The Psychic Cost of Tax Evasion

Abstract

Each year, the government loses hundreds of billions of dollars in tax revenue due to underreporting by individual taxpayers. According to standard deterrence theory, policymakers should be able to reduce tax evasion by increasing tax penalties, raising the audit rate, or some combination of the two. This Article refers to these strategies as increasing the “monetary cost” of tax evasion. To date, budgetary limitations and political hurdles have made these strategies difficult for the government to employ.

There is, however, another potential means by which the government can improve tax compliance, apart from raising the monetary cost of evasion. Empirical evidence shows that people experience some form of psychological discomfort when they are dishonest, which may deter them from cheating. This Article proposes employing subtle behavioral interventions that encourage more honest tax reporting by raising the level of psychological discomfort experienced from underreporting. I refer to this approach as increasing the “psychic cost” of tax evasion.

Adopting measures designed to increase the psychic cost of tax evasion, such as making small adjustments to the way that taxpayers fill out their tax forms, could generate much needed tax revenue. Moreover, these measures would impose very little administrative expense to the government as compared to traditional deterrence mechanisms like audits and penalties. While further empirical research is needed to test how to increase the psychic cost of tax evasion in the most cost-effective manner, this Article proposes a roadmap for beginning that process.

Keywords: Tax Evasion, Tax Compliance, Tax Fraud, Behavioral Economics, Law & Economics, Nudges

JEL Classification: E62, H20, H21, H23, H25, H26, H29, K34, D81, A12, K42