Does America’s Tax System Willfully Favor the Rich?
Who’s cheating on Uncle Sam the most these days? Earlier this year, two IRS researchers joined economists from Carnegie Mellon, the London School of Economics and the University of California at Berkeley to explore this question.
According to these analysts, Americans at the top and bottom of the income scale do not report all of their income. But the level of non-reporting varies enormously. Among Americans belonging to the poorest 50% in the country, only 7% of income goes unreported. In the top 1%, it’s almost 20%.
What is happening here? Or is it just deeply but unintentionally flawed?
This is a complicated question. But as a tax lawyer, I firmly believe that the flaws are intentional. Let’s take a look at the evidence.
Most of us don’t have the ability to exclude income from our tax returns. Our employers report all of our wages and salaries on W-2 forms. Our financial institutions declare interest on our savings and dividends on our 1099 shares.
But the type of income that many comes up with at the top of our income scale – business income from partnerships and other special categories of business enterprises – usually doesn’t appear on any form that needs to be filed with the IRS. .
In other words, we have a tax system with a built-in loophole in reporting information. This certainly counts as a major flaw.
An intentional fault? Maybe, but it’s debatable. So let’s take a look at the recent dramatic drop in IRS audit rates on the nation’s wealthiest.
Audits on revenues over $ 1 million have fallen by 71% since 2010, says the Center on Budget and Policy Priorities. This drop reflects fairly substantial cuts to the IRS budget – a 19% hit since 2010 – and what could be more intentional than budget cuts?
Some might argue that the drop in auditing on high-income earners may simply reflect the inevitable complexity of their returns, which can include all kinds of business entities and trusts.
Section 6707A of the tax code imposes a penalty for failing to disclose a âlisted transaction,â essentially any transaction that the IRS identifies as an abusive measure to avoid taxes.
The sanction for violation of article 6707A? An amount equal to 75% of the tax that a taxpayer sought to avoid through the transaction, even if the transaction itself is considered legitimate. Failure to disclose also gives the IRS unlimited time to verify reports of listed transactions, not just the regular three years.
Sounds like a squeeze for shady declarers, doesn’t it? Those who engage in listed transactions may disclose their abusive transactions in their tax return, a decision that will almost certainly trigger an audit. Or they can omit disclosure and risk a huge penalty.
But there is a catch. Section 6707A carries a maximum penalty. No person who fails to disclose a listed transaction can be fined more than $ 100,000.
Think about it for a moment. For a person who engages in a listed transaction to avoid multi-million dollar income tax, the penalty limit in Section 6707A essentially imposes no deterrent to tax evasion.
If you’re trying to avoid $ 50,000 in tax, the threat of a penalty of $ 37,500 on top of the tax owed will be intimidating. But if you’re trying to avoid $ 3,000,000 in taxes, that threat of a $ 100,000 penalty is insignificant. Without the possibility of a severe penalty, even the indefinite audit risk becomes much less threatening.
The bottom line: Section 6707A undoubtedly rigs our tax system in favor of the ultra-rich. What good policy could be served by intentionally limiting the exposure to penalties of very wealthy taxpayers and no one else? I can’t think of one.
Could the intentional rigging of the tax code in favor of the rich be limited to this one obscure sanction provision? Do you want to buy a bridge?
Bob Lord is a tax lawyer and associate researcher at the Institute for Policy Studies.