As featured in The Wall Street Journal, Money Magazine, and more!

Rich People are More Likely to Cheat on Income Tax Returns

This article was written by in Taxes. 16 comments.

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 The study compiled data from tax returns from 2001, audits, and unpublished data from the Internal Revenue Service.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]

Updated January 16, 2010 and originally published October 23, 2008.

Email Email Print Print
About the author

Luke Landes is the founder of Consumerism Commentary. He has been blogging and writing for the internet since 1995 and has been building online communities since 1991. Find out more about Luke Landes and follow him on Twitter. View all articles by .

{ 8 comments… read them below or add one }

avatar 1 Anonymous

I wonder what criteria is used for “under-reporting income.” Inflating deductions or not reporting Schedule C income is obvious, but is sheltering rental income, for example, really illegal or immoral?

And what about servers/bartenders? I’ve never met a single one who reported or paid taxes on more than the bare minimum assumed on their tips. Since their tips aren’t represented on any W-2, their compliance is likely to be over-stated in this study.

Reply to this comment

avatar 2 Anonymous

This is kind of a pointless study since the conclusion is obvious. It’s nearly impossible for many “poor” people to cheat on their taxes since all of their income is reported on a W-2. Wealthy people have more deductions thus more opportunity to under-report income or over-report expenses.

Further, since most poor people don’t pay taxes at all, it isn’t too surprising that they have no incentive to cheat. Rich people would have far more incentive.

But, in any event, the solution is easy,–simplify the tax code so there are fewer deductions. But Congress doesn’t want to do that.

Reply to this comment

avatar 3 Luke Landes

Mark: “Poor” people weren’t really the focus of the study. The premise does seem obvious but the study puts numbers behind the theory to “prove” it.

Reply to this comment

avatar 4 Anonymous

The more is at stake, the higher the probability of trying to do something about it. I’m not surprised.

Reply to this comment

avatar 5 Anonymous

I wonder what will happen when the Feds increase taxes on all these rich people? That will increase compliance I’m sure …

Reply to this comment

avatar 6 Anonymous

I thought income tax is unconstitutional, because it’s an unapportioned tax which the constitution forbids. Even with that, I also thought that not all the required number of States approved that amendment. Meaning, they passed it even though it’s not technically written as law. And the government is thus illegally collecting/forcing income tax from people and then jail them if they don’t pay? Quite the “democracy” I’d say.

Reply to this comment

avatar 7 Anonymous

Mike (um, the other Mike) says “I thought income tax is unconstitutional, because it’s an unapportioned tax which the constitution forbids.”

Ah, but in point of fact, the constitution reads: “The Congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration.”

That is the 16th Amendment which is, by definition, part of the constitution.

Of course, I suppose there are those who would argue that the constitution is unconstitutional. But if we assume the constitution is in fact constitutional, then the income tax is, alas, constitutional.

Reply to this comment

avatar 8 Anonymous

I agree with Mark.

I think that we should also look at the aspect of allowing expenses. Businesses have a wider scope for allowing expenses as tax deductibles as opposed to the salaried guy who has so little room.

It might not be just an issue of integrity.

Reply to this comment

Leave a Comment

Note: Use your name or a unique handle, not the name of a website or business. No deep links or business URLs are allowed. Spam, including promotional linking to a company website, will be deleted. By submitting your comment you are agreeing to these terms and conditions.