Article and Study on Tax Evasion by the Wealthy (6/28/21; 6/29/21)

This recent article is likely of interest to tax crimes fans.  Asher Schechter, How Insufficient Enforcement Led to Prevalent Tax Evasion and Contributed to American Inequality (U. Chicago Booth School Stigler Center Promarket 6/24/21), here.  The article expands on the recent publication of IRS data on the very wealthy by ProPublica.  See ProPublica Publishes Series Based on IRS Data Trove Produced by Anonymous Source (Federal Tax Crimes Blog 6/8/21), here; and Tax Crimes Core Concept Questions from ProPublica's Publication of Tax Return Information (Federal Tax Crimes Blog 6/10/21), here.

About the ProPublica disclosed data, the author of this article discusses the tax evasion – yes, the crime – aspects of the phenomenon, citing a recent NBER publication, John Guyton, Patrick Langetieg, Daniel Reck, Max Risch & Gabriel Zucman, Tax Evasion at the Top of the Income Distribution (NBER Working Paper Series No. 28542 March 2021), here.

Excerpts from the article:

             The other side of the coin is tax evasion, which unlike tax avoidance is illegal. How prevalent is tax evasion by the rich, and how significant is it to the overall picture of inequality? A working paper published in March by researchers John Guyton and Patrick Langetieg from the IRS, along with economists Daniel Reck (London School of Economics), Max Risch (Carnegie Mellon), and Gabriel Zucman (University of California, Berkeley) showed tax evasion at the top of the US income distribution is much worse than previously thought: while unreported or under-reported income is at 7 percent among the bottom 50 percent of the income distribution, the top 1 percent hide 21 percent of their true income.

            Tax evasion by high-income people is notoriously difficult to measure due to the myriad ways in which wealthy individuals can evade taxes, from unreported offshore accounts to pass-through entities like partnerships and S-corporations. To study the extent of tax evasion, Guyton et al. used a trove of IRS tax return data, mainly from the IRS’ random audit program, the National Research Program (NRP). What they find is that of the 21 percent of true income that top earners don’t report to the IRS, 6 percent is due to these sophisticated tax evasion strategies.

            In addition to the increasingly regressive US tax system (a trend that was also covered in Zucman’s 2019 book with Emmanuel Saez), the study also underscores how inadequate enforcement contributed to America’s current tax inequality, highlighting the asymmetry between high-income, high-wealth individuals, who have the funds to attempt ever more sophisticated methods of tax evasion, and the IRS auditors, who don’t have the resources to keep up.

Evasion Largely Goes Undetected

            Cracking down on wealthy taxpayers who hide or underreport their income to avoid paying taxes is a big part of the Biden administration’s effort to raise taxes on the wealthy to fund its ambitious legislative agenda (Biden’s American Families Plan cites Guyton et al.’s estimates), but one thing that complicates these attempts at fighting tax evasion is just how widespread it has become among America’s richest households.

            To measure the extent of tax evasion, the IRS relies on random audits that measure the amount of income that goes under-reported as a fraction of true income (under-reporting gap), and of the tax that is owed but not paid (tax gap).

            In theory, random audits are supposed to provide a pretty accurate estimate of the scope of tax evasion. In the academic literature, as the authors note, it is considered “the gold standard for understanding tax evasion.” The problem, however, is that random audits were designed with common forms of tax evasion in mind: for instance, self-employed people who don’t report their full income, or taxpayers who abuse the tax credit system. When it comes to more sophisticated forms of tax evasion—ones that are used almost exclusively by the very rich—the evasive tactics tend to go undetected, which means that random audits end up underestimating tax evasion at the very top.

            To show this, Guyton et al. looked into the thousands of individual tax returns of people who disclosed offshore assets as part of the government crackdown on offshore tax havens that followed the 2008 financial crisis. The authors tracked individuals who filed a Foreign Bank Account Report (FBAR) and individuals who participated in the Offshore Voluntary Disclosure Program (OVDP), an Obama-era program that enabled taxpayers to avoid prosecution by voluntarily reporting previously-undisclosed offshore accounts and paying a fine. Hundreds of these individuals were randomly audited prior to disclosing their foreign assets, and Guyton et al. compare these audits with the post-disclosure returns. What they find is that the auditors detected the hidden offshore wealth in just 7 percent of these cases.

            For pass-through entities—partnerships, proprietorships, and S-corporations that are not subject to corporate taxes and whose taxes “pass through” their owners’ individual tax returns—the authors find that among individuals who were subject to a random audit and under-reported their pass-through income, auditors detected the tactic in only 3.8 percent of the cases. The result? “While the income of taxpayers in the bottom 99 percent of the income distribution is comprehensively examined, up to 35 percent of the income earned at the top is not comprehensively examined in the context of random audits.”

            Because these forms of tax evasion are highly concentrated among the top earners, accounting for this unreported or under-reported income would significantly increase the income share of the top 1 percent, according to the authors by about 1.5 percent. Of the federal income taxes that are unpaid, they find, 36 percent are owed by the top 1 percent. Among the top 0.1 percent, taxes evaded are more than twice as large.

            In fact, the richer you are, the less susceptible you are to get caught evading taxes during a random audit: detected evasion, the authors find, “declines sharply at the very top of the income distribution, with only a trivial amount of evasion detected in the top 0.01 percent.” The reason is that NRP audits detect very little evasion on dividends, capital gains, and interest, the top sources of income for members of the top 0.1 percent. Nevertheless, the authors suggest that 60 percent of the wealth hidden in offshore tax havens belongs to the top 0.1 percent of earners, and 35 percent belongs to the top 0.01 percent.

            Such gains held in offshore accounts only became subject to reporting requirements in 2014, after the Foreign Account Tax Compliance Act [FATCA], enacted in 2010, went into effect; the period studied in the paper ends at 2013. When asked whether the picture would be significantly different today, post-crackdown on offshore havens, Reck wrote in an email to ProMarket that this is “a big open question that I am trying to understand better in other work. FATCA shows some promise but there’s a lot of uncertainty and disagreement out there about how optimistic we should be that it is making a big difference.”

            The reason that the very wealthy often get away with evading taxes, the authors suggest, is simple: auditors attempting to wade through networks of pass-through business entities and offshore havens to determine whether the income reported in an individual tax return is correct face considerable challenges in deciphering byzantine ownership and partnership structures. It takes significant expertise, resources, and personnel to detect evasion at these levels—things the IRS, in its current diminished form, does not have enough of.

Also, readers interested further should read the NBER report cited by the author of the article and which I cited and linked above.  From the article here are some key excerpts:

ABSTRACT

            This paper studies tax evasion at the top of the U.S. income distribution using IRS micro-data from (i) random audits, (ii) targeted enforcement activities, and (iii) operational audits. Drawing on this unique combination of data, we demonstrate empirically that random audits underestimate tax evasion at the top of the income distribution. Specifically, random audits do not capture most tax evasion through offshore accounts and pass-through businesses, both of which are quantitatively important at the top. We provide a theoretical explanation for this phenomenon, and we construct new estimates of the size and distribution of tax noncompliance in the United States. In our model, individuals can adopt a technology that would better conceal evasion at some fixed cost. Risk preferences and relatively high audit rates at the top drive the adoption of such sophisticated evasion technologies by high-income individuals. Consequently, random audits, which do not detect most sophisticated evasion, underestimate top tax evasion. After correcting for this bias, we find that unreported income as a fraction of true income rises from 7% in the bottom 50% to more than 20% in the top 1%, of which 6 percentage points correspond to undetected sophisticated evasion. Accounting for tax evasion increases the top 1% fiscal income share significantly.

John Guyton

Internal Revenue Service
Research, Applied Analytics, and Statistics
77 K Street, NE
Washington, DC 20002
john.guyton@irs.gov

Patrick Langetieg
Internal Revenue Service
Research, Applied Analytics, and Statistics
77 K Street, NE
Washington, DC 20002
Patrick.T.Langetieg@irs.gov

Daniel Reck
London School of Economics
Department of Economics
Houghton Street
London WC2A 2AE
United Kingdom
d.h.reck@lse.ac.uk

Max Risch
Tepper School of Business
Carnegie Mellon University
4765 Forbes Ave.
Pittsburgh, PA 15213
United States
mwrisch@andrew.cmu.edu

Gabriel Zucman
Department of Economics
University of California, Berkeley
530 Evans Hall, #3880
Berkeley, CA 94720
and NBER
zucman@berkeley.edu

Change as of 6/29/21 6:00pm

Caveat:  I just noticed that, for the NBER article which I covered below, there was a copyright notice as follows:

© 2021 by John Guyton, Patrick Langetieg, Daniel Reck, Max Risch, and Gabriel Zucman. All rights reserved. Short sections of text, not to exceed two paragraphs, may be quoted without explicit permission provided that full credit, including © notice, is given to the source.

In the original blog, I copied and pasted the following sections which I have just deleted from the Blog but provide links to the first page of those sections to permit readers to go easily to the original and read:

• 1 Introduction, here.
• 6 Conclusion, here

For the benefit of Blog readers of this Blog, I also provide links to certain other sections of the article that may be of particular interest.  In the section titled “3 What Random Audits Miss: Evidence,” the following subheadings are discussed:

• 3.1 Offshore Evasion, here (including discussion of evidence from OVDP/I)
• 3.2 Evasion on Pass-Through Business Income, here

My apologies to the authors of this research paper.