NCPA - National Center for Policy Analysis

Audit Warning Prompts Wealthy To Report Less Income

July 27, 1998

Economists at the National Bureau of Economic Research came up with some startling data in the course of an experiment involving Minnesota taxpayers.

The state sent out notices to some 1,700 Minnesotans in early 1995 informing them that their 1994 state and federal income tax returns would be "closely examined" by state authorities. After the returns were filed, they were compared with the group's 1993 returns, and to the 1993 and 1994 returns of a control group of similar taxpayers who had received no such notice.

  • As expected, most low- and middle-income taxpayers who had received the audit warning reported more income in 1994 -- with total taxes going up an average of 2 percent.
  • For middle-income filers who listed business or farm income, reported tax liabilities rose an average of 12 percent.
  • Astonishingly, however, filers with incomes over $100,000 actually reduced their reported incomes relative to the returns of the control group.
  • This wealthy group cut its taxes by at least 17 percent -- and in some cases by as much as 35 percent.

The researchers theorized that the wealthy group and their tax advisers took more care in preparing returns and thereby found legitimate ways to reduce their tax bill.

Another theory is that taxpayers and their advisers decided to take a more aggressive stance -- creating some potential tax liability as a negotiating gambit.

Source: Gene Koretz, "The Games Taxpayers Play," Business Week, July 27, 1998.


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