Does the Threat of an IRS Audit Affect Tax Returns?

by James Downie | April 13, 2011

This weekend, millions of Americans will hunker down with their IRS forms for the not-so-cherished tradition of filing tax returns. For its part, the IRS uses this last week to warn taxpayers against submitting fraudulent returns: for the ninth year in a row, the IRS has issued a  "dirty dozen list," which, unfortunately, is not a sequel to the 1967 classic war film, but a list of the dozen most common tax scams. But what if the "dirty dozen" list isn't enough to deter a potential tax fraud? (Let's be honest: a list warning people that the IRS is on the lookout for "hiding income offshore" will hardly strike fear in the most, um, "creative" tax accountants.) Would the threat of an audit deter taxpayers from fraud?

In 1999, professors at the University of Michigan, University of St. Thomas, and Arizona State University published the results of a study where over 1700 Minnesota taxpayers were "informed by letter that the returns they were about to file would be 'closely examined.'" Low and middle-income filers, the study found, "on average [reported] increased tax payments compared to the previous year, which we interpret as indicating the presence of noncompliance." The statistically significant increases in these two groups came among "high-opportunity" filers, i.e. those whose income sources more easily lent themselves to fraud, such as "income not subject to withholding tax and income from a sole proprietorship." Perversely, though, the authors found that tax liability reports among high-income filers actually fell, declining by 17% for "low-opportunity" filers, and by an astonishing 35% for "high-opportunity" filers. The authors suggested that the decline is "based on a perception that an audit will not automatically detect and punish all evasion, and the final outcome may be influenced by the initially reported income." F. Scott Fitzgerald was right: the rich are different from you and me. You see "audit"; they see "negotiate."

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