Al Capone was busted for tax evasion. Leona Helmsley was, too. But gangsters and entitled millionaires aren’t the only ones who hold something back from the tax man. Each year, Americans of all stripes underpay the IRS by hundreds of billions, aided by the fact that the agency lacks the resources to catch all the cheaters.
Recently, tax dodging has found a new champion: liberal state governments fighting back against the Republicans’ far-reaching tax reforms, which seem to hit a number of blue states particularly hard. New Jersey and California want to reclassify certain state and local taxes as tax-exempt charitable donations, while New York might swap the state’s income tax for a deductible payroll tax, among other ideas under consideration. There’s little doubt about the underlying goal of these potential changes, nicely summarized by Connecticut’s state revenue commissioner when he called his state’s plan a “bit of payback for what I think was the utter disregard of the Congress for the impact of this on states like Connecticut.”
Republicans, for their part, have long blessed other ways of avoiding paying taxes. When Hillary Clinton challenged then-candidate Donald Trump during the first presidential debate for not paying income taxes, he responded: “That makes me smart.” And by cutting funding for audits and enforcement, his party has made it easier for people and companies to fudge their returns.
The bipartisan flirtation with avoiding taxes, through both legal and illegal means, threatens a tax system that is already bringing in historically low levels of revenue and that pays for everything from social security to military preparedness. Three foes in particular are enabling tax dodgers, making their ploys more common and more damaging: reduced support for the IRS, new incentives for people to become cheaters and widening partisan distrust.
Foe No. 1: A weakened IRS
There may be no purer example of D.C. dysfunction than the effort to underfund the IRS. That’s because the IRS isn’t like other agencies; when you cut its funding, you actually lose money.
Every dollar devoted to the IRS budget generates four to five dollars in new revenue, according to statements and congressional testimony from former IRS chief John Koskinen. That’s because a portion of each dollar goes to paying auditors, updating computer tracking systems and otherwise expanding the agency’s ability to collect unreported money from taxpayers.
While this argument may sound self-serving coming from the head of the IRS, recent history seems to confirm Koskinen’s view. IRS funding has been cut substantially in recent years, from over $13 billion in 2010 to roughly $11 billion in 2016.1 And those cuts have set off a chain reaction of underenforcement and undercollection — including a 30 percent cut in “key enforcement occupations,” which has translated into fewer audits.
Specifically, that $2.2 billion funding cut between 2010 and 2016 coincided with an $8.6 billion decline in revenue from audits and investigations.
What’s more, this figure may actually understate the real losses because audits also have spillover effects. After being audited, tax filers tend to change their behavior, increasing compliance to avoid future investigations, according to a study conducted in Denmark. Recent research has also found that when businesses are visited directly by the IRS, other firms who use the same tax preparer also pay slightly more in taxes. With fewer IRS agents taking to the field, these indirect benefits don’t accrue.
Foe No. 2: Small businesses cheat, and tax reform fosters them
Tax evasion isn’t for everyone. Salaried workers who get regular paychecks and a W-2 form have fewer opportunities for it. The IRS simply knows too much about their pay, having gotten regular updates from their employer — not to mention regular payments via withholding.
Instead, the biggest cheaters are the ones for whom it’s easiest. And that tends to be on the business side, with an outsize role for smaller and less bureaucratic outfits — particularly small shops with single owners, self-employed freelance consultants and other independent contractors.
In these businesses (whose owners are generally referred to as “sole proprietors” or “nonfarm proprietors”), the people earning the income are the same ones who decide what information to share with the IRS. There is no third party — an employer or investment manager — to pass those details along in a non-self-interested way. And while the owner-workers are still expected to report every dollar they get from clients, along with a fair accounting of appropriate deductions, that doesn’t always happen.
The effect can be dramatic. The IRS regularly performs a “tax gap” analysis — comparing tax filings against census and other third-party data to estimate underreported and missing income. In 2008-2010, the most recent period for which the IRS has published this analysis, nonfarm proprietors underreported their taxable incomes by an average of 64 percent. And while they accounted for around 15 percent of all individual income tax returns, they were responsible for nearly 30 percent of all underreported dollars.2
The biggest tax evaders are those with the least oversight
Estimated underreported taxable income* by income type, 2008-10
| Amount of third-party information | Income type | Share of tax liabilities misreported | |
|---|---|---|---|
| Little or none | Farm income | 71% | |
| Nonfarm proprietor income | 64 | ||
| Rents and royalties | 62 | ||
| Other income | 49 | ||
| Form 4797 income | 42 | ||
| Some | Capital gains | 27 | |
| Partnership, S-corp, etc. | 16 | ||
| Substantial | Taxable Social Security benefits | 19 | |
| State income tax refunds | 13 | ||
| Dividend income | 7 | ||
| Unemployment compensation | 6 | ||
| Pensions and annuities | 4 | ||
| Interest income | 3 | ||
| Wages, salaries, tips | 1 | ||
Looking ahead, there’s reason to fear that the new tax bill will only make the situation worse. Among its key provisions is a sizable tax break for these sole proprietorships and other so-called “pass-through” businesses (non-corporate businesses whose profits are distributed among owners and recorded as a form of personal income).
This tax advantage functions as a kind of incentive, encouraging more people to file as sole proprietors in order to claim the new deduction. That in of itself is entirely legal, and in some cases could spur entrepreneurship as people jump at the lower-cost chance to start their own small businesses. But it would also mean more people moving from the well-regulated world of paystubs to the tax-evasion-rich world of self-reporting, providing easier paths to tax cheating for more people. Some workers could even use creative accounting to pretend that they are independent contractors in order to take advantage of such opportunities.
Foe No. 3: Partisanship
Norms matter, too, when it comes to tax evasion. Comparative studies of different tax systems have found that people are more likely to pay when they have faith in their government — and the overall fairness of its tax system.
This is a two-part problem for the United States. First, residents don’t have much faith in the U.S. government: Polls show that levels of trust hover around 20 percent, close to historic lows. Second, rising partisanship makes this trust problem harder to solve, because it means that whoever takes office will face opposition from a stalwart and sizable population of distrusting voters loyal to the other party.
The U.S. tax system hangs in the balance. A recent working paper from a team of university and government economists found that tax evasion is indeed wired — like a light switch — to the partisan outcome of presidential elections. The results suggest that when George W. Bush claimed the presidency in 2000, people in heavily Republican counties became more tax-compliant and suddenly started revealing more of their income to the IRS; ditto for heavily Democratic counties after Barack Obama’s election.3
And what was the source of this extra income, hidden from view until a friendly president assumed the Oval Office? Using proprietary data from the IRS, the researchers were able to show that more income was suddenly reported from those same under-inspected sources, including sole proprietors and other pass-through businesses.
Also, while you might expect these swings between Democratic and Republican tax evasion to balance out over time, that’s not guaranteed. If polarization continues to increase, it could be that each election produces a new level of evasion as ever more people on each side look to hide income from presidents they distrust.
One crucial piece of information is still missing in all this: How much are people currently concealing, year in and year out? The IRS makes that calculation as part of its “tax gap” reports, but that means that the most recent data, from 2008-2010, reflects a time when funding cuts were only beginning and the new Republican tax bill was barely a glimmer in the eye of current House Speaker Paul Ryan.
Even in 2008-2010, the share of taxable income being secreted from view was at its highest level since the mid-1980s, at 18.3 percent, although the IRS attributes part of this increase to technical changes in how it creates its estimates. Only the IRS knows for sure whether people have continued to hide more money from tax collectors since then, but apart from a few preliminary calls from legislators for extra funding to help the IRS oversee the latest tax reform package, there has been no effort to stop it. Quite the contrary, the foes of tax compliance have only gathered strength.