Tax evasion

Tax evasion appears in The Wisdom of Crowds as more than a matter of individual dishonesty: it is a pressure on the shared trust that makes collective provision possible. The account follows the offshore bank opened by John Mathewson, the scale and variety of evasion schemes in the 1990s, and the resulting challenge to voluntary tax compliance. Its central tension is that people can benefit from public goods without personally paying for them, yet those goods depend on enough people continuing to contribute.

Offshore banking and a revealing client base

In 1986, John Mathewson opened the Guardian Bank and Trust Company in the Cayman Islands. He had little banking experience, few clients, and only a cursory understanding of how banks worked. He did, however, recognize a market among Americans with money they wanted kept from the Internal Revenue Service. He helped clients establish shell corporations, failed to report their deposits to the IRS, and issued debit cards that gave them access to Guardian accounts from anywhere in the United States. The service was expensive: an account cost $8,000 to establish, and each transaction cost $100. At its peak, Guardian held $150 million in deposits for two thousand clients.

Mathewson left the Cayman Islands in 1995 after a dispute with a government official and moved to San Antonio to retire. Within months, he was arrested for money laundering. Facing prison and holding encrypted records of Guardian’s depositors, he agreed to cooperate with the government. He pleaded guilty, received five years’ probation and five hundred hours of community service, and disclosed what he knew about tax cheats. The records and his testimony turned a secretive bank’s customer list into evidence about the breadth of offshore tax avoidance.

The clients Mathewson described did not fit the familiar picture of offshore banking as a service used only by drug dealers and money launderers. Testifying before a Senate panel in 2000, he said that most of Guardian’s clients were legitimate business people and professionals. One was Mark Vicini, a New Jersey entrepreneur who ran the computer company Micro Rental and Sales. Vicini was regarded as a respected member of his community, helped relatives through college, and gave to charities. Between 1991 and 1994, however, he sent $9 million to the Cayman Islands and concealed $6 million from the IRS, avoiding $2.1 million in taxes. After pleading guilty to tax evasion, he served five months in federal prison. His case sharpened the book’s point: civic respectability and participation in community life did not necessarily rule out deliberate tax cheating.

The 1990s expansion

Guardian’s clients formed part of a larger boom. By the end of the 1990s, two million Americans had credit cards from offshore banks, whereas almost none had them fifteen years earlier. Promoters, often using the Internet, marketed schemes with names such as “layered trusts,” “offshore asset protection trusts,” and “constitutional pure trusts.” Other tax evaders revived more familiar methods: keeping two sets of books, or incorporating oneself as a charity or church and claiming personal expenses as charitable contributions. Some advised people that they did not owe income tax because, they asserted, Congress had never passed it. These arrangements varied, but the schemes described were illegal.

The sums involved made the change consequential beyond the individuals who adopted the schemes. Rough estimates put their cost to the United States at as much as $200 billion a year by the end of the decade. At the same time, the book distinguishes the growth of evasion from the conduct of most Americans: the vast majority continued to pay taxes honestly and told pollsters that cheating was wrong. The concern is therefore not that everyone had stopped complying, but that visible opportunities to evade—and the impression that others succeeded in doing so—could alter how compliant citizens understood their own obligations.

That impression took hold alongside two other developments. The tax system was becoming more complicated, making it harder for people to determine what a fair share meant, and corporate tax shelters were proliferating. In 1999, the Treasury Department described an “unacceptable and growing level of tax avoidance.” A 2001 Forbes article’s title, “ARE YOU A CHUMP?”, gave blunt form to the suspicion that honest taxpayers might be the ones losing out. The danger was not only lost revenue: when evasion appears common or consequence-free, paying one’s share can begin to feel less like a reciprocal contribution and more like being taken advantage of.

Taxation as a cooperation problem

The book frames taxpaying as a cooperation problem because public benefits are shared even with people who do not contribute. Taxes fund defense, schools, roads, police and fire protection, and basic research, among other services. Many of these are nonexcludable goods: a person can benefit from them regardless of whether that person paid taxes. A national missile defense system, if built, would protect a nonpayer’s house as well as a payer’s; once I-95 exists, its roads can be used by people who did not personally finance them. Each individual therefore has an incentive to avoid the cost while still receiving the benefit.

That incentive is individually intelligible but collectively destructive. If most people choose to free ride, the public goods on which everyone relies cannot be sustained. Tax evasion thus reproduces the collective-action dilemma discussed through Mancur Olson: each person may prefer that somebody else shoulder the expense, but the shared benefit depends on enough people doing so. Unlike participation in a voluntary interest group, however, tax payment is required by law. The distinction does not remove the cooperation problem, because the possibility of punishment has historically been limited. In 2001, the IRS audited only 0.5 percent of returns. In purely economic terms, the low chance of being caught could make evasion appear rational to an individual, even as widespread evasion undermines the system as a whole.

Fairness, enforcement, and contingent consent

Legal obligation alone cannot explain why a tax system with relatively high compliance continues to function. The account emphasizes reciprocity: people are more willing to pay when they believe others are paying too, and when those who evade taxes are likely to be caught and punished. Historian Margaret Levi describes Americans in this context as “contingent consenters.” Their willingness to contribute is conditional, not unlimited: it rests on a belief that the burden is shared and that rules are enforced.

The condition makes tax compliance vulnerable to public perceptions as well as to the actual rate of evasion. When people think others are breaking the law and getting away with it, they may feel that compliance leaves them at a disadvantage. The book’s closing formulation captures the moral as well as practical pressure: people may want to do the right thing, but they do not want to be suckers. Tax evasion matters, then, not simply because it reduces public revenue, but because it can weaken the reciprocal confidence on which voluntary participation depends. A system sustained by everyone’s contributions can be damaged when people cease to believe that everyone else is contributing too.