Transparency and Tax Evasion: Evidence from the Foreign Account Tax Compliance Act (FATCA)

• Author: KEVIN MARKLE,LISA DE SIMONE,REBECCA LESTER
• DOI: http://doi.org/10.1111/1475-679X.12293
• Published date: 01 March 2020
• Date: 01 March 2020

DOI: 10.1111/1475-679X.12293

Journal of Accounting Research

Vol. 58 No. 1 March 2020

Printed in U.S.A.

Transparency and Tax Evasion:

Evidence from the Foreign Account

Tax Compliance Act (FATCA)

LISA DE SIMONE ,∗REBECCA LESTER ,∗

AND KEVIN MARKLE †

Received 7 June 2018; accepted 26 September 2019

ABSTRACT

We examine how U.S. individuals respond to regulation intended to reduce

offshore tax evasion. The Foreign Account Tax Compliance Act (FATCA) re-

quires foreign financial institutions to report information to the U.S. gov-

ernment regarding U.S. account holders. We first document an average

$7.8 billion to $15.3 billion decrease in equity foreign portfolio investment

to the United States from tax-haven countries after FATCA implementation,

consistent with a decrease in “round-tripping” investments attributable to

U.S. investors’ offshore tax evasion. When testing total worldwide investment

out of financial accounts in tax havens post-FATCA, we find an average de-

cline of $56.6 billion to $78.0 billion. We next provide evidence of other im-

portant consequences of this regulation, including increased expatriations of

∗Stanford University †University of Iowa.

Accepted by Christian Leuz. We thank Peter Barnes, Brandi Caruso, Peter Cotorceanu,

Richard Harvey, Susan Segar (discussant), Devon Youngblood, John Zarobell, and two

anonymous investors for providing institutional insight. We also appreciate helpful com-

ments from two anonymous referees, Neviana Petkova (discussant), Sonja Rego (discus-

sant), Jake Thornock (discussant), Andrew Belnap, Patty Dechow, Omri Even Tov, Michelle

Hanlon, Stefan Huber, Alastair Lawrence, Jim Omartian, Joel Slemrod, and workshop par-

ticipants at Iowa State University, Santa Clara University, the 2017 National Tax Associ-

ation Annual Conference, 2017 Stanford-Berkeley Joint Seminar, the 2018 University of

California–Davis Accounting Research Conference, the University of Illinois Symposium on

Tax Research XV, and the 2018 Norwegian Tax Accounting Symposium. An online ap-

pendix to this paper can be downloaded at http://research.chicagobooth.edu/arc/journal-

of-accounting-research/online-supplements.

105

CUniversity of Chicago on behalf of the Accounting Research Center, 2019

106 L.DE SIMONE,R.LESTER,AND K.MARKLE

U.S. citizens and greater investment in alternative assets not subject to FATCA

reporting, such as residential real estate and artwork. Our study contributes

to both the academic literature and policy analysis on regulation, tax evasion,

and crime.

JEL codes: F42; H24; H26; M48

Keywords: tax evasion; automatic exchange of information; cross-border

deposits; investment; offshore locations

1. Introduction

A number of recent whistleblowing events and international data leaks

have exposed the extent of the offshore financial industry—$5.9 trillion of

wealth held in tax havens, by one estimate (Zucman [2013b])—prompting

public demands for regulatory action to address offshore tax evasion. Al-

though a broad literature examines the effectiveness of regulation in curb-

ing crime (e.g., Heaton [2012], Di Tella and Schargrodsky [2013], Adda,

McConnell, and Rasul [2014], Aizer and Doyle [2015], Immordino and

Russo [2015], Doleac [2017]), there is limited evidence on the effective-

ness of regulation in curbing offshore tax evasion, largely because of its

secretive and unobservable nature. This paper studies both direct and in-

direct effects of a U.S. regulation targeting U.S. individual offshore tax eva-

sion, including reduced financial investment activity from tax havens and

increased investment in alternative asset classes suggestive of continued

evasion.

In 2010, the U.S. government passed the Foreign Account Tax Compli-

ance Act (FATCA).1The law aims to limit the ability of U.S. persons to

evade U.S. taxes through the use of offshore accounts by requiring auto-

matic information transfers to the Internal Revenue Service (IRS) about

foreign accounts and related cross-border payments.2In contrast to the

previous self-reporting regime, FATCA requires all foreign financial institu-

tions (FFIs) to remit information about their U.S. clients directly to the IRS.

Coupled with its far-reaching and compulsory nature, FATCA represents a

significant change to the required tax reporting of worldwide financial in-

stitutions and U.S. citizens with foreign accounts.

Theories of tax evasion demonstrate that tax compliance increases with

detection risk (e.g., Allingham and Sandmo [1972]). Furthermore, the be-

havioral economics literature shows that even changes in the perceived prob-

ability of detection can affect taxpayer behavior (Kinsey [1992], Sheffrin

1FATCA was part of the Hiring Incentives to Restore Employment (HIRE) Act of 2010.

The FATCA acronym was intended to resemble the colloquial term“fat cats” as a reference to

cracking down on wealthy individuals (Sheppard 2009). We provide detailed information on

FATCA in section 2.

2A U.S. person is a citizen or resident of the United States, a domestic partnership, a do-

mestic corporation, any estate other than a foreign estate, or any trust under the control of

U.S. persons. This paper focuses on tax evasion by individuals.

TRANSPARENCY AND TAX EVASION 107

and Triest [1992], Durlauf and Nagin [2011], Slemrod [2018]). The dra-

matic shift under FATCA, from self-reporting to automatic third-party re-

porting, increases both the perceived and actual probabilities of detection

and theoretically should lead to less U.S. tax evasion via offshore accounts

(Dharmapala [2016]). In addition, implementation of FATCA by FFIs re-

duced opportunities for individuals to evade via foreign bank accounts.

Concurrent work finds a significant reduction in incorporations of offshore

entities to facilitate tax evasion following FATCA (Omartian [2017]).

However, prior literature suggests that evasion could continue as long as

it is profitable for the evader. If the costs of evasion are less than those

of complying (including financial costs, such as historical tax liabilities,

penalties, and interest, and nonfinancial costs, such as divergence from so-

cial norms), offshore tax evasion by some U.S. citizens will continue post-

FATCA via other evasion channels. For example, Langenmayr [2015] finds

that offshore tax evasion increased after a 2009 U.S. amnesty program tar-

geted at offshore accounts. Several studies examining previous informa-

tion exchange agreements and changes to European automatic report-

ing regimes show that taxpayers move assets hidden in offshore accounts

to jurisdictions not covered by new regulations (Huizinga and Nicod`

eme

[2004], Johannesen [2014], Johannesen and Zucman [2014], Caruana-

Galizia and Caruana-Galizia [2016], and Omartian [2017]). After FATCA

is in place, taxpayers could continue to avoid U.S. taxes by investing in

more opaque, nonfinancial asset classes not subject to the new reporting

regime. Therefore, how and how much FATCA affects tax evasion by U.S.

individuals is an open question. We address this question in two ways. First,

we attempt to measure a direct effect of the law in the form of changes in

U.S. citizens’ hidden offshore assets. Second, we examine indirect effects,

such as potentially continued evasion through the shifting of investments to

asset classes not subject to FATCA reporting,thereby permitting individuals

to continue to hide assets offshore.

The amount and location of U.S. citizens’ hidden offshore assets is not

directly observable. Instead, our tests of the direct effects of FATCA exam-

ine “round-tripping” tax evasion in which U.S. citizens hide assets from U.S.

tax authorities by placing them in foreign accounts, usually in tax havens,

and then invest those assets back in U.S. securities markets (Hanlon, May-

dew, and Thornock [2015]). We cannot observe the amount of assets leav-

ing the United States (the first stage of the round trip). Therefore, we es-

timate round-tripping, using the amount of foreign portfolio investment

(or hereafter “FPI”) by individual investors into the United States from tax

havens, relative to other countries. We then test how the amount of in-

bound FPI changes following FATCA to capture changes in the amount of

round-tripping. This research design assumes (1) investors prefer to invest

in their home country (a “home bias,” as shown in French and Poterba

[1991], Tesar and Werner [1995], and Kho, Stulz, and Warnock [2009]);

(2) foreign investors are unaffected by this particular U.S. tax law, (3) off-

shore accounts used by U.S. taxpayers to evade U.S. taxes are primarily