How Insufficient Enforcement Led to Prevalent Tax Evasion and Contributed to American Inequality

The prevalence of tax evasion among the top 1 percent of the income distribution is much worse than previously thought, a study by IRS researchers and economists recently discovered. Because it takes significant expertise, resources, and personnel to identify evasion at these levels—things the IRS, in its current diminished form, does not have enough of— sophisticated forms of tax evasion largely go undetected.

This month, ProPublica released a bombshell report that showed how America’s richest people—billionaires like Elon Musk, Jeff Bezos, Warren Buffett, and Michael Bloomberg—paid little to no income tax over the past 15 years. The 25 wealthiest Americans, the report found, paid a “true tax rate” of 3.4 percent between 2014 and 2018, even as their collective wealth grew by $401 billion during that time.

The ProPublica report—published amid President Joe Biden’s effort to raise taxes on the wealthy—caused an uproar, leading to a federal investigation into the anonymous source who leaked the tax data that ProPublica used in its report. Attorney General Merrick Garland said the investigation into the source “will be at the top of my list.” The news has also led to reportedly bipartisan interest in reforming the US tax code to ensure that billionaires would not be able to pay no taxes.

The revelations underscored the inequality embedded within the current American tax system, nominally a progressive one, yet in reality one in which the richest Americans can—and do—use a variety of sophisticated legal and financial tactics to pay far less in taxes than they otherwise would. 

The ProPublica report focused on one aspect of the diminishing progressiveness of the US tax system: tax avoidance. It didn’t allege any illegal conduct on the billionaires’ part. In fact, it notes, “billionaires don’t have to evade taxes exotically and illicitly—they can avoid them routinely and legally” by using “an array of techniques that aren’t available to those of lesser means.” 

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. 

The Solution: Increasing the IRS Budget?

Guyton et al. propose a number of remedies, including greater scrutiny of pass-through businesses, more comprehensive audits, new regulations that explicitly prohibit grey area tax avoidance strategies, and a whistleblower program. In an email to ProMarket, Reck suggests the success of the OVDP in cracking down on offshore tax havens could provide a valuable lesson: 

“The IRS made great progress on hidden Swiss accounts and set up the OVDP to get those people to come into compliance without thousands of lawsuits, but then through the OVDP people disclosed other offshore schemes the IRS knew nothing about. So then the IRS went after all of those. Another innovative policy is what HMRC [the UK’s tax agency] does, which is to require people adopting one of a large list of specific avoidance schemes (possibly legal, possibly ambiguous) to explicitly indicate to the HMRC that they are doing so, which at least helps them keep track of some trends,” he wrote. 

Collecting all the taxes currently unpaid by the top 1 percent, the authors estimate, would generate substantial tax revenues—about $175 billion annually. Their estimates, they note, are likely to be conservative, given the sophistication of the current methods of tax evasion and the “potential existence of many more such schemes.”

The main policy solution that Guyton et al. propose is providing more funding to the IRS. Since 2018, ProPublica has been covering the agency’s budgetary crisis: years of massive cuts which left the agency severely constrained, shrunk its enforcement staff by a third to levels unseen since World War II, lowering its audit rate to the lowest level in decades, and shrinking its enforcement revenues by 61 percent since 2010. 

Earlier this month, five former Treasury Secretaries—Timothy Geithner, Jacob Lew, Hank Paulson, Robert Rubin, and Larry Summers—also called for greater funding to the IRS, providing a grim picture of the agency’s current state in a New York Times op-ed, writing; 

“Faced with resource constraints, it is no surprise that the agency is not able to appropriately focus scrutiny on complex returns, where noncompliance is greatest. Of about four million partnership returns filed in 2018, the IRS audited only 140 of them. It did not pursue 300 high-income taxpayers who together cost the agency $10 billion in unpaid taxes over a three-year period when they failed to even file returns. And audit rates of those in the top 1 percent have fallen most staggeringly over the course of the past decade, such that rural counties in the Deep South have some of the highest rates of examination in the country.”

President Biden’s American Families Plan includes an addition of $80 billion to the IRS’ budget over the next 10 years to help the agency fight tax evasion by wealthy individuals (Biden’s Made in America plan aimed at corporate evaders as well). Citing Guyton et al.’s paper, IRS commissioner Chuck Rettig asked Congress to support the increase to the agency’s enforcement budget, telling the Senate Finance Committee in April that tax evasion may cost a lot more than previously estimated. “I think it would not be outlandish to believe that the actual tax gap could approach and possibly exceed $1 trillion per year,” said Rettig.

While increasing the IRS budget would help combat illegal tax evasion, it won’t completely solve the inequality within the US tax system. “Additional IRS funding would not change the fact, under current law, it’s easy for billionaires to pay a small amount of tax relative to their wealth (or relative to their true economic income),” Zucman wrote in an email to ProMarket.