The IRS estimated the annual tax gap of what was owed and what was collected as, “…the annual tax gap for 2008-2010 is estimated to be $458 billion, compared to $450 billion for tax year 2006.” We know that the Cebula-Feige estimate of tax evasion for the same period is $600 billion. These numbers can no longer be ignored by the Congressional leaders promoting tax reform, but they are still in denial about how to fix the problem.
As Fran Tarkenton, the great Minnesota Vikings quarterback, said, “Ignoring facts does not make them go away.” Congressional leaders must not ignore either the existing tax evasion situation, or the fact that it is going to increase in the next few years. The rapidly changing character of our U.S. workforce means that fewer people will be employees and subject to withholding and that, historically, people not subject to withholding will have much higher rates of evasion. Why?
Because taxes are not withheld before they receive their income, people not subject to withholding will receive 100% of their money. Then they calculate their taxable income and pay “their money” to the U.S. Treasury. Obviously, if they decide to “not report” some cash income or take some “exaggerated” deductions, they will be able to keep more of the money they received. Since there seems to be no public outcry against people who “falsify” their income, it is becoming more and more common.
If the income/payroll tax system will have higher levels of evasion in future years, why do these Congressional leaders cling to only making changes to the existing system? The answer is that the existing system works for them—if not for everyone else. However, they can’t say this so they rely on the false proposition that it is only necessary to lower the income tax rates and make filing returns simpler to reduce tax evasion. While there is some evidence that if all the tax rates were lowered that there would be less evasion, it is demonstrably not correct if only federal income tax rates are lowered.
Although this excerpt from an International Monetary Fund study is used to defend their actions, it is important to note the part that we have put in bold that is ignored by the Congressional leaders.
"Macroeconomic and microeconomic modeling studies based on data for several countries suggest that the major driving forces behind the size and growth of the shadow economy are an increasing burden of tax and social security payments… The bigger the difference between the total cost of labor in the official economy and the after-tax earnings from work, the greater the incentive for employers and employees to avoid this difference and participate in the shadow economy. …Several studies have found strong evidence that the tax regime influences the shadow economy."
Here Are The True Facts
Tax evasion is not done just by people who operate illegal businesses or mobsters. It is mostly done by people who are reporting income but who have found a way to not report cash they receive and/or people who exaggerate or even create deductions from taxable income. For example, instead of deducting the portion of their home that is their home-office, some will deduct the entire cost of the house as business rent. Others deduct all of their food and all of their families' cell phone expenses—even though they are not business related.
There are many other examples but not reporting cash and each of these fictitious or exaggerated deductions reduce the amount of taxable income that is subject to federal income/payroll taxes and state income taxes.
A person who is self-employed subtracts his/her business expenses from gross income to arrive at the amount of taxable income. Payments for Social Security and Medicare taxes are a percentage of this taxable income amount. State income taxes are also a percentage of this taxable amount.
If someone is going to reduce the amount of taxable income by either not reporting cash payments or by exaggerating or inventing deductions, they are not only evading federal income taxes but also Social Security/Medicare taxes and state income taxes. Most state income tax returns are based on the federal income tax return. This can be demonstrated by the example below of Jack the Plumber.
Jack operates his plumbing business as a sole proprietor and reports his income and expenses on Schedule C of his 1040 income tax return. Jack also pays 15.3% of the net income from his plumbing business for Social Security/Medicare taxes, and we assume the average state income tax rate of 5%. He is married and files a joint federal income tax return.
In the first example, Jack correctly reports his income and takes only proper deductions and has a net taxable income of $80,000. Below is an example of the taxes he will owe.
Taxable Income $80,000
Federal Income tax 11,549
Social Security & Medicare taxes 12,240
State income tax 4,000
Total Taxes $27,789
Combined Tax Rate 35%
In the second example, Jack doesn't report all the cash he receives and takes improper deductions and only reports taxable income of $60,000, reducing his combined tax rate from 35 to 25% Below is an example of the taxes he will owe.
Taxable Income $60,000
Federal Income tax 6,067
Social Security & Medicare Taxes 9,180
State Income Tax 3,000
Total Taxes $20,256
Combined Tax Rate 25%
By improperly reducing his taxable income by $20,000, Jack has an additional $7,533 available for his consumption. ($27,789 - $20,256 = $7,533)
If Congress passes legislation that reduces Jack's federal income tax rate by 25%, then Jack's tax calculation would be the following :
Taxable Income $80,000
Federal Income tax 8,661
Social Security & Medicare taxes 12,240
State income tax 4,000
Total Taxes $24,901
Combined Tax Rate 31%
In the second example, Jack doesn't report all the cash he receives and takes improper deductions and only reports taxable income of $60,000, reducing his combined tax rate from 31% to 28% Below is an example of the taxes he will owe.
Taxable Income $60,000
Federal Income tax 4,550
Social Security & Medicare taxes 9,180
State Income Tax 3,000
Total Taxes $16,730
Combined Tax Rate 28%
What Will Make Jack Stop Evading
Presently, Jack knows that his chances of being audited are less than 1%. He also knows that since he is reporting a substantial portion of his income, even if he is audited the chances of his evasion being caught are not assured. Finally, Jack knows that even if his evasion is discovered, it is almost 100% certain that the only punishment will be to pay the evaded taxes along with interest and some penalties.
Our question to the Congressional leaders is why will Jack suddenly start paying his actual taxes? He has already made the decision that it is ok to cheat.
Conclusion
Is it possible to reduce income/payroll tax evasion? It certainly would have an impact on a person’s decision to evade if Congress:
- Passed legislation to dramatically increase criminal prosecutions for income tax evasion
- Imprisoned 50,000 to 100,000 people each year instead of 2,000
- Authorized the hiring of tens of thousands of new IRS auditors and insisted that they conduct extensive audits requiring verification of every deduction
- Increased dramatically the penalties and interest imposed on anyone found to owe taxes by these IRS auditors
The Congressional leaders that are ignoring the facts that their "reforms" to the present income/payroll tax system will not lead to lower amounts of evasion should remember the words of Abraham Lincoln who said "You cannot escape the responsibility of tomorrow by evading it today.
YOUR CHANCE TO BRING ABOUT REAL TAX REFORM
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Through the "Hope and Change" of the last eight years and the promises to "Make America Great Again," what is Congress and the new administration offering us as tax reform? At this point, both President Trump and the Speaker Ryan are offering a modification of the current failed system. As Kerry Bowers, one of The FAIRtax Guys interviewees, said about Speaker Ryan's "A Better Way" plan, "It transforms the tax plan from a personal income tax, a corporate income tax and a payroll tax enforced and administered by the IRS to a system that includes a personal income tax, a corporate income tax and a payroll tax enforced and administered by the IRS." Is this the best way?
As The FAIRtax Guys discuss in their weekly podcasts, this plan does not represent "Hope and Change" and is not the way to "Make America Great Again." We need true tax reform; we need the FAIRtax. And we provide the listener new and novel ways to discuss the FAIRtax with your friends and neighbors every week.
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