April 18, 2011
Can electronification close tax loopholes opened by cash?
Happy Tax Day! Today is the deadline for paying 2011 federal taxes. Those of us who have waited until the last minute still have until midnight tonight to file our returns electronically. Although the vast majority of Americans will pay their taxes voluntarily, a small minority of evaders do not. According to a study conducted by the IRS for tax year 2001, for example, tax evasion resulted in a $345 billion federal tax gap. More than 70 percent of this gap can be attributed to individual small businesses, who the IRS estimates report only 43 percent of their income, with particularly low reporting of income received as cash. Underreporting is possible because cash payments are invisible to authorities, and therefore the social burden of tax evasion needs to be considered a risk of a cash payment system.
For those of us who do voluntarily pay our taxes, tax evasion by a few seems unfair and even immoral. Indeed, 87 percent of Americans feel that it is never acceptable to cheat on your taxes. Tax advocate Nina Olson further notes that "[t]he tax gap has real victims. Individuals and businesses that evade tax impose a significant burden on those who comply with their tax obligations." Evaders tend not to see the issue in terms of morality, however. The academic literature suggests that the primary driver of small businesses tax evasion is opportunity.
The temptation of cash income
Previously, I covered some of the risks of cash acceptance to small businesses: threats of robbery, employee theft, and counterfeit bills. Nevertheless, many small businesses seem to prefer cash. This is partly to avoid credit card processing fees and the risk of bad checks. But the greatest allure of cash to many small businesses may be its low visibility to tax authorities. Cash transactions do not automatically generate a paper trail and as such comprise the bulk of unreported income. The IRS's tax gap analysis actually understates the extent of evasion by limiting their estimate to federal income tax losses. Evaders are also dodging state income and employment taxes, as well as state and local sales taxes on the unreported income. A small merchant might be willing to accept some risk of theft in order to avoid such a hefty tax burden!
The burden of tax evasion
To achieve these illicit benefits, tax evaders take major risks and bear significant costs. The IRS conviction rate in the cases they pursue has never fallen below 90 percent. When caught in evasion, business owners often have to pay large fines and serve prison sentences. Even if they never face enforcement actions, tax evaders must invest considerable resources and change behaviors in order to avoid detection. The business owners may have to share illicit gains with a complicit accountant or spend significant time and effort to manufacture false numbers and backup documentation for claimed income. They also cannot deposit funds in a bank account, because doing so establishes a paper trail, so they must find other places to store the cash they receive. Not only do these tax-evading business owners risk theft and destruction of their hoarded cash, but they also are unable to use their unclaimed income to secure credit from banks. Furthermore, they run the risk of someone reporting their large cash purchases to the IRS or the Financial Crimes Enforcement Network, which would increase and the risk of an audit.
In addition to the costs borne by the evader, tax evasion imposes externalities on others. Businesses that voluntarily pay taxes operate at a competitive disadvantage, which results in a market distortion. Despite their having to charge market prices for their products, compliant businesses have higher costs than their tax-evading competitors.
The IRS takes action
We have a strong interest in collecting this revenue and correcting the market failures caused by tax evasion. Other countries have responded to unreported cash income in a variety of ways. Mexico has a two percent tax on large cash bank deposits to capture informal market activity. As part of their recent austerity plans, both Italy and Greece have banned high-value cash transactions in order to limit tax evasion. In the United States, the IRS will be using the electronic payments system to address underreporting of cash income: IRS rule 6050W will require merchant processors—the companies that process credit and debit card payments for businesses—to report their clients' receipts to the IRS annually. The IRS will use this data to improve audit algorithms. Third-party income reporting is a classic technique for increasing compliance. 6050W went into effect for tax year 2011, and the IRS will begin receiving the relevant data in January 2012.
Increasing electronification of both payments and tax administration should lead to increased transparency of small businesses income. This greater transparency might result in a natural decline in tax evasion over time. Is there a role for the payments industry in ensuring compliance? Cooperation among industry processors, compliant businesses, and regulators may represent an opportunity to lower the social cost of cash payments, and thereby mitigate risk in the payments system.
By Jennifer C. Windh, a payments risk analyst in the Retail Payments Risk Forum at the Atlanta Fed
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