Mind-Numbing Complexity

Posted: Apr 16, 2001 12:00 AM
One of the things that has puzzled me for a long time is why people aren't more upset by the high level of taxes they pay, the gross unfairness of the tax system and its mind-numbing complexity. One theory is that those most concerned about over-taxation have simply taken care of the problem for themselves by cheating on their taxes. Encouraging them in doing so are growing numbers of tax protestors, who preach that the federal income tax is unconstitutional. There is no good measure of tax cheating. The Internal Revenue Service has not published data on the subject since 1992. However, one can get an idea of the magnitude of how much income is not being taxed by comparing aggregate measures of income that are used to estimate the gross domestic product with that reported on tax returns. The Department of Commerce periodically publishes figures comparing the two. The latest figures appear in the November 2000 issue of the Survey of Current Business. They show that, in 1998, businesses paid out $6,087.7 billion of taxable income to individuals. This includes wages and salaries, pensions, interest, dividends and other forms of income. But only $5,389.3 billion showed up on tax returns, leaving a gap of $695.4 billion. Assuming that the first figure is correct, this means that 11.4 percent of adjusted gross income (AGI) was neither reported nor taxed in 1998. Looking at the AGI gap over time gives us a pretty good idea of whether tax evasion is rising or falling. The highest figure recorded since 1959 was 13.5 percent in 1984, and the lowest was 9 percent in 1968-69. In recent years, the AGI gap has been as high as 12.9 percent in 1994, falling more or less steadily to its present level. It is difficult to know how much tax was evaded because it would be a function of each individual's tax bracket. But assuming the unreported income would have been taxed at the same average rate as reported income, which was 20.9 percent in 1998, this suggests that about $145 billion in federal income taxes were evaded that year. The Commerce Department data tell us quite a bit about who is failing to report income to the IRS. For the most part, it is not workers. Only 5.5 percent of wage and salary income goes unreported, the data show. However, the figure is rising. In 1982, only 1 percent of wages and salaries were unreported. The current figure is the highest ever recorded. And with wages and salaries accounting for the vast bulk of all personal income, the result is that about a third of the income gap comes from this source. In percentage terms, unreported income is the highest in the area of business income. This stands to reason, since someone running their own business has many more opportunities to hide income than someone working for wages. The Commerce Department estimates that more than half of all proprietors' income goes unreported among nonfarm businesses. Farmers, however, are the worst offenders. Their true income is 136 percent greater than what they report to the IRS. Other problem areas are rental income and dividends. In 1998, 34.5 percent of the former and 29.7 percent of the latter did not appear on tax returns. However, more rent is showing up than it used to. In the mid-1980s, landlords had almost 200 percent more rental income than they paid taxes on. Non-reporting of dividend income, however, is rising, perhaps due to the broadening of stock ownership in America. In some areas, tax compliance appears to have improved enormously over the years. In 1959, 53 percent of pensions were unreported. By 1998, that figure had fallen to just 19.8 percent. In 1959, 62 percent of interest income went unreported. By 1998, the Commerce figures show individuals reporting 17 percent more interest on their tax returns than they actually got. The high compliance rate for wages and salaries is obviously a function of withholding, first instituted during World War II as a "temporary" wartime measure. The IRS would dearly love to extend withholding requirements to areas such as interest and dividends. However, when Congress tried to do this in the early 1980s, there was such a loud outcry from taxpayers that the law was quickly repealed. Some members of Congress would like to do the same for withholding on wages. On April 3, Rep. Ron Paul, R-Texas, introduced H.R. 1364 to abolish all tax withholding. One of the odd things about tax compliance is that it does not appear to be related very closely to tax burdens or general dissatisfaction with taxes. For example, in 1969 the 10 percent Vietnam War surtax was in effect and 69 percent of Americans told the Gallup Poll that their taxes were too high. Yet, the AGI gap was at its lowest ever level at this point. One would think that high taxes and complaints about them would encourage more tax cheating. Yet the income gap often rises in the aftermath of tax cuts. It rose from 9.8 percent before the Kennedy tax cut to 10.5 after it took effect, and from 11.9 percent before the Reagan tax cut to 13.5 percent after. The latest bump in the AGI gap came in the aftermath of the 1997 tax cut. One can only conclude that more research in this area is needed. It is difficult to say whether tax cheating is encouraged or discouraged by the political environment. Lately, there have been increased reports of tax protests, fueled by the Internet, where protestors can easily find support and techniques for evasion. Indeed, so bold have some protestors become that they are openly bragging about not paying taxes. For some unknown reason, the IRS seems to be shy about prosecuting them, which only encourages others to join them. My theory is that the IRS is allowing the protestors to get publicity in order to get more money from Congress to hire auditors. The IRS, in allowing its audit rate to fall, is like the Post Office threatening to cancel Saturday mail delivery or the National Park Service closing the Washington Monument because they need more money. It gets Congress' attention and almost always brings forth additional funds. In his new budget, George W. Bush gave the IRS its wish, granting it a large increase while many other agencies face cuts. This may lead to an imminent crackdown on tax protestors. Chart: Tax Gap as a Share of Total Adjusted Gross Income Year ---- Percent 1959 ---- 10.0 1960 ---- 10.2 1961 ---- 9.8 1962 ---- 10.1 1963 ---- 9.9 1964 ---- 10.3 1965 ---- 10.5 1966 ---- 10.2 1967 ---- 9.1 1968 ---- 9.0 1969 ---- 9.0 1970 ---- 9.7 1971 ---- 9.6 1972 ---- 9.6 1973 ---- 10.7 1974 ---- 9.9 1975 ---- 9.6 1986 ---- 9.9 1977 ---- 10.7 1978 ---- 11.4 1979 ---- 11.6 1980 ---- 11.9 1981 ---- 12.1 1982 ---- 11.6 1983 ---- 12.7 1984 ---- 13.5 1985 ---- 12.3 1986 ---- 12.9 1987 ---- 11.2 1988 ---- 9.7 1989 ---- 11.0 1990 ---- 10.7 1991 ---- 10.3 1992 ---- 11.7 1993 ---- 12.6 1994 ---- 12.9 1995 ---- 12.1 1996 ---- 12.0 1997 ---- 11.2 1998 ---- 11.4 Source: Department of Commerce