According to government reports, most individuals with business income fail to pay all their taxes, although some appear to cheat more than others. (1) Underpayment of tax on business income is commonly attributed to the receipt of cash. (2) The owner of a clothing store, for example, might sell a dress for cash and not report the cash. Underpayment of tax by individuals on business income contributes significantly to the federal tax gap--the difference between what taxpayers owe on legal source income and what they pay. (3)
The government estimates that the annual tax gap equals $345 billion. (4) About $109 billion of this is attributable to underpayment of taxes on business income by individuals. (5) Sole proprietors also underpay Social Security and other payroll and self-employment taxes. (6) Additional underpayments are attributable to individuals who operate businesses as partnerships and small corporations. In the aggregate, small business owners report less than half of their income, (7) and their underreporting (including informal workers such as gardeners) is estimated to comprise about half of the tax gap. (8)
This Article attempts to provide a qualitative picture of tax evasion in the small business sector. It provides details from almost 275 field study interviews with cash business owners and with tax preparers and bankers who serve cash business clients. Our research suggests answers to the questions of who evades taxes, what taxes they evade, and why and how they evade taxes.
This Article proceeds in three additional parts. Part II summarizes the main threads of relevant social science research on small business tax compliance. Part III describes the methodology and results of this interview study. Part IV concludes.
TAX COMPLIANCE IN THE CASH BUSINESS SECTOR: EXISTING RESEARCH
The standard economic analysis frames a tax compliance decision as a comparison between (1) the cost of paying tax and (2) the difference between the benefit of avoiding the tax and the cost of the imposition of tax, interest, and penalties, risk-adjusted for the possibility that the government will successfully challenge the tax avoidance strategy. (9) But this model does not provide a complete picture of taxpayer compliance or the reasons for variations in taxpayer compliance. Substantial behavioral research, including contributions from sociology and psychology, deepens the analysis, and our research here offers more descriptive detail.
One summary of the behavioral compliance literature lists fourteen factors that may affect tax compliance, including age, gender, education, income level, income source, peer influence, ethics, fairness, complexity, and tax rates. (10) For our purposes, two of these factors, income source and peer influence, are most relevant and are discussed below. We also discuss studies that explore the relationship between tax preparers and tax compliance.
By far the most important determinant of tax compliance is income source. Taxpayers report cash income less accurately than income subject to third party reporting and/or withholding. (11) As noted in the introduction and accompanying notes, individuals evade business-source income, which is commonly received in cash, at a rate of approximately 50%, (12) although this evasion is not evenly distributed. (13) In contrast, the evasion rate on wage income--which employers report to the government and on which taxes are withheld--is about 1%. (14)
Cash income represents one extreme of an income visibility spectrum while income subject to third-party reporting or withholding occupies the other end. Some studies show, for example, that taxpayers are more likely to report income received in check form than income received in cash. (15) Taxpayer concerns that the government will detect a failure to pay taxes appear closely related to, but not completely dependent on, income source. (16)
The strong relationship between evasion and income source suggests that the primary causal factor that explains evasion is opportunity. Employees whose employers comply with wage reporting rules cannot cheat successfully and so such employees do not cheat. Individual business owners can cheat successfully (because no one reports much of their income to the government and because their income is hard to detect on audit) (17) and, in the aggregate, individual business owners do cheat. The literature on income source, accordingly, applies directly to a study of evasion in the cash business sector: it predicts a high rate of evasion in the sector and identifies the sector as a, if not the, leading source of non-compliance.
Peer Influence and Social Norms
A substantial body of research shows that taxpayers who believe their peers evade tax are more likely to evade tax themselves. (18) This correlation does not necessarily translate to the conclusion that the behavior of a taxpayer's peers causes the taxpayer's behavior. For example, peer behavior may be used to defend a prior decision not to comply, or (less plausibly) a noncompliant taxpayer may seek out noncompliant peers. (19)
Some studies do find a causal relationship, however. For example, one paper reports, based on longitudinal survey data, that a taxpayer tends to internalize the taxpaying norms of a group with which the taxpayer strongly identifies. (20) The compliance norms of individuals outside a taxpayer's small circle may also have relevance, but the relationship is less certain. (21) Another study suggests, for example, that mere mention by the government of broad social compliance norms cannot persuade taxpayers to comply. (22)
Another social norm question is whether attitudes toward government in general, such as approval of government policies or the political party in power, have a significant effect on tax compliance. Some studies show no such effect, (23) while others support a link. (24) Several studies indicate that taxpayers' perception of the equity of the tax system affects their compliance behavior. (25)
Research on the effect of norms generally does not focus on the cash business sector, but some of its findings can extend to that sector and have relevance for understanding evasion in that sector. One plausible hypothesis, based on these findings, is that the (correctly) assumed high level of non-compliance within the cash business sector contributes to, and in fact, increases the level of, non-compliance in that sector. Another hypothesis, not inconsistent with the first, is that differing beliefs as to peer behavior account for a significant variation in compliance among those in the cash business sector. (26)
Tax Preparer Influence
Taxpayers with business income typically rely on preparers to help in tax filings. (27) These preparers serve as "gatekeepers" (28) who may (or may not) improve the compliance behavior of their clients. A number of studies have examined how taxpayers choose their preparers, with varying results. For example, one set of survey results suggests that taxpayers choose a tax adviser who reflects their attitudes toward compliance; (29) another study suggests that once taxpayers have chosen a tax preparer, they tend to somewhat passively follow the advice of that tax preparer. (30)
Other studies focus on possible connections between tax preparer characteristics and taxpayer compliance. (31) One line of research, for example, indicates that a licensed tax preparer is likely to influence a taxpayer to be more aggressive on ambiguous questions and less aggressive on unambiguous questions. (32) One study concluded from data gathered through experimental cases presented to CPAs and non-CPAs that CPAs took more pro-taxpayer positions in ambiguous situations but advised compliance with the law if the rules were sufficiently clear. (33) Another paper demonstrated, based on randomly selected I.R.S. audit data, that CPA-prepared returns result in fewer audit adjustments compared to non CPA-prepared returns. (34)
The preparer studies, like the work on taxpayer norms, do not focus specifically on the cash business sector. But the studies have relevance for our description below of the preparer market. (35) Consider the studies suggesting that licensed preparers such as CPAs confine their aggressive advice to ambiguous situations and decline to advise their clients outright on tax evasion strategies. These studies might predict that licensed tax preparers refuse to accept tax-evading cash business taxpayers as clients. Or, the studies might suggest that licensed tax preparers and taxpayers often have a tacit understanding that they will not discuss cash income, so as to permit the tax preparer to avoid the uncomfortable question of whether to participate in what is plainly an evasion scheme. Our research indicates that the latter prediction is more accurate.
What We Don't Know About Evasion in the Cash Sector
Notwithstanding an impressive body of work on tax compliance (only hinted at in the brief summary above), we know surprisingly little about tax evasion in the business sector, aside from the consensus that, in the aggregate, owners of small businesses with substantial cash revenue fail to pay about half their taxes. One fundamental problem is that we lack any thick qualitative description of the actions or attitudes of those in the sector. We do not know very much about how taxpayers evade tax, how they view their actions, how they use preparers, or how preparers in the sector view their role and their clients.
We suspect our lack of knowledge has resulted from a disconnect between the quantitative methodological tools used in most prior studies and the complex and norm-driven nature of the particular behavior at issue. The core government tax gap data emerges from the statistical sampling methods used in the work of the so-called National Research Program and its predecessor, the Taxpayer Compliance Measurement Program. (36) But neither these empirical techniques...
Cash businesses and tax evasion.
|Author:||Morse, Susan Cleary|
|Position::||Symposium: Closing the Tax Gap|
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