According to a new study by Joel Slemrod, a professor at the University of Michigan’s business school, and Andrew Johns, an IRS researcher, the more you earn, the more likely you are to cheat on your taxes. The study compiled data from tax returns from 2001, audits, and unpublished data from the Internal Revenue Service.

People who earn more money have been able to get away with paying less income tax than they would, had they followed the rules, according to the data. The misrepresentation of income is usually accomplished by neglecting to include unreported business income on Schedule C or by inflating deductions. Some get caught, but many don’t.

The study shows that those earning between $50,000 and $100,000 understated their income by 8% on average, while taxpayers whose true earnings were between $500,000 and $1,000,000 understated adjusted gross incomes by 21%. As income grows, there are more opportunities to hide income, such as through rental property income, capital gains, and self-employment. Sole proprietors who report self-employment income on Schedule C underreported their income by 57%. Compare that to those who earn a wage or a salary, reported to the IRS by the employer on a W-2 form. These taxpayers underreported their income by only 1%.

The data neglect to count taxpayers who may have certain offshore bank accounts, sheltering money from the Internal Revenue Service. The IRS hasn’t been able to determine the extent of this practice.

How should the IRS proceed in order to collect more legitimate tax payments due? Raise the income tax rate on those who are most likely to cheat? Or will that encourage those who are able to find new ways to underreport income? I’m starting to lean towards a more consumption-based tax system, but I don’t think there is a perfect solution.

Photo credit: rachaelvoorhees
The Distribution of Income Tax Noncompliance, Joel Slemrod and Andrew Johns, October 23, 2008 [pdf]

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