Budget Cuts Open the Door to More Tax Cheats

Budget Cuts Open the Door to More Tax Cheats

mediaphotos/iStockphoto/The Fiscal Times

No one likes paying taxes, but there's some comfort knowing everyone pays their fair share, right?

Think again. After years of increased enforcement efforts at the Internal Revenue Service, tax cheating is still rampant, costing the federal government an estimated $350 billion or more each year in missing or late taxes. That's more than the government collects annually from the corporate tax, and 16 percent of the government’s total revenue.

What’s worse, the IRS’s vaunted search-and-destroy reputation for cracking down on tax fraud – built up over the past decade -- is being threatened by Republicans’ efforts to cut the agency’s budget. “We’ve been in an era of increased funding and enforcement activity, but that could be coming to an end shortly,” says Mark Luscombe, a tax analyst at CCH, a unit of Wolters Kluwer in Riverwoods, Ill.

Republicans failed to push through $600 million in cuts to the IRS budget this year, but did manage to block President Obama’s proposed increases – leaving the IRS budget flat at $12.1 billion. The IRS is seeking a 10 percent increase in its budget for the coming year, with much of the new money going for stepped up enforcement efforts. But less is being allocated to financial services in general, which doesn’t bode well for the IRS.

IRS spending cuts are called for as part of the Republican plan to relieve the nation’s fiscal problems passed by the House, but this could backfire. Spending by the agency comes with a return: For every $1 it spends on enforcement, it gets at least $4 back in collected taxes. IRS Commissioner Doug Shulman warned a Senate subcommittee on Wednesday  that if the agency has less money to work with, the tax gap --that's the difference between what the IRS figures it will collect and what it actually brings in -- will get even bigger. Such agency budget cuts “would actually increase the deficit by decreasing revenue,” Shulman said.

For tax deadbeats, the prospect of a weakened IRS would be welcome news. These are some of the most common scams cheaters could have an even easier time getting away with:

  • The Death Master File may sound like a heavy metal cover band, but it is key to one of the fastest growing types of tax fraud -- identity theft. The DMF, as it’s called, is the database kept by the Social Security Administration with records of deceased citizens. It has been a growing source for scammers who access Social Security numbers, file fraudulent returns, and make off with refunds.

    Social Security numbers are obtained unlawfully in many other ways, such as using phony Web sites to request personal information or via email. Incidents of tax fraud through identity theft have exploded from 51,702 in 2008 to 248,357 in 2010, according to the General Accounting Office.
  • Over-reporting refundable tax credits is another favorite tactic among fraudsters these days. The earned income tax credit is the most widely exploited, with an estimated 30 percent  of all claims – amounting to about $12 billion -- believed to be either fraudulent or in error. But other credits, such as the first-time homebuyer credit, American opportunity tax credit and adoptions credit, are fair game for fraudsters as well.
  • Failure to report income is the black hole of tax fraud. Small business owners and independent contractors who file a Schedule C Form are the biggest violators: The IRS figures these taxpayers only disclose 43 percent of their income, leaving some $68 billion unreported. The IRS believes farmers to be the biggest scammers, because they report only 28 percent of their income.

    Boosting compliance is tricky, because most of these unlawful transactions typically leave no paper trail. Consider the last time you paid your plumber or landscaper. The IRS has no way of knowing that transaction took place and the payment could easily go unreported. To require customers to fill out Form 1099 for each transaction (think: every time you pay a cab driver) would be too cumbersome and time consuming.

  • Some of the biggest money is stashed away offshore. The IRS had one of its greatest successes weeding out tax cheats in 2009, when it pressured banking giant UBS to disclose the names of Americans with possible hidden offshore assets. In a sure sign that enforcement pays off, scammers got spooked and almost 15,000 came forward as part of a voluntary compliance program.

A voluntary compliance program is now in effect through August, offering taxpayers lighter penalties and the possibility of avoiding criminal prosecution if they pay up.

Two new rules go into effect this year to help the IRS combat fraud. One requires credit card companies to report transactions to the IRS. To weed out some of those unscrupulous filers of Schedule C forms, showing business income the IRS will be looking for cases in which spending far exceeds reported income. Another rule requires financial institutions to disclose tax basis of securities sold, so investors are less likely to get away with understating their capital gains.

Meanwhile, Congress can do more to attack the problem. For example, it can require that taxpayers file more documentation supporting eligibility for tax credits. And it can give the IRS broader authority to check returns for discrepancies before issuing a refund. As it is, changes to the tax code are often followed by a couple of years of non compliance before Congress gives the IRS the authority to do pre-refund checks specific to those changes, says Mike Brostek, director of tax issues at the U.S. General Accounting Office.

Ultimately, however, these and other measures will have only a pruning effect on the fraud epidemic. The system’s multiple tax rates and numerous credits and deductions create a myriad hard-to-detect opportunities for cheating – too many for the IRS to weed out.

The only way to unearth the problem at its roots is to reform the tax system. This could minimize unfairness created not only by fraud, but also by legal tax avoidance strategies that allow for large corporations like General Electric to pay little or no taxes. With a system that permits such avoidance, it’s worth considering whether an inherently flawed system that encourages dishonesty -- not just a lack of enforcement -- is contributing to the troubling and highly costly epidemic of fraud.

Related Links:
Offshore Operations Cost U.S. Billions (The Fiscal Times)
Social Security Scam the Latest Wrinkle in Tax Fraud (The Fiscal Times) 
Simplify!  Dump the Current Tax Code and Start Over (The Fiscal Times)