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$3 Trillion Lost to Tax Evasion in Past Decade. Wealthy Cheat Most

David Callahan

The new IRS report on the "tax gap" is a good news, bad news story -- although mostly bad news.

The IRS released a shocking study on the tax gap back in the Bush years -- showing that the federal government lost a $290 billion due to tax evasion. That study was based on 2001 data. The IRS has now updated it's findings, using data from 2006.

First the good news: Tax evasion didn't increase between 2001 and 2006 in percentage terms. The IRS collected about 85.5 percent of funds due to the U.S. Treasury in 2001, and 86.3 percent in 2006 -- not much change. So it's good to know that the anti-regulatory zeal of the Bush years didn't serve to push up tax evasion. Spending on enforcement by the IRS didn't increase much during the Bush years in real terms -- and obviously was no match for the problem at hand -- but at least it didn't fall, as this chart shows.

But the bad news is pretty bad. The new study estimates that the net tax gap in 2006 was $385 billion. (Americans underreported $450 billion in taxes, but the IRS recovered $65 billion, hence the "net" figure.)

That is a staggering amount of money to slip through the government's fingers in a single year. The figure was substantially greater than the $248 billion budget deficit in 2006. As we have estimated before, these tax gap numbers are especially alarming when viewed over a period of years. The United States government has lost well over $3 trillion to tax evasion since 2001. That sum is equal to a fifth of the entire current federal debt. The amount of new debt incurred by the federal government during the Bush years is nearly exactly the same as the amount lost to tax evasion.

So who is mainly cheating on their taxes?

Well, as we noted previously, not everyone has an equal opportunity to cheat on his or her taxes. Employees who have income withheld have fewer options for tax evasion than people who are self-employed or have complex business or financial dealings. Likewise, large corporations with foreign subsidiaries and sophisticated accounting departments have more opportunities to cheat. In all, it is wealthier Americans who are most likely to cheat on their taxes.

In estimating the tax gap, the IRS found that the largest share of tax evasion—over 50 percent—was by individuals with business income. A more detailed breakdown of losses in 2008 by the scholar John Slemrod and IRS analyst Andrew Johns found that the single biggest source of lost revenue was from proprietors of businesses who don’t report the full amount of their income. Other big cheaters include professionals whose income comes through S corporations, partnerships, and real estate.

The study by Slemrod and Johns found that misreporting “generally increases with income, although it peaks among taxpayers with adjusted gross income between $500,000 to $1,000,000, and is lower than the peak ratio for individuals with income above $1,000,000.”

Tax evasion is a big problem, and even if you believe in lower taxes, you should want to see the government collect everything that it's owed and for all Americans to obey the law. So it's been pretty disturbing to see Republicans in Congress continually trying to cut the IRS budget in recent years -- even in the face of evidence that these cuts would actually increase the deficit overall.