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Fix the Tax Gap: Fewer Audits, Clearer Rules

Underreporting income has long plagued our tax system, with individuals failing to pay some $345 billion in 2001, the latest year analyzed by the Internal Revenue Service (IRS) for which data are publicly available. And estimates suggest the number is rising. In a study released this year, Jacksonville University professor Richard Cebula and University of Wisconsin professor Edgar Feige estimated the tax gap at half a trillion dollars.

Analysis by financial consultancy Quantria Strategies for the Small Business Administration released last month shows that underreporting of business income on individual tax returns was one of the biggest sources of the 2001 tax gap, accounting for between 25 percent and 30 percent of it.

The IRS's primary strategy for dealing with the gap has been to increase audits on owners of pass-through entities—sole proprietorships, S corporations, and partnerships. From 2005 through 2009, the IRS decreased its audit rate on large corporations and increased its audit rate on small business owners and other individuals. According to a report by Transactional Records Access Clearinghouse (TRAC), which obtains and analyzes data on the IRS, the number of hours the IRS spent auditing small businesses—those which the IRS defines as companies with less than $10 million in assets—increased by 30 percent from 2005 to 2009.

Nickel-and-Dime Blunders

This strategy has been largely ineffective, because most people underreport accidentally, not deliberately. A 2007 GAO report found that half of those sole proprietors who underreported income did so by less than $903. Even if the average marginal tax rate for these taxpayers was 28 percent (the rate that married couples pay on income between $137,300 and $209,250), their underreporting would save them each less than $253. It hardly seems likely that half of underreporting sole proprietors would deliberately cheat to save such a small sum of money. Moreover, IRS auditors conducting special examinations to measure the extent of tax noncompliance found that taxpayer mistakes accounted for 94 percent of underreporting cases, IRS taxpayer advocate Nina Olson reported to Congress in 2006.

The IRS's own approach to civil penalties doesn't suggest that the agency believes most taxpayer noncompliance is deliberate. According to its 2010 Data Book report, the agency assessed penalties in less than one-third of the 2009 tax returns it examined. If the tax agency chooses not to impose penalties in the vast majority of cases where it audits taxpayers, it must believe that many of the errors are unintentional.

In 2006 Congressional testimony, Olson said IRS data suggest that more taxpayer education is necessary to improve small business owner tax compliance. Based on its analysis in its 2007 report, the GAO agrees. It's not difficult to see why. As the GAO explains, "IRS's examinations are limited in number and scope and do not find much of the unreported income." Figures from the 2010 Data Book report reveal that less than three percent of business owners' returns from the 2009 tax year were audited. And in only about half the cases did the audit result in the taxpayer owing additional taxes. That means that for no more than 1.5 percent of small business owners did IRS audits bring in unpaid business income tax.

Because errors are the main cause of small business owners' underpayment of taxes, educating them on tax rules would help to remedy the problem. Even simple steps such as making the instructions for completing a Schedule C on the individual income tax return easier to understand would go a long way. With tax laws affecting small business owners constantly changing and difficult for even accounting professionals, it's unrealistic to expect owners to get the calculations right all the time. In short, a kinder, gentler approach would likely recoup more taxes than auditing taxpayers more vigorously.

Scott Shane is the A. Malachi Mixon III Professor of Entrepreneurial Studies at Case Western Reserve University.

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