ECONOMIC ANALYSIS:

Self-Reporting Drives $385 Billion ‘Tax Gap’

The real divide in U.S. incomes isn’t between the top 1 percent and the other 99 percent. It’s between those whose income is reported by their employers to the Internal Revenue Service, and those who self-report. The divide is costing the Treasury about $200 billion a year, and Congress should gradually phase it out.

Tax compliance studies have consistently linked self-reporting with Treasury shortfalls. The link was underscored early this year when the IRS released its latest estimate of the nation’s “tax gap”—the difference between true tax liabilities and what the Treasury receives. The IRS put the gap at $385 billion, with more than half stemming from unreported work income.

Here’s the key statement from the IRS summary of the new gap numbers: “For example, the net misreporting percentage for amounts subject to substantial information reporting and withholding is 1%; for amounts subject to substantial information reporting but no withholding, it is 8%; and for amounts subject to little or no information reporting, such as business income, it is 56%.”

Think for a moment about an income misreporting percentage of 56%. It means that taxpayers with incomes “subject to little or no information reporting” are paying, on average, less than half what they should be paying. The better part of the tax gap comes from assuming that human beings will act like angels when they self-report their work income. (True, there’s always the chance of an IRS audit. But odds are there won’t be any audit, and thousands of taxpayers are obviously playing the odds.)

The new gap totals should impel Congress to beef up income verification. Any such move, of course, would generate fierce resistance. Economist Bruce Bartlett held top posts under presidents Reagan and George H.W. Bush and now blogs for a major daily. His remarks on the IRS data touched on the obstacles to reporting reform: “People don’t like the intrusion into their privacy—and the diminution of their opportunities for tax evasion—and businesses don’t like the cost or the alienation of their customers.”

The straight up answer to all such complaints comes from 2008 GOP presidential candidate John McCain: “Country First”. Fiscal prudence, national togetherness and tax fairness all argue powerfully for less porous reporting rules.

The billions that lose their way to the Treasury will likely increase the federal deficit, leaving a hard choice. We can raise taxes, or go without the societal benefits that $385 billion would buy. We could also stem the leakage. The nation and all taxpayers benefit from income reporting for wages and salaries. The nation would also benefit, and it would only be fair, if information reporting could become the norm for current honor system tax filers—self-employed professionals, small business owners, landlords and others. As Bartlett wrote, “It’s unfair to honest taxpayers and undermines tax morale when large numbers of people and businesses don’t pay their taxes.”

President Obama’s State of the Union address called for an America where “everyone does their fair share, and everyone plays by the same set of rules.” A current example on Wall Street shows that income reporting rules can move closer to that goal, and even gain bipartisan backing.

This is year two of the three-year phasing in of new rules for reporting capital gains. Proceeds from the sale of stocks and mutual funds were formerly reported to the IRS, but not the purchase price, called the basis. Since capital gains can’t be verified without knowing the basis, it was easy for taxpayers to misreport their investment income. Basis reporting began as the initiative of former Senator Evan Bayh (D-IN). It became a bipartisan bill when Bayh convinced fellow fiscal hawk Sen. Tom Coburn (R-OK) to sign on. The Bush Administration later added its endorsement.

The reasons for basis reporting of capital gains apply many times over to information reporting of work income. The Treasury’s loss is far greater, as are the potential gains to taxpayers from simplified record-keeping and tax preparation. Businesses, for example, could have bank accounts with deposits coded as income and checks coded as expenses. At year’s end, banks could report the totals to businesses and to the IRS—and begin making business income reporting almost as simple as wage and salary income reporting (and much closer in tax compliance as well).

“Trust, but verify” became President Reagan’s trademark phrase during his Cold War nuclear negotiations with Russia. America’s foe today is a mammoth deficit coupled with a $385 billion tax gap. Congress could slash the gap by slowly but surely bringing self-reporting taxpayers into a “trust but verify” system. Ronald Reagan would approve.