What Makes Sole Proprietors Fudge on Their Taxes

The IRS “Office of the Taxpayer Advocate” has released a preliminary report on its study of tax compliance and noncompliance among sole proprietors, who represent a large portion of the “tax gap” the agency hopes to close.

They want to know the factors that might cause such people to evade their taxes, and so do I, though with much different motives, and so I took a peek at the report. Here are some bits that stood out to me:

Most taxpayers believe tax laws are unfair.

Only 15 percent of both groups agreed or strongly agreed that the tax laws are fair. Rather, most taxpayers believe that:

  • Large businesses have loopholes to reduce their taxes that smaller businesses do not have;
  • The wealthy have ways of minimizing their taxes that are not available to the average taxpayer;
  • Not everyone pays his or her fair share; and
  • The federal tax laws are unfair

Those in the low-compliance group were more likely to participate in local organizations.

Among respondents who belong to local organizations, those in the low-compliance group were more likely to report that they usually participate. This was true for various organizations identified by the survey, including local business organizations (50 percent from the low-compliance group usually participate vs. 30 percent from the high-compliance group), local trade, labor, or occupational organizations (40 vs. 24 percent), and local civic, community, or fraternal organizations (67 vs. 47 percent). Thus, active participation in these groups appears to be negatively correlated with tax compliance, possibly promoting social noncompliance in terms of the typology. Perhaps those with a closer connection to local groups feel a weaker connection to the federal government, and a weaker obligation to comply with federal tax laws. They may also chose to associate with those who hold similarly negative views about the federal government and tax compliance, which reinforced their own views

Those in the low-compliance group were more likely to report that other members of local organizations view tax laws and the IRS negatively.

Those in the low-compliance group were more likely than those in the high-compliance group to report that other members of local business organizations believe tax laws are unfair (48 percent of the low-compliance group vs. 28 percent of the high-compliance group) or that the IRS treats taxpayers unfairly (37 vs. 21 percent). They were more likely to report that other members of local trade, labor and occupational organizations believe tax laws are unfair (42 vs. 38 percent) or that the IRS treats taxpayers unfairly (46 vs. 28 percent). They were also more likely to report that other members of local civic, community, and fraternal organizations believe the tax laws are unfair (50 vs. 23 percent) or that the IRS treats taxpayers unfairly (36 vs. 18 percent). Participation in these organizations may have allowed taxpayers to learn that noncompliance is an acceptable norm among other participants, or perhaps they assumed that other participants shared their negative views. In any event, the differences in the responses to these questions by members of the high- and low-compliance groups may suggest that a person’s perception about whether other participants in local organizations feel the tax law or the IRS is fair has an effect on their own compliance behavior (e.g., social and symbolic noncompliance), perhaps eroding tax morale.

Another thing they noted was that “Surprisingly, those in the low-compliance group were also more likely than those in the high-compliance group to believe that the IRS detects and penalizes noncompliance.” This is another data point that suggests that deterrence via tax enforcement is not particularly effective, and that fear of IRS reprisals is not the prime motivator keeping people from refusing to pay.

Also surprising is that people in the high-compliance group were more likely than those in the low-compliance group to report that they felt their business competitors were not tax compliant. This upsets the theory that people “flock” in their tax compliance behavior — tending to behave in the way they believe their peers are behaving.

[T]he results of both surveys [they also did a study that divided people up geographically into low- and high-compliance communities] associate distrust of the national government and the IRS with the low-compliance groups and communities. For example, respondents from the low-compliance group were more likely to report that the government is too big and wastes tax dollars, that tax laws are unfair, and that the IRS is unfair (e.g., often believing the IRS is more concerned with collecting as much as possible instead of the correct amount, and indicating less satisfaction with IRS services).

The results of both surveys suggest that norms and distrust of the national government, the law, and the IRS may promote noncompliance. Respondents from both the low-compliance groups and from low-compliance communities held negative views about government and the IRS and were more likely to participate in local organizations. They were also more likely to believe that other members of those organizations held similarly negative views, which appeared to reinforce their own views, though they generally professed that noncompliance was morally wrong. In other words, they affiliated with others who reinforced noncompliance norms at the local level, and probably feel a closer connection to a local collective than to the national collective. In terms of the typology discussed above [which divides non-compliant taxpayers into several categories based on the causes or motivations for their noncompliance], this tendency to affiliate where distrust of government is the norm may be a form of social and symbolic noncompliance.

The authors say that “social and symbolic” noncompliance are emerging as “the primary types of noncompliance among small businesses.” These are defined as:

Acted in accordance with social norms and peer behavior
Perceived the law or the IRS as unfair

…and are in contrast to a motive they call “Asocial” (“motivated by economic gain”) and a variety of other motives that have to do with ignorance of the law, laziness, difficulty following complex tax laws, or acting on advice from crafty tax professionals. The “Symbolic” category amounts to tax resistance, and so it is interesting to see that the IRS is coming to believe that much of what it has traditionally categorized as selfish, “asocial” tax evasion, is really motivated by feelings of dislike for the government and how it spends tax money (only about 6–8% of respondents believe “the federal government spends tax dollars wisely”).

Interestingly, people in the low-compliance group were more likely to report that everyone should correctly report all of their income — 97%! (And they were just as likely to report that “I feel a moral obligation to correctly report all of my income” — 96%) That should give you some skepticism about the value of such survey questions. The report notes that “the low-compliance group may have answered these questions aspirationally (e.g., they may not be living up to their aspirations because tax morale does not drive their tax compliance behavior) or defensively, to avoid making an admission.”

One caveat: the people who conducted the survey divided the respondents into “high-compliance” and “low-compliance” categories, but they did so not by measuring actual compliance, but by using “IRS tax compliance estimates to identify sole proprietors most likely to have high or low levels of reporting compliance.” These estimates are based on the taxpayer’s “examination activity code,” their “total gross receipts” and their “total positive income.”

[I]t is difficult to measure actual compliance with perfect accuracy. Taxpayers are not likely to confess any noncompliance in response to a survey, and even detailed audits conducted by the IRS’s National Research Program (NRP) are likely to contain errors. Even assuming that NRP audit results, as adjusted by IRS researchers, reflect actual compliance, the audit itself has an effect on the taxpayer’s attitude about the tax system, potentially biasing the taxpayer’s response to any subsequent survey. Thus, TAS decided not to survey taxpayers who had been subject to an NRP audit. While surveying taxpayers immediately before they were subject to an NRP audit might have been more productive, TAS deemed it overly deceptive. Thus, TAS opted to rely on DIF scores as an imperfect, but acceptable, measure of actual compliance.

There’s a possibility that the way they divided people up has biased the results, making some of their conclusions logically circular. And also, you should keep in mind that the “low-compliance” group in this survey is not “a group of people all of whom are less tax compliant” but “a group of people in which the IRS believes you are more likely to find individuals who are less tax compliant.”