Tax Evasion: The Real Costs

Click to enlarge

Tax evasion will cost the U.S. government $305 billion in 2010 and has cost $3 trillion over the past decade. It is a major contributor to budget deficits and the accumulation of national debt since 2001. Tax evasion also costs state treasuries billions of dollars. Every tax filer will pay an extra $2,200 in 2010 to make up for the funds lost to tax cheating. Even modest success in reducing tax evasion would free up significant new resources for spending or deficit reduction. Yet last weekÕs budget deal nixed a proposal by the Obama Administration to strengthen the IRS’s enforcement capacity.

A Massive “Tax Gap”

Tax cheating gets fleeting coverage this time of year, but at the U.S. Treasury it is a source of constant angst. Why? Because the amount of money lost to tax evasion is large. Really large.

The last time the IRS crunched the numbers to estimate the “tax gap” was in 2005. Using data from 2001, it estimated that the “noncompliance rate is 15 percent to 16.6 percent of the true tax liability” that individuals, employers, estates, and corporations owe to the federal government. The IRS estimated final losses to the U.S. Treasury for 2001 at $290 billion (a figure which accounts for cheats who eventually paid the government back).

The IRS hasn’t updated its estimate of the tax gap in recent years, but using its same methodology it is possible to extrapolate the cost of tax evasion since 2001. Assuming that the level of tax evasion has remained constant—a conservative guess since over the past decade IRS enforcement hasn’t kept pace with sophisticated cheaters, particularly those stashing cash offshore—we estimate that the annual costs to the U.S. Treasury from tax evasion since 2001 have ranged between $257 and $376 billion a year. Cumulative losses during this period are estimated at just over $3 trillion.

The Wealthy Cheat More

Not everyone has an equal opportunity to cheat on his or her taxes. Employees who have income withheld have fewer options for tax evasion than people who are self-employed or have complex business or financial dealings. Likewise, large corporations with foreign subsidiaries and sophisticated accounting departments have more opportunities to cheat. In all, it is wealthier Americans who are most likely to cheat on their taxes.

In estimating the tax gap, the IRS found that the largest share of tax evasion—over 50 percent—was by individuals with business income. A more detailed breakdown of losses in 2008 by the scholar John Slemrod and IRS analyst Andrew Johns found that the single biggest source of lost revenue was from proprietors of businesses who don’t report the full amount of their income. Other big cheaters include professionals whose income comes through S corporations, partnerships, and real estate.

The study by Slemrod and Johns found that misreporting “generally increases with income, although it peaks among taxpayers with adjusted gross income between $500,000 to $1,000,000, and is lower than the peak ratio for individuals with income above $1,000,000.”

Tax Evasion, Deficits, and the Debt

The vast losses to the U.S. Treasury from tax evasion have compounded the fiscal pressures on the federal government. The estimated $305 billion lost to tax evasion in 2010 is equivalent to 24 percent of the .

Between 2001 and 2010, the federal government accumulated $7.7 trillion in new debt—the same period during which it failed to collect $3 trillion in taxes owed. This unrealized revenue is the equivalent of 39 percent of the new national debt accumulated by the federal government between 2001 and 2010.

Looking forward, reducing tax evasion could have a big impact on future deficits. If tax evasion were just a third lower in the next decade than the last, it would mean at least $1 trillion in additional revenues to the U.S. Treasury.

Who Wants to Stop Tax Cheating?

Reducing tax evasion has been an important priority for the Obama Administration. The IRS is engaged in a major new push to better understand and narrow the tax gap. Beyond developing a host of new analytical tools and enforcement techniques, the IRS has increased audits on wealthy tax filers. In fall 2009, IRS Commissioner Douglas Shulman reported that the IRS had created a special group within the agency focused on “global high-wealth individuals.” And, according to data recently released on IRS audit rates, filers in the highest income category were at least 18 times more likely to be audited in 2010 than middle class filers. That is way up from last year, when the IRS reported an audit rate of 10 percent for top filers. And it is way, way up from a decade ago, when the IRS audit rate for high-income filers was below 2 percent.

But efforts to reduce tax evasion have been strongly resisted by conservatives in Congress. A measure to increase tax compliance among businesses and their vendors, included as part of the Affordable Care Act, was recently repealed. House Republicans also voted to whack $600 million out of the IRS’s budget earlier this year. According to IRS Commissioner Shulman, testifying to Congress on March 1, if the cuts go through the “IRS would need to make substantial immediate cuts to its enforcement programs.” Shulman estimates that the federal government would collect $4 billion less in tax revenue, further increasing the budget deficit. While the recent budget deal will freeze IRS spending, conservatives are unlikely to give up on their push to downsize the agency.

The Battle for Compliance: Building Public Trust

Ultimately, one key to reducing tax evasion is to increase faith among all taxpayers that the system is fair. Many cheats rationalize their actions by pointing to loopholes used by corporations and the super rich. The revelation that General Electric may pay no taxes in 2010 is sure to increase public cynicism about the fairness of the tax system. These perceptions lend special urgency to the IRS’s campaign to reduce tax cheating among the wealthy.

— By David Callahan, Demos Senior Fellow and Editor of Policy Shop