The Internal Revenue Service estimates that some $350 billion in taxes owed to the federal government is evaded or otherwise unpaid every year. That sum, also known as the “tax gap,” nearly equals the current federal budget deﬁcit.
Of this $350 billion, enforcement efforts eventually recover about $43 billion -- and much more could be collected if the nation's tax-enforcement system were permitted to operate more effectively. Most of the tax gap stems from underreporting of net income -- reporting too little income or too much in the way of expenses -- under the individual income tax. The type of income in question is mostly business income to proprietors, partnerships, “S-corporations,” ordinary corporations, and the self-employed, as well as capital income (like dividends and capital gains) to individuals. A lesser part of it derives from wages and salary.
Noncompliance with tax law takes other forms, too, such as the failure to ﬁle in the ﬁrst place and underpayment of stated tax liability. This last bit, worth about $30 billion a year, is money the IRS fails to collect for lack of organizational resources. Here is true low-hanging fruit: The tax debts in question have names and addresses, and could be collected for about $2 billion -- making for a pretty good return on investment of 1,400 percent. (If private Social Security accounts were invested in that sort of enterprise, the president might have a viable proposition!) Most other expanded enforcement measures could yield very favorable returns as well.
Inadequate reporting for ordinary workers is not an option. The employer reports wage and salary income to the government, and this provides an instant, computer-driven check on what the individual reports. Moreover, tax is withheld on this income. By stark contrast, the government relies to a great extent on individual taxpayers for information on their business and capital income, and for payment of estimated tax as income accrues.
The fruits of this honor system are predictable. Where evasion is easy, estimated evasion rates are high. The most avid offenders are the self-employed, for whom perhaps 20 percent of income taxes and 60 percent of self-employment taxes owed (for Social Security and Medicare) are not paid.
Among the most egregious miscreants are the wealthy persons who employ highly compensated professionals to push the boundaries of the law through arcane tax-shelter schemes, blending the illegal with the barely legal in a fashion difﬁcult to disentangle. The globalization of ﬁnance makes such behavior more difﬁcult to police, as it may be conducted under the protection of conniving tax-haven governments like those in the Grand Caymans or Vanuatu, behind the shield of bank secrecy laws.
The Tax Justice Network, a new international coalition aiming to reverse harmful trends in global tax policy, estimates that $10 trillion in assets has been stashed in tax havens to escape exposure to the world's tax authorities. No small part of this hoard is thought to have resulted from criminal activity, not to mention ties with international terrorist networks.
At the start of 2001, the Bush administration's take on the offshore problem paralleled its lackadaisical posture toward terrorism. Paul O'Neill, then the treasury secretary, constrained Clinton-era efforts to cooperate with other advanced industrial nations in pursuit of hot offshore money, presumably out of solicitude for the administration's wealthy supporters and allies. Even after September 11, the administration's vigor in this endeavor has been muted. In effect, criminals beneﬁt from ﬁnancial privacy considerations invoked by the wealthy.
Yet for all the Sturm und Drang over taxes, the United States is blessed with a high degree of voluntary compliance with federal tax law. About 85 percent of all taxes owed are paid on time. But evasion feeds on itself, and in our age of record deﬁcits, inﬂated defense spending, and burgeoning health-care outlays, we can ill afford to squander such an advantage. Alas, squandering public assets is the current regime's specialty.
An obvious remedy for the understatement of capital income is, wherever possible, to require reporting of income and withholding of taxes on income by banks, corporations, and other sources of dividends, capital gains, and interest. Banks already report interest income to the IRS.
Absent the opportunity to match taxpayers' information to independent sources, the authorities need to scrutinize more returns. That need grows every year with increases in the size of the economy, the number of taxpayers, and the complexity of ﬁnancial arrangements, corporate organization, ﬁnancial instruments, and more. But the response of the Republican Congress and the Bush administration has been to deprive the IRS of the resources it needs to keep up with the demands of its job.
Similarly, the threat of being caught by the audit lottery keeps taxpayers honest, but for most, that threat has declined over time. Today, the overall average “face-to-face” audit rate for high-income individuals is a minuscule 0.35 percent (less than four in 1,000), down from 2.9 percent in 1992. For corporations, it is 0.65 percent, down from 2.9 percent as well. This drop is partly offset by so-called correspondence audits, conducted by mail. But even after factoring in these narrow, friendlier audits, the overall rates are still well below those prevailing a dozen years ago.
And why hasn't auditing kept up with the increase in tax returns? There are fewer staff available for enforcement because of deliberate budget cuts. With fewer pairs of eyes, not surprisingly, fewer returns are examined, fewer miscreants are brought to heel, and greater disincentives abound to comply with the law.
The IRS is compelled to process all returns. Checks have to be deposited, and taxpayers have to get their refunds. Thank your Congress for an increasingly complex tax code, which generates its own political demands: The IRS must devote ever-greater resources toward customer service for legions of confused taxpayers. Enforcement is a bottom priority, orphaned by reduced funding -- with one notorious exception: the extraordinary enforcement measures directed at the Earned Income Tax Credit (EITC), which mostly beneﬁts the working poor.
Treatment of the EITC is the egregious exception that proves the rule of abysmal enforcement zeal. Out of a possible tax gap of $350 billion, the maximum estimate on overclaims for the EITC is $9 billion. At the same time, too many poor families -- equally confused by the tax code -- fail to claim the EITC and other beneﬁts to which they are entitled. In this vein, the right-wing furor over errors in EITC claims ought to be some kind of scandal itself. A recent article in Tax Notes, the insider's professional tax periodical, recounted an experiment where the same tax information was provided to six professional tax-preparation ofﬁces near Washington, D.C. These experts produced six different results -- one of which accorded with Tax Notes' own reckoning of the correct answer. And here we are, upbraiding the working poor for misﬁling their returns!
Tax increases are no fun, but abiding deﬁcit realities will force politicians to search for revenues, sooner or later. In that event, enhancing tax collections without resorting to increases in tax rates should attract interest. We can only hope that an improved political climate will make it safe for elected ofﬁcials to advocate a little more law and order when it comes to the bad neighborhood of tax compliance.
Max B. Sawicky is an economist at the Economic Policy Institute and the author of the MaxSpeak blog.