IRS officials reveals only 1 evasion from 10 by the billionaires gets caught by the IRS

The starting point of our analysis is the IRS random audit program, known as the National Research Program. Random audits are commonly used to study and measure the extent of tax evasion. Researchers use random audits to test theories of tax evasion (Kleven et al., 2011), and tax authorities use them to estimate the overall extent of tax evasion and target audits (IRS, 2019). The academic notion of the random audit as the gold standard for understanding tax evasion comes from the traditional appeal of random sampling, combined with the classic deterrence model of tax evasion (Allingham and Sandmo, 1972), an implicit assumption of which is that audits lead to the detection of all tax evasion. In the real world, however, random audits do not detect all forms of tax evasion. Random audits are well designed to detect common forms of tax evasion, such as unreported self-employment income, overstated deductions, and the abuse of tax credits. But, we argue, these audits may not detect sophisticated evasion strategies, because doing so can require much more information, resources and specialized staff than available to tax authorities for their random audit programs.

Our first contribution is to document and quantify the limits of random audits when it comes to detecting top-end evasion in the United States. We find that detected evasion declines sharply at the very top of the income distribution, with only a trivial amount of evasion detected in the top 0.01%. Our analysis uncovers two key limitations of random audits which can account for much of this drop-off: tax evasion through foreign intermediaries (e.g., undeclared foreign bank accounts) and tax evasion via pass-through businesses (e.g., partnerships). First, we find that offshore tax evasion goes almost entirely undetected in 2 random audits.1 To establish this result, we analyze the sample of U.S. taxpayers who disclosed hidden offshore assets in the context of specific enforcement initiatives conducted in 2009–2012. A number of these taxpayers had been randomly audited just before this crackdown on offshore evasion. In over 90% of these audits, the audit had not uncovered any foreign asset reporting requirement, despite the fact that these taxpayers did own foreign assets. Second, we find that tax evasion occurring in pass-through businesses (whose ownership is often highly concentrated) is substantially under-detected in individual random audits. Examiners usually do not verify the degree to which pass-through businesses have duly reported their income, especially for the most complex businesses. Thus, while the income of taxpayers in the bottom 99% of the income distribution is comprehensively examined, up to 35% of the income earned at the top is not comprehensively examined in the context of random audits.

Our second contribution is to propose improved estimates of how much income (relative to true income) the various groups of the population under-report—and to investigate the consequences of this underreporting for the measurement of inequality. We do so by starting from evasion estimated in random audits and proposing a correction for sophisticated evasion that goes undetected in these audits. Although our corrected series feature only slightly more evasion on aggregate than in the standard IRS methodology, our proposed adjustments have large effects at the top of the income distribution. Our adjustments increase unreported income by a factor of 1.1 on aggregate, but by a factor of 1.3 for the top 1% and 1.8 for the top 0.1%. After these adjustments, we find that under-reported income as a fraction of true income rises from about 7% in the bottom 50% of the income distribution to 21% in the top 1%. Out of this 21%, 6 percentage points correspond to sophisticated evasion that goes undetected in random audits. We also show that accounting for under-reported income increases the top 1% fiscal income share significantly. In our preferred estimates, the top 1% income share rises from 20.3% before audit to 21.8% on average over 2006–2013. The result that accounting for tax evasion increases inequality is robust to a wide range of robustness tests and sensitivity analysis (for instance, it is robust to assuming zero offshore tax evasion).

Our third contribution is to explain why general-purpose random audits are not uniformly able to detect noncompliance across the income distribution. We present a model in which high-income taxpayers adopt sophisticated evasion strategies. We show that introducing this element in the canonical Allingham and Sandmo (1972) tax evasion model changes our understanding of tax evasion by high-income persons.

The model allows a taxpayer to adopt some costly form of tax evasion that is unlikely to be discovered on audit at some cost. We show that adoption of such an evasion technology is likely to be concentrated at the top of the income distribution for two reasons. First, high-income taxpayers have a greater demand for sophisticated evasion strategies that reduce the probability of detection if (i) the desired rate of evasion does not become trivial at large incomes, and (ii) the cost of adopting becomes a trivial share of income at large incomes. This is true even holding the probability of audit by income fixed. Second, overall audit rates and scrutiny of tax returns are substantially higher at the top than at the bottom of the distribution, making evasion that is less likely to be detected and corrected on audit more attractive at the top. We can also reinterpret the model to think about situations where the outcome of an audit, if it occurs, is uncertain. With this interpretation, for the same reasons as before, we show that high-income people are then more likely to adopt positions in the “gray area” between legal avoidance and evasion. From the point of view of the tax authority, we show theoretically that high resource costs of pursuing sophisticated forms of tax evasion, such as protracted litigation or more sophisticated audits of a complex network of closely-held businesses, can pose practical limits on the extent to which the tax authority can pursue these types of tax evasion by high-income people. This is especially the case when resource constraints are exogenous and not changed when sophisticated evasion becomes more prevalent.