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Should the IRS Audit More Taxpayers?

May 1, 2006

The Byzantine US income tax code is the subject of innumerable complaints and the Internal Revenue Service is often vilified. One complaint that is not often heard, however, is this: "There are way too few audits!"

Currently, the IRS only audits a tiny fraction of the tax returns filed each year. Less than one-fifth of one percent of taxpayers had to endure a face-to-face audit last year. Given the propensity of some people to evade taxes by understating income, overstating deductions, or other stratagems, Steven Levitt and Stephen Dubner, co-authors of the widely discussed book Freakonomics contend that most Americans should favor a significant increase in IRS auditing.

Writing in the April 2, 2006 New York Times Magazine ("Filling in the Tax Gap," only available online to "Times Select" subscribers), the authors point to IRS data showing that tax cheating deprives the federal government of about $345 billion annually — a sum that is almost equal to the projected federal budget deficit for this year.

What if Americans could be frightened into complete honesty on their 1040s? Although many citizens regard the IRS as a "tough and cruel" agency, "in fact, it is not nearly tough and cruel enough," write Levitt and Dubner.

Apparently, most Americans would applaud the IRS if it really cracked down on tax evasion. The authors site an IRS-commissioned poll showing that 93 percent of respondents agree that anyone who cheats on his taxes "should be held accountable."

So there you have it. Audit more people — especially self-employed people who are most likely to understate their taxable income — and we would simultaneously get much more revenue into the government's coffers and make the tax system fair. Obviously, it's a good idea, right?

Not so fast. Levitt and Dubner have left some matters out of account.

First, let's think about the consequences of transferring all those billions from the pockets of the people who earned the money to the US Treasury. Levitt and Dubner say nothing about that, evidently assuming that it's better for the federal government to have more resources at its disposal. The taxaholics in our midst always make that assumption, envisioning all sorts of splendid, idealized programs that could be undertaken if only the government wasn't being cheated of so much money by those selfish taxpayers.

But what about the beneficial uses to which that $345 billion is put by the people who earned the money? It would be spent, invested, or donated as those people thought best. Taxing an additional $345 billion out of the private sector will mean less demand for everything from pizzas to pianos, less capital investment in an array of businesses, and less charity. Diverting those dollars from the best uses as determined by the individuals into the best uses as determined by the politicians will have a cost.

Now, what would the government do with the added revenue? We can't say for sure. Maybe it would be devoted to some fabulous new program — universal health insurance is a current favorite — intended to cure some "social problem" as envisioned by the interventionists on the Left. Maybe it would be consumed in some new foreign policy escapade favored by interventionists on the Right. Maybe it wouldn't be spent at all so that there would be a much smaller budget deficit. The most likely outcome, I submit, is that the politicians would squander the money on more of just about everything they currently squander money on.

Which is going to do more good — allowing individuals to direct the money they have earned, or having the politicians take over? If you think that's a tough question, contemplate whether you are more careful when spending your own money, or when spending someone else's.

A second serious problem with the Levitt-Dubner view is that it overlooks the disincentives of taxation. Having to pay taxes on earnings reduces the payoff from work, so to some extent people will choose to do less work when they're taxed more.

To make this point more tangible, let's consider Bob, a self-employed roofing contractor. He reports an income of $100,000 to the IRS, but because he does a substantial amount of roofing work for cash, his actual income is, we'll say, $200,000. Bob ought to be paying additional taxes of about $40,000. Instead, he keeps the money and spends, invests, and donates it as he chooses.

If the IRS were to increase audits (and why not impose far stiffer penalties, too?) to the point where Bob was frightened into complete compliance, would the government get its additional $40,000? Probably not, because he might very well choose to do less work. He already lives reasonably well. Extra money is nice, but at some point, it's not worth the time and effort. Bob and many other Americans who used to under-report their income now pay more in taxes, but also do less useful work than previously.

Lastly, we can't forget that the necessary IRS enforcement activity won't be free. The government would have to hire more auditors, thus taking yet more resources from the private sector.

 For Good and Evil (Expanded 2nd edition) Taxes destroy civilization: $30

So here's the trade-off. By significantly increasing its auditing of tax returns, the government could collect billions in additional revenue, which it then proceeds to blow on a vast array of pork, subsidies, and boondoggles that benefit the politicians and various special interest groups. To get that additional tax money, private spending shrinks, less work is done that can be subjected to taxation, and the government sucks more people into its employ.

That doesn't seem to be such an appealing deal.

Auditing more tax returns to collect more money for the government won't make anyone's taxes go down. The only appeal this policy has is to the imaginary fairness of making everyone pay all the taxes he owes under a tax system that is inherently unfair to begin with. Instead of trying to get people mad over the alleged unfairness of some taxpayers paying less than they're supposed to, I would rather try to get them mad over the fact that the government makes all of us pay for trillions in federal spending that's wasteful and counterproductive.


George Leef is executive director of the John William Pope Center for Higher Education Policy. georgeleef@popecenter.org. Comment on the blog.


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