Economic Analysis of Tax Evasion Law

Soyoung Kayla Kim

Law and Economics

Economic Analysis of Tax Evasion

The taxation system in the United States is highly complex and growing more so each year, with a mass of different types of taxes. The issue of tax reform arises in every election season in the United States as politicians try to reassure as many voters as possible that they will pay the least possible amount of taxes (while still receiving all of the services that they find valuable!). But beyond the issues of how much in taxes it is fair and reasonable to expect people to pay and what services should be provided by the government and so funded with taxpayer contributions is the question of tax evasion. The current tax codes in the United States are complex to the point of opacityso far from being clear that there is far too much room for people to avoid paying taxes that they are legally required to do. This paper examines the ways in which people avoid paying income tax that they legally owe. Comment by James Miller: To vague.

Not only does this tax evasion starve the government of moneyreduce the amount of money that the government takes in to use that it needs for legitimate services such as providing medical care for the elderly and safe schools for the young, but it creates an atmosphere in which people do not feel that they need to respect their own government. This paper looks at the problem of tax evasion in the United States, including its causes, the harm that it does, and possible ways in which this situation might be remedied. Comment by James Miller: Considering how much money the government takes in starved is not the appropriate word but rather tax evasion reduces the amount of money that the government takes in. We

It is important to begin with a definition of tax evasion. Not all attempts to avoid paying taxes constitute tax evasion, which is a felony under both federal and state law in the United States. Indeed, tax avoidance is both perfectly legal and even encouraged by government agencies in that it is the legal use of the tax code to an individual's (or company's) advantage. Government agencies, including the primary federal tax agency, the Internal Revenue Service (IRS) do not expect anyone to pay more in taxes than are legally owed and therefore fully support individuals reducing their taxes by whatever means are available to them. In this way, tax avoidance can be considered to be like a speed limit: The government can sanction or punish an individual if he or she drives even one mile over the speed limit, although in all likelihood someone will not get a speeding ticket unless they are speeding a fair amount over the limit. However, so long as one is going exactly the speed limit or below, the government will not intervene.

Gregory v. Helvering

The basic principle that taxes can be avoided but not evaded (that is, that individuals can use any means available to them to legally reduce their taxes but not a cent below this) was outlined in a 1935 U.S. Supreme Court decision, Gregory v. Helvering, 293 U.S. 465. This landmark decision has been instrumental over the last four generations in setting U.S. income tax law. The ruling reads in part:

It is earnestly contended on behalf of the taxpayer that since every element required by [the statute] is to be found in what was done, a statutory reorganization was effected; and that the motive of the taxpayer thereby to escape payment of a tax will not alter the result or make unlawful what the statute allows. It is quite true that if a reorganization in reality was effected within the meaning of [the statute], the ulterior purpose mentioned will be disregarded. The legal right of a taxpayer to decrease the amount of what otherwise would be his [or her] taxes, or altogether avoid them, by means which the law permits, cannot be doubted. [ . . . ] But the question for determination is whether what was done, apart from the tax motive, was the thing which the statute intended. The reasoning of the court below [i.e., the reasoning of the Court of Appeals] in justification of a negative answer leaves little to be said. Gregory v. Helvering, 293 U.S. 465

The ruling continues to delineate the ways in which tax avoidance and tax evasion are fundamentally different both legally and ethically:

When [the statute] speaks of a transfer of assets by one corporation to another, it means a transfer made 'in pursuance of a plan of reorganization' [ . . . ] of corporate business; and not a transfer of assets by one corporation to another in pursuance of a plan having no relation to the business of either, as plainly is the case here. Putting aside, then, the question of motive in respect of taxation altogether, and fixing the character of the proceeding by what actually occurred, what do we find? Simply an operation having no business or corporate purpose -- a mere device which put on the form of a corporate reorganization as a disguise for concealing its real character, and the sole object and accomplishment of which was the consummation of a preconceived plan, not to reorganize a business or any part of a business, but to transfer a parcel of corporate shares to the petitioner. No doubt, a new and valid corporation was created. But that corporation was nothing more than a contrivance to the end last described. It was brought into existence for no other purpose; it performed, as it was intended from the beginning it should perform, no other function. When that limited function had been exercised, it immediately was put to death. (Gregory v. Helvering, 293 U.S. 465) Comment by James Miller: please explain this in your own words in greater detail.

The above ruling emphasizes the fact that corporations as well as individuals can use all possible "wiggle room" in the tax code to avoid paying taxes, even if such a strategy would seem to be inherently unfair, such as a wealthy individual paying no income tax.

In other words, the line between tax avoidance and tax evasion may be a very thin one, but it does exist. Intention is very much at the heart of such discussions, and while documentation is also very important in terms of demonstrating what financial procedures one has followed, documentation of whether or not one intended to defraud the government rather than simply saving every penny that one could is central to any argument about the legitimacy of tax decisions.

A great deal of what may be determined by government agents as tax evasion may well have been seen by individuals as simple tax avoidance. For example, individuals who work at home can deduct some portion of their rent or mortgage along with their utilities from their tax burden. However, it can be legitimately confusing for individuals to determine what portion of the square-footage of their residence can be counted such purposes. If they deduct from their taxes an amount that the government later determines is too large, then the individual will have to pay back taxes to cover this amount and possibly some penalties. It is unlikely that they will face serious sanctions such as imprisonment.