The Weird World Of Economics

Why Do People Cheat On Taxes?

Make Easy Money

By STEPHEN J. DUBNER AND STEVEN D. LEVITT

Mr. Szilagyi's Billion-Dollar Idea
This is the time of year when American citizens inevitably think about
the Internal Revenue Service and, also inevitably, about how deeply
they hate it. But most people who hate the I.R.S. probably do so for
the wrong reasons. They think it is a tough and cruel agency, but in
fact it is not nearly as tough and cruel as it should be.

The first thing to remember is that the I.R.S. doesn't write the tax
code. The agency is quick to point its finger at the true villain:
''In the United States, the Congress passes tax laws and requires
taxpayers to comply,'' its mission statement says. ''The I.R.S. role
is to help the large majority of compliant taxpayers with the tax law,
while ensuring that the minority who are unwilling to comply pay their
fair share.''

So the I.R.S. is like a street cop or, more precisely, the biggest
fleet of street cops in the world, who are asked to enforce laws
written by a few hundred people on behalf of a few hundred million
people, a great many of whom find these laws too complex, too
expensive and unfair.

And yet most Americans say they are proud to pay their taxes. In an
independent poll conducted last year for the I.R.S. Oversight Board,
96 percent of the respondents agreed with the statement ''It is every
American's civic duty to pay their fair share of taxes,'' while 93
percent agreed that everyone ''who cheats on their taxes should be
held accountable.'' On the other hand, when asked what influences
their decision to report and pay taxes honestly, 62 percent answered
''fear of an audit,'' while 68 percent said it was the fact that their
income was already being reported to the I.R.S. by third parties. For
all the civic duty floating around, it would seem that most compliance
is determined by good old-fashioned incentives.

So which of these incentives work and which do not? To find out, the
I.R.S. conducted the National Research Program, a three-year study
during which 46,000 randomly selected 2001 tax returns were
intensively reviewed. (The I.R.S. doesn't specify what these 46,000
people were subjected to, but it may well have been the kind of
inquisition that has earned the agency its horrid reputation.) Using
this sample, the study found a tax gap -- the difference between taxes
owed and taxes actually paid -- of $345 billion, or nearly one-fifth
of all taxes collected by the I.R.S. This sum happens to be just a few
billion dollars less than the projected federal budget deficit for
2007; it also amounts to more than $1,000 worth of cheating by every
man, woman and child in the U.S.

But most people aren't cheating. And when you take a look at who does
cheat and who doesn't, it becomes pretty clear just why people pay
their taxes at all. The key statistic in the I.R.S.'s study is called
the Net Misreporting Percentage. It measures the amount that was
misreported on every major line item on those 46,000 returns. In the
''wages, salaries, tips'' category, for instance, Americans are
underreporting only 1 percent of their actual income. Meanwhile, in
the ''nonfarm proprietor income'' category -- think of self-employed
workers like a restaurateur or the boss of a small construction crew
-- 57 percent of the income goes unreported. That's $68 billion in
unpaid taxes right there.

Why such a huge difference between the wage earner and a restaurateur?
Simple: The only person reporting the restaurateur's income to the
I.R.S. is the restaurateur himself; for the wage earner, his employer
is generating a W2 to let the I.R.S. know exactly how much he has been
paid. And the wage earner's taxes are automatically withheld from his
every check, while the restaurateur has all year to decide if, and how
much, he will pay.

Does this mean that the average self-employed worker is less honest
than the average wage earner? Not necessarily. It's just that he has
much more incentive to cheat. He knows that the only chance the I.R.S.
has of learning his true income and expenditures is to audit him. And
all he has to do is look at the I.R.S.'s infinitesimal audit rate --
last year, the agency conducted face-to-face audits on just 0.19
percent of all individual taxpayers -- to feel pretty confident to go
ahead and cheat.

So why do people really pay their taxes: because it is the right thing
to do, or because they fear getting caught if they don't? It sure
seems to be the latter. A combination of good technology (employer
reporting and withholding) and poor logic (most people who don't cheat
radically overestimate their chances of being audited) makes the
system work. And while it sounds bad to hear that Americans underpay
their taxes by nearly one-fifth, the tax economist Joel Slemrod
estimates that the U.S. is easily within the upper tier of worldwide
compliance rates.

Still, unless you are personally cheating by one-fifth or more, you
should be mad at the I.R.S. -- not because it's too vigilant, but
because it's not nearly vigilant enough. Why should you pay your fair
share when the agency lets a few hundred billion dollars of other
people's money go uncollected every year?

The I.R.S. itself would love to change this dynamic. In the past few
years, it has increased significantly its enforcement revenue and its
audit rate, despite a budget that is only fractionally larger. A main
task of any I.R.S. commissioner (the current one is Mark Everson) is
to beg Congress and the White House for resources. For all the obvious
appeal of having the I.R.S. collect every dollar owed to the
government, it is just as obviously unappealing for most politicians
to advocate a more vigorous I.R.S. Michael Dukakis tried this during
his 1988 presidential campaign, and -- well, it didn't work.

Left to enforce a tax code no one likes upon a public that knows it
can practically cheat at will, the I.R.S. does its best to fiddle
around the edges. Once in a while, it hits pay dirt.

In the early 1980's, an I.R.S. research officer in Washington named
John Szilagyi had seen enough random audits to know that some
taxpayers were incorrectly claiming dependents for the sake of an
exemption. Sometimes it was a genuine mistake (a divorced wife and
husband making duplicate claims on their children), and sometimes the
claims were comically fraudulent (Szilagyi recalls at least one
dependent's name listed as Fluffy, who was quite obviously a pet
rather than a child).

Szilagyi decided that the most efficient way to clean up this mess was
to simply require taxpayers to list their children's Social Security
numbers. ''Initially, there was a lot of resistance to the idea,''
says Szilagyi, now 66 and retired to Florida. ''The answer I got was
that it was too much like '1984.''' The idea never made its way out of
the agency.

A few years later, however, with Congress clamoring for more tax
revenue, Szilagyi's idea was dug up, rushed forward and put into law
for tax year 1986. When the returns started coming in the following
April, Szilagyi recalls, he and his bosses were shocked: seven million
dependents had suddenly vanished from the tax rolls, some incalculable
combination of real pets and phantom children. Szilagyi's clever twist
generated nearly $3 billion in revenues in a single year.

Szilagyi's immediate bosses felt he should get some kind of reward for
his idea, but their superiors weren't convinced. So Szilagyi called
his congressman, whogot the reward process back on track. Finally,
five years after his brainstorm became the law, Szilagyi, who earned
about $80,000 annually at the time, was given a check for $25,000. By
this point, his idea had generated roughly $14 billion.

Which suggests at least one legitimate reason to dislike the I.R.S.:
if the agency hadn't been so stingy with Szilagyi's reward back then,
it probably would have attracted a lot more of the anti-cheating
wizards it really needs today.

posted by UncommonBusiness @ 8:52 AM