One of the people to suffer fallout from the Panama Papers leak is David Cameron, Britain’s prime minister. After a few days of equivocation, he was forced to admit that he had personally benefited from offshore financial arrangements that had been put in place by his father.
The publicly available evidence does not suggest that he did anything illegal. Nonetheless, this has led to political debate in Britain about the fairness of a tax system in which the rich and privileged are able to take advantage of offshore tax shelters and the like to limit their tax liability.
[interstitial_link url=”https://www.washingtonpost.com/world/putin-denounces-panama-papers-leaks-as-attempt-to-weaken-russia/2016/04/07/d69473e6-fcbf-11e5-9140-e61d062438bb_story.html”]British Prime Minister David Cameron acknowledges profiting from offshore trust[/interstitial_link]
Janan Ganesh, a prominent U.K. columnist writing for the Financial Times, suggests that this whole debate is misconceived. He claims that the whole idea that a tax system ought to be fair is nonsense, given the many different ways we might define fairness. Instead, we should just rely on the regulations as they are written. Here’s why the political science says that he’s wrong.
Taxes depend on social trust
Ganesh doesn’t like perceptions of fairness, which he attacks as being vague and fuzzy. Instead, he advocates attention to the rules. If someone is acting within the rules, then that’s all we ought to care about. He says that it simply isn’t politicians’ business to change the ‘culture’ around taxpaying.
The problem is that the rules don’t work on their own. Tax systems can’t simply rely on the threat of enforcement. Tax authorities just don’t have enough resources to investigate everyone to ensure that they are paying their taxes. This is especially true in the United States, where the Internal Revenue Service has been systematically starved of resources for enforcement over the last decade, but it is also true in countries such as the U.K. If people were purely self-interested rational actors, their best course of action would probably be to cheat on their taxes, because the expected benefits are high, and the likelihood of punishment is low.
So why is it that most people in countries like the United States and U.K. are reasonably honest in paying their taxes? The answer isn’t that they like paying taxes — few people do. It’s that they trust in the honesty of the system. For example, John T. Scholz and Mark Lubell have undertaken important empirical research on why people pay taxes. They find that taxpayers become more likely to cheat, as the opportunity to cheat without getting caught increases. However, they do not cheat nearly as much as one might expect. As Scholz and Lubell describe it:
Trust in government and trust in other citizens significantly influence tax compliance, even after controlling for the influence of any internalized sense of duty and of self-interested fear of getting caught.
Tax compliance requires an effective state
Margaret Levi, who has written a classic book on taxation and the state, extends this insight further. She argues that people only ‘quasi-voluntarily’ pay taxes. However, their willingness to volunteer depends, as in Scholz and Lubell’s argument, on their views of the state and their fellow citizens. People are more willing to pay taxes when they “credit government with generally doing the right thing with their monies.” Furthermore:
Citizens are more likely to trust a government that ensures that others do their part. Those who choose not to be free riders are eager not to become suckers. Thus, the willingness to pay taxes quasi-voluntarily … often rests on the existence of the state’s capacity and demonstrated readiness to secure the compliance of the otherwise noncompliant.
Where there is a democratically responsive state that spends its money well, and is strong enough to ensure that others comply, then people will be willing to pay their taxes. Where there isn’t, a culture may develop in which people don’t pay their taxes. Italy, for example, is a Western democracy that has a weak state and perennial problems with tax cheating. In colloquial Italian, the same gendered insult (cornuto) is sometimes used for a man whose wife cheats on him, and for someone who pays all their taxes.
This is what the Panama scandal threatens
The Panama scandal reveals both that many rich people in the U.K. and elsewhere have not been paying the taxes they might have been expected to pay, and that the state has been unwilling or incapable of doing anything about it. Some of these people may have been engaged in legal (but politically problematic) forms of tax minimization or tax avoidance. Others may have been engaged in outright tax evasion. The relevant social science research suggests that this may weaken tax compliance among previously honest taxpayers. As Levi notes, no one wants to be played for a sucker, and those who have paid their taxes diligently and not taken advantage of exotic offshore arrangements may reasonably feel that they are the suckers who have been keeping the system going. This is especially true when it is the prime minister, and perhaps other senior politicians, who have complex international arrangements.
Here’s how fairness counts for taxes
Ganesh complains about the vagueness of the term fairness. However, his op-ed itself seems to confuse two very different notions of what fairness involves. One — which is the form of fairness that his op-ed focuses on — is the question of the tax burden that different segments of society should pay. Should the rich — who can pay more — be stuck with the bill? Or should poorer people, who benefit more directly from state spending, shoulder the burden? Ganesh has rather less to say about the second kind of fairness, which is in fact much more relevant to the Panama Papers scandal. Here, the question is whether it is fair to expect people to pay their full tax liability, while others take advantage of complex international arrangements to minimize it?
Interestingly, Scholz and Lubell’s work suggests that the first kind of fairness is not very relevant to paying taxes. People’s beliefs about whether the tax system distributed the burden fairly or unfairly between different social classes didn’t really affect their willingness to pay taxes.
Again, what did affect people’s willingness to pay taxes was their perception about whether other taxpayers were paying too. When they believed that others were underpaying, they too, were more likely to underpay. When they believed that others were honest, they too were likely to be honest. This is how perceptions about fairness affect tax paying. This research would lead one to predict that the Panama Papers revelations will make previously honest British taxpayers less likely to pay their taxes than before, unless the state is able to act visibly and successfully to curb tax avoidance and tax evasion.