Are we a nation of tax cheaters? New econometric evidence on tax compliance

Abstract

In 1982, then Commissioner of Internal Revenue Roscoe Egger reported to Congress that legal sector noncompliance with the Federal Income Tax statutes generated an "income tax gap" of $81 billion in 1981, up from $29 billion in 1973. He further projected a gap of $120 billion for 1985 (U.S. Congress, 1982). Perceptions of accelerating noncompliance inspired a crisis mentality within the Internal Revenue Service, Congress, and the tax bar. The IRS responded in part by funding a major independent study of tax noncompliance via the National Academy of Sciences, and the American Bar Foundation initiated an investigation of its own in 1984. Congress enacted compliance legislation in 1981, 1982, and 1984, and completely overhauled the federal income tax laws in 1986. These enactments added a wide variety of new penalties for noncompliance and strengthened others, dramatically expanded requirements for third-party reporting of information to the IRS, added to the IRS's arsenal of procedural weapons, and adopted everyone's favorite vehicle to combat noncompliance--lower tax rates. All this clamor and action has taken place in the absence of any solid factual foundation (Graetz and Wilde, 1985). We are not at all certain of the actual decline in tax compliance during the past decade, and even if noncompliance has increased significantly, its causes, and thus appropriate remedies, simply are not known. For example, recent unpublished IRS estimates have significantly reduced Commissioner Egger's projections for 1985-to $92 billion; in fact, the real income tax gap for individual returns is now thought to have fallen from $39.1 billion in 1981 to $36.8 billion in 1986, measured in 1972 dollars. These figures do not support the widespread claims that the American public is becoming a nation of tax cheaters, or that the integrity of the tax system is seriously at risk, but the complete story is much more complex. Not only must there be additional efforts to determine what circumstances imply increased noncompliance, but the effects of recent tax law and penalty changes as well as changes in IRS budgets and audit capacity must also be taken into account. Ultimately this is an empirical story, but valid empirical work must be based on the proper theoretical foundation. The theoretical basis for the economic approach to tax compliance has, at least until recently, been inadequate, and the limited empirical work based on it is seriously flawed. In this paper we briefly review both, as well as new theoretical and, especially, empirical work on the tax compliance problem.