The Cost of Tax Evasion

Every time the top US tax rate increases by one percentage point, there is a more than 2% increase in US investors attempting to evade taxes by disguising themselves as foreign investors, according to the results of a new study.

Michelle Hanlon, a professor of accounting at MIT, and colleagues published their findings about the tax evasion technique called “round-tripping” in the Journal of Finance. According to the authors, in round-tripping, Americans hide funds in offshore tax havens and, then, invest those funds in the US securities market. In doing so, they are disguising themselves as foreign investors, who are not subject to the same capital gains and interest income tax rates.

According to the study, for every 1% increase in the top US tax rate, foreign portfolio investment from tax havens increases by 2.1% to 2.8%.

“It’s very hard to identify tax evasion, because obviously people are trying to hide it,” Hanlon said in a statement. “Once we started seeing the data, we realized we could try to tackle this problem. We had to do a lot of tests to try to isolate the effect we’re looking for, [and] we think it’s a big step to try to put some numbers around this phenomenon.”

The authors estimate that round-tripping has to between $34 billion and $109 billion of foreign portfolio investment from tax havens, which has results in tax revenue losses of $8 billion to $27 billion.

The Cayman Islands, a notorious offshore tax haven, had the third highest total equity foreign portfolio investment into the US in 2008 with more than $200 billion. Other tax havens with significant foreign portfolio investment in 2008 included Switzerland, China (mainland), and Singapore.

“The higher the tax rate, the more securities appear to be purchased from tax haven jurisdictions,” Hanlon said. “This seems to indicate that US individuals are pretending to be foreigners who then invest in the US markets.”

To determine which investments from tax havens should be considered as tax evasion, the researchers consider changes in investment levels from tax havens after changes in the US tax rates, plus whether or not the US has a bilateral Tax Information Exchange Agreement with the offshore sovereignty. When the US created this agreement with other sovereign parties, both equity and debt investments decreased by 32%, according to the authors.

Although tax evasion will continue, the creation of more Tax Information Exchange Agreements will make it more difficult for people, according to Hanlon. She adds that the more costly and risky tax evasion is, the less likely people are to do it.

“We felt it was important enough that someone try to do research like this, to get people thinking about other data sources and other ways to examine [tax evasion],” Hanlon said. “Our hope was that it would lead to more research and that people would take more risks to look at things like this.”