March 27, 2009, 10:55 am

Lets Talk About Tax Cheating: A Freakonomics

Quorum
By Stephen J. Dubner

Photo:
hoggardb
The Internal Revenue Service presumably never likes tax cheats, but when money is tight
there is more pressure put on the I.R.S. to step up enforcement and collect more money.
The most recent gambit, reported today, is an amnesty program designed to root out
offshore tax havens. We once wrote of another I.R.S. measure that produced $3 billion
with one astonishingly simple and creative idea.
With tax day nearly upon us and with President Obama calling for future changes that
will probably alter tax-paying behavior a great deal, we thought it might be a good time
to think about how people cheat. So we asked a group of people who know a lot about tax
cheating (but who surely dont do it themselves) Mark A. Luscombe, William A.
Raabe, Peggy Richardson, and Joel Slemrod the following questions:
1. What are the most pervasive forms of tax cheating?
2. What are some new cheating wrinkles youll be looking for under the
new Obama tax proposals, and what are a few things that should be done
about them?

Here are their answers.

William A. Raabe is a tax professor at Ohio State University.
Tax cheating will never be eliminated, but leakage of tax revenues
could be better managed with a more effective use of technology by the
Treasury.
Prediction: tax cheating will increase significantly during the Obama
years.
Prescription: make the I.R.S. more digital, and eliminate the annual Form
1040 ritual altogether for most individuals.
Tax cheating to me means only the purposeful understatement of tax, not a
simple error due to ignorance of the law, poor math skills, or confusion
due to a difficult point of the tax law. And one is not a tax cheat if the
taxing jurisdiction is not fairly enforcing a tax provision, e.g., in the case
of sales/use tax collections by states for online purchases.
Tax cheating occurs when there is a combination of all three of these
conditions: inclination, reward, and opportunity.
Some people seem inclined to take risks that most see as inappropriate,
like speeding and not wearing a seat belt, shaving strokes off of a golf
score, and stepping out on a significant other. Risky behavior, like tax
cheating, is attractive to some, and it seems to be addictive. By either
repetition or rationalization, tax cheats seem to find it hard to break the
habit; in fact, it gets easier to understate a tax and do it in larger amounts
over time. When cash is short, short-changing the tax system becomes
more than just a bad habit.
Prediction: in difficult economic times, more taxpayers will give in to
temptations to cheat on their taxes.
The rewards derived from tax cheating are a function of the amounts of
the understated income and the overstated deductions, and the tax rates
that would apply to them. Tax cheating increases when the corresponding
tax rates go up, and the prescription for significantly higher tax rates
during the Obama years will result in greater transgressions by tax cheats;
the rewards for taking such risks have increased. For most business
taxpayers it is easier to overstate deductions than it is to hide income, as
there are more requirements that third parties report income items directly
to the I.R.S. (e.g., credit card payments, sales of realty, payments to
contractors) than there are reporting requirements relating to deductions
(e.g., for business supplies, advertising, and cost of sales).

Prediction: tax-cheating behavior will increase significantly during the

Obama years as tax rates increase.
Opportunities to cheat on ones taxes tend to arise when structural changes
in the tax law occur. The Obama team seems to favor the use of tax credits
against the federal income tax to carry out the stimulus, health, energy,
and education agendas that it is committed to. Tax credits, though, have
been easy for tax cheats to use. The Earned Income Tax Credit, a federal
welfare system mainly for low-income families, is notorious for attracting
improper behavior, often via false taxpayer names and ID numbers.
Education credits can be overstated when the taxpayer self-reports
qualifying expenditures for supplies and travel. Oversight of energy
credits (say for green home improvements) is almost nil. So the
increased use of a credit of this sort by itself over the next few years will
trigger new tax cheating.
Prediction: the tax-cut devices chosen by the Obama team will prove to be
vulnerable to a new wave of tax cheating.
Tax cheating will never be eliminated, but such leakage of tax revenues
could be better managed with a more effective use of technology by the
Treasury.
Tax auditors need better training to monitor taxpayers financial software,
as well as that used to coordinate their own reviews of returns. Matching
of documents to track business transactions, including payments for
services and for sales of securities, should be expanded.
The banking industry should be encouraged to move even more rapidly
toward a cashless economy, focusing on direct deposits and debit card
usage, as cash-oriented businesses are the most likely to underreport their
tax liabilities.
The clunky annual Form 1040 filing system must be overhauled; most
taxpayers need not even file a return, as the Treasury already has all of the
information necessary to compute the tax, with Forms W-2, 1099, and the
like. Only those taxpayers with income and deductions from other sources
(like proprietors and partners) should be filing returns at all! For most
individuals, the I.R.S. should simply send them a mocked-up tax form by
March 15, with a refund check or a voucher for the tax due. Then the
government could focus efforts on collecting the correct tax from the
taxpayers who remain, and who are the most likely to cheat anyway.
Mark A. Luscombe is a principal analyst for the tax and accounting group at CCH.

It is much easier for the I.R.S to recover $10 million dollars in taxes by
going after 10 taxpayers who underpaid taxes by $1 million dollars each
than to go after 100,000 taxpayers who underpaid taxes by $100 each.
The I.R.S. in recent years has tried to focus its limited audit resources to
try to get the largest possible recoveries for the audit resources expended.
This has meant a focus on tax cheating through offshore bank accounts
and credit card abuse, usually by high-income taxpayers; tax cheating by
small businesses with hidden income or personal expenses being deducted
as business expenses; and abusive tax-shelter schemes usually designed to
create paper losses for tax purposes to offset otherwise taxable income.
Tax cheating can also occur, however, at the lower income levels, and this
form of cheating can be much more difficult for the I.R.S. to attack. It is
much easier for the I.R.S to recover $10 million dollars in taxes by going
after 10 taxpayers who underpaid taxes by $1 million dollars each than to
go after 100,000 taxpayers who underpaid taxes by $100 each. Yet some
of Obamas tax proposals are most likely to generate tax cheaters in this
second category.
One area likely to be a concern for President Obama and the I.R.S. is
Obamas fondness for refundable tax credits. Refundable tax credits result
in checks issued to taxpayers when no taxes are owed. The temptation of
getting a check from the government is too attractive for many taxpayers
and preparers with a stake in the size of the refunds that they obtain for
their clients to resist. The Earned Income Tax Credit, one of our first
efforts at refundable credits, has had a history of abuse. A recent effort to
refund the telephone excise tax through the income tax system produced
many extravagant claims. Under President Obama, we have already
expanded the refundable child tax credit and first-time homebuyer credit
and added a new refundable Making Work Pay credit and a partiallyrefundable education credit.
Abuse of refundable credits creates the scenario of a large number of
taxpayers cheating by small amounts. To counter potential abuse from the
growth of refundable credits, the I.R.S. might have to revise its general
approach of paying out claimed refunds and asking questions later. As was
done with the telephone excise tax refunds, the I.R.S. will have to better
develop systems to screen out questionable refunds before they are paid
out. Following the telephone excise tax refund problem, a new penalty
was added to the tax code aimed at excessive refund claims.
Another possible avenue of pursuit would be for Congress and the I.R.S.
to further develop third-party reporting requirements that might support
claims for deductions and credits on the return. Statistics tend to show that
tax cheating occurs most often when there is no independent source of

information for the I.R.S. to check what is put on the return. There is very
little underreporting of wage income due to the Form W-2 reporting
system by employers. Form 1099 provides some additional third-party
reporting of income and Form 1098 provides some third-party reporting of
deductions, but there are considerable gaps on the income side and even
more holes on the expense/deduction side. Third-party reporting has
recently been added to the tax code to require broker-basis reporting.
Third-party reporting also, however, puts an additional burden on the
reporting entity, so there is usually a Congressional lobby actively fighting
expanded third-party reporting efforts.
Joel Slemrod, a professor of economics at the University of Michigan, was the senior
staff economist for tax policy in President Reagans Council of Economic Advisers, and
is co-author of Taxing Ourselves: A Citizens Guide to the Debate Over Taxes.
One out-of-the-box idea is for the I.R.S. to reward or reimburse people
who come through an audit relatively unscathed.
According to the latest I.R.S. tax gap study for tax year 2001 tax
that should have been paid but was not totaled $345 billion. Of the $345
billion, the I.R.S. expected that it would eventually recover $55 billion,
resulting in a net tax gap of $290 billion, which is 13.7 percent of the
tax that should have been reported.
About two-thirds of all underreporting of income happens on the
individual income tax. Of that, business income as opposed to wages or
investment income accounts for about two-thirds.
Most striking is the huge variation in the rate of misreporting by type of
income. Only 1 percent of wages and salaries and only 4 percent of
taxable interest and dividends is underreported. In sharp contrast, 57
percent of non-farm proprietor income is not reported.
Why the disparity? Payments of wages and salaries, interest, and
dividends must all be reported to the I.R.S. by those who pay them;
moreover, wages and salaries are subject to employer withholding. Most
self-employment business income is subject to neither information
reporting nor withholding, so the I.R.S. knows little absent a thorough
audit.
The I.R.S. estimates that the net misreporting rate is 53.9 percent, 8.5
percent, and 4.5 percent for income types subject to little or no, some,
and substantial information reporting, respectively, and is just 1.2
percent for those amounts subject to both withholding and substantial
information reporting.

That noncompliance rates are lower when there are information reports
and employer withholding provides compelling support for the
deterrence model of tax evasion that people remit what they owe
because theyre afraid of being caught and penalized. To be sure, some
people pay what they owe out of a sense of duty or a predilection for
honesty. Both duty and calculation may matter. In a recent survey, 96
percent of people mostly or completely agreed that It is every Americans
civic duty to pay their fair share of taxes; but also 62 percent said that
fear of an audit had a great deal or somewhat of an influence on whether
they report and pay their taxes honestly.
High-income people apparently evade more dollars, and for the most part
evade more as a percentage of their true incomes. This is in part, but not
entirely, due to the fact that they tend to receive the kind of income that is
more difficult for the I.R.S. to monitor.
Tax noncompliance depends on the extent and effectiveness of I.R.S.
enforcement. Among industrialized countries, the United States has one of
the lowest ratios of administrative costs to revenue collections less than
half the average and the lowest ratio of full-time staff of the national
revenue body to the labor force. Unlike many industrialized countries, the
United States does not utilize withholding at source for the collection of
personal income tax on dividends, interest, independent personal services,
or rents. However, the United States maintains one of the most substantial
programs of information reporting.
What will surprise many readers is that the United States is in the minority
of industrialized countries that require individuals to file tax returns.
About half of them operate a system in which most wage earners need not
file due to exact, cumulative employer withholding; and in other countries,
the tax authority sends taxpayers a pre-populated tax return based on the
information they receive from third parties, requiring the taxpayer only to
verify that the information is correct. Theres no tax filing deadline to
dread.
Eliminating the tax gap completely is not a reasonable policy goal, no
more so than completely eliminating all robberies; the benefits would not
outweigh the costs in resources and intrusiveness. Decreasing the tax gap
is very reasonable, and would allow reductions in the tax burden for
honest taxpayers. Expanded and smarter auditing would make a dent, as
would enlarging the scope of third-party reporting of business transactions
but all come with downsides.
Simplifying the tax system is unlikely to have much of an impact on
noncompliance; its worth doing for other reasons, but doesnt seem to be
in the cards. One out-of-the-box idea is for the I.R.S. to reward or

reimburse people who come through an audit relatively unscathed. It

might be worth a try.
Peggy Richardson, co-counsel at the law firm Baron & Budd, served as I.R.S.
commissioner from 1993-1997.
In light of the current economic conditions, and with more people
working part-time in self employment situations, more misreporting and
underreporting can be expected.
Probably the most pervasive forms of tax cheating are not the large taxshelter scams that have garnered headlines in recent years, but less sexy
and more mundane forms of cheating, such as underreporting of income
and claiming excessive deductions by large numbers of taxpayers. For
example, people who are self-employed often fail to report all of their
income properly. Since their income is not subject to withholding
(employees wages are subject to withholding, but amounts paid to selfemployed individuals or independent contractors are not) and payments to
self-employed individuals are frequently not reported on information
returns, those payments are often not reported or underreported on
individuals tax returns.
Although it may not sound like much tax revenue would be involved in
the underreporting or omission of income by self-employed individuals,
including small business owners, given the numbers of people who are
self-employed or who may earn a little extra income in addition to their
wages earned as employees, the total amount of lost revenue has been
estimated to be in the billions of dollars. In light of the current economic
conditions, and with more people working part-time in self-employment
situations, more misreporting and underreporting can be expected.
Claiming excessive deductions is also a form of tax cheating that
presents compliance concerns; again, its not sexy, but its costly to the
government. For example, if every individual tax return were to have
deductions that were overstated (for example, inflated amounts claimed as
gifts to charities) by just $25, that amount might seem trivial or innocuous
individually, but since there are over 100 million individual returns filed
annually, the total revenue lost from those overstated deductions would
amount to over $2.5 billion.
One concern about potential for tax noncompliance under some of the
current tax proposals relates to the various proposals for refundable tax
credits. Because tax-credit computations can be very complex (the Earned
Income Tax Credit is a prime example of a credit requiring a complex
calculation), and the dollars that potentially could be refunded could be
significant under some of the proposals, without stepped up enforcement

by the Internal Revenue Service, these additional credits could present a

significant opportunity for underreporting or out-and-out cheating.
Additional compliance resources for the I.R.S. to conduct audits and
match information that is reported to the I.R.S. will be essential to curbing
additional tax-compliance problems arising from some of the current
proposals.