U.S. Tax System – Incentives for Compliance
The United States has an extensive taxation system designed to raise money for government salaries and projects. This system includes global taxation, including taxes for income, capital gains, rents, and other means of accruing wealth. It also includes specific program taxation, including taxes for social security and Medicare. Nearly all financial transactions in the United States result in a percentage of the funds going to the federal government. When a citizen swipes their credit card at a local restaurant, the business owner has created income that will be taxed. When a local fisherman sells his used boat, the fisherman must calculate capital gains on the sale. When a homeowner pays his maintenance man in cash, the maintenance man has received income that is taxable. When a stockholder receives a dividend payment, the payment is taxed as ordinary income. The rules allow the government to place their hand into nearly every financial transaction within the United States.
Under our system, the government relies on individual citizens to gather their records, isolate their financial transactions, and voluntarily submit their financials via a tax return at year’s end. This return will result in a tax liability based on their transaction history. In short, the government relies on the truthfulness of its citizens to obtain the tax revenue assigned to them under the code. Though the system operates under an “honor code,” it is not by design. If the government could review every return for accuracy, they would. The number of returns is just too voluminous to make such oversight feasible.
The Civil Penalties to Incentivize Compliance
Given the reliance on the individual taxpayer to accurately calculate their own tax liability, the United States has built a network of laws to incentivize compliance. In the United States, the tax system uses punitive measures to incentivize citizens to accurately report their income and pay their tax obligations. The most common measure involves applying penalties and interest to the tax liability for non-compliance. These penalties apply a percentage fee based on failure to timely pay a tax or file a return. The penalties are triggered on the day the return should have been filed or paid. The penalties grow month over month until reaching their maximum penalty amounts. The failure to file penalty accrues at 5% of the tax owed per month. It maxes out at 25%. The failure to timely pay penalty accrues at .5% per month and maxes out at 22.5%. If a taxpayer fails to file and pay their tax returns for multiple years, they can quickly accrue an additional tax debt of 47.5% of the underlying liability. Put differently, a taxpayer can turn a $50,000 tax bill into $73,750 by maxing out the two penalties outlined above.
In addition to the penalties associated with non-compliance, the IRS charges interest against the tax debt each day it remains unpaid. The interest rates are normally in line with the current rates issued by the federal reserve. The interest accrual has no maximum. It will continue to accrue during the life of the debt.
When taxpayers refuse to pay or file their returns, they will be hit with at least these three sanctions. These sanctions alone can cause an aggressive increase in one’s tax liability. For example, let’s assume a taxpayer makes $5,000,000 from his business in 2023. On that income, he owes the IRS $1.4 million in taxes. On April 15, 2024, the taxpayer decides to forego filing a return and refuses to send any money to the IRS. The IRS does not notice the taxpayer’s failure. The taxpayer decides to repeat this behavior for 2024, 2025, and 2026.
If we assume his income was identical in all four years, the taxpayer’s true tax liability would have been $5.6 million for these four years. However, by 2030, his tax profile will look far different. By that time, the penalties for failure to file and failure to pay will be maxed for every year. This balloons his $5.6 million tax debt to $8.26 million. In addition to the increase based on penalties, the taxpayer will have interest accruing during the life of the debt. In this example, interest would have accrued on the 2023 tax debt for six years, the 2024 debt for five years, the 2025 debt for four years, and the 2026 debt for three years. Assuming an interest rate of 5%, the $1.4 million in debt would accrue an additional $70,000 annually per tax year. A rough estimate would add over $1.2 million in interest that has accrued by 2030 (this is a very rough estimate that does not account for compounding interest and variable rates).
This taxpayer’s refusal to take part in the system transformed his tax liability from $5.6 million for four years into a total debt of $9.46 million. This serves as a 70% increase in the liability. And of course, the damage does not have to stop in 2030. The interest will continue to accrue until the debt is paid.
Most citizens that find themselves before the IRS are dealing with this civil process. The civil division could review a taxpayer’s books for a formal audit or open a collections action following multiple years of non-compliance. This civil process is the most common contact from the IRS. However, the most egregious actors, or taxpayers that decide to take affirmative steps to hide transactions from the IRS, can be referred to a parallel criminal process. This process carries the same stiff penalties for non-payment and not filing, but it also attaches the consequences under Title 26 of the United States Code. These consequences include potential felony conviction and considerable time in a federal prison.
The criminal process is normally reserved for the most flagrant actors. Taxpayers that fail to file a return for one year, fall behind on tax payments, or commit honest errors in their returns will likely stay with the civil process. However, taxpayers who intentionally run afoul of the terms within the Internal Revenue Code can fall into the criminal process. Criminal tax offenses are charged and tried in federal courts regularly throughout the country.
Hotbed for Criminal Acts
The reliance of our tax system on the “honor code” makes it a hotbed for mistakes and intentional bad acts. In April or October of each year, a taxpayer gets to decide how much tax he will pay the federal government. Any person that has used Turbotax can watch their liability increase with the addition of each taxable transaction. A failure to disclose certain transactions results in immediate savings. Adding illegitimate expenses lowers the taxable income and the liability for that year. For small business owners, and other middle-class citizens, the incentive to play the system is obvious. When a taxpayer is living on small margins, there is an easy way to free up thousands for business investment and life expenses – game the tax system.
This reality, buttressed by the inefficiencies in the system, creates the perfect storm. The shear number of returns filed each year ensures the IRS cannot review all of them. The government does not have the manpower to review each filing. In response, the government chooses to focus on certain industries or filing statuses. They have a good idea where the most egregious fraud will exist, and they choose to focus their attention on these areas. This approach leads to further incentives to cheat as many taxpayers get by with underreporting income or otherwise lying to lower their liability. Once multiple years pass with no repercussions, the tax rules become recommendations that do not need to be followed. The failure of the government to hold taxpayers accountable creates the perfect environment for continued transgressions.
While many slip under the radar, others find themselves under investigation by the civil or criminal divisions of the IRS. These taxpayers feel the swift and immediate wrath of the treasury department. The financial penalties are severe. Criminal sanctions can be life altering. While the incentive to fudge numbers is apparent from the overall structure, it is a dangerous game. Every person caught in this dragnet wishes different decisions were made with their tax filings and payments.
Deterrence is the Only Path
The government knows that people lie on their taxes. They know these tax filers cost the government billions in tax revenue every year. They also know there is no mechanism to efficiently fill the gap in revenue. As long as individual taxpayers are relied upon to accurately report their income, and comply with the Internal Revenue Code, tax loss is inevitable.
The government’s response has been to enforce civil penalties and criminal sanctions to enhance voluntary compliance. Put differently, the government imposes lofty sanctions under the civil and criminal rules to deter others from lying on their returns or failing to participate. Their only way to combat the known instances of waste is to hang the ones they do catch high from the rafters to deter others from similar behavior.
The issue with their proposed model is taxpayers must internalize the consequences before those consequences will dictate their decisions. Most taxpayers are so far removed from the inner workings of the tax system that the penalties, civilly or criminally, produce no impact on their actions. Most taxpayers do not know about the over one-hundred penalties that can be enforced civilly. Or the various criminal statutes that may be triggered by their actions. Many of our clients are caught off guard when the criminal division of the IRS enters the picture. It is that moment where they first internalize the seriousness of tax offenses.
When finances combine with a lack of oversight, fraud will exist. This is true in nearly every government program that has ever been created. Recently, the Payment Protection Program during COVID was entangled with fraudulent claims. The ERTC program during COVID was shut down in 2023 due to fraud. Medicare estimates they lose over $60 billion a year to fraud and inaccurate billings. The IRS estimated in 2021 they are losing nearly $1 trillion each year to tax cheats who either abuse existing rules or outright lie on their returns.
There does not appear to be a solution for stopping fraud in the tax system. It is too easy to execute. For now, the government will continue to flag who they can and make examples of them when they do. Their hope is word will continue to spread that cheating on taxes is not worth it. Under a “honor code” system, deterrence is an uphill battle with little progress year over year.