Photograph by Daniel Acker/Bloomberg
IRS 1040 Individual Income Tax forms
The season of W-2s and 1099s is nearly upon us. As millions of Americans gear up for the annual national agony of filing tax forms, a minority are deciding how much of their income they actually want to report. Almost $400 billion in federal revenue is lost to tax cheats each year—much of it connected with firms and individuals under-reporting the income they make from selling goods and services to consumers.
One way to deal with that problem is to encourage consumers to report how much they’ve spent and where they spent it, providing a check on the sales figures. The city of Sao Paulo, Brazil, has found a way to encourage people to accurately report that information: It pays them for it. The result has been a dramatic rise in tax revenue. It’s time to try something similar in the U.S.
The IRS’s latest estimates (for 2006 ) suggest that about 83 percent of all federal taxes due are paid voluntarily and on a timely basis. Another 2.4 percent are paid late or after the IRS enforces payment. That leaves close to 15 percent of federal taxes owed that are never paid—about $385 billion a year. If that $385 billion were collected, it could fund universal pre-K for 4-year-olds. double the size of both the Earned Income Tax Credit and the U.S. Air Force budget. and reduce the deficit by more than a quarter —all at the same time.
One simple way to reduce the amount of unpaid taxes would be to hire more professional auditors at the IRS. The return on investment in more auditing is about $10 in extra revenue for each additional dollar spent on IRS audit and collection efforts. But an additional way would be to enlist American citizens to help audit some of the most consistent tax cheats: retail businesses.
The IRS tax gap report notes that “Overall, compliance is highest where there is third-party information reporting and/or withholding. … As a result, a net of only 1 percent of wage and salary income was misreported. But amounts subject to little or no information reporting had a 56 percent net misreporting rate.” That includes things like rents and, most significant, retail business income. Whereas firms have an incentive to report wages paid because it reduces their own tax liability, retail customers don’t get anything from reporting where and how much they spent on a meal out, or a bathroom remodel, or a guitar at the local music store. As a result, businesses can get away with under-reporting sales, which reduces their reported income, and so the taxes they report due to Uncle Sam.
A number of countries and states are experimenting with a way to encourage customers to report that sales information by submitting receipts. Tax authorities in Brazil, China, Puerto Rico, Bolivia, and Italy, among others, use tax refunds, lotteries, or fines to encourage consumers
to collect and report payments they make to retailers.
In the State of Sao Paulo in Brazil, customers who ask for a receipt can give their social security number to the cashier. Businesses have to submit their copy of those receipts—with or without social security numbers—to the tax authority. The authority creates an account for every social security number entered into the system and reports to customers which receipts have been entered with their social security number and how much they are for. Customers receive a rebate worth about 30 percent of their share of sales taxes paid through the business each month, and for every $50 of receipts they are entered into a lottery with a maximum payout of $500,000. They can complain online if they think receipts are missing or have the wrong price.
Joana Naritomi, a Harvard economist, studied the impact of the Sao Paulo experiment, which has been running since 2007. She found 13 million consumers enrolled in the receipts database at the end of 2011. The system registered more than 1 million complaints involving about 13 percent of the 1 million retail and wholesale establishments in the region. Most important, Naritomi finds that the program increased the reported revenues of retail firms by 22 percent over four years. She shows that reported revenues went up not because real revenues increased, but because reporting became more honest. The result was an additional $2 billion in tax payments. The system paid out $1.6 billion in rewards to consumers over that time, translating into a $400 million increase in net income for the region.
In Sao Paulo the big impact of the program was to increase value added tax payments (that’s a form of sales tax) to the regional government. And, to return to the U.S. that points up the fact that it isn’t just the federal government that loses out from retail businesses under-reporting sales income. In 19 American states the sales tax accounts for more than one-third of total revenue. So if we created incentives like Sao Paulo’s, we’d be doing a favor at both the state and federal level.
The IRS reports that more than half of revenue from activities where there’s no easy way to confirm taxpayer income information is misreported to the government. The biggest perpetrators are small retail businesses, alongside those earning rents and royalties. The same misreporting percentage drops to 11 percent where there is at least some additional information available to double-check taxpayer statements—in cases like deductions and exemptions. Reduce the misreporting ratio on the currently unconfirmed revenues from 56 percent to 11 percent through techniques like receipt collection and you’d add $70 billion to federal coffers alone—which sounds like a good investment. Even small government advocates should like such a program, because consumers get tax rebates as rewards. In other words, honest people pay lower taxes and only crooks and scroungers pay more. That might bring a smile to many a harried filer this April 15.