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Caught Cheating: When Sin Taxes Forge Unforeseen Fallout

Dec. 14, 2021, 9:45 AM

Sin taxes are a key legislative tool to reduce unhealthy behaviors such as the use of tobacco. These taxes are generally effective in decreasing the purchase and consumption of targeted products, but they may have unintended consequences.

In a recently published research paper, we examine whether taxpayers targeted by a cigarette tax hike are more likely to defraud other individuals in unrelated transactions. This would clearly be an unintended and unwanted consequence of the sin tax increase. Understanding whether there is a link between changes in sin taxes and fraud is important, as fraud can erode trust in markets and leads to billions of dollars in stakeholder losses.

We propose two reasons why affected taxpayers might commit more fraud following a sin tax hike. First, tax increases can reduce the buying power of targeted taxpayers. This reduction in purchasing power could increase the value of additional income to affected taxpayers and, accordingly, their incentive to commit fraud. Second, being treated unfairly makes cheating behavior easier to rationalize, even when the potential victims of fraud are not responsible for the taxpayer’s unfair treatment. Surveys consistently report that affected taxpayers view sin tax hikes as unfair, which suggests that they may find it easier to rationalize defrauding others in the aftermath of sin tax hikes.

Of course, taxpayers subject to sin taxes might not defraud others more frequently after a sin tax hike, because most people have a strong internal compass that discourages dishonesty even in the face of outside financial pressure and unfairness.

We test the relation between sin tax increases and fraud using data from New York City tax rides, which allow us to identify drivers who cheat and drivers affected by the increase in cigarette taxes—taxi drivers who smoke. We define cheating as overcharging on taxi rides, where drivers charge the “out of town rate” for rides taking place within New York City. We identify taxi drivers who smoke via tickets for violating the taxi regulator’s prohibition on drivers smoking in cabs. We then examine how their likelihood of committing fraud changes around a large increase in federal sales taxes on cigarettes. We find that in the month immediately after the tax hike, smokers ramp up their cheating by about half—this represents an increase of about 1.1 fraudulent trips per month.

Further, we find that taxi drivers who both smoke and had low earnings in the recent past are even more likely to increase their level of fraud following the tax hike. Given the modest earnings of most taxi drivers, they likely notice their increased costs from a cigarette tax hike. The pain from the tax increase is probably felt even more keenly by taxi drivers with low earnings in the recent past. As a result, these drivers commit more fraud.

As with any academic research, it’s not clear how much these findings generalize to other taxes and settings—what researchers call external validity—but these results do offer initial evidence that taxes can impact taxpayers outside the decision of whether to pay or avoid the tax. And moreover, that there may be spillovers to individuals in completely unrelated transactions.

As governments seek to collect more revenue, our findings illuminate a societal cost of increasing sin taxes. The type of taxicab fraud we study is quite small in magnitude, but it offers a helpful glimpse into how taxpayers’ behavior changes following a tax hike. That these taxpayers respond by cheating others more frequently is worrisome, given both the direct costs of fraud and the indirect costs, like reduced trust and less economic activity. We encourage participants in the ongoing debate about taxes and avenues for tax revenue generation to consider our paper’s crux: Some types of tax hikes can have negative fallout that stretches beyond the taxpayer in person.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Author Information

Thomas Shohfi is an assistant professor at the Lally School of Management at Rensselaer Polytechnic Institute. He has long led research into alternative data sources in the analysis of stock markets. His latest projects have him developing a novel price index for the rare and vintage bourbon whiskey market and examining the relevance of sell-side analyst reports in financial activism.

David Kenchington is an Assistant Professor of Accountancy at the W. P. Carey School of Business at Arizona State University. His research primarily focuses on how taxes affect asset prices and corporate decision-making.

Jared Smith is an associate professor of finance at North Carolina State University’s Poole College of Management. His research interests span a variety of topics in corporate finance and economics, including norms, financial policy and capital structure, and the interaction of law and finance.

Roger White is an Associate Professor of Accountancy at the W. P. Carey School of Business at Arizona State University. His research is focused on fraud, incentives, regulation, corruption, and investor behavior.

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