Wealthy Americans are concealing large amounts of income from the I.R.S. There is a straightforward corrective.
By The New York Times Editorial Board [March 20, 2021]
When the federal government started withholding income taxes from workers’ paychecks during World War II, the innovation was presented as a matter of fairness, a way to ensure that everyone paid. Irving Berlin wrote a song for the Treasury Department: “You see those bombers in the sky? Rockefeller helped to build them. So did I.”
The withholding system remains the cornerstone of income taxation, effectively preventing Americans from lying about wage income. Employers submit an annual W-2 report on the wages paid to each worker, making it hard to fudge the numbers.
But the burden of taxation is increasingly warped because the government has no comparable system for verifying income from businesses. The result is that most wage earners pay their fair share while many business owners engage in blatant fraud at public expense.
In a remarkable 2019 analysis, the Internal Revenue Service estimated that Americans report on their taxes less than half of all income that is not subject to some form of third-party verification like a W-2. Billions of dollars in business profits, rent and royalties are hidden from the government each year. By contrast, more than 95 percent of wage income is reported.
Unreported income is the single largest reason that unpaid federal income taxes may amount to more than $600 billion this year, and more than $7.5 trillion over the next decade. It is a truly staggering sum — more than half of the projected federal deficit over the same period.
The government has a basic obligation to enforce the law and to crack down on this epidemic of tax fraud. The failure to do so means that the burden of paying for public services falls more heavily on wage earners than on business owners, exacerbating economic inequality. The reality of widespread cheating also undermines the legitimacy of a tax system that still relies to a considerable extent on Americans’ good-faith participation.
Proposals to close this “tax gap” often focus on reversing the long-term decline in funding for the I.R.S., allowing the agency to hire more workers and to audit more wealthy taxpayers. But Charles Rossotti, who led the I.R.S. from 1997 to 2002, makes a compelling argument that such an approach is inadequate. Mr. Rossotti says that Congress needs to change the rules, by creating a third-party verification system for business income, too.
The core of Mr. Rossotti’s clever proposal is to obtain that information from banks. Under his plan, the government would require banks to produce an annual account statement totaling inflows and outflows, like the 1099 tax forms that investment firms must provide to their clients.
Individuals would then have the opportunity to reconcile what Mr. Rossotti dubs their “1099New” forms with their reported income on their individual tax returns. One might, for example, assert that a particular deposit was a tax-exempt gift.
Mr. Rossotti has proposed that the I.R.S. require the new forms only for people with taxable income above a generous threshold. A bill including Mr. Rossotti’s plan, introduced by Representative Ro Khanna of California, sets that threshold at $400,000, to minimize the burden on small business. The money is undoubtedly in chasing wealthy tax cheats, but equity argues that business income, like wage income, should be subject to a uniform reporting standard. Small businesses ought to pay their taxes, too.
The proposal would not increase the amount anyone owes in taxes. It would, instead, increase the amount paid in taxes by those who are currently cheating.
It would have the immediate benefit of scaring people into probity.
Consider what happened after Congress passed legislation in 1986 to require taxpayers to list a Social Security number for each person claimed as a dependent. The government could not easily crosscheck all of those claims then, but the requirement itself caused a sharp drop in fraud. The next year, seven million children abruptly disappeared from tax returns.
To realize the full benefit of the new data, however, Congress does need to make a significant investment in upgrading the I.R.S.’s outdated computer systems, and in hiring enough qualified workers to examine suspicious cases and to hold accountable those who cheat.
In 2008, for example, Congress passed a bill to require credit card processors to report payments processed on behalf of online retailers on an annual form called a 1099-K so the I.R.S. could verify the income reported by those retailers. But in December, the Treasury Department’s inspector general reported that “resource limitations” had prevented the I.R.S. from investigating more than 310,000 cases in which individuals and businesses failed to report more than $330 billion in income documented on 1099-Ks.
Congressional Republicans, unable to muster public support for reductions in federal spending, have pursued that goal indirectly by constraining federal revenue, in part by hacking away at the I.R.S.’s budget. The share of all tax returns subject to an audit declined by 46 percent from 2010 to 2018, according to the Congressional Budget Office. For millionaires, the decline in the audit rate was 61 percent. Today, the government employs fewer people to track down deadbeats than at any time since the 1950s.
The result is a parallel increase in federal debt and in tax fraud.
Mr. Rossotti, together with the Harvard economist Lawrence Summers and the University of Pennsylvania law professor Natasha Sarin, argued in an analysis published in November that investing $100 billion in the I.R.S. over the next decade, for technology and personnel, in combination with better data on business income, would allow the agency to collect up to $1.4 trillion in lawful tax revenue that otherwise would go uncollected.
The logic of such an investment is overwhelming. The government can crack down on crime, improve the equity of taxation — and raise some needed money in the bargain. There are many proposals to raise taxes on the rich. Let’s start by collecting what they already owe.