Cheating Rises as Tax Rates Fall, Study Finds

According to conventional wisdom, the new tax law with its lower rates should lead to a drop in the number of Americans who cheat on their income taxes. With lower rates, this logic says, the incentive to hide income or inflate deductions is reduced because the payoff is much less at a 33% tax rate than at a 50% rate.

All wrong, said Louis L. Wilde, professor of economics at California Institute of Technology. Wilde, working with Jeffrey A. Dubin of Caltech and Michael J. Graetz of Yale Law School, studied taxpayer compliance and Internal Revenue Service behavior over the past 10 years and found that the exact opposite of the conventional wisdom is true.

As tax rates go up, cheating goes down, Wilde contends.

“We found that increases in tax rates increase compliance, although everyone thinks the opposite.

“Why? If you increase the tax rate, you increase the benefit of under-reporting income. But you also increase the cost if you get caught. The penalty is based on how much tax you’ve evaded. Also, the IRS bases its audits on a ‘yield’ criteria. They chose returns to audit based on where they expect to get the greatest additional tax and penalty, on where they think they’ll get the most bang for the buck.”

Wilde said that taxpayers instinctively know that the greater their income and the higher their tax rate, the more likely they are to be audited and the greater the penalty if they get caught. So they cheat less, his study found.

The converse also proves true, Wilde said. “More taxpayers are going to be tempted to cheat at lower tax rates. They figure the IRS won’t be watching as closely.” And they’ll have less to lose if they get caught.

The researchers also studied IRS audit procedures and found that the frequency of audits has been dropping steadily since 1977 because of declining IRS budgets and changing agency priorities.

In California, for instance, 3.41% of individual income tax returns were audited in 1977. By 1985, the figure had fallen to 1.7%.