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THE TAX GAP AND THE SCHMUCK FACTOR

December 29, 2005

The recent "tax gap" figures from the Commerce Department's Bureau of Economic Analysis have triggered divergent comments on the tax blogs.

Kerry Kerstetter of TaxGuru.net calls the tax gap "fictional," and says:

I saw a summary of that report yesterday and figured right away that this was another case of our rulers comparing apples and oranges. There are so many ways to calculate the value of economic activity in this country (GNP and GDP are just two), that it is impossible to match any of them up with what is shown on income tax returns. Anybody who claims that such a comparison is possible has been smoking far too much wacky weed to be trusted.

As we have seen for several years, the mainstream media don't care one whit about accuracy when it gets in the way of their agenda. Giving more power to the IRS has obviously been their goal for a very long time, and anything they can use to bolster that argument will be used regardless of its legitimacy.

Villanova's Dr. Maule says the gap is all too real:

The tax gap, for those unfamiliar with the term, is the difference between income that is reported to the IRS and income that should have been reported to the IRS. The BEA uses economic data from other sources, such as payroll information provided to state and federal agencies, to determine how much income of a particular sort was derived by taxpayers. It then uses IRS data to determine how much of that income was reported.

The tax gap for calendar year 2003, the latest year for which sufficient statistical information is currently available, is $1.0417 trillion. Yes, more than $1 trillion. Compute the tax on that amount, pay it to the Treasury, and re-determine the budget deficit.

Mr. Kerstetter has said that he believes people overpay their taxes. He bases this conclusion on what he sees in his own practice, where he typically gets refunds when taxpayers hire him. That's surely true, but it is also an example of "selection bias." The people who see Mr. Kerstetter want to pay their taxes -- or, perhaps more accurately, they don't want to get in trouble for not paying their taxes. These are the people most likely to have overpaid their taxes out of excessive caution.

He doesn't see those who aren't afraid to cheat. He doesn't see the restaurant owners who don't ring up the cash sales, the e-bay entrepreneurs who put their income off the books, or the business owners that have their company pay their personal expenses.

Tax cheating is in many ways more natural than tax paying. The government will still be there if any given person cheats on their taxes; why pay for it if it will be there anyway -- especially when you suspect that guy next door is cheating, too.

In "The Wisdom of Crowds," James Surowiecki explains what it takes to get people to pay their taxes:

When it come to solving the collective problem of how to get people to pay their taxes, then, there are three things that matter. The first is that people have to trust, to some extent, their heighbors, and to believe they will generally do the right thing and live up to any reasonable obligations. The political science professor John T. Scholz has found that people who are more trusting are more likely to pay their taxes and more likely to say it's wrong to cheat on them. Coupled with this, but different from it, is trust in the government, which is to say trust that the government will spend your tax dollars wisely and in the national interest. Not surprisingly, Scholz has found that people who trust the government are happier (or at least less unhappy) about paying taxes.

The third kind of trust is the trust that the state will find and punish the guilty, and avoid punishing the innocent... If people think that free riders -- people not paying taxes but still enjoying all the benefits of living in the United States -- will be caught, they'll be happier (or at least less unhappy) about paying taxes. And they'll also, not coincidentally, be less likely to cheat.

The "schmuck factor" is the inverse of these "three kinds of trust." The lower these levels of trust, the higher the schmuck factor. If you think you are paying for something your neighbors are getting for free, and they are getting away with it, you feel like a schmuck. Nobody wants to be schmucked.

I suspect that the rise of the tax shelter industry and the decline in audit coverage during the 1990s caused a lot of people to feel schmucked. The ridiculous degree of complexity that has crept into the tax law since 1986 surely hasn't helped. Along with the anti-enforcement legislation resulting from the farcical Congressional hearings on IRS abuses of the 1990s, these problems have raised the schmuck factor to dangerous levels.

Dr. Maule identifies (correctly, in my view) two steps needed to close the tax gap:

Congress must reform the income tax system so that it is easy to understand, inviting of compliance, and difficult to evade. Congress must also put in place safeguards that prevent noncompliance and punish tax evaders.

Unfortunately, the longer Congress waits, the more painful the fixes, and they don't seem to be in any hurry.

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