Tax Evasion and the Fraud Diamond

By: Leandra Lederman

There is an extensive set of literatures on tax compliance and evasion, often discussing the traditional economic model (the deterrence model) and/or behavioral theories such as social norms or tax morale. (For recent examples summarizing the theories, see this article by Kathleen Delaney Thomas, this one by Adam Thimmesch, or this one by yours truly.) There is also a separate accounting literature on fraud.

A key concept in this accounting literature is the “Fraud Triangle.” Yet despite the important role this theory plays within the accounting literature, the Fraud Triangle does not seem to have permeated the tax compliance literature, particularly the relevant legal literature.

For example, a search in “Secondary Materials” in Lexis for “‘fraud triangle’ w/50 tax!” turns up only one article, which is not a tax article but does cite a 2006 Tax Notes article authored by three CPAs. That article is James A. Tackett et al., “A Criminological Perspective of Tax Evasion” (paywalled). Yet, the Fraud Triangle should not be overlooked by scholars outside of accounting. It provides a powerful tool with which to conceptualize tax evasion. And, as discussed below, it helps provide a framework that both supports the deterrence model and allows other factors to coexist with deterrence.

The Fraud Triangle and the Fraud Diamond

The Fraud Triangle derives from three factors that criminologist Donald R. Cressey originally identified in a 1951 article in the Journal of Accountancy, “Why Do Trusted Persons Commit Fraud?: A Social-Psychological Study of Defalcators.” As discussed in his 1951 article and his 1953 book, “Other People’s Money: A Study in the Social Psychology of Embezzlement,” Cressey developed the factors that became the Fraud Triangle out of in-depth interviews with inmates who had been convicted of trust violations such as embezzlement. The three factors were labelled the “fraud triangle” by Steve Albrecht in the early 1990s. The elements of the Fraud Triangle, as discussed by Albrecht and others, are “perceived pressure” (usually financial), “perceived opportunity” to commit the fraud, and “rationalization” that the actions are justifiable or appropriate in the context of the situation. Albrecht and his coauthors of a 1979 KPMG study of convicted perpetrators of fraud “found that the decision to commit fraud is determined by the interaction of all three forces.”

The Fraud Triangle is very well known, as Albrecht has noted:

“It didn’t take long for anyone interested in writing about fraud to begin using the Fraud Triangle. For example, in 2002, the Auditing Standards Board of the American Institute of Certified Public Accountants used the Fraud Triangle as a critical element of ‘SAS 99: Consideration of Fraud.’ President Josiah Bartlet’s aides discussed the Fraud Triangle in an episode of the television show, ‘The West Wing.’ (http://tinyurl.com/mkgzo3r)”

In a 2004 article in The CPA Journal, David T. Wolfe and Dana R. Hermanson proposed adding a fourth element—“an individual’s capability” to perpetrate the fraud—resulting in what they termed the “Fraud Diamond.” (Wolfe and Hermanson also labelled the pressure element as “incentive.”) The “capability” component includes the knowledge and intelligence necessary to carry out the fraud, as well as the skills needed to avoid detection, such as the ability to lie convincingly.

Applying the Fraud Triangle/Diamond to Tax Evasion

Although the Fraud Triangle originates from the study of embezzlement and similar occupational frauds, the Fraud Triangle’s three factors—(1) an incentive or perceived (usually financial) pressure, (2) perceived opportunity to cheat, and (3) rationalization of one’s actions—seem fairly easy to extend to the context of tax evasion. Yet, despite the iconic nature of the Fraud Triangle in fraud studies, the Fraud Triangle is not a common topic in the legal literature on tax compliance. The Tackett et al. Tax Notes article mentioned above does apply it, arguing that “In most situations, tax evasion can be viewed as embezzlement of government funds. The fraud triangle is particularly applicable to embezzlement because Cressey’s original study used embezzlers as subjects.” Tackett et al. explain that someone may feel financial pressure regarding the tax liability, perceive an opportunity to cheat because of the lack of monitoring of voluntary compliance, and rationalize that the tax system is inequitable and that honest taxpayers are unfairly burdened. The Fraud Triangle thus provides a fairly intuitive way of thinking about the criminology of tax evasion.

The Fraud Triangle also supports the importance of deterrence to tax enforcement. That is particularly because of the “opportunity” factor, as discussed below, but also because visible enforcement may reduce the ability to rationalize that “everyone cheats” or “only chumps declare everything.” (This is another angle from which to approach the idea that enforcement helps buttress compliance norms.)

A number of scholars have accused the deterrence model of being incorrect or have said that current tax compliance levels in the U.S. and elsewhere are a “puzzle,” on the basis that at real-world audit and penalty levels, the model would predict zero voluntary compliance. (For example, see the cites in footnotes 114-116 here.) In a series of articles, I have rebutted that claim and its sometime corollary that enforcement may backfire, undermining compliance norms or the taxpayer’s intrinsic motivation to comply (tax morale). In a forthcoming article that synthesizes the empirical evidence, I find that audits are highly effective deterrents, and enforcement does not crowd out intrinsic motivations to comply. In a previous article, I argued, based on a synthesis of empirical studies, that enforcement actually buttresses tax compliance norms and can help tip a noncompliance norm in a particular community to one of compliance.

I have also argued in several articles (such as this one and this one) that the purported compliance “puzzle” ignores the issue of opportunity to evade. If the taxpayer has little opportunity to evade tax, we should not expect to see much evasion, even if audit and penalty rates are low. Third-party information reporting (such as on Form W-2 or 1099 in the United States) makes the payment visible to the tax authority. The taxpayer receives the information report containing the figures reported to the government (which also simplifies compliance). The taxpayer could omit the amount on the information report, but simple document matching would likely detect it. The IRS no doubt does not collect every dollar of unreported income it detects this way, but the obvious visibility of third-party-reported income is a strong deterrent to evasion. IRS statistics—which show extremely high reporting of income subject to substantial information reporting—support that (see p.5 here), as does the fact that asking to be paid in cash “under the table” is synonymous with not planning to pay taxes.

The Fraud Triangle adds another perspective that underscores the importance of opportunity to evade. Tackett et al. provide the following analogy:

“Suppose a department store operated on the honor system, in which customers selected merchandise, tallied their bill, and remitted their payment without any supervision other than a 1 percent chance of being audited. Assume further that customers who are caught cheating are almost never prosecuted, but merely have to pay the accurate amount of their purchase along with a modest financial penalty. How long would such a store remain in business? The scenario is analogous to the federal income tax system.”

This is an interesting analogy that highlights the importance of the “opportunity” element to tax evasion. Unfortunately, however, it reflects the same trap that scholars who only look at audits and penalties when evaluating the deterrence model fall into: it is apt only for amounts not subject to third-party reporting. Imagine if Tackett et al.’s hypothetical store also had a department with all of its merchandise in locked cases, where a salesperson had to take the merchandise and an invoice to a cashier to await customer payment. That department would no doubt experience much less nonpayment. (The closest tax-administration analogue to such a department would be with respect to wages and salaries, which are subject not only to information reporting but also withholding, and have an estimated 99% voluntary compliance rate (p.5).)

The Tackett et al. article, as well as a 2014 Journal of Economic Psychology article, “Behavioral Dynamics of Tax Evasion—A Survey”, apply the Fraud Triangle to tax evasion, but they do not apply the Fraud Diamond. As noted above, the Fraud Diamond adds the fourth element of “capability” of perpetrating the fraud. Tax fraud may not involve defeating an organization’s internal controls, but capability matters for tax evasion, too. The tax laws are complicated, and some evasion is, as well. Some evasion may involve the assistance of a return preparer or other tax professional. Other evasion, such as intentionally failing to report cash income received, requires little capability. Moreover, for self-preparers, the fact that return-preparation software typically keeps a running total of the expected tax refund or payment due likely makes the mechanics of cheating easier, as someone can instantly see what effect an alteration in a particular number would have. The software thus likely makes the “capability” factor a much lower bar.

The bottom line is that the Fraud Triangle and Fraud Diamond theories may assist the understanding of tax evasion, which, after all, is a type of fraud. For example, the Fraud Triangle/Diamond supports the idea that opportunity is a critical factor in tax evasion (but not the only factor). It may also help suggest a mechanism by which other factors, such as the taxpayer’s view of government (p.75), may affect the taxpaying decision. For example, a belief that the government or tax system is unjust or inequitable could be part of the “rationalization” prong by which someone justifies evasion. This set of issues likely warrants further study. In addition, the usefulness of theories on tax fraud to the understanding of tax evasion underscores the value of the criminology and accounting literatures to the study of tax compliance and evasion.