May 16, 2002

May 16, 2002 | Commentary on Taxes

Tax Reform - Not More Audits

Does the IRS always merit the harsh criticism it receives? No. Politicians deserve much of the blame for the way our tax system operates.

Take, for instance, the Earned Income Tax Credit. It was Congress that created the EITC-essentially an income-redistribution program-not the IRS. But rather than provide this wage subsidy directly to lower-income workers, lawmakers dubbed it a tax benefit and put the IRS in charge of operating it. The result: a complicated mess that is riddled with fraud.

It's unfair to condemn the IRS, as The New York Times recently did, for investigating a high number of suspicious EITC claims. With fraud rates as high as 25 percent, what choice does the agency have?

Well, the Times says, the IRS can audit more rich taxpayers. Statistics show that corporations and upper-income taxpayers face a relatively small risk of being audited (about 1 in 145 of those making more than $100,000 a year, versus 1 in 47 for those who claim the EITC). But those who think this would cause tax revenue to rise are confusing tax avoidance with tax evasion.

Tax avoidance is the legal use of shelters, loopholes, preferences, credits, deductions and exemptions to reduce tax liability. Not surprisingly, rich people and corporations make extensive use of these provisions. Indeed, there's an entire army of Washington lobbyists who earn six-figure incomes getting these goodies placed in the tax code on behalf of well-heeled clients and interest groups.

Many of these provisions are horrible tax policy. They complicate the tax system and encourage taxpayers to ignore economic fundamentals and make decisions on the basis of tax considerations. But it's perfectly legal for taxpayers to use these provisions to lower their tax bills. As such, the IRS frequently is unable to collect much money when it audits corporations and the rich.

This isn't the IRS's fault. It's the result of almost 90 years of social engineering and back-door industrial policy by Congress. Politicians from both parties have used the tax code as a tool to reward friends and punish enemies. The IRS, meanwhile, is left with the unenviable task of trying to enforce one of the world's most complex tax codes.

It's not that the rich are less likely than the poor to scam the system. There are many ambiguous provisions in the tax code, and some well-to-do taxpayers do stretch the law well beyond its breaking point. But wealthy taxpayers aren't easy targets for the IRS. Armed with lawyers, accountants and financial planners, they have the resources to fight -- and often win -- a battle with the tax collector.

There are two ways of increasing tax compliance. One is to create a more intrusive government by giving the IRS more power to snoop into our affairs. A good example: the IRS's recent proposal to examine the credit-card records of Americans who have foreign bank accounts. This fishing expedition would violate privacy and run roughshod over civil liberties. Yes, it likely would catch some taxpayers who aren't reporting income from foreign accounts, but do we really want to give the IRS that much power?

The second way is tax reform. Ironically, America can learn much from Russia on this topic. Two years ago, the former communist state had a Western-style "progressive" income tax. But high tax rates drove capital out of the country and encouraged workers to accept income under the table. So Russia's leaders decided to junk the tax code and replace it with a 13 percent flat tax.

The results have been spectacular. Russia's flat tax has been in effect since January of last year, and inflation-adjusted tax revenues have jumped by nearly 30 percent. And now that President Vladimir Putin and his band of reformers are beginning to tackle the problem of punitive payroll tax rates, there is every reason to expect that tax revenues will continue to rise. Russia faces other challenges, of course, but it's taken a huge step in the right direction.

And if former communists can implement a flat tax, maybe there's hope for the U.S. Congress. It certainly would mean less tax evasion, as lower tax rates and tax simplification reduce both the incentive to evade and the opportunity to avoid. And while it may not be good news for the thousands of IRS bureaucrats and the legions of well-paid tax lawyers, lobbyists and accountants, it would make life better for the American people.

Daniel Mitchell is the McKenna senior fellow in political economy at The Heritage Foundation (www.heritage.org), a Washington-based public policy research institute.

About the Author

Daniel J. Mitchell, Ph.D. McKenna Senior Fellow in Political Economy

Related Issues: Taxes

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