Paul L. Caron

Tuesday, August 5, 2008

Johnston: Trust, but Verify

Tax_analystsDavid Cay Johnston has published Trust, but Verify, 120 Tax Notes 485 (Aug. 4, 2008):

New data, not yet published by the IRS, establish beyond a doubt that America has two income tax systems, separate and unequal. One system effectively taxes people with wages, while the other system is a sieve of untaxed income for investors and business owners.

The data show that 99% of wages people report on their income tax returns matches what employers list in verification reports. In contrast, the share of actual income from capital gains and business, which is not independently verified, is much less. Only about half of Schedule C profits show up on tax returns. And the new IRS data show that only 88% of capital gains is reported, a figure that almost certainly understates reality by a substantial degree. ...

Now, how do we have two systems, separate and unequal?

Congress treats Americans who work for wages, claim deductions for spouses and children, collect interest and dividends, and withdraw from pension and retirement savings accounts the way Ronald Reagan said we should treat the Soviets on arms reduction: Trust, but verify. Congress does not trust this vast majority of citizens to report their incomes honestly and, with good reason, demands verification by employers, banks, brokerages, and mutual funds. Congress also requires Social Security numbers for all dependents.

Business owners and investors are another story. Congress trusts them to fully and accurately report their revenues, their profits, and their capital gains and not to charge personal expenses as tax-deductible expenses. For these favored citizens, there is no independent reporting, except for capital gains, in which only the amount realized at sale is reported and the individual is trusted to accurately report basis. Except for requiring audits, which are rarely performed today compared to two decades or more ago, Congress assumes that these taxpayers keep their books the same way Rome's vestal virgins retained their privileged status. ...

Now if political reporters on the campaign planes would just ask hard questions about taxes and spending instead of hunting for gaffes, the next president and Congress could be pressured to weed out officially enabled tax cheating for business owners and investors through verification and withholding, which encourages tax return filing.

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Tracked on Aug 8, 2008 10:55:28 AM


Another reason -- as if we needed more -- that we should redirect our taxes away from productive effort and onto superior tax bases, like land, natural resources and other things which are far more difficult to hide.

So-called "capital" gains are frequently, at their base, actually land gains. Genuine capital tends to depreciate -- notice your car, notice your house itself, notice any machinery you own -- even with the very best maintenance and attention. Unused and unattended capital returns to dust.

The classical economists had it right, and utilizing their observations could bail us out of many of our most serious problems, including taxing the wrong things and taxing mostly the people at the bottom of the income and ownership spectrums.

Posted by: LVTfan | Aug 13, 2008 10:10:20 AM

The implication of the unpublished data is that a significant number investors do not avoid but in fact evade the tax (this is the point referring to reporting of basis). That issue should be bad news for everyone (except the evaders). This has nothing to do with avoiding taxes, which is a perfectly legitimate activity.

And it's true that the wealthy (as a group) collect a higher proportion -- up to 100% -- from investments. Those are unfairly referred to as "unearned" income (a term with roots in the labor theory of value) but are in fact results of investing already taxed income. We do tax it for a variety of reasons including the desire for a progressive tax system, but it's perfectly fair for it to be taxed at a lower, or even better much lower basis. Don't forget that anyone with a pension will be living on this same "unearned" income -- and did they not work to fund the investments in the first place?

The proportion of taxes paid by the wealthy and not so wealthy is an issue for a progressive tax system and is unrelated to the article.

Posted by: DV Henkel-Wallace | Aug 8, 2008 6:08:30 PM

Curious set of responses here, but on two of them:
1. The only thing you can say that is un-American is that we cannot solve a problem. This problem of under-rerpoting by business is actually easy to significantly reduce, as I will show in a future Tax Notes column (so, yes, I am recommending you subscribe to Tax Notes, which has no ads and is entirely financed by subscriptions).

2. The post "freedom" needs to do a lot more study. For example, the Boston Tea party was a protest against a tax exemption and the creation of a royal monopoly. The Constitution grants Congress the power to tax in a broad way because of the experiences of the colonists with the crown's use of tax favors for political purposes.

Posted by: David Cay Johnston | Aug 6, 2008 4:08:18 AM

What a crock! You're ALL very wrong in your assumptions and perceptions concerning Taxes.
Taxes are a religion-based fees designed to enhance the rich and delineate the actual performers of labour.
In law, it is called "Rico" (racketeering).
Remember, ALL judges have Birth Certificates registered in Puerto Rico (Port of Racketeering).
As long as you still possess a Birth Certificate, and have not given it back to who it rightfully belongs, you WILL be taxed out of existence.

Posted by: BlueyBlogger | Aug 5, 2008 4:29:50 PM

I agree with BRS. I have to wonder why all of you seem to fine with armed robbery, you just want to tweak it a little. Look here people, armed robbery is wrong, it doesnt matter if it's a street hood sticking a gun in your ribs or some dude in a snappy uniform wearing a shiny badge, armed robbery is armed robbery. I can't believe the stupidity of most so-called "Americans." It is all of your collective fault we are in this mess, wake up and smell the tuna fish.

Posted by: Bill | Aug 5, 2008 2:27:21 PM

There is nothing wrong in these numbers.

The income is undisputable and it that would not be correct the companies would be cheating, not the people.

The capital gains are different as one can match any sales to any buys and transfer the tax liability from one year to another. They all come up and correct on due time.

Posted by: Ruutana | Aug 5, 2008 2:05:34 PM

They should tax us more, I have too much money. Trust the Government to
manage your life, they know all!

Posted by: Taxmonkeyman | Aug 5, 2008 1:49:50 PM

The article poses a fair point that has larger implications to the tax system. In the media we hear about how the top 5% of earners, or "rich" (typically people with AGI's over 100,000) don't pay enough taxes. However, in demarking such a line, all are relying on reported income. Thus, wage earners typically are labeled as the richest in society, while many business owners and capital investors skirt under the radar.

However, one commentator has a fair point in how to make business owners verify their numbers? (Most capital gains transaction should be relatively easy to verify by things like making brokers report initial basis, include copy of purchase receipt with tax return...) Unlike wage earners there is no third party to verify amounts. Congress would need to be creative and impose some strict records-keeping on business owners, a move that would create a lot of political opposition. Even with auditing under today's standards, it is difficult to verify many business transactions.

It is Congress, not the IRS, who needs to address these problems.

Posted by: vb | Aug 5, 2008 10:34:14 AM

not all schedule C filers are fat cats hiding millions in income from the IRS. most of them, I would guess, are small business owners with incomes lower than your typical middle class wage-earner. after paying income tax, self-employment tax, and various other local business taxes and fees (not to mention health insurance and tax preparers!) you can find yourself making about as much as someone working at wal-mart. so don't generalize too much about what sort of people are benefiting from this "preference".
also, schedule C filers are required to pay estimated tax quarterly based on last year's income. (do corporations?) this can be even more damaging than witholding if your business is not generating as much revenue as last year.
furthermore, wage earners get to chose how much is withheld through their self-reported "exemption" and so could make their witholding drop to zero.

Posted by: tjr | Aug 5, 2008 10:23:25 AM

As if taxes are in any way acceptable. Whether wages OR capital gains, where is the LAW that dictates we must give the fruits of our labors to some pinhead tax collector? Do you recall what the response to the tax man was in the late 1700's? Let me give you a hint- tar, feathers, rough hewn rail, and a 'free' ride out of town.

I work, I have people who depend on me for survival. I do NOT recall anyone from the IRS sitting with me, helping me earn my pay. I do not recall EVER being asked if it was OK for the government to spend my grandchildren into poverty before they are even born.

Instead of griping about how one group of people isn't 'doing their fair share', why don't you focus on getting the extortionist IRS off ALL OUR BACKS.

Posted by: Freedom | Aug 5, 2008 9:58:33 AM

Another preference is the lower rate on capital gains. This may have had some limited value in the days when investors made productive investments, it makes no sense at all today when "investments" may be inflation of housing prices or sending jobs to China. Capital gains should be taxed the same as regular income

Posted by: brs | Aug 5, 2008 9:02:52 AM

Everybody knows that the rich can avoid and evade taxes on investment income. Some very smart people in government have been trying to find ways to improve compliance without imposing undue paperwork costs on honest taxpayers. They have largely failed, as anyone who reads the various "Tax Gap" reports can see. The problem appears to be intractable, although it does improve somewhat with lower tax rates and higher audit rates.

The article's title implies that it is possible to verify compliance by most business owners and investors. In the absence of specific workable recommendations that add up to closing most of the tax gap, I find that implication misleading.

Posted by: AMTbuff | Aug 5, 2008 8:20:48 AM