When our kids were in high school, a very wise principal told us: “Any sentence with the word ‘nobody’ or the word ‘everybody’ is wrong. “ Since then, I have been startled at how many times I hear such sentences rationalizing a failure to pay taxes – “Nobody pay tax unless they have to.” “Everyone knows the tax code is unfair.” “Everyone fudges on their deductions.” “Nobody’s hurt when I pay a little less.”
In August, the IRS issued yet another Tax Gap report. The IRS estimates that in 2006 alone, the Treasury missed out on $385 billion in revenue due under the current tax law from a combination of underreporting of income, overstatement of deductions or other benefits, or non-payment of taxes owed. To put that in perspective, increased revenue of $385 billion annually likely would be enough to make the Bush tax cuts permanent and to permanently patch the Alternative Minimum Tax.
There can be good reasons for making a mistake in filing taxes under our complex code. It is easy to get confused with some of the rules ad records can be lost or mistaken. But most of the tax gap reflects a more sinister reality. It is the results when individuals fail to take responsibility for filing their returns accurately or, worse, when they feel entitled to ask other taxpayers to carry a burden for them by deliberately failing to pay the share of the tax burden assigned to them by the law.
So who are these freeloaders? The IRS estimates a $450 billion shortfall in tax payments in 2006, which it reduced to $385 through enforcement and receipts from late payments. Of this $450 billion, 40 percent ($179 billion) related to underreporting of business income by individuals as well as underpayment of self-employment taxes. Tax lost to other unreported individual income added another $68 billion to the tax gap while individual non-filers and non-payment added another $25 billion and $36 billion respectively. Add all that up, and you have nearly 70 percent of the tax gap arising with respect to business and personal income reported in individual tax returns.
We all know about these under-reporting individuals. Some are members of the 47 percent. Many are in the 53 percent. And, yes, some are even in the one percent. They are the small business owner who does not report cash, the worker who asks us to give them cash rather than a check, the self-employed person who deducts the family car and the sophisticated taxpayer we see in the news who hides income by using secret bank accounts or structures phony complex transactions to make income disappear.
There are three commonly suggested ways to address this challenge. The first is to impose additional information reporting or withholding requirements. Studies of income reporting by individuals conducted as part of the IRS National Research Program indicate that individuals report virtually all of their income that is subject to substantial information reporting and tax withholding (e.g., wages). Only about 8 percent of income that is subject to substantial reporting (such as 1099 reporting), but not to withholding, falls out of the system. In contrast, the IRS estimates that as much as 56 percent of income received by individuals is not reported on tax returns when there is no reporting or only minimal reporting (e.g., sole proprietor income). Adding administrative burdens on business in order to improve tax compliance is not easy, as recent fights over requiring 1099s for payments to businesses, reporting of rental expenses, withholding on government contractors and payment card reporting have demonstrated.
The second possibility is to increase IRS enforcement efforts focused on small businesses and individuals. This approach has very limited possibilities. The level of enforcement intrusion that would be necessary to achieve substantial changes in compliance likely would be politically unacceptable and, indeed, could adversely affect compliance by creating a view that the tax administrators are oppressive.
The third standard recommendation for improved compliance is tax reform. Across the political spectrum, proponents of reform assert that a simpler tax code would reduce cheating. We should not be naïve about this. Obviously, if there were no itemized deductions, taxpayers could not cheat by overstating them. But, the largest single element of the tax gap comes from under-reporting income. Changing the rate at which income is taxed would change the amount of the reward for not reporting it, but not the fundamental incentive.
However, if tax reformers can begin to untangle how and why cheating behaviors occur, reform could be more targeted and potentially more successful. An accessible starting point could be Duke Professor Dan Ariely’s recently published book, “The (Honest) Truth About Dishonesty: How We Lie to Everyone – Especially Ourselves.” This work and others suggest that taxpayers cheat when they believe others who are like them do, when they do not expect to be discovered, when rules are fuzzy, when they have convinced themselves that the system is unfair or when they are disconnected from the consequences of their behavior to others.
When political leaders engage in seemingly ceaseless tirades about the overbearing and unfair nature of our current tax system, and the wastefulness of government spending, they are offering a ready-made excuse for those who are tempted to pay less tax than the law requires. Tax and budget reform could possibly reduce future tax gaps if our political leaders were willing to change the tone of the current dialogue and move more in the direction of Oliver Wendell Holmes, Jr, who saw that taxes are, “the price we pay to live in a civilized society.”
Wouldn’t it be great if the exception to the principal’s rule about “everyone” and “nobody” was the following: “Everybody pays their taxes.”
Bookmark/Search this post with