By Clark Merrefield
January 14, 2020
Every tax season people try to get out of paying the full share of what they owe the U.S. government in income taxes. The Internal Revenue service usually starts accepting tax returns in late January and returns typically need to be filed by April 15. Here are a few ins and outs of federal tax evasion — why it matters, why people do it and how they do it.
How big is the problem?
U.S. government reports describe the effects of tax evasion in terms of lost revenue. On the federal level, lost revenue from intentional evasion and unintentional errors comes to about $458 billion per year — $406 billion after the IRS pursues late payments and enforcement actions, according to a 2019 report from the Government Accountability Office. That report relies on data from the IRS covering 2008 to 2010, and it provides the most recent estimate of yearly federal revenue lost due to individual and corporate tax evasion.
Total taxable annual income is about $2.5 trillion, according to that report, and the $406 billion is what the IRS calls the “net tax gap.” How does the tax gap stack up to other items on the government ledger? It’s a couple drops in the bucket compared to the $23 trillion in total public debt. But it’s also 37% of the $1.1 trillion Department of Defense budget for 2019 and is far more than the annual budget for just about every other government agency.
All income is taxable at the federal level, no matter how it is earned. Remember, 1920s Chicago gangster Al Capone went to jail for 7 years — not because he brewed, distilled and distributed alcohol during the Prohibition era, but because he did not pay federal taxes on the millions of dollars he made from those then-illegal activities.
Even though tax evasion leads to hundreds of billions of dollars in lost federal revenue each year, Americans by and large think they’re an honest bunch when it comes to tax compliance. The IRS’s 2018 Comprehensive Taxpayer Attitude Survey, the most recent year available, found 85% of Americans say it’s never OK to cheat on taxes — though this was down from 88% in the 2017 survey.
What’s the difference between tax avoidance and tax evasion?
Tax avoidance refers to working within the law to legally lessen one’s tax burden. Write off interest paid on a home loan? That’s simple tax avoidance, which the IRS encourages.
Tax evasion involves breaking the law by not reporting earnings to the IRS. Pet sit for a neighbor for a week at $20 a day? If those earnings go unreported, that’s tax evasion.
Using tax havens to conceal income is another type of tax evasion. U.S. citizens and permanent residents have to pay taxes on all income made inside and outside the U.S. People who aren’t permanent U.S. residents are only taxed on income they earn in the U.S. — not on income earned in other countries, such as interest from holdings in non-U.S. banks. Non-permanent residents can legally avoid some U.S. taxes by parking their money overseas.
U.S. citizens and permanent residents also turn to offshore tax havens to conceal income from U.S. authorities. Two investigative series from the International Consortium of Investigative Journalists in the mid-2010s — the Panama Papers and Swiss Leaks — shone unprecedented light on tax haven arrangements through millions of leaked documents related to 214,000 offshore companies.
People who use offshore tax havens may be subject to civil and criminal penalties — if the IRS catches them. Overall, IRS criminal prosecution referral rates are at their lowest point in more than 30 years, according to data from Syracuse University’s Transactional Records Access Clearinghouse, an organization that gathers and analyzes data on a range of civil and criminal justice topics. A special team the IRS formed in the late 2000s to go after high-earning tax evaders “never had a chance” against innumerable (and expensive) lawyers and lobbyists, finds a ProPublica investigation from 2019.
Why and how do people evade taxes?
They do it because they don’t want to pay taxes, or because they make a mistake, or because they follow bad advice. Actor Wesley Snipes famously served time in prison in the early 2010s for evading income taxes. He had followed erroneous advice claiming that neither he nor anyone else had to legally pay income tax. Telecom investor Walter Anderson became the biggest personal tax evader in U.S. history after pleading guilty in 2006 to using a complicated offshore tax haven scheme to dodge more than $200 million in taxes owed to the federal and Washington, D.C. governments.
But most tax evasion cases aren’t so headline-grabbing. Taxes are usually evaded in one of three ways: underreporting, underpayment and non-filing. In most cases the IRS has three years after the yearly tax deadline — April 15 — to go after tax evaders.
Underreporting is the most common form of tax evasion and made up 84% of the tax gap from 2008 to 2010, according to the 2019 Government Accountability Office report. Say someone works part-time at a warehouse and also fixes lawnmowers on the side. If they report the warehouse income but not the lawnmower income, that’s underreporting. The other big sources of evasion are underpayment — when returns are timely and reflect all income earned but don’t include all taxes owed — and non-filing, when an income earner doesn’t file taxes at all.
Sometimes, people might evade taxes because they don’t like the politicians at the top. The authors of a July 2019 National Bureau of Economic Research working paper looked at IRS data before and after the 2000 and 2008 presidential elections across nearly 2,000 partisan counties — those that consistently vote Democratic or Republican. Their findings suggest that “individuals who disapprove of government tax and spending policies evade more, relative to comparable individuals who have a more positive outlook about the government.”
Similar results emerged from Canada in a 2003 paper in The Journal of Socio-Economics, which concludes that “strong evidence has been found that trust in government, pride, and religiosity have a systematic positive influence on tax morale.”
Who evades taxes?
The wealthiest people are among the biggest tax evaders, according to a June 2019 paper in the American Economic Review. The authors — Annette Alstadsæter, Niels Johannesen and Gabriel Zucman — analyzed 685 records from Norway, Sweden and Denmark exposed following the Panama Papers and Swiss Leaks investigations, along with tax amnesty data from 1,422 households in Norway and 6,811 in Sweden.
They find the wealthiest 0.01% of asset holders — who own half the wealth in the sample — evade 25% of their tax liability, compared with 5% across the entire sample. Some 35% of the top 0.5% richest households in the distribution engaged in tax evasion.
“The most important insight is that government policies have a critical role to play to reduce tax evasion,” the authors write. “Increasing penalties for tax evaders has not proved to be a very practical way to curb tax cheating so far.”
Tax evasion is also rampant among the self-employed, according to U.S. government analyses. As the authors of the AEA paper note, the likelihood of self-employment rises as wealth increases. In instances where there is no third-party reporting — like an employer submitting employee wage information to the federal government — the noncompliance rate is 63%, according to IRS research. Misreporting is only at 1% when income amounts are subject to substantial information reporting and withholding.
The IRS calls this “visibility.” Income that self-employed people earn is less “visible” than income earned by someone who works for a company or nonprofit, both of which would report wage information to the IRS every year. Business income made up the biggest chunk — $125 billion — of all underreported individual income, according to the Government Accountability Office report.
“This variation is, in my view, stark and compelling evidence for the primary importance of deterrence as an explanation of tax evasion,” writes Joel Slemrod, director of Office of Tax Policy Research at the University of Michigan, in a July 2018 NBER working paper.
The Earned Income Tax Credit, a tax break for households that earn below certain income thresholds set every year, is another source of tax misrepresentation. EITC over-claims — for example, claiming a non-existent dependent to net a larger tax credit — is more accurately described as tax fraud, not evasion. An IRS study of 2006-to-2008 tax data puts the total EITC over-claim amount at between $14 billion and $19.3 billion during that period. Even at the high end of the range, EITC over-claims would make up less than 2% of the federal tax gap over a three-year period.
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