Starting the New Year is a time for renewal and resolutions, but it’s also the time people begin to think about filing their income tax returns. In 2009 the IRS estimated that compliance rate for income tax returns were approximately 84 percent, which sounds reasonable; however, the IRS views it as 16 percent who are cheating on their returns.
In 2005, the IRS estimated the gross tax gap to be in the realm of $345 billion. After the IRS obtained some of that missing revenue through enforcement or other late payments, the net tax gap was still a staggering $290 billion for that year. So it’s clear that attempting to retrieve the revenue is an ongoing process for the IRS.
But why do people cheat on their taxes, and is there an underlying reason why? LiveScience interviewed David Callahan, author of The Cheating Culture: Why More Americans Are Doing Wrong to Get Ahead and The Moral Center: How Progressives Can Unite America Around Our Shared Values.
"It's interesting because one of the biggest complaints people have about their taxes is not that they pay too much, or that taxes are too complex, it's that the wealthy don't pay their fair share," Callahan told LiveScience.
Callahan separates people into two main groups: the winning class and the anxious class. The winning class is made up of wealthy individuals, whereas the anxious class is made up of people who struggle more to make ends meet. Cheating on taxes can occur in both groups, Callahan explained, but the motivations behind the dishonesty are often triggered by the underlying tension between them.
Income inequality is one of the reasons for the rise of the Occupy Movement, which has emphasized the disappearing middle class as the 99% and the corporate class that holds the majority of the wealth of this nation as 1%.
The wealthy have at their disposal tax accountants and lawyers who seek out loopholes and methods to evade paying taxes. Indeed, Mr. Callahan says one of the most popular is storing money in overseas bank accounts or tax shelters.
Rationalizing Cheating and What Makes an Honest Person Cheat
"If you feel that others are cheating on their taxes, especially people who make more money than you, you're more likely able to rationalize cheating on taxes yourself," he said. "Many people in the anxious class who haven't seen their incomes grow, and who were hit hard by the recession , may think, if the people at the top don't pay all their taxes, why should I pay every dime that I owe?"
As a result, many otherwise honest people are tempted to cheat simply because they are operating in a dishonest system. This is a classic dynamic in the cheating culture, said Callahan.
"Even if we consider ourselves honest, we believe other people aren't honest," Callahan said. "If there's a perception that everybody does it, more people will be tempted to abandon their integrity and go along with that. Nobody wants to be the only chump that is playing by the formal rules when everyone else is playing by the 'real rules.'"
While the country's federal tax code is considered progressive, some people feel that it grants the wealthy many loopholes – something that further perpetuates the resentment among those who believe the tax burden can sometimes fall unjustly on those who are least able to afford it.
"Many wealthy people earn income, such as capital gains, that is taxed at lower levels than regular income," Callahan said. "So, in some cases, a wealthy guy sitting by his pool, living off his stock portfolio is paying a lower tax rate than the guy cleaning his pool. Tax evasion scams by the wealthy are so often revealed, and so there's the perception that the rich cheat heavily on their taxes. There's truth to that perception, which is what keeps it alive."
Not Everyone Cheats
For Dan Ariely, a behavioral economist and author of the book, Predictably Irrational: The Hidden Forces That Shape Our Decisions (Harper, 2008), understanding why people cheat is far more simple than understanding why people do not.
"We cheat on taxes because we stand to gain money – that's not a big surprise," Ariely told LiveScience. "What's more interesting is why we decide not to cheat and what makes us decide to limit our cheating."
Ariely, who teaches behavioral economics at Duke University, has done extensive research on cheating, and on the motivations behind the various degrees that people cheat.
Through his research, Ariely observed that there are often discrepancies between peoples' perceptions of cheating and their actual behavior. In other words, Ariely found that people operate with moral flexibility, and this sliding scale plays an important role in a person's cheating calculus.
Group Dynamics of Cheating: It’s OK if it’s hidden
"Given the great flexibility of our minds, we can cheat and still feel good about ourselves – but not under all conditions," Ariely said. "We can still feel alright while acting immorally when a few things happen: when we cheat just a little bit – so, if it's not a big transgression – when a lot of people around us do the same, and when the act is more hidden."
Ariely observed that those three main conditions allowed people to cheat and still feel that they were honest, which essentially created a moral threshold that served to limit the deceitful behavior.
Like Callahan, Ariely believes that if people think others are also cheating, it becomes more acceptable for them to cheat as well.
"Corporate corruption and government misdealing is very salient in people's minds," Ariely said. "It's easier under those conditions to justify misbehavior. If you think of this as an exercise in justification, the last three years have given us a lot of excuses."
Justifying the cheating
If a person distances themselves from the cheating, they can justify the act.
"It's true that taxes are a lot about money," Ariely said. "But, I would suspect that it's easier for people to simply forget a receipt, than to have a receipt and type in a false number. If I pretend that I forgot the receipt, that can help me feel better about cheating, but if I take a receipt that says $1,000 and just write it as $2, that's more challenging. That makes it feel like you're really lying."
Ariely believes that one way to control the amount of cheating on federal income taxes is by simplifying the tax code. The complexity and ambiguity of the current code makes it easier for people to cheat, because people can interpret it in a way that suits them and is more selfishly beneficial, he said.
Callahan believes that the IRS has made some important changes to curb non-compliance, but still has a long way to go. The introduction of the W-2 form, which requires employers to fill out tax information on behalf of their employees, makes it more difficult for these employees to fudge data on their income tax returns. But, Callahan notes that more oversight is still needed.
"The number of people who don't have W-2 incomes has been growing," Callahan said. "Independent contractors, people who are self-employed, doctors, dentists and restaurateurs are all people who don't have W-2 incomes. And there's a lot more of these people than in earlier times."
Still, Callahan says it is imperative that the IRS continue to make improvements to their enforcement capabilities.
"It's very important to not let tax evasion get too out of hand," he said. "If you pass a tipping point whereby tax evasion becomes commonplace, and if it's perceived as normal, there'll be less stigma attached to it. Cheating carries less stigma the more people do it. Fortunately, we're not past that tipping point yet."
Does Flat Tax or Fair Tax Eliminate Cheating?
A true flat rate tax is a system of taxation where one tax rate is applied to all income with no deductions or exemptions. The amount suggested by proponents is 17-19%. Sounds good? And yes, it might reduce the ability to cheat, but what are we giving up in return? It’s simple for sure, but also it’s regressive. This means that lower income people will percentage wise pay more of their income. 17% of $30,000 a year takes a bigger chunk than 17% of someone making $70,000 a year.
There would be no deductions of, say, your mortgage interest or property taxes. Childcare deductions would not apply, nor would business expenses, or the other myriad ways individuals are able to reduce their taxable income. Corporations rely on loopholes, and the rest of us rely on deductions and exemptions.