Federal personal income tax has been a controversial and perennial favorite of congressional committees and presidential proposals since the ratification of the 16th Amendment in 1913.
Most of the time, when we argue about taxes, we simply assume enforcement, unless and until some egregious abuse brings it to the fore. Amidst all the economic, ethical, political, philosophical, and sociological implications of an income tax, we tend to gloss over the fact that a portion of our collective tax obligation goes uncollected.
Without enforcement there is no collection, and without collection taxation is much more costly and less effective. Recent proposals to re-fund and reorganize our collection agency, the Internal Revenue Service, have brought this into view once again.
Enforcement is the mandate of the Internal Revenue Service, which began in 1916 (as did the income tax) as the Bureau of Internal Revenue. In those early days, without any automation, processing returns was labor intensive, but relatively few citizens needed to pay income tax.
Staffed mostly by patronage and political appointments, the Bureau’s responsibilities expanded during Prohibition. Still, at the beginning of U.S. involvement in World War II, only about 4 million citizens, about 3 percent of the population, were federal taxpayers. As more and more taxes were legislated to pay for the war, by the time it ended there were 42 million taxpayers, about 30 percent of the population. Taxation and thus enforcement became more significant to civic life.
In 1952, after it came to light that many of its own agents were evading taxes, the Bureau was reorganized into the Internal Revenue Service, staffed by the civil service, and decentralized to local offices. It was restructured again in 1998, this time along functional rather than geographical lines. Since the advent of online filing, in the mid-1990s, the number of actual processing centers has dwindled, with only two remaining.
By IRS estimates, the tax gap, the difference between taxes owed and taxes paid, has fluctuated between 15-18 percent over the past 30 years. The latest figures available, for 2011-13, show a gap of about 14 percent. There are three reasons for the gap: not filing, not paying, and not reporting taxable income.
The IRS estimates that not filing and not paying--on time or at all--accounts for about 20 percent of the gap in any given year. Some of that revenue is eventually recovered, but only through investigation and enforcement. Most of the gap (80 percent) is created by underreporting or not reporting taxable income.
Taxpayers are supposed to declare, and pay taxes on, many kinds of income, most of which is reported twice: once by the payer and once by the receiver. For example, wage income is reported by employers as well as by employees, dividends and capital gains are reported by brokers as well as by investors, etc.
In some cases, the tax on that income is withheld from the taxpayer and remanded directly to the government on the taxpayer’s behalf; in essence, it is paid in advance. This system of double reporting and/or prepayment is designed to keep us honest, or at least give us some incentive to be.
But some income is not reported twice, and then it’s an honor system, relying solely on the taxpayer to report it. Not surprisingly, about 70 percent of underreporting happens on individual tax returns, and about 55 percent of that is estimated to be unreported business income, which is much harder to verify.
Tax avoidance--legally seeking to minimize our tax burden by taking advantage of allowances, credits, deductions--is not a crime, and we all do it: tax preparation services are estimated to be a $3.3 billion industry in the U.S.
Underreporting, aka tax evasion, is a crime. As with many financial crimes, it is very tempting, because the rewards are obvious and lucrative, and it’s an easy thing to do. In addition, the probability of getting caught is relatively small and getting smaller: since 2010, the IRS’s enforcement budget has declined by 14.5 percent, its enforcement staff by 33 percent, and the number of audits by 42 percent.
Despite the budget and staffing cuts, the IRS processed over 141 million individual returns in 2019. What we can’t know, and never will, is how much revenue it did not collect, and never will. When taxes go unpaid, budgeted revenue goes missing, and that shortfall must be made up by borrowing, adding to the federal debt. Oliver Wendell Holmes, Jr. famously noted that “taxes are what we pay for a civilized society,” but uncollected taxes have an even higher price.