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America’s Rigged Tax Collection System

Charges of rigging fill the air in today’s America. Elections, the economy, college admissions, the list seems endless. Whatever the truth in other cases, our tax collection system is undeniably rigged. It’s been so from the beginning, rigged against the vast majority of workers.

In 1943, under pressure to pay for World War II, Congress passed a law requiring employers to withhold taxes and report the incomes of their employees. The same law implicitly allows self-reporting by huge numbers of largely high-income taxpayers: landlords, self-employed professionals, small businesses, et al.

Tax compliance figures for the two groups differ starkly. The latest estimate from the Internal Revenue Service shows 99% compliance by wage and salary earners. Self-reporters, by contrast, are evading scores of billions in taxes year after year.

Here are the crucial IRS numbers:

“Findings from earlier tax gap analyses that compliance is higher when amounts are subject to information reporting and even higher when also subject to withholding, continue to hold….Misreporting of income amounts subject to substantial information reporting and withholding is 1 percent; of income amounts subject to substantial information reporting but not withholding, it is 7 percent; and of income amounts subject to little or no information reporting, such as nonfarm proprietor income, it is 63 percent.”

Self-reporters take several forms, for example partnerships, S corporations and limited liability companies (LLCs). They self-report via numerous avenues: business income, corporate income, self-employment taxes, credits, and more. If self-reporters have taken any capital gains in the stock market, brokerage firms are now required to report that income to the IRS. It’s the only significant instance of their income getting the same reporting treatment as wages and salaries.

The most recent IRS figures cover the period 2008-2010. Adding up all the under-reported categories, the agency estimated Treasury losses at $387 billion a year. Stunningly, self-reporters paid little more than a third of what they should have. (Really, you say? Go back to that IRS quote, and do the math for yourself.)

The agency knows full well what the under-reporting means:

“A high level of voluntary tax compliance remains critical to help ensure taxpayer faith and fairness in the tax system. Those who don’t pay what they owe ultimately shift the tax burden to those who properly meet their tax obligations. The new tax gap estimate updates long-standing research findings that information reporting and withholding are strongly associated with higher levels of voluntary compliance.”

The words may be measured, the volume low—but it’s actually a primal scream with an unmistakable message. The IRS is telling Congress that self-reporting dooms the federal government to losses of about $400 billion a year. It’s also saying that America’s wage and salary workers deserve an unrigged tax collection system—everybody’s income should be reported, not just theirs.

Employers do the reporting for their employees; brokerage firms do it for stock market capital gains; let’s turn to banks to do the job for current self-reporters. Income and expenses are the major information components. Some way, somehow, those components have to be identified, separated, and added up. At year’s end, the totals should be reported to the IRS and to the income recipient. It would be nothing more (and nothing less) than a W-2 for self-reporters: the same as most American workers have been getting for decades.

If current technology isn’t up to the job, then invent technology that is. There’s nothing digital magic can’t do. If you don’t believe it, ask Siri (or better yet, Zora).

The bigger obstacle by far is political. The investment community fought relentlessly against basis reporting of capital gains. Entire other communities will do likewise to resist, demonize and delay any self-reporting reform. Listen to Bruce Bartlett in a 2012 op-ed examining, yes, the tax gap: “People don’t like the intrusion into their privacy — and the diminution of their opportunities for tax evasion — and businesses don’t like the cost or the alienation of their customers.” To which the obvious answer is: what does “liking” have to do with it?

Let’s finish with a billion-dollar idea.

The Treasury could attack that $387 billion-a-year revenue loss by inviting all techies to compete for a $1 billion prize. The goal: develop easy-to-use, non-intrusive software that eliminates the self-reporting shortfall.

The nation could wind up with the bargain of the century. The loss from under-reporting of income amounts to $1.06 billion a day. Prize-winning software could recover that amount by the first coffee break of Day Two.

And in the process, end 75 years of tax unfairness.

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