🟪 Productive illegality

Breaking the law can be productive (for everyone)

Here are two things I believe: Tipping in cash so your server doesn’t owe taxes is good — but officially making income earned from tips tax-free is bad.

Let me explain.

Paying tips in cash is good because it helps low-margin businesses like restaurants hire staff they might not otherwise be able to afford.

More broadly, cash payments for off-the-books work enable quick hiring and firing, which benefits both high-risk businesses and workers in informal or gig-style jobs.

This makes the economy more efficient, to everyone’s benefit.

But officially making tips tax-free is bad because it would unfairly favor one industry over others and distort incentives by making income earned in tips more valuable than income earned in salary.

Also, it’s regressive.

Consider the case of the exotic dancer in Miami who made $710,635 last year, including $297,385 of “self-reported cash.” 

(That’s 14,869 $20 bills, in case you’re wondering.)

As detailed in her very revealing TikTok video, she chose to report that cash to the IRS only because she wouldn’t otherwise be able to explain where her substantial investment income comes from.

But if that cash income was made tax free, high-income dancers in Miami would pay a lower marginal tax rate than, say, medium-income newsletter writers in Chapel Hill.

I know what you’re thinking, and, in this particular example, it’s hard to argue — some professions contribute more to society than others, so maybe her tips should be tax free.

But the tax code shouldn’t be making judgment calls like that.

Ideally, the IRS would treat all forms of earned income equally — if the goal is to help low-income workers, then just lower taxes for all low-income workers, not just for those who get tips.

But tax-free tips is good politics and politics is what has turned the tax code into an incomprehensible labyrinth of counterproductivity.   

To escape that labyrinth, you sometimes have to do something “productively illegal” — like tipping your waiter in cash, paying someone to clean your house without reporting it on your taxes, or hiring an undocumented migrant to harvest crops that would otherwise wither in the fields.

This is one of the benefits of physical cash: “You want to have ways you can evade the law up to a point,” Ken Rogoff, an otherwise law-abiding economist, recently told Tyler Cowen.

Cowen agreed: "You’re lowering output by not enabling them to pay the nanny with cash.” 

In other words, people probably wouldn’t bother hiring a nanny if it meant complying with the full suite of employment bureaucracy, so the economy would be less productive if physical cash didn’t enable them to break a few laws.

But what about breaking laws with crypto?

Stablecoins, for example, enable people to hold and send money without being KYC’d in the same way physical cash does.

But cash allows people to evade the law “up to a point.” With stablecoins, there is no stopping point — cash enables law evasion at a small scale and crypto enables it on a large scale.

That might still be a net positive, though, assuming there are some forms of socially desirable economic activity that are precluded by KYC — like using stablecoins to avoid banking rules in countries with hyperinflating currencies or autocratic governments, for example.

The places where stablecoins have most caught on are also the places most likely to benefit from the “productive illegality” of informal economies, as scholars like Friedrich Schneider and Hernando de Soto have documented. 

In the relatively sensible US economy, by contrast, stablecoins have so far mostly been used to trade crypto tokens, many of which are functionally equivalent to equity, but with no investor protection, no rights, and no rules. 

I’d argue that makes them illegal under current US law.

But that, too, may be productive.

If unregulated crypto equity is used to fund useful new services that would not have been funded otherwise, then it could well be a net positive that regulators are currently leaving crypto unregulated.

Not for much longer, of course — both stablecoins and equity-like crypto tokens are on the verge of being legally recognized in the US. 

But if they go on to be truly productive, their few years of illegality will be equally to thank.

— Byron Gilliam

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