The Cost of Norms: Tax Effects of Tacit Understandings

Abstract

Most human interactions take place in reliance on tacit understandings, customary practices, and other legally unenforceable agreements. A considerable literature studying these informal arrangements (commonly referred to as social norms) has a decidedly positive flavor, arguing that many, if not most, of these norms are welfare-enhancing. This Article looks at the less-appreciated darker side of social norms. It combines the analysis of the modern sophisticated tax planning techniques with the existing empirical studies of commercial relationships to reveal a disturbing connection. By relying on tacit understandings rather than express contractual terms, many taxpayers shift some of their tax liabilities to those whose opportunity to take advantage of social norms is more limited or non-existent. The resulting inefficiency and inequity is the social cost of social norms. Reducing this cost, however, turns out to be a challenging task. The Article introduces a tax-focused classification of social norms and singles out the type of norms that are particularly inefficient. Unfortunately, while reducing the use of these norms (or eliminating them altogether) would be welfare-enhancing, it is unlikely to succeed in practice. Indiscriminately attacking all norms is easier administratively, but socially costly. The Article proposes a compromise between these two courses of action that is more administrable than the first approach and less costly than the second. It also offers a guide that would assist the government in identifying particularly inefficient norms.

Keywords: tax policy, tax avoidance, social norms, relational contracts, externalities

JEL Classification: H23, H29