The top 1 percent of U.S. households by income fail to report 21 percent of their earnings to the IRS—a level far higher than previous estimates—according to a joint study between the tax collection agency and academics, who reached for new tools to gauge just how much people avoid paying taxes.
Studying the problem of tax evasion—or avoiding paying taxes by illicit means—the authors of the National Bureau of Economic Research (NBER) working paper (pdf) found that random audits underestimate the degree to which people hide income.
Previous estimates undershot the true extent of dodging taxes by high-income households chiefly because random audits fail to capture “most tax evasion through offshore accounts and pass-through businesses, both of which are quantitatively important at the top,” the authors found. They said that of the 21 percent of unreported income among the top 1 percent of earners, 6 percent comes from “undetected sophisticated evasion” techniques—including misrepresentation of business income, dividends, interest, and capital gain in pass-through businesses.
Correcting for this by reaching for data from operational audits carried out by the IRS and from “targeted enforcement activities,” such as on offshore bank accounts, and then combining it with random audit data, the authors believe they arrived at a more accurate estimate of the true extent of the tax-dodge problem.
“We find that unreported income as a fraction of true income rises from seven percent in the bottom 50 percent to more than 20 percent in the top one percent” of earners, the authors wrote in the paper, which was jointly authored by two IRS researchers—John Guyton and Patrick Langetieg—and three academics: Gabriel Zucman from the University of California–Berkeley, Max Risch from Carnegie Mellon University, and Daniel Reck from the London School of Economics.
The problem is even more acute at the very highest sliver of earners—the top 0.1 percent—the study found. While unreported income by the top 1 percent was higher than previous estimates by a factor of 1.3, that figure rose to 1.8 for the upper 0.1 percent.
“We estimate that 36 [percent] of federal income taxes unpaid are owed by the top one [percent] and that collecting all unpaid federal income tax from this group would increase federal revenues by about $175 billion annually,” the authors wrote.
They said their research supports the view that it would be worthwhile for tax authorities to invest in improved tools and deploying more resources to tax enforcement at the top of the income distribution, as this “could generate substantial tax revenue.”
These findings represent an upward revision to federal tax revenue estimates by the Congressional Budget Office, which said in a report last July that boosting the IRS’s funding for audits would increase revenues by $61 billion to $103 billion over 10 years, depending on how much the agency’s budget was increased.
These recommendations come as audit rates have declined in recent years, particularly for large businesses and wealthy taxpayers. A Center on Budget and Policy Priorities report from February 2020 found that audit rates dropped 46 percent from 2010 to 2018, while for millionaires, they fell 61 percent.
The IRS periodically estimates the difference between the amount of taxes owed and the amount collected each year—called the tax gap. In its most recent report, the IRS estimated that the average annual gross tax gap was $441 billion between 2011 and 2013.
The net tax gap, which is the gross tax gap reduced by the amount that the IRS collects through enforcement, was estimated at $381 billion per year, on average, over that same period.