Tax Audits, Economics, and Racism
Tax Audits, Economics, and Racism
- Francine J. LipmanFrancine J. LipmanWilliam S. Boyd School of Law, University of Nevada Las Vegas
Since 2010, Congress has significantly cut the annual budget of the Internal Revenue Service (IRS) while requiring the IRS to manage more responsibilities, including last-minute comprehensive tax reform, health care, broad-based antipoverty relief, and a variety of economic stimulus provisions. As a result, the IRS has sustained across-the-board decreases in staffing, with the most significant decreases in tax enforcement personnel. The IRS has fewer auditors than at any time since World War II, despite an explosion of concentrated income and wealth. Predictably, the tax gap, the difference between what taxpayers owe and what taxpayers pay, has skyrocketed to almost $1 trillion a year. Economists have estimated that funding the IRS will pay for itself severalfold, raising more than a trillion dollars of uncollected tax revenues over a decade.
Despite evidence that funding will remedy budget shortfalls severalfold, Congress continues to defund the IRS. While the bulk of the tax gap is due to unreported income by high-income individuals, the audit rate of these households has dropped precipitously. By comparison, the lowest income wage earners are being audited five times more often than all other taxpayers. Given centuries of racist policies in the United States, households of color are disproportionately impoverished and white households are disproportionately wealthy. Accordingly, lower income working families of color, especially in the South, are audited at rates higher than their white northern counterparts. Moreover, because these households and the IRS have limited resources, many of these audits result in taxpayers losing antipoverty benefits that they have properly claimed. This discriminatory treatment is counter to Congressional intent to support these families and exacerbates existing racial income and wealth gaps. With President Biden’s 2021 executive order on advancing racial equity and support for underserved communities through the federal government, the U.S. Treasury, IRS, and Congress have been charged to “recognize and work to redress inequities in their policies and programs that serve as barriers to equal opportunity.” Properly funding the IRS is a necessary step to advancing racial equity.
- Health, Education, and Welfare Economics
- Law and Economics
- Public Economics and Policy
The Internal Revenue Service (IRS) is the federal agency charged with tax revenue collection. In fiscal year 2020, the IRS collected $3.5 trillion in taxes, which represented approximately 96% of aggregate annual federal funding (IRS, 2020a). In its mission statement, the IRS asserts that its primary role is to enforce tax laws. The IRS’ website announces that it is responsible “to help the large majority of compliant taxpayers with the tax law, while ensuring that the minority who are unwilling to comply pay their fair share,” among similar duties (IRS, 2020b). Nevertheless, the IRS’ most recent official estimate of the “tax gap” or the amount of net taxes owed by taxpayers who did not “pay their fair share” even after IRS enforcement efforts was $1.143 trillion for the 3-year period 2011–2013 or $381 billion average annually (Forman et al., 2021). This amount is more than all the income taxes paid by 90% of all taxpayers (Forman et al., 2021; Rossotti & Forman, 2020, Rossotti, 2020). Assuming constant compliance rates, the U.S. Treasury has estimated that the tax gap in 2019 was $584 billion, $7 trillion over the decade, or 15% of annual tax liabilities (IRS, 2019; Forman et al., 2021). Economists have estimated that the tax gap was at least $630 billion in 2020 (Sarin & Summers, 2020).
Despite these titanic uncollected tax obligations and the IRS’ patent failure to accomplish its charge and stated goal every year, Congress has significantly cut the IRS budget since 2010. Budget cuts have occurred even though Congress has been requiring broader and deeper IRS engagement in tax reform, health care, antipoverty programs, and economic stimulus payments. The IRS has responded to these budget cuts and additional work with meaningful decreases in its enforcement activities even with increasing annual tax gaps. Most notably, the audit rates of corporations and high-income individuals have dropped precipitously. Audits on millionaires have plummeted 71% (Center on Budget and Policy Priorities, 2021), and those on large corporations have dropped 51% (Huang, 2020). Thus, voluntary compliance rates likely have not stayed constant and more likely have declined.
Past IRS commissioners and notable economists have found that the IRS’ reported estimate of the tax gap significantly understates sophisticated tax evasion among wealthy taxpayers and large corporations (Alstadsaeter et al., 2019; Debacker et al., 2020; Forman et al., 2021; Guyton et al., 2021; Johns & Slemrod, 2010). In testimony before Congress, IRS Commissioner Charles Rettig estimated that the tax gap could be as high as $1 trillion a year or almost 30% of gross revenues (Davison, 2021). Unless systemic changes are made, Americans can expect to lose 3% of gross domestic product (GDP) or $7.5 trillion in tax liabilities due and payable under current tax law over the next decade (Rossotti et al., 2020; Forman et al., 2021; Sarin, 2021).
The IRS, economists, scholars, and policy experts generally agree on an effective remedy. The tax gap could be reduced by increased funding for targeted IRS enforcement that would more than pay for itself severalfold (Forman et al., 2021; Holtzblatt, 2021; Huang, 2020; U.S. Department of the Treasury, 2021). Despite this obvious and lucrative remedy, Congress has done the opposite while certain representatives simultaneously complain about increasing federal deficits. Why has Congress defunded the IRS when the annual tax gap has soared? Why has the IRS decreased audits of the highest income taxpayers and largest corporations when economists have estimated they are responsible for more than 70% of the tax gap? This article attempts to provide a critical tax framework with which to analyze this enigma.
Tragically, the problem is consistent with the misallocation of funding in other government enforcement agencies (e.g., militarization of state and local police in cities that are predominately Black and excessive spending on Mexican versus Canadian border control). When laid bare, the tax system through enactment of statutes passed by Congress and enforced by the IRS privileges white wealthy households and disadvantages households of color (Lipman, 2006, 2011; Lipman et al., 2020), especially Black families (Brown, 2021). This article contributes to the critical tax literature by revealing systemic and institutional racism in the economics of the IRS’ administration of tax audits.
Specifically, this article demonstrates that Congress’ chronic underfunding of the IRS, despite a documented substantial return, is not only inconsistent with fundamental economic goals of collecting tax revenues and reducing debt and borrowing but also grounded in racist policies. The IRS disproportionately audits low-income households of color despite evidence that the tax gap is overwhelmingly due to high-income white households underreporting their income. Lower income households that are disproportionately Black and Latinx because of centuries of racism are audited at five times the rate of all other taxpayers (Transactional Records Access Clearinghouse, 2022). Moreover, given that these households lack the necessary resources to respond timely compared to their wealthy neighbors and the IRS’ inability to even answer its phones and timely open its mail, most low-income households that are audited lose properly claimed antipoverty tax benefits (National Taxpayer Advocate, 2020b). This structure is not only unjust but also undermines the integrity of and faith in the U.S. tax system. Given that the tax system funds most of the federal government through a self-assessment structure, confidence is paramount to its stability and success (Fichtner et al., 2019). This article details the depth and breadth of the racial inequities in Congress’ defunding of the IRS, including the crippling cost of racist tax administration for all of us.
In this article, the next section on “Racial Wealth/Income Inequality” describes the demographics of the populations that are at issue in this analysis. The tax system does not work in a vacuum but, rather, is imposed on populations with existing profiles that are the result of societal values and short-term and long-term economics. Because of “baked in” tax profiles from hundreds of years of economic advantage or discrimination, facially neutral laws may obscure racism that is apparent when disparate consequences are revealed (Brown, 2021). Because these demographic profiles are readily available and known, especially to legislators, seemingly even-handed laws are racist when no other rational basis exists for structures that cause patently racially discriminating results. A striking example presented is the economic overpolicing of tax benefits in communities of color (Harriot, 2019; Kiel & Fresques, 2019).
As a result of targeted auditing of the Earned Income Tax Credit (EITC) despite a relatively modest or even effectively no contribution to the tax gap or aggregate net cost to the federal government, certain counties of color essentially have been denied EITC benefits. From 2012 through 2015, taxpayers in the top 100 audited counties in America, 62 counties of which are in Georgia, Mississippi, and Texas, were conspicuously poor, Black, and Latinx. Yet up to 70% of the perhaps $1 trillion annual tax gap was due to wealthy, predominately white taxpayers (Sarin & Summers, 2019). By comparison, the top 15 highest income counties in America, which are disproportionately white, have an average audit rate of 7.75 (about equal to the national average audit rate of 7.69) returns per 1,000 filers. Impoverished communities of color suffer high audit rates in America (as high as 11.8 returns per 1,000 filers) even though white wealthy households are overwhelmingly responsible for the tax gap (Harriot, 2019.
The section on “Tax System Design” includes a brief description of foundational issues in tax system design. These structural designs generally advantage white taxpayers over taxpayers who are disproportionately individuals of color. The section of the article on “Tax System Institutional Racism” describes Congressional defunding of the IRS that has led to a significant reduction in enforcement. Together with unjust targeting of certain social benefits, the IRS increasingly audits lower income working families, who are disproportionately impoverished and Black, at the same rate as the highest income taxpayers, who are disproportionately wealthy and white due to economic advantages. This has led to an irrational economic policing of Congressionally approved social benefits at the cost of an exploding tax gap. Moreover, this unjust targeting financially harms families of color, especially children, and their similarly economically challenged communities and businesses. The section on “Tax Gap Analysis” presents the magnitude and components of the tax gap.
The tax gap is overwhelmingly due to wealthy white households relative to impoverished households of color. However, county-by-county audit rates show that communities of color are aggressively audited with little meaningful recourse (Harriot, 2019; Kiel & Fresques, 2019). Tragically, there are many economic consequences to these communities when as much as a trillion dollars of tax revenue annually in the United States goes uncollected. Without these resources, Congress has increased financial pressure to fund fiscal needs with new taxes and fees on honest taxpaying Americans or alternatively impose spending shortfalls on known financial needs. Fortunately, the remedy is obvious: Fund and target IRS enforcement on the perpetrators of the tax gap (Marr et al., 2021; Forman et al., 2021). Treasury must no longer financially advantage wealthy white households and disadvantage communities of color through tax enforcement. This article lends compelling evidence to confirm that the misallocation of tax enforcement on impoverished communities of color is not only unjust, inequitable, and racist but also exacerbates the racial wealth and income gaps through the tax system.
Racial Wealth/Income Inequality
This section describes the financial consequences of hundreds of years of discrimination that have advantaged white Americans and disadvantaged families and communities of color. Context matters, because government systems and institutions do not operate in a vacuum but, rather, interact with existing populations that are neither homogeneous nor treated uniformly. This has proven to be true even if the laws or Constitution demand otherwise (e.g., racial and sex-based discrimination is unconstitutional, and tax laws must be uniform). As a result of these distinctions and disparities, taxpayer profiles emerge that cannot be ignored because they impact economic consequences on a micro and a macro level. Indeed, statutory requirements based on specific taxpayer profiles (e.g., phase-in and phase-out thresholds, household structure, age-based benefits, character of income, and immigration status) are used by Congress to target certain tax benefits or burdens to specific populations (Huang & Taylor, 2019). Even laws, systems, and institutions that appear to be neutral can be discriminatory and racist in application and economic consequences (Brown, 2021). This is especially true if the playing field has not been and is not equal, causing ostensibly neutral laws and procedures to have unequal or racist impact. As a result of significant differences in power, society does not afford equal opportunity to all (McIntosh et al., 2020).
Centuries of explicit and implicit discrimination suffered by communities of color, particularly Black, Latinx, and Indigenous individuals, have caused significant income and wealth inequality in America (Wiehe et al., 2018). Income and wealth gaps are not an accident but, rather, the result of centuries of federal and state policies that have systematically facilitated the financial success of white households and the impoverishment of households of color (Darity & Mullen, 2020). Substantial systemic and institutional changes and redress are necessary (rather than “individual responsibility”) to narrow gaps related to insurmountable barriers such as generational asset poverty, legacies of wealth-stripping tactics in housing and lending markets, and other discriminatory practices (Kent & Ricketts, 2021).
Wealth and income disparities between white households and households of color have persisted for centuries. Compelling federal, state, and local data have been apparent and reported consistently demonstrating these gaps for at least three decades (Kent & Ricketts, 2021; Weller & Roberts, 2021). Even before the COVID-19 pandemic, racial income and poverty gaps were crippling. The Census Bureau reported that 2019 median income for white households was $76,057 and only $56,113 and $45,438 for Hispanic and Black households, respectively (Creamer, 2020; Semega et al., 2020). More than a quarter of Black children and 20.9% of Hispanic children fell below the poverty line in 2019, compared to 8.3% of white children (Semega et al., 2020; Wilson, 2020). The Federal Reserve notes that before the global pandemic, white families had eight times the wealth of Black families and five times the wealth of Hispanic families (Bhutta et al., 2020; Dettling et al., 2017). White families have and have had the highest median ($188,200) and mean ($983,400) family wealth, whereas Black families’ median ($24,100) and mean ($142,500) wealth are less than 15% of those of white families’ (Bhutta et al., 2020).
In addition to the magnitude of net worth, there are substantial disparities in the nature of the assets owned by race and ethnicity. Not only are white families much more likely to receive an inheritance, own a home, hold equities, and have a retirement plan but also in all cases the values of these assets are significantly more for white households compared to households of color (Bhutta et al., 2020). The wealth gap between Black households and white households was larger in 2019 than in 2004 and 2007, before the Great Recession (Weller & Roberts, 2021). Post-2019 data suggest that the 2020–2021 pandemic has resulted in a similar pattern of widening the already dehumanizing racial wealth gap (Weller & Figueroa, 2021).
Discriminatory tax policies have meaningfully contributed to income and wealth inequality generally and have exacerbated America’s persistent racial wealth gap (Huang & Taylor, 2019; Lipman et al., 2020). Together with a long history of systemic racism in government policies and institutions and in American society at large, tax policies have built and continue to build wealth for white households at the expense of the economic well-being of households of color (Lipman et al., 2020). The federal government spends more than $400 billion annually through the income tax system supporting wealth building predominately benefiting high-income white households (Urban Institute, 2017). The top 20% of income households receive approximately 67% of aggregate homeownership and retirement subsidies. The bottom 20% of income households receive less than 1% of these tax benefits. Black, Latinx, and Indigenous families have lower median and average household incomes and receive meaningfully fewer tax benefits than white households both in total amount and as a percentage of their incomes (Huang & Taylor, 2019; Urban Institute, 2017).
Despite record U.S. income inequality, not only relative to its own five decades of history but also relative to all G7 developed nations according to the Organisation for Economic Co-operation and Development, and an even more severe wealth gap that has doubled from 1989 to 2016, Congress has continued to exacerbate rather than mitigate overall and racial inequality. For example, in 2017, Congress wrote and passed into law the $1.9 trillion 2017 Tax Cut and Jobs Act (2017 TCJA). Experts have estimated that 80% of the 2017 TCJA tax benefits go to white households, resulting in a 2018 average tax cut of $2,020 for white households, $970 for Latinx households, and $840 for Black households (Schaeffer, 2020; Wiehe et al., 2018). The top 20% of income households received 78% of the 2017 TCJA aggregate tax cuts. Although the largest number of low-income households are white, because white Americans continue to outnumber other races, due to centuries of discrimination Black and Latinx households are disproportionately lower income and make up 74% of the bottom 60% of income households (Creamer, 2020; Wiehe et al., 2018). Consistent with 2017 TCJA targeting, Black and Latinx households represent 10.2% and 11.9% of tax filers but received only 5.0% and 6.7% of the benefits, respectively (Wiehe et al., 2018).
Racial disparities exist even more dramatically at the highest levels of household income and wealth. In 2010, Black Americans comprised 13.6% of the population but only 1.4% of the top 1% of households by income. white households represented 96.2% of the top 1% of households by income, and Latinx households represented merely 0.9% (The Grio, 2011). Even more dramatically, the median wealth of the top 1% of white households was $8.3 million, whereas median wealth of the top 1% of Black households was less than 15% of this amount at $1.2 million. This measure of lower median wealth reflects not only fewer assets and lower values but also more debt than that of their white counterparts. Median household debt for these wealthy Black households was $1,370,000 in 2010, which was 356% higher than that of white counterparts at $300,000 (The Grio, 2011). Whiteness correlates positively with wealth (Brown, 2021; Traub et al., 2017).
The federal tax system continues to exacerbate these differences. The average tax cut in the 2017 TCJA for white households in the top 1% of income levels was more than $52,000, whereas Latinx and Black counterparts only received $19,850 and $19,290, respectively (Wiehe et al., 2018). This stark difference results from the significant 2017 TCJA tax benefits that Congress delivered for income from wealth or capital versus income from work or labor. Because of historic discrimination, even the wealthiest Black and Latinx households own relatively fewer wealth-producing assets and, therefore, a higher percentage of their income is based on labor rather than capital. Because of this economic profile, even the highest income Black and Latinx households were targeted to receive aggregate 2017 TCJA tax benefits that are less than 40% of amounts enjoyed by their white counterparts. This targeting of tax spending to wealthy white households is antithetical to mitigating the racial wealth gap and to an equitable and fair tax system.
Racial income and wealth gaps cannot be explained by lack of individual responsibility, family values (e.g., marriage), education, or work (Hamilton et al., 2015). For families of color, working and studying hard do not translate into the same wealth accumulation as that of their white counterparts (Kent & Ricketts, 2021). Stratification of economic data has demonstrated that the payoff for education for Black families pales by comparison to that of white counterparts and even by comparison to white families who have invested significantly fewer resources in their education (Francis & Weller, 2020). Black families whose heads of household earned a college degree have less than 67% of the average wealth of white families headed by a high school dropout (Hamilton et al., 2015). Black families headed by individuals with professional or graduate degrees have less wealth than white families headed by individuals without a college degree but some college attendance (Hamilton et al., 2015). Recent research shows that Black college graduates’ wealth declines after graduation because they are more likely to support family members financially and carry higher debt loads compared to white counterparts (Meschede et al., 2017).
Racial identity is a stronger predictor of wealth than occupational sector for Black households (Addo & Darity, 2021). Similarly, even full employment does not remedy the racial wealth gap. As a result of discrimination, including “occupational segregation,” individuals of color earn up to $1 million less than white individuals over their lifetimes (Urban Institute, 2017). This lifetime earnings gap increases by almost 50% at the intersection of race and gender (Urban Institute, 2017). White families with a head of household who is unemployed have nearly twice the median wealth of Black families with a head of household who is employed full-time ($21,892 vs. $11,649) (Hamilton et al., 2015).
Even aggregate household income fails to mitigate the racial wealth gap. At every income level, the wealth of Black households is a fraction of that of their white counterparts even though Black households save slightly more (Gittleman & Wolff, 2004). Despite incessant focus, family structure is not the cause of the racial wealth gap given that median single-parent white households have more than twice the wealth of median two-parent Black or Latinx households (Traub et al., 2017). Since the time of slavery, families of color have faced structural barriers to income and wealth accumulation while white families have received meaningful government subsidies (Hamilton et al., 2015; Lipman et al., 2020).
The global pandemic, like the Great Recession, has exacerbated income and wealth inequality especially for communities of color that have been disproportionately segregated into essential work. These workers and their families have notably fewer health care benefits and safety nets and, therefore, have suffered higher rates of COVID infection, hospitalization, and death (Monte & Perez-Lopez, 2021; Snowden & Graaf, 2021). Scholars note that economic calamities such as COIVD-19 cause a feedback loop with income and wealth inequality causing poor health and poor health exacerbating economic inequality (Snowden & Graaf, 2021). Despite record COVID relief saving approximately 18 million from monthly poverty at the height of the economic crisis in April 2020, 8 million people were pushed into poverty (Parolin et al., 2020). This increase in poverty was especially acute for Black and Latinx households as well as for the 2.5 million children who were pushed into poverty during this period (Francis & Weller, 2020). By comparison, the aggregate wealth of predominately white U.S. billionaires increased 60% from $2.9 trillion on March 18, 2020, to $4.7 trillion on July 9, 2021 (Collins, 2021). These trends have exacerbated inequality and increased the poverty gap between white and Black or Latinx individuals by approximately 1% to 2% (Parolin et al., 2020).
Given generations of systemically subsidized white households versus generationally deprived households of color, predictable financial profiles emerge for these households that are a direct result of racially targeted institutional benefits and burdens. The next section includes a brief description of how foundational structures in the U.S. tax system exacerbates benefits and burdens. These structural designs further advantage white taxpayers over taxpayers of color because of these pre-existing and persistent financial and tax profiles (Brown, 2021; Lipman et al., 2020).
Tax System Design
Under the Constitution, Congress has plenary power to enact U.S. tax laws. The U.S. tax system has been and is a long-standing self-assessment system. Individuals, rather than the government, generally have the burden of tax liability calculations, assessment and proof including record-keeping, documentation, preparation, and tax return filing. The legislative branch of the government passes tax laws, the president signs them into law, and the U.S. Treasury, through the IRS, enforces them. Since the late 1990s, fiscal social benefits have been increasingly delivered by the Treasury through the federal income tax system. Congress has used the tax system to deliver these benefits for several reasons, including that it has increasingly required annual earned income as a condition precedent (e.g., welfare-to-work) for means-tested benefits. Moreover, participation in these tax system benefits tends to be higher than that for other delivery methods because taxpayers with earned income must use the tax system to determine their annual earnings, tax liability, and claim any tax refunds or pay any amount due every year. Because the federal income tax withholding system is designed to over- versus underwithhold, taxpayers subject to withholding must prepare and file annual tax returns to receive their overpaid taxes or tax refunds.
Taxpayers whose income comes predominately from wages are disproportionately lower income and Black or Latinx. Communities of color, compared to white wealthy households, are more likely to overpay their tax liabilities throughout the year through wage withholding and file their tax returns to collect their overpayments or tax refunds. Consequently, tax compliance for wage earners is 99% or at least twice the compliance rate for most other types of income (IRS, 2020a). Using the federal income tax system, a system that working families are already having to engage with each year to collect their tax overpayments, to similarly deliver social benefits should be efficient. As a result of this structure and delivery design, lower income wage-earning families who are predominately white, but disproportionately Black and Latinx, have been increasingly reliant on the IRS to deliver critical financial resources. Generally, because of their financial profiles and the tax system design, these families are part of the “large majority of compliant taxpayers” given that as a group they are more likely to be subject to wage withholding, seeking cash refunds, including Congressionally approved and appropriated social benefits, delivered by the IRS.
By comparison, higher income white households that generally have more net worth than their counterparts of color have relatively more investment income from accumulated capital than labor income (Bhutta et al., 2020; Gebeloff, 2021). As such, white households have a relationship with the IRS that is more likely self-reporting taxable transactions, not subject to withholding, and must affirmatively self-elect to pay tax liabilities quarterly through estimated tax payments or at year end. Given this tax profile, these households are less likely to have a significant percentage of their income subject to automatic income tax withholding or even information reporting. Accordingly, these wealthy households, which are disproportionately white, engage in interactions with the IRS that can be characterized as disclosing transactions rather than reconciling income with information reported amounts (e.g., W2s and Form 1099s) to calculate and pay their tax liabilities. Whereas wages are subject to significant information reporting and withholding requirements resulting in compliance rates of 99%, business and investment income is less likely to be reported to the IRS by third parties and therefore income underreporting makes up 60% of the individual income tax gap (IRS, 2019). Recent data indicate that the compliance rate for income subject to substantial information reporting but no withholding is 95% (e.g., interest and dividend income) and only 45% for income subject to little or no information reporting, such as pass-through business income (IRS, 2019).
Because of increased tax complexity and significant income and assets, these taxpayers have the resources and motivation to engage sophisticated tax professionals, including certified public accountants and attorneys, to structure, prepare, file, and manage their tax matters. Given this financial profile and tax attributes, these high-income white households are more likely to be part of the “minority who are unwilling to pay their fair share” and are significant contributors to the tax gap. Economists have recently estimated that 70% of the tax gap can be traced to the top 1% of income households (Forman et al., 2021; Sarin & Summers, 2019). The next section reviews how the IRS’ enforcement division differently administers these distinct households.
Tax System Institutional Racism
Defunding the IRS
To address racial economic inequality, policymakers must not only address discriminatory substantive tax laws but also review and address how the Treasury and IRS enforce tax laws (Fichtner et al., 2019; Debacker et al., 2020). For the past 25 years, Congress has been defunding the IRS (Rossotti et al., 2020). At the same time, the number of tax returns has increased by 31%, and Congress has mandated that the IRS implement and integrate new areas of tax law, including complex tax provisions and additional reporting obligations (Rossotti et al., 2020). In fiscal year 2021, the IRS’ enacted budget of $11.9 billion was $200 million less than its budget in 2010 of $12.1 billion in nominal (not adjusted for inflation) dollars (Rettig, 2021).
Since 2010, Congress has decreased the IRS’ budget by 22% in real terms while it simultaneously mandated implementation of significant tax legislation, in some cases retroactively, including, without limitation, the Affordable Care Act in 2010 (ACA), the 2010 Foreign Account Tax Compliance Act, Protecting Americans from Tax Hikes Act in 2015, the 2017 TCJA, and significant 2020 and 2021 COVID economic relief. In the ACA alone, the IRS successfully implemented 47 tax and insurance subsidy provisions, including at least 18 provisions affecting $1 billion or more in federal funds in the first 3 years. In 2020 and 2021, the IRS processed and distributed hundreds of millions of COVID relief payments aggregating $800 billion, including payments to millions of lower income individuals who have not been part of the IRS’ 145 million traditional individual taxpayer base (Holtzblatt, 2021). For decades, the IRS has been asked to do more with less.
Defunding Tax Enforcement
For 35 years, IRS staffing increases remained relatively consistent with GDP growth. However, since 1995, real GDP has increased by 76% and IRS staffing has decreased by 32% (Rettig, 2021). Although Congress has cut the IRS’ budget across all areas, the largest budget cuts have been in IRS enforcement. IRS enforcement suffered a 26% budget decrease and a significant cut in full-time equivalent staff. The IRS’ entire workforce decreased from 112,000 in 1990 to 74,000 in 2019, equal to 1973 staffing levels. More than two-thirds of full-time equivalent personnel losses occurred in enforcement activities. The IRS has fewer auditors than it has ever previously employed since World War II (U.S. Department of the Treasury, 2021). Correspondingly, tax enforcement activities have dropped precipitously.
In response to the decreased budget, aggregate audit rates have decreased by 45% (Huang, 2020). However, audits have not decreased uniformly across all taxpayer types and income ranges. Audit rate reductions have been most significant for the highest income households earning $1 million or more at 75% and the largest corporations with reductions of 50% (Center on Budget and Policy Priorities, 2021; Huang, 2020). In 2011, almost 13% of millionaires and nearly all the largest corporations were audited, compared with only 3.3% of millionaires and less than half of the largest corporations in 2018 (Huang, 2020; Treasury Inspector General for Tax Administration, 2021e). The IRS made these reductions even though estimates suggest that the top 1% of household income individual filers account for as much as 70% of the tax gap (Sarin & Summers, 2019) and the top 0.5% of income households account for 20% of all underreported income (Johns & Slemrod, 2010).
The IRS, aware of this misallocation of resources, developed a “Global High Wealth Industry Group” with the experienced personnel needed to audit high-income taxpayers and the complex entities they own, including pass-through businesses, corporations, foundations, and trusts. IRS Commissioner Steven Miller, during the Bush and Obama administrations, had planned to assign almost 250 examiners to the “wealth squad” in 2009 (Eisenger & Kiel, 2019). However, soon after this concept was implemented, wealthy individuals successfully lobbied IRS, Treasury, and Congressional leadership. In response, Congress defunded rather than funded this well-targeted IRS enforcement effort (Eisenger & Kiel, 2019). During the Obama administration, in 2010 the IRS recommended additional tax assessments on individuals with more than $1 million in income of $5.7 billion. By 2017, during the Trump administration, this amount had dropped to $1.8 billion due to reduced enforcement (Eisenger & Kiel, 2019).
Data on the deterrent effects of audits demonstrate that reduced IRS audit coverage levels during the past few decades have likely emboldened taxpayers to take more aggressive tax positions and undermined voluntary compliance rates (DeBacker et al., 2018b). In turn, public perception of integrity and fairness in the tax system generally and tax enforcement specifically has suffered given increased publicity of high-profile, high-income tax evasion, including allegations about former President Donald Trump. Any reduction in voluntary compliance rates is costly, given that a 1% decline in the rate can result in the loss of more than $30 billion in annual tax revenues (Rettig, 2021).
Policing the EITC
The smallest percentage decrease in audit rates has been for lower income working households that rely on the tax system to deliver their tax refunds including critical social benefits, specifically the EITC (Rossotti et al., 2020). Because of Congress’ defunding of the IRS and targeting of EITC claimants, a lower income working family with children claiming the EITC is as likely to be audited as the top 1% of income households (approximately $500,000 or more) (Kiel, 2019a). In 2021, EITC claimants with $25,000 or less in gross receipts were audited at five times the rate as all other taxpayers (Transactional Records Access Clearinghouse, 2022).
Incongruously, this is the case even though the EITC represents less than 6% of the tax gap (Fichtner et al., 2019; National Taxpayer Advocate, 2018). By comparison, underreported pass-through business income accounts for almost 50% of the tax gap due to underreported income or 35% of the tax gap (Center on Budget and Policy Priorities, 2021). Even the low 6% estimate of the EITC tax gap is likely overstated because of shortfalls in tax gap measurement, demographics of claimants, and the lack of access to tax assistance for most of these taxpayers (Fichtner et al., 2019; National Taxpayer Advocate, 2018).
EITC tax gap estimates are derived from audit results that do not determine whether an EITC claim is legitimate in approximately 85% of cases (National Taxpayer Advocate, 2020b). These disallowances are characterized as overpayments even though this was not determined. Including all EITC disallowances in the EITC tax gap is misleading at best for several reasons. First, these alleged overpayments do not include EITC underpayments. Nationally, EITC participation rates average approximately 80%, with a higher percentage of EITC dollars being distributed of approximately 85% of all EITC estimated benefits (Treasury Inspector General for Tax Administration, 2018). The IRS has calculated that unclaimed EITC benefits represent approximately 40% of aggregate improper payments (National Taxpayer Advocate, 2020b). An example of how this issue might present itself is as follows: Assume a noncustodial parent claims an EITC for her child; the EITC counts as an overpayment because the qualifying child fails the household residency test (National Taxpayer Advocate, 2020b). However, the amount that the proper claimant, the custodial parent, was eligible to claim is not considered. In such cases, the actual loss to the Treasury is the net amount, if any. Moreover, these EITC benefits might be spent on behalf of the qualifying child even though the child did not reside with the noncustodial parent for the required period. Recently, when comparing actual EITC payments with estimated EITC amounts based on U.S. Census data, scholars have concluded that aggregate EITC overpayments are generally equal to aggregate EITC underpayments (Jones & Ziliak, 2019). If accurate, aggregate EITC underpayments fully offset aggregate EITC overpayments. Using this analysis, the net EITC tax gap would be negligible.
Similarly, Bastian and Jones (2020) have concluded that EITC benefits, including program expansions, pay for themselves. These scholars have monetized fiscal savings of 83% of EITC budget costs through a reduction in other government benefits and increased tax revenue. They note that federal EITC benefits will in some cases inure to the benefit of state and local governments given that EITC claimants likely spend their EITC benefits and pay state and local sales and other regressive taxes. These scholars also examined the social value of EITC benefits, including the physical health and well-being of children and members of EITC claimant households; reduced crime and criminal recidivism; reductions in drug use, suicides, and poverty; increased short-term and long-term educational successes and attainments; and increased household income, including retirement benefits. Upon reviewing this long list of societal benefits, they found “strong evidence that the EITC completely ‘pays for itself’” (Bastian & Jones, 2020). Other scholars have noted that there is at least a two-time multiplier benefit effect from the EITC because these tax refunds are spent locally (Avalos & Alley, 2010). Thus, EITC benefits have been shown to stimulate financially challenged communities, including increased local purchasing power, resulting in job creation (Nichols & Rothstein, 2015).
Unlike most taxpayer audits, EITC audits are predominately pre-refund audits (National Taxpayer Advocate, 2020b). This means that the refund due to the EITC claimant is frozen and not dispersed to the taxpayer until they prove affirmatively that they are eligible for the benefits. Ninety percent of self-employed taxpayer EITC audits are pre-refund and are focused on auditing the self-employed income amount, whereas 75% of EITC wage earner audits are pre-refund and focused almost exclusively (96%) on the residency of the qualifying child (Leibel et al., 2020). Therefore, unlike most audits, the taxpayer is suffering an immediate cash shortfall until they prove their eligibility rather than the government seeking monies owed to them from the taxpayer. This structure is different from most tax audits.
Another notable difference is that 99% of EITC audits are correspondence audits, meaning that EITC claimants who are audited receive a letter through the U.S. Postal Service describing the EITC audit issues to be addressed (National Taxpayer Advocate, 2020b). Researchers have found that a significant percentage of EITC correspondence audits result in the IRS denying the credits due to the taxpayer’s nonresponse or insufficient response. Between 69% and 80% of audited claimants never received the notice, failed to respond, or stopped responding before an affirmative determination that they did not qualify for EITC benefits (Guyton et al., 2019; National Taxpayer Advocate, 2020b). These data demonstrate that audited EITC claimants, who are lower income and disproportionately individuals of color, most of whom are working and caring for young children, are unlikely to receive EITC tax refunds even though their claims are not determined to be invalid. By far most audited EITC claims are not confirmed to be valid (or invalid), because the taxpayer does not carry their burden of proof within the time frame according to the IRS. The IRS only confirms ineligibility of 13–15% of EITC audited claims, full eligibility of 6% or 7%, and partial eligibility of 2% of these claims (Guyton et al., 2019; National Taxpayer Advocate, 2020b). Because the disallowance rate is so high, 85–90% of EITC correspondence audits result in changes to the return (National Taxpayer Advocate, 2020b). Most of these changes deny families their EITC benefits without affirmatively determining that the families do not qualify.
The existing EITC audit structure disallows most claims without determining that the taxpayer failed to qualify. This result is due to many societal hurdles such that working families claiming the EITC do not have the resources to carry their burden of proof (National Taxpayer Advocate, 2020b). Similarly, the IRS has not allocated the necessary resources to work with claimants effectively to determine based on the facts at issue whether the taxpayers qualify for the benefits claimed (National Taxpayer Advocate, 2019). Because of these barriers, most EITC claimants who are audited have their EITC claims disallowed. Those aggregate dollars, without offset for any underpayments due to the qualifying taxpayer, and which may not represent actual overpayments, represent the EITC tax gap.
Because of lack of financial resources, time, and professional networks, EITC claimants are generally unrepresented by tax professionals. Like many taxpayers, they struggle to effectively communicate and work with the IRS (National Taxpayer Advocate, 2019). The IRS sends computer-generated letters to EITC claimants stating that they are being audited and requesting that they substantiate their EITC claims within 30 days. Given the lack of IRS infrastructure, including even timely opening written correspondence and answering telephones, correspondence audits are increasingly difficult, if not impossible, for EITC claimants to navigate (National Taxpayer Advocate, 2019, 2021; Transactional Records Access Clearinghouse, 2022). The National Taxpayer Advocate (2020b) has reported to Congress on several occasions that correspondence audits confuse and intimidate taxpayers, failing to provide them with sufficient time to respond or any IRS contact with whom to communicate.
The structure of EITC audits as pre-refund correspondence with an initial 30-day deadline and an agency that only responds to a small percentage of limited contact options undermine delivery of critical financial resources to the targeted taxpayers. Increasingly, EITC claimants struggle to document their claims to the IRS’ satisfaction. The Taxpayer Advocate Service has reported that in a 2002 study of 67,000 files, 43% of audits that denied the EITC were reversed after the taxpayer received competent assistance (National Taxpayer Advocate, 2020b). Many EITC recipients do not have a tax professional representing them, and they face language barriers as well as significant time constraints given inflexible work and child care schedules. IRS services (e.g., telephone call access and taxpayer assistance centers) to assist taxpayers with their required response to receive their tax benefits have been significantly reduced (National Taxpayer Advocate, 2021).
Navigating IRS telephone assistance is challenging even for experienced professionals, with more than 75% of calls unanswered (National Taxpayer Advocate, 2020a). In 2021, the IRS received more than 167 million calls, a nearly 300% increase from 2018, with only 9% of calls answered by an IRS customer service representative (National Taxpayer Advocate, 2021). The IRS telephone number that is specifically designated to support taxpayers received approximately 85 million calls, with only approximately 3% reaching a customer service representative (National Taxpayer Advocate, 2021). Twenty percent of Taxpayer Assistance Centers have been closed, and 42% of IRS copiers have been found to be inoperable. (Treasury Inspector General for Tax Administration, 2021a). EITC audit claimants must prove eligibility within short deadlines without assistance to an agency that is almost inaccessible (National Taxpayer Advocate, 2019). Given this severe lack of resources, EITC claimants, who are disproportionately lower income and individuals of color, are effectively denied meaningful opportunity to access their tax benefits.
IRS research suggests that EITC correspondence audits not only have behavioral consequences that impact the taxpayer and their household but also have spillover effects to other households and the economy at large (Guyton et al., 2019). Most taxpayers subject to EITC correspondence audits suffer EITC disallowances and are less likely to claim EITC benefits or even file a tax return in subsequent years (DeBacker et al., 2018a, 2018b). Because this includes so many EITC claimants who are never affirmatively determined to not qualify for the EITC, it likely includes claimants who do qualify for the EITC and will not receive it in the year of audit or in subsequent tax years. This is antithetical to Congressional goals of targeting antipoverty EITC to these families and their communities.
Notably, qualifying children disallowed on EITC audited returns are likely to be claimed by other taxpayers after the audits (Guyton et al., 2019). Thus, EITC overpayments may be materially overstated because the eligible claimant on behalf of the qualifying child did not receive any EITC benefits. Researchers found that net EITC overpayments due to failure to demonstrate the residency of a qualifying child could be overstated by 33–50% because the qualifying child in most cases resides in a U.S. household for more than half of the year and EITC benefits with respect to the qualifying child have not been claimed or paid out by the Treasury (Guyton et al., 2019).
Finally, consistent with research that demonstrates that EITC benefits incentivize and increase wage earning, taxpayers who are denied EITC benefits pursuant to correspondence audits suffer reduced wage employment in years after being audited (Guyton et al., 2019). Not surprisingly, reduced wage employment is greater for taxpayers with young children ages 0–5 years in their households, perhaps due to the inability to afford child care and other work-related costs without EITC subsidies. Notably, households with individuals who are self-employed during the year of audit tend to have an increase in employee wages in tax years after the EITC audit (Guyton et al., 2019). Researchers have concluded that analogous to findings of positive EITC economic benefits, excessive EITC correspondence audits have adverse micro- and macro-economic impacts.
Despite these adverse consequences, the IRS Commissioner has stated that EITC correspondence audits are “the most efficient use of available IRS examination resources” (Kiel, 2019b). As a result, 43% of all 2018 IRS audits were of EITC claimants, and 37% of all audits in 2018 were EITC audits (National Taxpayer Advocate, 2020a). EITC claimants for this tax year had household income levels below $54,000. One of the stated reasons it is “efficient” to audit EITC claimants relative to high-income households is that the latter have significantly more resources to respond to the IRS and fight back compared to EITC claimants, as well as the IRS (Kiel, 2019b). Targeting taxpayers because they lack the capacity to respond effectively violates several statutory taxpayer rights. Moreover, designing EITC audits as pre-refund, correspondence audits in which the taxpayer must prove eligibility to receive their financial benefits to an agency that is increasingly impossible to reach is unjust.
Auditing EITC claimants is not the most efficient use of IRS resources. The Treasury Inspector General for Tax Administration has repeatedly criticized the IRS’ inefficiencies and misallocation of audit resources even given budget constraints resulting in a reduction of high-income audits (Treasury Inspector General for Tax Administration, 2015, 2018, 2020). The IRS has focused nearly half of its high-income audits on taxpayers earning between $200,000 and $399,999 even though these taxpayers are more likely to be wage earners and, therefore, “low risk” due to information reporting and withholding (Treasury Inspector General for Tax Administration, 2015).
Taxpayers with incomes in the top 1% of households who are responsible for up to 70% of the tax gap have incomes at or above $500,000. The hourly audit adjustment for revenue agents auditing taxpayers with more than $5 million of income is $4,545 or 7.5 times more than the return on audits of the $200,000 to $399,999 income households (Nessa et al., 2016). A recent study found that if the IRS’ enforcement budget had been increased $1 billion annually from 2002 to 2014, the IRS would have collected an additional $34 billion in revenue from large corporations, reducing the corporate tax gap by almost 20%, in addition to more revenue from individuals and other businesses (Nessa et al., 2016). Although in-person audits conducted in the field are more labor-intensive and thus more costly, the tax revenue collected on average is 10 and 8 times that for correspondence audits in 2010 and 2017, respectively (Hanlon, 2020). The Treasury Department has estimated that each dollar spent in tax enforcement activities yields $20.80, including $5.20 in direct revenue and $15.60 in indirect revenue (Hanlon, 2020). Investing in targeted tax enforcement is very lucrative.
Scholars have found that even these high returns on enforcement dollars invested understate the aggregate return, especially if dollars are targeted away from lower income households toward high-income households, which are by far the greatest tax system abusers. A large payoff from high-income taxpayer audits has several components. Because of progressive tax rates, those who have higher income have larger tax liabilities; thus, discrepancies between what is owed and what is paid are likely larger in magnitude. High-income households have greater opportunity, motivation, and resources to lower their tax liabilities. These households also have higher rates of underreporting because more of their income is not subject to information reporting or tax withholding. If the IRS were to audit 50% of individuals who earn $10 million or more, 33% of those who earn between $5 million and $10 million, and 20% of those who earn $1 million or more, this would have corresponded to roughly 70,000 additional audits of those earning $1 million or more annually in 2018 (Sarin & Summers, 2019). Summers and Sarin estimate that if the IRS were to engage in this level of targeted high-income audits from 2020 through 2029, the additional tax revenue collected would be nearly $535 billion.
Another reason given for excessive EITC audits other than disputable efficiency is that the Office of Management and Budget (OMB) has targeted the EITC as a high-priority program susceptible to significant improper payments. In 2002, Congress enacted the Improper Payments Information Act, a federal statutory regime focusing on waste and requiring government agencies to strictly track, monitor, and report on “improper payments” (Treasury Inspector General for Tax Administration, 2020b). The Act requires agencies such as the IRS to identify high-priority programs and develop plans for reducing improper payments in those programs. Federal agencies report annual improper payments on more than 160 programs. Until 2018, the EITC was the only tax provision classified as an improper payment. The focus on the EITC rather than on other tax gap provisions that cause significantly more government waste in improper payments makes little economic sense.
In 2018, despite even lower estimated tax gap contributions than the EITC, three additional tax credits were added to the targeted “improper payment” watch list: the Child Tax Credit (CTC) (2% of the tax gap), the Premium Tax Credit (PTC) (less than 1% of the tax gap), and the American Opportunity Tax Credit (AOTC) (1% of the tax gap) (Treasury Inspector General for Tax Administration, 2021d). These additions to the list make even less sense given the low tax gap contributions. What these credits do have in common is that to some extent each one is refundable. However, refundability in and of itself should not render a tax provision subject to improper payment scrutiny.
Researchers have determined that improper payment rates for the refundable portion of a tax credit are not more significant than the portion of the credit that offsets a tax liability. Moreover, after years of audits and disclosure, the consensus seems to be that most of the errors in the EITC are due to the complexity of the statute and targeted claimants’ lack of resources to carry their burden of proof in a timely manner (Fichtner et al., 2019; Nichols & Rothstein, 2015; Transactional Records Access Clearinghouse, 2022). Treasury analysts have reported that only a minority of EITC improper payments stem from fraudulent actions (Holtzblatt & McCubbin, 2003). Given the modest contribution to the tax gap relative to most other tax provisions, the targeting of these credits is inconsistent with economic data, rational decision-making, and the government’s goal to reduce waste.
Other areas of the tax code that have high revenue losses, such as corporate transfer pricing or income reporting of pass-through businesses (Treasury Inspector General for Tax Administration, 2020, 2021c, 2021d), have not been identified as high-priority improper payment tax provisions. An IRS study covering the 2008–2010 period found that 63% of sole proprietor income was unreported and that unreported pass-through business income cost $125 billion in uncollected tax revenues per year (IRS, 2016). This amount and other significant tax provisions that are known to contribute to the tax gap are not targeted as improper payments.
Every tax dollar that goes unpaid has the same effect on the U.S. Treasury as a dollar that is “overpaid” by a government program. The inclusion of the EITC, CTC, AOTC, and PTC as improper payments because the government has characterized these as government outlays makes no economic sense given their relatively modest contribution to the tax gap. Because these tax provisions are contingent on certain levels of earned income, they are designed to deliver targeted benefits to lower income households, which are disproportionately families of color. More notable contributions to the tax gap, such as pass-through income, which is predominately due to wealthy white households not reporting their income, receive much less attention than improper payments. For example, the audit rates for both S Corporation and partnership returns have decreased by more than 40% since 2010 to just 0.2%, and 97 out of 100 millionaires are never audited (Sarin, 2021). The government suffers significantly more economic harm due to tax noncompliance, as evidenced by the massive annual tax gap, than from targeted improper payments. In 2018, improper payment estimates totaled $151 billion, or 4.6% of total spending for the programs, compared with the 2011–2013 net tax gap of $381 billion per year, or 14% of actual tax liability (Treasury Inspector General for Tax Administration, 2021d). And estimates of the 2021 tax gap are $600 billion to $1 trillion (Davison, 2021; Rettig, 2021; Sarin, 2021).
Fortunately, there has been pushback against this excessive scrutiny of the EITC, CTC, AOTC, and PTC as improper payments. In October 2020, the Treasury and IRS notified the OMB in a report titled “Business Case to Eliminate Redundant Reporting of Refundable Tax Credits” that they do not believe that refundable tax credits are outlays that meet the definition of payments and, therefore, should not be monitored under the Payment Integrity Information Act of 2019 (Treasury Inspector General for Tax Administration, 2021b). The report argues that these refundable credits, like deductions and tax-exempt and tax-rate preferred income, are embedded in the tax system and should not be segregated from their integral nonrefundable components or other tax provisions. The IRS argued it reviews its tax administration portfolio through a comprehensive enterprise risk management program including, but not limited to, regular tax gap analysis. It also noted that errors are “largely due to the credits’ statutory design and the complexity taxpayers face when self-certifying eligibility for the refundable tax credits, not internal control weaknesses, financial management deficiencies, or reporting failures” (Treasury Inspector General for Tax Administration, 2021b). If OMB’s goal is to reduce government waste, rather than targeting lower income households that are disproportionately Black, Latinx, and Indigenous families through excess audits of refundable tax credits, OMB should facilitate the targeting of the most significant abuse of government resources—the tax gap.
Tax Gap Analysis
The annual tax gap (difference between what should be paid in taxes and what is actually paid) represents a massive amount of due, owed, and uncollected government revenue. To put the estimate of the average annual 2011–2013 tax gap of $381 billion in context, it is more than the federal government spent on all required income security programs, including supplemental nutrition assistance, Supplemental Security Income, unemployment compensation, family support and foster care, and refundable tax credits, for each of the measured years (Hanlon, 2020). However, even this jaw-dropping estimate does not capture the potential depth and breadth of the tax gap given potential tax evasion through offshore bank accounts and pass-through business structures. Economists at the National Bureau of Economic Research conservatively estimate that undetected tax evasion by high-income households contributed an additional $33 billion to the $441 billion 2011–2013 gross tax gap and $46 billion to the estimated $600 billion 2019 tax gap (Guyton et al., 2021).
The tax gap has three components: underreporting, underpayment, and nonfilers. Most of the tax gap comes from unpaid or underpaid business and self-employment income taxes, the vast majority of which (49% of the total tax gap) comes from pass-through entities such as sole proprietorships, partnerships, and S corporations (Committee for a Responsible Federal Government, 2021). Only 18% of the tax gap comes from taxation of wages, salaries, government benefits, and other ordinary income, even though this category covers most taxable income and taxes paid. The tax gap is more than all income taxes paid by 90% of individual taxpayers and is predominately due to high-income households underreporting their income and not paying their tax liabilities (Sarin, 2021, Rossotti & Forman, 2020, Rossotti, 2020).
Underreporting of tax occurs when taxpayers either understate their income or overstate their deductions, exemptions, and credits on timely filed returns. Underreporting of income is the highest component of the tax gap. This component represents approximately 80% of the aggregate tax gap or $352 billion in the 2011–2013 tax gap estimate (IRS, 2019). Individual taxpayers underreporting makes up approximately 70% of this component, and more than 68% of the underreporting for individuals was due to failure to report pass-through business, investment (interest, dividend, and capital gains), rental, royalty, and farm income (IRS, 2019). Underreporting of pass-through income accounts for more than any other source or approximately 32% of the total underreporting gross tax gap at $110 billion (Center on Budget and Policy Priorities, 2021). Underreporting for corporations is approximately 11% of the tax gap, and underreporting of employment tax makes up the difference of approximately 19% (Center on Budget and Policy Priorities, 2021).
Underpayment occurs when taxpayers file their return but fail to remit the amount due by the payment due date. The percentage of the tax gap due to underpayment of taxes for 2011–2013 was 11% or $50 billion, with most of the underpayment from individual taxpayers of $39 billion and $5 billion from corporate taxpayers (IRS, 2019). Underpayment of $6 billion of employment taxes comprises the balance of the aggregate underpayment in the 2011–2013 tax gap (Center on Budget and Policy Priorities, 2021).
The nonfiler component of the tax gap for 2011–2013 is approximately 9% of the aggregate amount or $39 billion (Center on Budget and Policy Priorities, 2021). As resources allocated to the IRS’ nonfiler programs have declined, the nonfiler component of the tax gap has grown. Since 2010, the estimated number of nonfilers has risen by nearly 50% to more than 10 million estimated nonfilers in 2016. Historically, the IRS pursued most nonfiler leads with automated notices. This was one of the IRS’s most cost-efficient enforcement strategies. A recent study reviewing tax years 2014–2016 concluded that 400,000 of nearly 900,000 high-income nonfilers, or 44%, were never investigated (Treasury Inspector General for Tax Administration, 2020). Three hundred of the most egregious of these nonfilers, or approximately 100 nonfilers from each year, have not been pursued despite the fact that the IRS has their names and contact information and that it has cost the Treasury $10 billion in unpaid tax liabilities (Treasury Inspector General for Tax Administration, 2020).
Economists and the IRS estimate that the present tax gap is $600 billion to $1 trillion or even more annually. These amounts are staggering, and the failure to focus more IRS resources on collecting it from the primary perpetrators cannot be justified by efficiency. Moreover, allocating limited resources to auditing low-income working families claiming proven antipoverty benefits without the infrastructure for them to respond timely is not efficient and violates many statutorily enumerated taxpayer rights. When viewed from a racial justice perspective, given that the tax gap perpetrators who are not being pursued are disproportionately white and those who are EITC audit victims are disproportionately Black, Latinx, and Indigenous, these violations are also discriminatory.
Many economists agree that increased funding of the IRS could help better target the tax gap and if properly allocated would more than pay for the funding many times (estimates range from $24 to $72 collected for each $1 invested). The Congressional Budget Office (CBO) has estimated that an additional $20 or $40 billion of enforcement funding over 10 years would generate net revenue increases of $41 and $63 billion, respectively (CBO, 2018, 2020). The CBO has also estimated a $200 billion increase in collected tax revenue from the Biden administration’s proposed $80 billion IRS budget increase (CBO, 2021). The Biden proposal is $80 billion over 10 years, including approximately $60 billion for enforcement and related operations support and $20 billion for other improvements such as enhanced information reporting (Forman et al., 2021). The CBO’s $200 billion increased revenue estimate does not include increased tax revenue from funding for enhanced financial institution information-reporting systems or indirect revenue efforts, which can be significant (CBO, 2021). Separately, the Biden administration has estimated that the $80 billion proposal in its American Families Plan would generate $700 billion in additional tax collections over the first 10 years and $1.6 trillion over the course of the second decade if funded through 2041 (Sarin, 2021).
IRS economist Alan Plumley has found that indirect revenue effects of audits are 12 times as large as the direct effects and that an additional $1 spent on audits returns $55 in indirect revenue in addition to direct revenue (Plumley, 2002). Another researcher has found that each new dollar invested in audits resulted in $58 in additional revenue by deterring noncompliance, but that a $25 million investment in criminal IRS investigations would produce a $1.7 billion return or a $68 return per dollar invested (Dubin, 2004, 2012). Finally, former IRS Commissioner Charles O. Rossotti and economists Lawrence H. Summers and Natasha Sarin have outlined that an investment of less than $100 billion in targeted IRS enforcement measures over 10 years would generate $1.2 trillion to $1.4 trillion primarily from high-income individuals (Rossotti et al., 2020). Thus, there are ready and lucrative remedies for the current failures of and discrimination in IRS audits. Simply stated, fund the resources necessary to target and collect all tax revenues, focusing on tax enforcement to reduce the growing tax gap.
Disparate Racial Impact of Audits
The disproportionate focus on EITC claimants when the tax gap is due overwhelmingly to high-income households is irrational and inequitable. Even more untenable is that the highest federal audit rates in America are in counties that are predominantly poor and Black in the rural South. The top 10 counties with the highest audit rates in 2012–2015 include 8 in Mississippi, 1 in Louisiana, and 1 in South Dakota. Each of these counties is home to predominately impoverished communities of color that endured audit rates higher than 40% above the national average. A map of audit intensity for this period demonstrates that the IRS concentrated audits in communities of color in the Black southern poverty belt, in U.S.–Mexico border towns, and on Native American reservations (Harriot, 2019; Kiel & Fresques, 2019). Nearly every county in America where there are pockets of Black poverty experiences higher than average audit rates (Harriot, 2019).
In a recent report on EITC audits, the Treasury Inspector General for Tax Administration (2021a) notes that the southern states that experience the highest rates of EITC audits do not have the highest rates of EITC claimants but do have the highest rates of returns that trigger IRS EITC audit filters. This conclusion is not telling but, rather, is self-evident. The heavily redacted report does not contain any description of what the triggering filters are or even suggest that the triggers themselves should be re-evaluated given this disparate impact on certain states in the South that are home to the highest percentages of households of color, especially Black families. Moreover, when the Inspector General suggested that these targeted states should receive enhanced EITC education and outreach, the IRS disagreed with the recommendation, stating that it has a nationwide EITC education and outreach program. The Inspector General responded that “without targeted outreach, based on examination results or concentration of filter rule breaks, disproportionate error rates will continue in these areas” (Treasury Inspector General for Tax Administration, 2021a). Moreover, the report notes that this disparate impact is not new but, rather, that since at least the mid-1990s southern states with higher populations of communities of color have experienced relatively higher targeted EITC audits (General Accounting Office, 1998). Hence, the IRS’ EITC education and outreach efforts have not been effective with regard to these taxpayers.
These data are even more egregious given that approximately 50% of EITC claimants are white and less than 20% are Black (Murray & Kneebone, 2017). The highest 15 audited counties, 12 of which are in predominately Black impoverished neighborhoods in Mississippi, have an average audit rate of 11.1 per 1,000 filers, including the highest audit rate nationwide of 11.8 in Humphreys County, Mississippi. The other 3 top audited counties are predominately non-white and disproportionately poor, including East Carroll County, Louisiana (70% Black and 38% impoverished); Oglala Lakota County, South Dakota (92.4% Indigenous and 40% impoverished); and Greene County, Alabama (80% Black and 32% impoverished). A map of the non-white population in America is comparable to a map of areas where IRS audit rates are higher than average (Harriot, 2019).
In sharp contrast, a map of the white population is comparable to where IRS audits are lower than average (Kiel & Fresques, 2019). The 10 poorest counties in the 10 whitest states in America have an average audit rate of only 8.1 per 1,000 filers. For example, Crawford County, Indiana, is 97% white and one of the poorest counties in the country, but the 7.7 audit rate per 1,000 filings is equal to the national average. Although inconsistent with tax gap data and the mission of the IRS to collect tax revenue, relatively high audit rates correlate with race and poverty.
Conclusion: Reconciling the Irreconcilable
Funding and targeting IRS enforcement would not only pay for itself but also provide enough tax revenue to finance remedies for debilitating social problems, including ending homelessness, providing universally affordable quality child care, and rebuilding America’s infrastructure, without any statutory tax law changes (Hanlon, 2020). Why has Congress moved in the opposite direction, defunding the IRS, causing reductions in enforcement during the past two decades from this economically sound and prudent move? Why is the IRS cutting back on tax enforcement of corporations and higher income taxpayers when the tax gap related to these taxpayers and the demonstrated return on these audits are much more significant than those of other audits? Why is the EITC, which scholars have determined effectively pays for itself and contributes little to the tax gap, excessively audited? Why are the only tax provisions categorized as improper payments tax provisions that disproportionately benefit households of color? Why are impoverished households of color effectively denied tax benefits with no meaningful recourse when wealthy white nonfilers owing billions of taxes are not even pursued? Why are poor households of color more likely to be targeted for audit than their white counterparts when more white households receive the EITC than households of color?
These questions, when viewed objectively with the data and details described in this article, demonstrate that consistent with many government institutions, federal tax enforcement advantages white wealthy households and disadvantages households of color. When the top 1% of income households are not paying hundreds of billions of tax liabilities due and payable annually, it is just a matter of time before historically stable voluntary compliance rates erode. The IRS’ stated mission is not being fulfilled but, rather, is being upended into a two-tier tax system (Hanlon & Hendricks, 2021)—a system that is separate and unequal, in which the richest predominately white households do not follow the laws and suffer few consequences while the lowest income families who are predominately households of color are denied their legal benefits without the opportunity to be heard.
Centuries of racial exclusion and discrimination have been hardwired into U.S. systems and institutions enduring until now normalized, endemic, and deemed neutral even though patently improvident, unjust, and racist. Evidence of disparate racial impact of audits not only harms children of color, their families, and communities and businesses but also undermines confidence in and the integrity of U.S. tax systems and the federal government. Moreover, the annual fiscal cost to the Treasury is catastrophic. Systemic and institutional racism exacerbates, rather than mitigates, racial inequities, including racialized economic injustice, which has resulted in pernicious wealth and income inequality. Irrational, uneconomical, and racially discriminatory audits must stop. Funding IRS targeted high-income enforcement measures and building institutional resources to facilitate rather than undermine EITC participation are obvious and economically sound solutions.
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