The IRS has reported that its overall audit rate is continuing to fall, especially for businesses and high-income individual taxpayers. The Service audits less than 1 percent of individual and partnership returns, though large corporations are much more likely to be reviewed.
Does it matter? To cut to the chase: Will people and firms be more likely to cheat on their income taxes if they are less likely to get caught?
Economic theory says they will. But in the post-Tax Cuts and Jobs Act world, compliance patterns may get more complicated. Many taxpayers will have much less opportunity to dodge taxes but some will have more.
Let’s focus on the individual income tax. Start by thinking about how taxpayers cheat: They either underreport income or claim excessive deductions or credits.
For most taxpayers, it is not easy to hide income from the IRS since nearly all is reported by third party payers. The IRS estimates that only about one percent of income is underreported to the Service when there is “substantial” third party reporting or withholding. But it estimates that 63 percent of income is misreported by tax filers when there is “little or no” information reporting.
The vast majority of individual taxpayers have nearly all their income reported by third parties. Employers report wage income on W2s. Mutual funds and other financial firms report dividend, interest, and capital gains income on 1099s. The exceptions: workers and businesses that are paid in cash, and the very highest-income taxpayers who may receive partnership and investment income that is not fully reported.
What about deductions? Big ones, such as mortgage interest and state and local taxes, come with a paper trail. For most taxpayers, other deductions are relatively small and cheating is hardly worth the bother.
There are some exceptions. Wealthy taxpayers may overstate the value of appreciated assets such as art or overvalue property that is preserved through tax-subsidized easements. Low- and moderate-income households may claim inappropriate Earned Income Tax Credits.
The big problem, however, is with small business owners who don’t report income or claim improper deductions. You know the story: They sell goods and services at a lower price for cash or they put the family car or their monthly cell service on the business. The IRS estimates that of the $264 billion in income that taxpayers failed to report in 2008-2010, nearly half was business income.
How will the TCJA interact with the low audit rate? On one hand, it reduces the opportunities for millions of taxpayers to overstate deductions, making many audits less necessary. For example, by increasing the standard deduction and capping the benefit of the state and local tax (SALT) deduction, the TCJA will slash the number of itemizers from 46 million to 21 million.
If you don’t itemize, and your income is entirely W2 wage income or 1099 investment income, it is tough to cheat, even if you know the IRS isn’t looking over your shoulder.
Similarly, taking the standard deduction, combined with the near-ubiquitous use of tax software or tax preparers, significantly reduces math errors and other mistakes.
But, at the same time, the TCJA opens the door to more cheating—and more mistakes--by one group of taxpayers. It is all about the new law’s incentives for people to create pass-through businesses such as sole proprietorships, limited liability companies, and partnerships.
That may give many more taxpayers the opportunity to earn income that is not subject to third party reporting; claim deductible business expenses that are, shall we say, inappropriate; and adopt aggressive tax avoidance strategies to get around the new law’s ambiguous guardrails. Other business owners may simply bungle their returns as they try to file under a new and poorly drafted law.
In recent years, the IRS has audited less than 0.5 percent of partnerships. The logic: Partnerships don’t pay taxes, their shareholders do, so why not just review the returns of the owners.
But that may not work well in the wake of the TCJA. The IRS may have to audit both business owners and their firms to figure out if proper taxes are paid.
With its budget for enforcement and compliance continuing to shrink, the IRS is going to have to be much more strategic in how it uses its resources, especially given the challenges of the TCJA.
