Tax Evasion and Risk Perceptions among Lawyers in China

Shu-Yi Oei

I recently read an interesting article by Prof. Benjamin van Rooij (UC Irvine), Weak Enforcement, Strong Deterrence: Dialogues with Chinese Lawyers about Tax Evasion and Compliance, 41 Law & Social Inquiry 288 (2016), available here.

The article studies a particular form of tax evasion practiced by some lawyers in China: The lawyer, although affiliated with a law firm, retains clients privately, accepts cash payments from such clients without giving the client a tax receipt, and does not report the case to the law firm. This behavior actually contains both a tax evasion and a business-driven purpose: it enables the lawyer to underreport income for tax purposes while also avoiding payment of a significant cut to the law firm. Unsurprisingly, the law prohibits these practices. The paper employs qualitative “semistructured” interviews with lawyers at large and medium-sized law firms using open-ended questions, in order to generate a nuanced picture of how enforcement, deterrence, and risk are perceived by these lawyers.

The findings are fascinating, and provide a unique perspective on legal ethics, tax compliance, and perceptions of enforcement and deterrence among lawyers in China.

The study shows that lawyers perceive a high risk of detection and enforcement, despite low “proactive” enforcement by the state and despite vague understandings of sanctions severity. Most notably, the interviews show that much of the perceived risk of detection comes from fear of clients, who possess information about lawyers and their evasive practices, may need tax receipts from lawyers in order to take their own tax deductions, and may complain and report lawyers if dissatisfied with case outcomes. Such client complaints may cause the state to “reactively” enforce. In addition, the study found that lawyers perceive a detection risk emanating from their own law firms, which may lose revenue and reputation from such evasive acts and may take steps to verify amounts paid by clients. The lawyers interviewed did also perceive some detection and enforcement risk from the state. The interview subjects also thought that detection risk varies based on frequency and amount of tax evaded, the lawyer’s position in the firm (e.g. partner vs. associate), the nature of the legal matter (for example, litigations, which can be lost, pose more risk), and the strength of the client relationship (for example, if the lawyer has had repeat interactions with the client or if the client has been referred by a trusted source). Thus, perceptions of detection risk come not only from actual sanctions and detection probabilities but also stem from perceptions about client, firm, and government motivations and seem to depend on the specific context.

Interestingly, the study also found that those interviewed had vague ideas about severity of sanctions and expressed more concern about loss of practice license and law firm sanctions than about punishment by the tax authority. Finally, the study discusses how lawyers manage detection risks using various strategies, including by using contracts that include only part of the sum paid by the client and by returning the fees paid by clients if things go wrong.

From a tax compliance and enforcement point of view, the findings are interesting on two fronts:

First, as van Rooij indicates, these findings don’t fit within the standard deterrence model, which assumes a rational actor who weighs the probability of being caught and the severity of the sanction. For example, this is not a case in which clients are performing corroborative information reporting through formal legal procedures (for example, by reporting payments made to lawyers to the taxing authority on a Form 1099). In such cases, lawyers are complying with tax laws because they know that the information will be reported and that the risk of detection is therefore high. Rather, it is the perceived threat of what clients might do in the future with information they hold that creates the perception of detection risk. The findings do, however, fit quite nicely with more recent work in behavioral psychology and tax compliance. The study sheds light on how taxpayer assessments of detection risk may be greater or less than the actual risk. It specifically suggests how relationships with third parties, information imperfections, and cognitive factors may affect perceptions of that risk.

Second, it’s significant that the behavior being studied is essentially the purposeful creation of an unreported “cash sector” against a regulatory backdrop in which transactions are supposed to be documented and reported and in which other actors may know, care about, and have evidence of such unreported cash transactions. From a U.S. perspective, it would be interesting to see whether similar dynamics and risks are in play in cash sector transactions, particularly those occurring in contexts where these unregulated and undetected cash transactions may be occurring alongside (or in resistance against) regulated and detectable non-cash ones. For example, if I hop into a taxicab and at the end of the ride I take out my credit card and the driver says “I prefer cash,” one might infer that this is because cash is easier to hide. It’s possible that in the cab-ride context the perceived threat from the client (i.e., me) is quite low, given the small payment amount, the isolated nature of the transaction, and the fact that most people just wouldn’t bother reporting the cab driver. But it would be interesting to see how risk perceptions stemming from client behaviors and incentives may vary in other contexts—for example, in situations involving repeat players, cases where there is greater risk of customer dissatisfaction, and cases where the amounts at stake are larger.

5 thoughts on “Tax Evasion and Risk Perceptions among Lawyers in China

  1. Interesting stuff. I do think similar dynamics play out in some US cash-sector contexts. The example that comes to mind is the sign at some cash registers saying “If you aren’t offered a receipt, your purchase is free.” I suspect that is to give the customer an enforcement incentive that deters employees from avoiding using the register and pocketing the cash. (Of course, it is easier to use this enforcement method in a store than in your cab hypo because in a store, there usually is a manager or other worker present during the transaction to report the problem to.)

    I’m not seeing how these findings fail to accord with the standard deterrence model. Isn’t the calculus here still perceived probability of detection and perceived sanction, with some detection possibility being added by clients and some of the possible sanction nonlegal? Is the idea that a perceived probability of detection that differs from the actual probability is outside the traditional model?

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  2. I think you’re probably right about the cash register example. That hypo is especially interesting, because here, again that’s a mix of tax and business-related evasion. I’m also thinking about situations of more repeat transactions (e.g. suppliers, perhaps) involving bigger amounts and what incentives/perceptions may underlie the decision to go with cash transactions in those contexts.

    And, on the standard deterrence, yes, I think the article’s point is that it’s perceived detection that matters (in particular, perceived detection due to “soft-ish” power wielded by clients with whom the lawyer interacts, as opposed to, say, actual information reporting), rather than actual detection probabilities. I do agree that it’s possible to reconcile this with standard deterrence, though perhaps the more interesting point is whether lawyers over or underestimate detection probabilities in coming to their perceptions of risk due to the actions of their clients.

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    1. Clients as a subcategory of third-party enforcers is very interesting, and I think is a contribution of the article. More generally, I guess I don’t see perceived detection rate as being a departure from the standard deterrence model–it’s just objective vs. subjective enforcement rates, as in Andreoni et al., Tax Compliance, 36 J. ECON. LIT. 818, 844-46 (1998).

      For example, even with information reporting, perceived detection rate must matter. Taxpayers may perceive the likelihood of detection (and IRS contact) from information reporting as close to 100%, whereas actual computer matching rates are lower, as I recall, and the IRS only follows up on a fraction of those. For example, the NTA reported in 2013, “the IRS identified almost 23.8 million mismatches [between the taxpayer’s return and third-party information] on TY 2010 returns, but only worked about 5.3 million cases (22 percent).” http://taxpayeradvocate.irs.gov/userfiles/file/2013FullReport/Fundamental-Changes-to-Return-Filing-and-Processing-Will-Assist-Taxpayers-in-Return-Preparation-and-Decrease-Improper-Payments.pdf (p.74).

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      1. As noted in my comment regarding U.S. lawyers in a firm the “nontax avoidance” reasons (e.g., professional responsibility, ethics, loyalty) seem to trump this nefarious behavior in my small sample anecdotal experience. My experience regarding information reporting is that it is extremely effective as a device for tax compliance and relied upon by taxpayers (e.g., W2 income reporting is high 90s% more or less). Governments should use more and have tried to implement with significant pushback (usually framed as too administratively costly and burdensome). Interestingly, among some of my less sophisticated clients I have seen the failure to report interest income of less than $10 because they did not receive a Form 1099 (because not required). We discover that it exists when it is included in an IRS notice (together with another more significant issue, that is not readily resolved with information reporting). A new (to me at least) sophisticated EITC fraud scheme relies on information reporting by manufacturing W2s for taxpayers and corresponding compensation deductions for the business.

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  3. Interesting on many levels. First, I am struck by the risk that these officers of the court are taking with respect to their professional reputations and licenses. My experience (predominately with large and medium size law firms) is that although the cost is great (with respect to sharing client profits broadly) this does not happen. The law firm partnership has a cultural integrity that in my experience was sacrosanct and that even spin off firms were inherently discouraged by a deep sense of commitment to The Firm (h/t John Grisham). The lack of integrity and enormous downside risk (loss of license, ability to practice, and reputation) is also striking given the marginal upside. I also wonder about the client side interaction — integrity, discipline, and respect for the rule of law are attributes most clients want in their representation so I am surprised clients don’t flee when it is suggested. I wonder if it matters what the practice area is — e.g., criminal law versus tax planning? I have experienced US retail sellers of large ticket items suggesting that we negotiate a cash deal (e.g., new cars) for a reduced price. My reaction was that this was a retailer that was not someone I would want to deal with because they likely were not transparent/following rules/guidelines/legitimate. And that this transaction was more likely to result in an inferior product or follow-up service. Integrity and character in legal representation would seem to have an even higher bar. As would medicine …

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