Why Pay Income Tax?

Copyright, The New York Times Company Millions of taxpayers are filling out their tax returns over the next several days. Economists are still not sure whether taxpayer honesty or fear of the Internal Revenue Service explains why taxpayers’ income reporting is pretty accurate.

But with the Treasury spending more than ever, it’s important to know why people pay their taxes and what will continue to motivate them to pay in the future.

It’s difficult to get exact numbers on income tax cheating, but I.R.S. studies (read about them and other tax-evasion analysis in Prof. Joel Slemrod’s paper) suggest that reporting of wages and salaries is so high that the Treasury receives 99 percent of what it would if all taxpayers were honest about that income (see Page 2 of this I.R.S. report).

You might think that people pay taxes merely to stay out of trouble with the I.R.S. But 99 percent of people are not audited by the I.R.S., and even the remaining 1 percent are penalized only about 10 percent of the amount underpaid. (The I.R.S. is, however, increasing its audits of the wealthy.) From a financial point of view, underpaying taxes looks like a high expected return investment: a 99 percent chance of keeping the, say, $10,000 that you underpaid the Treasury and a 1 percent chance of having to pay the $10,000 plus a $1,000 penalty (on average, you get $9,790 for every $10,000 you hold back from the Treasury).

Some economists have tried to reconcile low penalties with high compliance, arguing that people obey the tax laws for non-economic reasons – people want to be honest and pay their share. Or perhaps individuals don’t understand that any one person’s tax payment is not critical to the functioning of our government, while the aggregate of millions of tax payments are.

To the extent that much of the Treasury’s revenue arrives because taxpayers are honest, public policy might not want to take honesty for granted. For example, the Treasury may receive less revenue over time if taxpayers increasingly distrust government because they perceive their tax dollars are wasted.

There’s some truth to the honesty theory (I’ll write next week about a study of integrity and tax compliance), but tax compliance still responds to incentives. When the probability of audit falls, compliance falls.

It’s difficult for the I.R.S. to verify many types of business income: as a result the amount of proprietor, rent and royalty income that is reported is actually less than the amount unreported.

Nanny taxes -– self-employment taxes paid for household employees -– are another type of tax on which many people cheat, and enforcement on this front is weak. Though on this and other tax issues, high-profile people –- like political appointees –- should beware.

Among those whose failure to pay various taxes were widely publicized were Tom Daschle, President Obama’s nominee as secretary of health and human services; Treasury Secretary Timothy Geithner, and Zoe Baird, President Clinton’s nominee for attorney general.

A Ph.D. dissertation being written by Mark Phillips, a University of Chicago student (and an I.R.S. intern) argues that a reasonable fear of penalty explains much of why taxpayers pay their income tax. He agrees that I.R.S. audits are rare, but that the audits are well targeted, so the agency would quickly detect many ways that taxpayers might consider underreporting.

For example, Mr. Phillips asserts that the I.R.S. would easily notice a taxpayer who reported less wage and salary income on her return than appeared on the W-2 reported by her employer to the I.R.S. Taxpayers understand this, so they are pretty careful that their return matches the W-2, and the result is that deliberate discrepancies are infrequent and frequent audits are unnecessary.

For now, it looks as though both honesty and incentives help bring revenue to the Treasury.