WSJ: The Problem With The IRS Pledge Not To Audit More Earners Under $400,000

Wall Street Journal, The Problem With the IRS Pledge Not to Audit More Earners Under $400,000:

What are your odds of being audited? ...

The audit rate sounds straightforward: the share of taxpayers with a given level of reported income who are audited. In fact, a look at how that number is calculated reveals some important challenges for U.S. tax collection.

The audit rate has newfound relevance because of the IRS’s new $80 billion in funding. Treasury Secretary Janet Yellen had directed that “any additional resources—including any new personnel or auditors that are hired—shall not be used to increase the share of small business or households below the $400,000 threshold that are audited relative to historical levels.” ...

At all income levels, the audit rate has plunged over the past decade amid declining IRS resources and head count, as a Government Accountability Office report released last year shows. 

$400,000 is a fairly high threshold—fewer than 2% of tax returns have adjusted gross income above that, according to IRS data. But why pursue those families when there might be multimillionaires and billionaires dodging millions of dollars in taxes?

Well, one reason is that the standard calculation of audit rates falls short. They are based on what taxpayers report their income to be. But tax dodgers are by definition underreporting their income.

“People might think it’s very clear who is and who isn’t high net worth,” said Natasha Sarin, a Yale law professor and former Treasury official. “The whole point of tax evasion is people with high net worth are doing a lot of maneuvering and accounting tricks to look like they’re not.”

So while most people who report, say, $300,000 in income are upper-middle-class households with straightforward finances—salaries, a mortgage, children—some are very rich people whose actual income is far above that level but are especially audacious or creative in reporting a lower figure. Those are the people the IRS might very much want to audit. ...

Audit rates also present an incomplete picture of how efficiently the IRS allocates enforcement efforts. Why would the IRS ever audit a lower-income taxpayer when auditing a wealthy taxpayer presumably yields more tax? Because from the IRS’s perspective, not all audits require the same effort. It spends a little over six hours on average auditing a taxpayer reporting $25,000 to $200,000 in income, but almost 34 hours on one reporting $500,000 to $5 million. So audit efficiency is best measured by additional revenue per hour of work, rather than audit rate. ...

So to answer the original question—what are your odds of being audited?—the audit rate turns out not be a good metric, because audits aren’t random. They are triggered by something unusual or a conspicuous mistake. The task facing the IRS: What is the trigger for identifying a taxpayer pretending to be middle class?