In principle, a well-functioning tax system should elicit high compliance rates. However, individual adherence to tax law depends on how income is accrued and reported. Wage earners exhibit near-perfect compliance, while those who accrue their income through hard-to-trace sources evade the law at significantly higher rates.
Recent efforts to address high-end noncompliance have been met with intense opposition. Nonetheless, research suggests that these reforms may work.
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Taxes
Taxes are the primary source of revenue for governments and fund public works, services, and infrastructure. There are many types of taxes – some, like income or payroll taxes, are applied based on an individual’s earnings, while others, such as sales taxes, are collected when goods and services are purchased.
Navigating the intricacies of tax obligations can be daunting, but having a comprehensive state and federal tax guide is invaluable for individuals and businesses.
Noncompliance with tax regulations can lead to expensive penalties and fees. To help reduce these costs, it is essential to understand the various aspects of the tax code and how they impact taxpayers.
The Office of Information and Regulatory Affairs (OIRA) estimates that Americans spend more than 6.5 billion hours each year complying with IRS forms, schedules, and instructions. This includes nearly 2 billion hours spent preparing and filing income tax returns and 1.1 billion hours filing corporate and small business income tax returns. This does not have the thousands, or even millions, of hours Americans spend trying to get help from the IRS when they run into problems.
A healthy tax compliance system requires the IRS to have the resources to investigate underreported income cases and prosecute egregious tax evaders. This means a substantial investment in technology that allows the IRS to unpack better-complicated tax returns, track income across numerous opaque sources, and verify tax submissions. It also means the IRS can target audits and help compliant taxpayers avoid unnecessary examinations more efficiently.
Filing
Whether an individual is filling out tax forms, reporting income, or accessing wealth from a new source, or a business is collecting sales taxes on its products or services, all taxpayers must comply. Noncompliance imposes costs that divert time and resources away from the economy. For example, the hours a family spends filing taxes is an hour they could have spent working in the family business or that an entrepreneur can’t use to grow their company. These are what economists call opportunity costs.
In the United States, compliance rates vary by how taxpayers accrue income. Wage earners exhibit near-perfect compliance rates because their income is reported and withheld by third parties. But only some other forms of income enjoy this level of compliance, including self-employment, interest, dividends, and capital gains.
The Administration’s recent tax reform proposals would help close this gap by enabling the IRS to get the information it needs to identify hidden sources of upper-income noncompliance better and pursue enforcement efforts against sophisticated, high-end evasion. The proposals also include transformative investments in the IRS to overhaul 1960s technology and meet threats like 1.4 billion cyberattacks that hit the agency annually.
For businesses, a key to compliance is determining which jurisdictions they have nexus and establishing sales tax collection systems that automatically report and remit the correct amounts to the appropriate state and local authorities. This typically involves system integration between a company’s ERP/ecommerce platform and third-party sales tax software to automate the process.
Payment
As the tax regulatory landscape becomes more complex, ensuring compliance is more critical than ever. In 2021 alone, the IRS is projected to collect over $4 trillion in taxes, penalties, and user fees. This revenue is vital for all of the federal and state programs that are funded through these payments. Noncompliance can result in hefty fines and penalties and cause significant delays and disruptions.
Individuals can ensure compliance by utilizing a reputable CPA or IRS-certified enrolled agent-tax preparer to assist with their tax return preparation. In addition, individuals who receive W-2 income from their employers can use reputable tax return software to help ensure they file an accurate income tax return by the deadline.
Businesses can ensure compliance by implementing an automated system to capture the proper data for the tax returns they submit. This process can also help minimize human error and eliminate costly mistakes such as transpositions of numbers, missed deductions, or other errors.
Many state and local governments are increasing their enforcement of tax compliance. In some cases, this can result from a state’s budget deficit or as part of a strategy to combat rampant fraud. In either case, these increased efforts can lead to higher auditing rates and fines. For example, the Department of Revenue has invested resources in Vermont to review capital gains for real estate sales and investment properties.
Audits
Many individuals and businesses are subject to audits that result from various reasons. These include errors in filing forms, miscalculations, or even human error, such as transpositions of numbers. These can lead to penalties for a variety of tax violations.
Many of these issues arise from a need for more understanding of the tax laws. For example, some taxpayers may incorrectly assume that bundled transactions are nontaxable when sales tax must be collected on the total selling price of all products included in a bundle (such as an umbrella and raincoat sold for one combined retail price).
Policymakers face a challenging balancing act to collect the taxes that are legally owed and necessary to fund government services while not imposing an excessive compliance burden on small firms. Research suggests that a high compliance cost is not only costly for firms. Still, it can also lead to failure because non-surviving firms are less likely to invest in future growth and innovation if they must devote much of their resources to meet regulatory requirements.
For this reason, greater proactive outreach and education are needed. This includes initiatives like the recently enacted “Taxpayer First” Act, which prioritizes outreach and education to ensure taxpayers have the information they need to comply with the law. This can be as simple as providing more explicit guidance on what constitutes a bundled transaction and how sales tax applies.