NCPA - National Center for Policy Analysis

Lower Tax Rates Increase Compliance

April 20, 1998

Tax evasion is a growing problem. The IRS depends heavily on self-reporting of income and voluntary compliance with the tax laws. Auditing only reaches fewer than one percent of taxpayers. Not surprisingly, there is strong evidence that more and more taxpayers are failing to fully report income and pay all the taxes they owe.

However, a good estimate of the amount of income that is unreported can be obtained by comparing the IRS's figure for adjusted gross income (AGI), which comes directly from tax returns, and the Commerce Department's estimate of AGI from aggregate sources, such as total wages paid by corporations and interest paid by banks. If compliance were perfect, the two figures should be the same.

  • But the Commerce Department reports over $600 billion more in AGI than shows up on tax returns -- called the AGI gap.
  • The relative AGI gap is very sensitive to changes in tax rates (see figure); for instance, when rates were cut in 1986, the AGI gap fell from almost 14 percent of AGI to 10 percent.
  • But when tax rates were raised in 1990 and 1993, the gap rose as the tax saving from noncompliance increased.

Efforts to force taxpayers to pay have proven to be futile. The New York Times reports that when rules for paying "nanny" taxes on household help were tightened in 1994, the number of taxpayers paying such taxes fell from 500,000 to 300,000.

According one estimate, there are now 25 million Americans who are self-employed, independent contractors or temporary workers. These workers find it much easier than traditional wage employees to avoid taxes. As more and more home-based workers join their ranks, the problem of tax evasion will only grow.

Source: Bruce Bartlett (senior fellow, National Center for Policy Analysis), April 20, 1998.


Browse more articles on Economic Issues