Funding the tax police is very good

Republicans need to stop coddling criminals

In April of 2021, I argued that boosting IRS funding would have two major benefits: it would more than pay for itself through increased tax revenue, allowing the government to do useful things without raising tax rates, and it would allow the IRS to invest in customer service, better serving the average taxpayer.

Now that this funding increase has come to pass as part the Inflation Reduction Act, Republicans have made it the focus of their complaints about the law.

And I think it’s worth diving into because on the merits, this is probably their least valid complaint, but by the polling, it’s their politically strongest argument. If you think that spending a few hundred billion subsidizing zero-carbon energy production is a bad idea, then that’s fine. But the government collecting the tax revenue it’s owed is unambiguously good, and the Republican Party’s opposition to it is telling and disturbing.

After all, they wrote a tax reform bill in 2017, and even though their bill cut taxes on net, it did raise a bunch of revenue (most famously from curbing the SALT deduction) to partially offset the cost of the tax cut. The GOP could have increased tax enforcement as another offset, and instead of letting Democrats spend the revenue, they could have used it to make the cuts in the Trump tax bill even bigger.

But they didn’t. Because separate from the party’s overall view on the desirable level of taxation, they’ve developed a peculiar soft spot for tax cheats.

Don’t be like Italy

Because taxes are levied on broad macroeconomic categories, it’s possible to predict, in a top-down kind of way, how much taxes should theoretically be coming in. And in every country I’ve seen data for, actual revenue received is less than this top-down analysis predicts.

A lot of that is fairly banal — people getting paid in cash transactions that aren’t recorded or reported — but most of it stems from the complexities of small business taxation.

The good news, as this Tax Foundation report shows, is that the American tax gap is on the lower side. But pay attention to some of the countries at the top of the list:

I think Republican Party elected officials and their non-specialist allies in the conservative movement are underrating how bad it would be for the United States to migrate closer to the top of that list. The countries with huge tax gaps are not dynamic, business-friendly free market societies — they tend to be stuck in a dysfunctional paradigm in which businesses struggle to grow or adopt professionalized management because so much money hinges on their ability to keep two different sets of books. Italy and Greece are dominated by small, closely held businesses with family-centric management that are reaping huge economic gains by cheating on their taxes. Even the best-run of those companies tend not to expand or professionalize because to do so successfully, they’d have to actually pay what they owe.

If you believe that taxes should be low, the goal is to be like Ireland or New Zealand, where taxes are low but compliance is very high. Or you could be like Denmark, where tax compliance is very high and the taxes are high. But you don’t want to be like Italy where everyone is cheating on their taxes. As I wrote in “What’s Not Wrong With Italy,” there’s actually a bunch of good stuff happening in Italian public policy. But it’s swamped by this trap of bad government and small, badly managed companies.

Small business owners have room for hijinks

I wrote that article after a family vacation in Italy. While there, a bunch of people joked that I should write something about the political crisis that was unfolding in Italy and then write the whole trip off as a business expense.

I didn’t do that, of course. But it is true that I did some writing work while I was in Italy, and Kate did some editing work. I did do a story about Italy. I had a few conversations with people that have informed my work, and I got to investigate first-hand a couple of transportation things that will inform my journalism. Some work occurred. But because I’m not a crook, I don’t take advantage of incidental journalism occurring while on vacation to mischaracterize leisure spending as a business expense. But on another recent trip to visit my in-laws in the Texas Hill Country, I met a lawyer from Dallas. He was there vacationing with his family at his country house, or at least that is what we in the northeast call a second home owned by a rich person and used as a family vacation destination. He called it his “ranch” because he keeps cattle on the property, not so much to make money but so as to create a situation in which a lot of the money spent on the upkeep of the property can count as business expenses.

One can get into a lot of metaphysical disputes about who is and is not rich. My guess is that the Dallas lawyer with a ranch considers himself a middle-class person, even though his household income is far above the national median.

And Republicans would like you to think that increased IRS enforcement means a big burden on roughly average, middle-class people. That is not the case. Average people who derive their income from wages and salaries or pensions and Social Security are already paying what they owe. Again, to quote the Tax Foundation, the tax gap stems from small business income:

Specific types of income drive the individual income tax gap. Income subject to reporting requirements and withholding, such as employee wages, has a very low level of underreporting. The payroll tax gap is low as well for the same reason. However, the individual income tax covers many types of income that are subject to fewer reporting requirements, like passthrough business income, and contribute more to the tax gap.

More broadly, income subject to substantial information reporting requirements includes pensions, annuities, interest income, dividend income, unemployment compensation, and taxable Social Security benefits. Income subject to some information reporting includes partnership and S corporation income, capital gains, and alimony payments, while the income subject to little or no information reporting includes farm income, nonfarm proprietor income, and rents and royalties.

As a small business owner myself, I want to emphasize that we are not inherently dishonest. The fundamentals of the situation are just that while Stripe reports a clear and unambiguous revenue figure for Slow Boring to the IRS, calculating our income requires deducting our expenses. And that’s appropriate — if you didn’t let businesses deduct legitimate expenses, you’d kneecap the economy. But all kinds of things could be a legitimate business expense. An unethical person needs to consider the financial upside of claiming bogus expenses versus the odds of detection versus the severity of penalty. And without enough audits, you get lots of non-compliance.

I find that a lot of conservatives arguing against this point seem to have fully taken on the logic of police abolitionists. They’ll say that getting audited is annoying and sometimes people need to suffer through audits when they’ve done nothing wrong or committed only minor violations. Both of those things are true. But just as in the general policing case, if your only solution is to have no enforcement at all, you’re going to be in trouble.

Tax enforcement could raise a lot of revenue

The Congressional Budget Office thinks that an $80 billion investment in the IRS will generate a bit over $200 billion in increased tax revenue. That net gain of $120 billion somewhat understates the upside to tax enforcement because about a quarter of the $80 billion for the IRS is going to customer service rather than enforcement functions.

Natasha Sarin, an economist who worked on this issue extensively before joining the Biden Treasury Department, thinks the real benefit is larger and that it will bring in over $300 billion in revenue.

This is the kind of thing that is inherently hard to estimate. CBO is relatively pessimistic for two reasons:

• They believe the IRS is already using its enforcement resources on the highest return-on-investment cases, so the marginal ROI of new revenue will be lower.

• They believe stepped-up enforcement’s benefits will fade over time as taxpayers adapt with new avoidance mechanisms.

The more optimistic view stems from a conception of the IRS as more like a beat cop than a homicide detective. Knowledge that it isn’t just the very most obvious and egregious cases that are leading to audits will, she argues, generate a large amount of voluntarily compliance from people whose odds of detection have gone from super-duper-low to just low.

These are both plausible theories of the case, and I just don’t think we have a significantly rich enough set of empirical information to know which is right. The official estimates of the bill all rely on the CBO score, so the thing to know is that if Treasury is right, the deficit reducing impact of the bill will be larger.

The Sarin point that I do think is clearly convincing and politically relevant is that the vast majority of unpaid taxes are coming from rich people.

So you can be as cynical about the IRS and its agents’ motives as you like, but unless they are being specifically pressured by congressional Republicans to focus their audits on the poor (which they do tend to do), the place to get more money is rich people.

Culture matters

After running a small business for a while and also thinking about the tax gap issue, I’ve developed a greater appreciation for the role of norms.

I’m sure that I know people who’ve committed lots of different kinds of crimes, but they overwhelmingly haven’t bragged to me about it. But affluent people are very open about discussing tax shenanigans with casual acquaintances. There’s a real attitude of “if you can get away with it, it’s not really wrong,” an attitude that I think those exact same people would, in other situations, say is at the root of some of the entrenched social problems in poor neighborhoods. People are less likely to engage in anti-social behavior if they believe the people around them will strongly disapprove of that behavior. And people are more likely to believe the people around them strongly disapprove if they observe them following the rules and if they see rule-breakers getting punished.

Italy and Greece are in a tax equilibrium where for a huge share of the population, if you pay what you owe, you’re a sucker, not a solid citizen.

The United States isn’t there. The vast majority of people have simple taxes with their wages and salaries well-reported to the IRS, and they pay what they owe. And while there are certainly plenty of controversies about the operation of the corporate income tax, these are policy disputes about whether various credits and deductions are a good idea — the underlying facts are rigorously reported, and companies mostly pay what they owe. The “passthrough business owner pulling shenanigans” phenomenon is real and genuinely costly but also fairly non-mainstream at this point.

We ought to try to keep it that way, and increasing our enforcement efforts is a good way to do that. People who of their own accord try to report their revenue and expenses correctly should be made to feel like we are prudent, not like we are suckers.

Obviously, Republicans aren’t going to stop criticizing the Inflation Reduction Act, both for partisan reasons and because it does plenty of stuff like spending money on health care and clean energy and curing pharmaceutical prices that they genuinely oppose. But I sincerely hope that whenever the right is in power again and starts making policy changes, they will reconsider some of the things they’ve been saying this August about the IRS. If you want to reduce federal revenue, then make the tax rates lower — don’t undermine the rule of law by coddling tax cheats.