Who Benefits Most From Tax Evasion, The Rich or The Poor?

By Deepak Bhalla Wed 06 July 2016 4 min read

Answering this question may seem obvious: it is the rich are able to gain significant advantage by evading larger taxes, paying for the privilege, while the poor, who may receive government benefits ultimately suffer. The super rich can at times seem to evade income taxes in its entirety and so the rich would seem to be the only beneficiary of tax evasion.

The answer is not as simple to answer when you consider that both groups evade tax, the marginal benefits from the poor evading tax are much greater than the rich's. The rich are able to reduce their tax burden through esoteric external asset managers who give them access to complicated tax arrangements while the poor that are more likely to form and engage in non-taxable transactions in the informal economy. If the poor benefit from tax evasion is there a chance that they are the ones who benefit most from tax evasion?

The informal economy consists of paid activities that are unregistered by, or hidden from, the state for tax and labour law purposes but are legal in all other respects. Sectors with informal economies such as the construction sector run on mutual agreements between sellers and buyers of goods and services. These sectors have a greater ability to avoid tax as transactions or parts of transactions are often not reported to the tax authorities. The term informal economy is far reaching, it encompasses waged informal employment but also any form of informal self employment or paid favours.

The ‘marginalisation’ thesis holds that participation in the informal economy is concentrated amongst marginalised populations such as the unemployed and low-income groups, who disproportionately participate in and gain from this realm. So if the poor are more likely to engage in informal economies, and they gain a greater relative benefit per pound sterling evaded than the rich can they be the group who gains most from tax evasion?

Well, even that is not entirely clear. While low-wage workers can receive immediate benefits from tax evasion they receive almost no net advantage in the long run. This is because there are general market forces that work toward the elimination of the tax advantage created by evasion opportunities through equilibrium adjustments. Take a look at the evader vs non-evader analogy to see how this works.

The Evader vs The Non-Evader

Imagine two markets, one in Manchester and one in Liverpool. Both cities produce goods which attract people in to the city. Liverpudlians are able to avoid adequate checking of taxation and tax evasion is common (an informal economy) while Manchester’s constituents are taxed correctly. Liverpool’s evasion of taxes allows labour to be paid more and investors to get more out of their money in terms of output. Liverpool’s wages, being more attractive have workers from Manchester moving to seek a more financially satisfying life. Liverpool’s total output increases as there is more labour and capital available. This is the immediate benefits from tax evasion.

Information Asymmetry

Let’s assume Manchester does not suffer from a drop in production with its lower labour levels if it is able to fund production with cash. Producing goods can be done through labour or money, and it is relatively easy to replace labour with equivalent levels of capital. The city is therefore still able to compete against Liverpool. Now, Manchester and Liverpool begin to compete. Manchester’s capital vs Liverpool’s labour force. Competition and replication of services in Liverpool lowers output per person and investors start to look elsewhere for investment. In Liverpool yet another factor takes hold as wages begin to lower as more and more labour flows in to the city. A lower wage means lowered cost of goods, a lower cost of goods means better prices for consumers in both cities.

Manchester, not suffering from the same lowering of wage price, is able to attract back labour and capital. This backwards-lagging effect is so large that research suggest’s Liverpool’s net welfare benefit from tax evasion would be along the lines of 1.1-3.4%. If Liverpool were to experience an increase in the expected penalty associated with tax evasion the city would benefit even less. It seems Liverpool gained a very little advantage from evading tax in the long run.

Information Asymmetry

Arriving back at the main question, if the poor form more of the informal economy and the market moves to reduce the net benefit to evaders, the poor ultimately benefit very little. Due to the cost of evading tax and punishments for tax evasion increasing the poor effectively gain nothing from tax evasion. The poor and the rich both suffer equal consequences for evading tax.

So who gains the most, the rich or the poor? I would argue it is the rich, but not because they have access to more evasion techniques but it is the rich who consume more - and tax evasion benefits consumption. The only guarantee is the net loser of tax evasion is the government who takes the immediate and long term brunt of non-taxed transaction. Indirect methods of tax evasion analysis on the UK economy shows tax evasion to account for roughly £150 billion yearly, thats just over 10% of the total GDP of the UK in 2012.

Deepak Bhalla