Simple Dishonesty: Our Greatest Economic Threat

After we completed our first study on honesty in 1979, my brother, Dr. J. Owen Cherrington, and I were invited to discuss our results on a few radio talk shows.  We thought it would be a good idea to end our interviews with a couple of inflammatory statements that emphasized the importance of honesty.  One of our favorites was:  The greatest threat to the health of America’s economy is not inflation, unemployment, or any other economic variable; the greatest threat is simple dishonesty.

At that time, we didn’t have data to support our inflammatory rhetoric; but over the years we have continued to accumulate evidence regarding the incredible cost of simple dishonesty to our economic system.  The results are really quite overwhelming.  It is hard to imagine what a prosperous and abundant life we could create if some of the simple acts of dishonesty that occur in every corner of life could be reduced.

In the retail industry, shoplifting and vendor theft are the most popular form of dishonesty; but the most costly is employee theft – employees stealing from their own employers.  No one knows the exact percentage to attribute to each source; but most estimates say employees steal more than customers and vendors combined.  The numbers reported in this newsletter document that this continues to be a very serious problem. Employee theft comes directly from the bottom line; but the real bottom line is that many retail companies could double their profitability if they could eliminate employee theft.  This is something we all pay for; to compensate for their losses, merchants must charge higher prices to stay in business.

In the insurance industry, it is estimated that between ten and twelve percent of each premium dollar is lost to fraud through dishonest employees and fraudulent claims.  Although countless millions are lost through hard fraud, such as criminal rings who deliberately concoct accidents and fires for profit, much more is lost through soft fraud by policy holders who exaggerate their claims.  Insurance companies, like retail firms, have to offset their losses and they do this by increasing their premiums – thus all of us pay for these losses.

In the health-care industry, it is estimated that three to five percent of our health-care expenses are lost to intentional dishonesty, such as charging for services not rendered.  About twice this amount is wasted on unnecessary health care, such as additional visits or tests.  This does not include the cost of defensive medicine to protect doctors against being sued, which most people would classify as another unnecessary expense.

In the banking industry, most of the losses are due to managers and employees; bank robbers account for less than ten percent of the total losses.  In manufacturing, mining, transportation, and construction, the story is about the same; thefts by criminal rings who steal millions of dollars make exciting news stories, but the greatest losses are employees who take things that don’t belong to them.

Simple dishonesty in the housing industry is the primary culprit that ought to be blamed for the downturn in our economy.  Commentators have argued about who to blame for the housing collapse, including the mortgage lenders Freddie Mac and Fannie Mae, Wall Street bank managers, loan officers, housing appraisers, investment advisers or the people who created and sold the bundles of collateralized debt obligations.

The answer is that all of them are to blame; a careful analysis reveals that this collapse was precipitated by simple dishonesty at every level of the housing and banking industries.  It was dishonest for loan officers to give loans to people who they knew could not repay them.  It was dishonest for housing appraisers to adjust their appraisals according to what was needed to refinance a house rather than its actual value. It was dishonest for investment advisers to bundle and sell them as if they were sound investment products.  Granted, some of these decisions could be debated as moral dilemmas; but most people would agree that the majority of them were clear illustrations of right and wrong.

Finally, what about the people who bought homes that were much more than they could afford?  They assumed housing prices would continue to escalate and they expected to profit from their purchase.  But, was this a simple business miscalculation that should be excused, or did some cross the line of dishonesty when they skipped their mortgage payments, declared bankruptcy, or accepted federal loan assistance?

Perhaps the biggest dishonesty, the one that includes the most people and does the greatest damage to our economy, is the tax gap, which refers to the difference between the taxes we pay and what we owe.  Over the years, the Internal Revenue Service estimates from its audits that between 81 and 84 percent of Americans make a good-faith effort to pay their taxes honestly.  It also estimates that it receives only half what is should from self-employment tax.  This means that our tax revenues are shorted hundreds of billions each year.

Until recently, the tax gap has exceeded the federal budget deficit, meaning that the United States would have a budget surplus and taxes could be reduced if everyone paid their taxes honestly.  According to the current trajectory, however, the United States is acquiring such an enormous debt that our tax revenues will not even pay the interest on the debt.

Although the tax gap in the United States is serious, the situation in the U.S. is much better than other countries.  The percent of the U.S. economy that escapes taxation, called the informal economy, is among the lowest in the world.  The informal economy includes such activities as undocumented  immigrant labor, home businesses, and freelancing, but excludes drug trafficking and criminal enterprises.  The informal economies of different nations range from 9 percent of GDP in the U.S. to more than 70 percent in Bolivia and Georgia (Bloomberg Businessweek, Aug. 2-8, 2010, p.16).  China’s informal economy in its urban areas is 13.5 percent.  The economic stability of each country and the quality of life enjoyed by its citizens are closely correlated to how honestly the citizens pay their taxes.

Our tax system is based on a foundation of trust where citizens are expected to make a personal declaration of their income and pay whatever taxes they owe.  Since our system relies on voluntary  reporting, the system would collapse if people lost confidence in it because they thought others were not contributing their fair share.   $

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