Hoosiers, as Americans everywhere, have prepared or are preparing their 2011 tax returns. These voluntary and timely payments account for about 85 percent of the taxes owed to the federal government. Are you part of the 15 percent not in compliance with the tax laws?
Every few years the Internal Revenue Service estimates “the tax gap.” The latest study was released this year and relates data for 2006.
In that year, before the recent recession and recovery, $2.2 trillion in federal taxes were paid voluntarily and on time. Late payments and enforced settlements accounted for another $65 billion. That left a “gap” of $385 billion of taxes never collected.
Did you get that number? $385 billion not collected. That’s more than $1,000 per American. It is a sum that would buy a few arms for wars we don’t want to fight. It would pay for the operations and treatments of more than a few sick people. It is enough to supplement our education budget, improve our infrastructure, and restore many acres of environmentally damaged brown fields.
Of this vast sum, 98 percent ($376 billion) results from underreporting — the failure to tell the IRS how much you actually made or the fabrication of expenses you did not incur. (Excuse me, in your case it was an honest error that you’d be glad to correct if the IRS contacts you.) More than three-fifths of that $376 was the responsibility of individuals.
This “underground” or “informal” economy includes the legal activities of the very rich as well as the very poor. It does not include illegal acts such as dealing drugs and selling hot cars.
The rich may “neglect” to report capital gains, dividends or cash receipts. They may invent phantom expenses or charge personal activities as business outlays. Self-employed professionals are strong candidates for this behavior.
The unwealthy or poor generally do not have capital gains or dividends to neglect. They may underreport cash income for their off-the-cuff businesses. Casual construction, domestic work, and personal services (haircuts) often are performed with the expectation of untraceable cash payments.
The IRS tries to estimate how much income might be collected if there were strong voluntary compliance by taxpaying citizens. Famously, they estimate how much in tips is earned by waiters and cab drivers, pole dancers and masseurs.
For new business owners, eager entrepreneurs, tax avoidance could be the difference between survival of the enterprise or bankruptcy. For the very poor, tax avoidance may be necessary for survival itself.
As a society the problem of this massive tax gap is clear. We want each citizen and each enterprise to pay its fair share of taxes. We have a complex, often inadequate, system to help individuals, but it tends to stifle entrepreneurial activity. If you are running a beauty parlor, you are not unemployed, yet your earnings may be inadequate to support your needs. Yet you cannot qualify for unemployment compensation because you are self-employed. The earned income tax credit may still leave you short of sufficiency.
The new JOBS act is intended to help small businesses, but has loopholes that worry many observers into thinking that large corporations will be the ultimate beneficiaries. Somehow, we have to modify the tax laws so they do not suppress enterprise while they encourage compliance with the law.
Morton Marcus is an independent economist, writer and speaker formerly with the IU Kelley School of Business.