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America's Broken Tax System

Rick Newman

·Senior Columnist

Yahoo Finance

President Biden wants sizable tax hikes to pay for green-energy investments, better health care and a host of other programs. But the existing tax system is so porous that evaders dodge more in taxes each year than Biden’s tax plan would raise if Congress passed the entire thing. Biden could get all the money he’s looking for, and then some, if the Internal Revenue Service simply collected what taxpayers owe.

Wealthy Americans, not surprisingly, dodge taxes the most. A new working paper published by the National Bureau of Economic Research finds that the wealthiest 1% of Americans underreport their income by 21%, using complex tax-dodging schemes the IRS often fails to detect even when they audit returns. That means the IRS might not find this income even if they audited every American in the top 1% of earners, or those with incomes above $740,000 or so.

Using decade-old data, the IRS estimates the annual “tax gap”—the amount taxpayers owe but don’t pay—is around $280 billion. But updating that number for inflation and income growth would produce a 2020 tax gap closer to $400 billion, according to Daniel Reck of the London School of Economics, one of five authors of the NBER study. Those researchers think the tax gap is even larger, at about $450 billion, because the agency undercounts hidden income it doesn’t find even during audits. In a 2019 paper, Natasha Sarin and Lawrence Summers estimated that it’s larger still: $630 billion per year.

Those are huge numbers, even by Washington’s inflated standards. Biden’s tax plan, if fully enacted, would raise $2.1 trillion during the next decade, or $210 billion per year, according to the Tax Policy Center. That’s less than half the amount of money lost through tax dodging. Biden’s plan to raise income taxes on households earning more than $400,000 would raise about $76 billion per year, just 17% of the tax gap. Hiking business taxes, as Biden wants to do, would raise about $112 billion per year, or just 25% of the tax gap. Put another way, fully closing the tax gap would generate more than twice the amount of revenue Biden wants to raise through tax hikes.

Weakened by cutbacks

No tax system achieves 100% compliance, but IRS enforcement has been worsening for a decade, with Congress cutting the IRS’s budget by 20% during that time, accounting for inflation. Republicans began pushing for IRS funding cutbacks after they took control of the House of Representatives in 2010. Bigger cutbacks came when Republicans controlled both houses of Congress, from 2015 to 2019. Part of the Republican strategy has been to “starve the beast” by curtailing government revenue, to cut back on spending and shrink government. But spending has gone up anyway, with the gap financed by borrowed money, adding to the national debt.

IRS funding shortfalls have forced sharp cutbacks among enforcement staff who go after tax evaders. IRS computer systems date to the 1960s and are among the oldest at any federal agency. Workers earning most of their money through labor pay most of what they owe, because employers deduct taxes automatically and it’s hard to cheat. It’s a different story for wealthy taxpayers with a lot of income from investments or privately owned businesses that provide tax experts numerous opportunities for creative tax-avoidance schemes. A recent Treasury Department Inspector General report found that high earners (AGI of $200,000 or more) delinquent on their taxes pay only 39% of what they owe within the first year the money is due. The IRS could collect more money later, but it often turns those cases over to collection agencies that reclaim a small fraction of what’s due.

Better enforcement could essentially be free money. The IRS has a budget of about $12 billion per year, and Sarin and Summers estimate that an additional $100 billion in funding over a decade for more IRS staff, more audits and better technology would produce $1 trillion in additional revenue, or $100 billion per year. That would shrink the tax gap by only about 15%, but it would still be a 1,000% return on investment. Other analysts think that estimate is too high but still agree that more enforcement money would yield a handsome return.

Democrats who now hold a slim majority in Congress—for the first time since 2011—plan to address these problems. Sen. Ron Wyden of Oregon, who chairs the Senate Finance Committee, says he wants to “rebuild” the IRS according to guidelines published by the IRS’s taxpayer advocate. Suggested reforms include more funding above all, along with other changes that would simplify parts of the tax code and the process of dealing with the IRS.

That type of legislation could make it into the huge infrastructure bill Democrats are now preparing, which could top $3 trillion in spending, spread over several years. Biden says he wants tax hikes in the bill, to finance some of the spending. He probably won’t get every tax hike he’s looking for, but collecting more of the tax people already owe will make up for some of that.

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