WASHINGTON — Rates of tax compliance in the United States are based in large part on the ways taxpayers accrue income. Those who receive their income that is reported on by a third-party source, such as wage earners, exhibit near-perfect compliance rates on their salaries--since the payer of the income also reports the income paid as a deduction.
By contrast, taxpayers who accrue income in hard-to-trace ways exhibit much lower rates of compliance, as there is no third-party source that reports income to tax authorities. Instead, these taxpayers take advantage of the fact that certain income streams are hidden from the IRS, with no information that the IRS can use to detect noncompliance.
Ultimately, this difference in compliance has led to a two-tiered system of tax administration in the U.S., whereby taxes are mandatory for wage earners and beneficiaries of federal programs—like Social Security recipients—while other taxpayers have far more discretion over whether they pay their taxes. Additionally, since less visible income streams accrue disproportionately to higher-income taxpayers, this tax compliance divergence means that low- and middle-income taxpayers have higher rates of compliance, while upper-income taxpayers likely have higher rates of evasion. Treasury estimates that the cost of tax evasion among the top 1 percent of taxpayers exceeds $160 billion a year.[1]
The only way to ensure that upper-income taxpayers pay what they owe is by giving the IRS the resources and information required to close the tax gap. The Administration’s compliance proposals will do just this by providing a bit of additional information and making transformative investments in the IRS, such as hiring enforcement agents who are trained to pursue tax evasion by sophisticated, upper-income taxpayers.
Congress reviewed the Administration’s proposed tax compliance reform released in conjunction with the Fiscal Year 2021 Budget. In response to considerations about scope, it has crafted a new approach to include an exemption for wage and salary earners and federal program beneficiaries. Under this revised approach, such earners can be completely carved out of the reporting structure. This is a well-reasoned modification: for American workers and retirees, the IRS already has information on wage and salary income and the federal benefits they receive. The Treasury Department is supportive of Congress’s tailoring of the compliance regime to shed light on income that is unreported to the IRS presently.
Question: How does the financial reporting proposal work?
Answer: Financial institutions and banks will add just two additional numbers to the information that they already supply to taxpayers and the IRS: the total amount of funds deposited into the account and the total amount withdrawn over the course of a year. The scope of this information sharing is extremely limited. Banks will not share with the IRS any information to track individual transactions under this proposal, and the IRS will have no ability to track individual transactions.
The rationale for this reform is that the IRS can use this additional aggregate information to focus its enforcement efforts on wealthy tax evaders, with an improved ability to identify tax evasion and to decrease audits of compliant taxpayers.
Misinformation regarding the Administration’s Compliance Proposals
In the months since the Administration’s compliance proposal was released, these reforms have been subject to widespread mischaracterization. One prominent misconception concerns whether banks will have to report individual transactions to the IRS.
To be clear: The financial reporting proposal does not include reporting on individual transactions of any amount. Instead, banks would add two additional data points to the information that is already supplied to tax the IRS: how much money went into the account over the course of the year, and how much came out.
Question: How would this information be useful?
Answer: Imagine a taxpayer who reports $10,000 of income; but has $10 million of flows in and out of their bank account. Having this summary information will help flag for the IRS when high-income people under-report their income (and under-pay their tax obligations). This will help the IRS target its enforcement activities on those who are actually evading their tax obligations—decreasing costly and burdensome audits for the vast majority of taxpayers who pay what they owe.
A second misconception is that all Americans will be swept up in greater IRS scrutiny as a result of the compliance proposals.
In reality, many financial accounts are already reported on to the IRS, including every bank account that earns at least $10 in interest. And for American workers, much more detailed information reporting exists on wage, salary, and investment income. There is nothing novel about the scope of the information reported to the IRS. The only difference is the group of taxpayers that it is extended to, as this reporting would serve to eliminate the existing disparity between American workers, whose income is already reported on the IRS; and disproportionately wealthy individuals who earn income in ways not visible to the IRS, and thus, are easily able to evade.
Under the current proposal, financial accounts with money flowing in and out that totals less than $10,000 annually are not subject to any additional reporting. Further, when computing this threshold, the new, tailored proposal carves out wage and salary earners and federal program beneficiaries, such that only those accruing other forms of income in opaque ways are a part of the reporting regime.
Any additional reporting will be minor. As stated earlier, only total money into accounts and total money out of accounts will be reported to the IRS. To further help safeguard taxpayer privacy, financial services providers could report these totals to the nearest $1,000. The proposal also includes significant data security investment, giving the IRS the tools it needs to overhaul 1960s technology and meet threats to the security of the tax system, like the 1.4 billion cyberattacks the IRS experiences annually.
A third misconception concerns raising taxes on American workers.
It cannot be emphasized enough that this proposal does not involve raising taxes on any taxpayers. Instead, the proposal is designed to collect taxes that are already owed under current law. This is an economically efficient and progressive way to raise revenue.
It is also important as a matter of equity: As IRS enforcement resources have deteriorated significantly over the past decade, enforcement actions directed at high-income taxpayers, which are the most costly and labor-intensive, have decreased the most. As a result of the Administration’s compliance efforts, additional IRS resources and information will be focused on detecting and addressing high-income evasion. In fact, audit rates will not rise relative to recent years for taxpayers making under $400,000 a year.
A further misconception is that greater tax enforcement will create new burdens for taxpayers and financial institutions.
This proposal was designed to ensure that taxpayers do not have to take any action at all. There is no reconciliation or paperwork burdens for taxpayers resulting from this proposal. All that will happen from a compliant taxpayer’s perspective is receiving two additional data points from their bank and a lower likelihood of a costly audit. And leading banking experts have stated publicly that the reporting regime under consideration would be simple to enact and virtually cost-free for banks.[2] Financial institutions are quite technologically sophisticated, as the advent of mobile banking illustrates. It is implausible that a requirement to add two pieces of information on a report that is already sent by financial institutions to the IRS could be onerous.
Ultimately, these efforts are focused on addressing tax evasion by shedding light on hidden income sources and giving the IRS the resources that it needs to address high-end noncompliance. Given the substantial revenue at stake, it is unsurprising that Interests that have marshaled strong opposition have deployed significant resources to derail these efforts.
But it is important to be clear about the facts: Under the version of the proposals before Congress, no additional information needs to be reported to the IRS about American workers. Further, audit rates will not rise relative to recent years for any taxpayer who makes less than $400,000 annually. All told, a robust attack on the tax gap will generate $700 billion of additional tax collection in next ten years—and roughly $1.6 trillion in the decade that follows. It will also increase the efficiency and competitiveness of the economy and help redress long-standing inequities in our tax system.
[1] Natasha Sarin. “The Case for a Robust Attack on the Tax Gap.” September 7, 2021. https://home.treasury.gov/news/featured-stories/the-case-for-a-robust-attack-on-the-tax-gap
[2] Charles Ellis and Alexander Boyle. “Banks are Wrong to Fight Proposed New IRS Disclosure Rule.” Bloomberg. September 28, 2021. https://www.bloomberg.com/opinion/articles/2021-09-28/banks-are-wrong-to-fight-proposed-new-irs-disclosure-rule?sref=LPdcbdXL