Coordination In Tax Evasion
Imagine you are driving down a narrow dirt road relatively fast and as you turn a corner you notice that another car is heading right at you. There are multiple strategies at play in this situation. Consider the fact that road isn’t big enough for either car to stay in the center (in this case there will be an inevitable accident) you have the choice of swerving left or swerving right. This isn’t the only factor at play. The person in the other car has the same strategies in mind. Your decision and ultimately your safety are dependent on the other person’s decision as well. This situation is what is known in Economics as “The Coordination Game”. The best outcome is strictly dependent on the coordination of the decisions of all player involved. If you both go right then an accident is avoided. If you both go left the accident is avoided. However, if you both go opposing directions there will be an accident. In game theory the Nash Equilibrium occurs when both players make the best possible decision for themselves which is known as the dominant strategy. The two best outcomes (both going left, or both going right) are the Nash Equilibria where both players are choosing the dominant strategy.
In Alm & Mckee (2000), these concepts are applied to tax evasion. When income tax returns are presented to the government they must find a way to make sure that people aren’t underpaying for their taxes. Due to the fact that people disclose there own information, falsifying information is relatively simple and convenient to do. Considering the process by which people are caught for presenting false information on their tax returns, it is generally surprising that more people don’t underpay their taxes. The simplest way that government agencies check for tax evasion is what is known as the “random audit rule”. By taking everyone’s tax return and randomly selecting which ones to audit they can hypothetically find some false tax returns and hopefully deter others from taking part in faulty practices. However, this isn’t the exact method that the IRS uses. To be more efficient the IRS uses what is known as “The Discriminant Index Function” (DIF), where “individuals who deviate from the average behavior of their assigned cohort send up a red flag”. This red flag is only a function of your behavior and the behavior of others in your tax bracket. Once a red flag is raised the IRS audits the person to see if they have lied on their tax return. If indeed they have lied they have to pay back all of their required taxes plus a fine.
The strategies involved in a situation where one is trying to decrease the amount of taxes paid can be explained in the Coordination Game. People in similar tax brackets should pay similar amounts of taxes and exhibit similar behaviors, and if everyone cheats on their taxes then the IRS won’t see any deviations and therefore won’t audit anyone. Similar to the oncoming cars, if all players make the same decisions than all will experience the most desirable outcome. However, if a number of people in the tax bracket defect and choose to report their taxes in a more extreme way they are exhibiting different behaviors than the others and the IRS will notice the discrepancy. Due to the nature of audit selection, the success of tax evasion is ultimately dependent on the coordination of the players involved. If one looks at the payoffs of making “anti-coordinating” decisions both players will receive no payoff for choosing different information to disclose. For example, the degree to which someone decides to underpay their taxes can be an ultimate deciding factor. If one person discloses information that would lead them to slightly underpay and another person tries to shoot for a large tax reduction this difference will be noticed and both parties will be audited. Alm & McKee take an interesting look at how players in a tax evasion game operate. This game can seem to be a hypothetical situation considering that realistically people will try and opt out of tax evasion because they are apprehensive about the guilt and embarrassment they will feel if they get caught.