For example, would the government use the additional reve-
nue for the purpose of reducing some other tax? I doubt it, but it is
possible. Or would the government use the money to do something
that produces more benefits than the cost? Once again, I doubt it,
but cannot be certain.
Hernando de Soto’s The Other Path is an important book that is
available in both English and Spanish.8

He estimates that the black
market or, as he calls it, the informal market accounts for roughly
half of economic activity in Peru. He views the informal market in
a positive light and as helping the poor to raise the income of the
poor. In general, de Soto argues that in many of the less advanced
parts of the world similar situations exist with the unreported econ-
omy. On my last visit to Rio de Janeiro I stayed in the same hotel
that I stayed in five years earlier. The hill overlooking the hotel
provides a good example of this phenomenon. People had built
houses thatwereactuallyongovernmentlandratherthanonprivate
land. Following the South American tradition, they had set up a
government of their own and, since my last visit, had made such
‘‘public’’ improvements as sidewalks and a flight of stairs. Because
of the topography of the location, roads could not be put in. No
doubt this activity is an improvement in the economy of Brazil. I
have no doubt that it does not appear in Brazil’s official economic
statistics and that the inhabitants do not pay taxes.

Concluding Comments

The end product of all of this analysis is, unfortunately, that there
are no clear conclusions. In general, people frown on the tax cheater,
but does such tax avoision actually harm anyone? Its mere existence
increasesthetotalproductofthenation,althoughnotnecessarilythe
formalgrossdomesticproduct.Furthermore,ifthepeopleconcerned

8

Hernando de Soto, The Other Path: The Invisible Revolution in the Third World
(London: I. B. Tauris, 1989). I recommend this important book to everyone interested
in the topic.

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were engaged in nonblack production, they would make a larger
social contribution. Finally, its mere existence puts a certain amount
of restraint on the government. Whether the restraint is good or bad
depends on what the government does.

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