Who’s Most Likely to Dodge Taxes?

The reason: Greek citizens understate their earnings to tax authorities, but tell banks a more realistic income. Armed with that knowledge, UMass Amherst’s Nikolaos Artavanis, University of California at Berkeley’s Adair Morse, and Chicago Booth’s Margarita Tsoutsoura used bank figures to back out how much money is going unreported to Greece’s tax authorities. They estimate that the country had €28 billion in unreported income in 2009, which added up to 31 percent of the annual deficit, and an additional €11.2 billion that could have been collected to offset the deficit.

Welcome to the murky world of tax evasion and avoidance, where the amount people avoid in taxes is hard to track because, after all, “it’s an activity that’s meant to be hidden,” says Tsoutsoura. In the past seven years, she and other researchers in academia and in the government and nonprofit sectors have been on a global hunt to document what individuals and companies are evading—or legally avoiding paying.

Eschewing official tax returns, researchers are calculating missing taxes by creatively slicing data and working with third-party sources to cross-reference information. The end goal is to push governments to change complicated and often-ineffective tax systems.

The Panama Papers

On a global scale, the amount of capital floating out of regulators’ sights is staggeringly large, says Copenhagen Business School’s Brooke Harrington, author of Capital without Borders: Wealth Managers and the One Percent.

Some of that is due to tax avoidance practiced by the very rich, which the “Panama Papers” have helped corroborate. In the Panama Papers, the names of 140 officials from 50 countries were leaked from a single wealth-management firm, Mossack Fonseca. “We don’t appreciate how much they have in common with each other—whether it’s a Russian oligarch or some Asian dictator—it’s like they are all going to the same hairdresser,” says Harrington, who has studied the professionals who create tax-avoidance strategies.

Many wealth managers, including those at Mossack Fonseca, work with the world’s 168,000 ultra-high-net-worth individuals, who have at least $30 million. Most practices of wealth-management firms are legal and make use of offshore legislation to pursue tax avoidance—sometimes in countries that are not known as tax havens. “Wealth managers are like hackers,” Harrington says. “They are hacking the legal systems of other countries.”

This year, several EU member states have put more pressure on tax havens to encourage transparency by creating a blacklist of territories with weak banking laws that don’t comply with the Organisation for Economic Co-operation and Development’s (OECD) Automatic Exchange of Information standard, says Vanessa Mock, European Commission spokesperson for the Taxation and Customs Union. Because being listed as a tax haven can affect long-term investment in a country, Panama, Lebanon, and the South Pacific island nation of Vanuatu have all recently signed up to implement international tax standards.

While avoidance is legal, evasion is not. And the price of evasion is high. The United States alone had an average $458 billion gross tax gap annually for the 2008–10 tax years, with $319 billion of that due to individuals, according to the Internal Revenue Service. Evasion can be particularly problematic for developing countries. About $1 trillion illicitly leaves developing countries every year, according to Global Financial Integrity (GFI), a Washington-based nonprofit. “A good chunk of [illicit financial flows] is likely related to tax evasion, but we don’t have the resources here to go further to determine how much,” says Matthew Salomon, a senior economist at GFI.

Besides draining government coffers and inhibiting development, “evasion leads to distortions in the economy between activities that are taxed, and others that are not,” says Harvard’s Dina Pomeranz. “It can push people into activities that are easier because of evasion but economically inefficient.” For example, smaller companies—not obligated to track their revenues or spending in much detail—may stay purposely small to evade tax collectors.

But despite the problems caused by tax nonpayment, “there’s hesitation on the part of some political elites to look at this,” says Gail Hurley, a New York–based policy specialist for development finance at the United Nations Development Programme (UNDP). “Governments are wary if you start digging into these activities.”

Follow the paper trail

But researchers are digging anyway as they attempt to quantify the problem.

Traditionally, authorities have attempted to track tax evasion through random auditing, but private-sector data are allowing a new approach. “Because the private sector adapts to a culture of tax evasion, private sector data offer a window into the magnitude of, distribution of, and motivation for tax evasion,” Artavanis, Morse, and Tsoutsoura write.

One of the first studies to use private data was conducted in 2010 by Carnegie Mellon University’s Serguey Braguinsky (currently at the University of Maryland), Clemson University’s Sergey Mityakov, and then–Harvard PhD candidate Andrey Liscovich, and compared car registries in Moscow with car owners’ salary records. By looking at the price of the car, the researchers could detect unreported income. This kind of data provides the ability to cross-check official sources of income with private, and perhaps unexpected, data sources.

Not all the activity that turns up in cross-checking is nefarious. In a 2012 study, Chicago Booth’s Erik Hurst sought to determine whether researchers could trust household data. In comparing spending data to reported income data for self-employed Americans, he finds that the self-employed generally underreported income by 25 percent; but he doesn’t assume that’s due to evasion, which implies intentionally either understating your income or overstating your deductions.

Computing the incomes of self-employed workers gets complicated, as they or their accountants have to identify business and personal expenses. Income-computing mistakes in this group often result in lower taxes. “Given the complexity, errors tend to accrue in a way that leads income to be underreported,” says Hurst. “Some of it may be nefarious, while some of it may be just systematic errors when income is being reported. My data does not allow me to distinguish between the two. Given this, I cannot conclude that explicit evasion is taking place.”

Hurst finds that privately collected data about how the self-employed spend their money are more accurate than government data. “People don’t skew their expenditure data,” he says. “They eat a certain amount of food, drive a certain car, and [from that] I can infer their income.”

Artavanis, Morse, and Tsoutsoura collected private banking data about people who applied for credit. The anonymized data included incomes, debts, occupations, and more.

They saw that professions that generated the least amount of data—leaving little in the way of paper trails—had the highest incidence of evasion. That was particularly true for the self-employed. Self-employed doctors, engineers, and educators generated relatively few receipts and documents, and were more likely to evade taxes. People working in the pharmacy and transport industries, meanwhile, had naturally higher paper trails and were less likely to evade taxes.