A W-2 for Business Income

An interesting proposal to improve tax collection.

I love taxes police money Euros
Image under CC0 Public Domain license from pxhere.

Earlier this week, the New York Times Editorial Board offered up a plan on “How to Collect $1.4 Trillion in Unpaid Taxes.”

The premise:

When the federal government started withholding income taxes from workers’ paychecks during World War II, the innovation was presented as a matter of fairness, a way to ensure that everyone paid. Irving Berlin wrote a song for the Treasury Department: “You see those bombers in the sky? Rockefeller helped to build them. So did I.”

The withholding system remains the cornerstone of income taxation, effectively preventing Americans from lying about wage income. Employers submit an annual W-2 report on the wages paid to each worker, making it hard to fudge the numbers.

But the burden of taxation is increasingly warped because the government has no comparable system for verifying income from businesses. The result is that most wage earners pay their fair share while many business owners engage in blatant fraud at public expense.

In a remarkable 2019 analysis, the Internal Revenue Service estimated that Americans report on their taxes less than half of all income that is not subject to some form of third-party verification like a W-2. Billions of dollars in business profits, rent and royalties are hidden from the government each year. By contrast, more than 95 percent of wage income is reported.

Unreported income is the single largest reason that unpaid federal income taxes may amount to more than $600 billion this year, and more than $7.5 trillion over the next decade. It is a truly staggering sum — more than half of the projected federal deficit over the same period.

I lack the time to read through the analysis. While I’m a wee bit skeptical that the IRS can reliably estimate how much unpaid taxes it is getting screwed out of and yet not collect it, one presumes they have a reasonable supply of expertise. And, as I have noted more than once before, they’re simply outmatched by the very wealthy in terms of lawyering and resources.

Regardless, to the extent we’re going to rely on a system of income taxation and onerous filing requirements to finance our government, it’s perfectly reasonable to demand that people and businesses pay what they owe. So, what’s the proposal? Well, it’s someone else’s:

Proposals to close this “tax gap” often focus on reversing the long-term decline in funding for the I.R.S., allowing the agency to hire more workers and to audit more wealthy taxpayers. But Charles Rossotti, who led the I.R.S. from 1997 to 2002, makes a compelling argument that such an approach is inadequate. Mr. Rossotti says that Congress needs to change the rules, by creating a third-party verification system for business income, too.

The core of Mr. Rossotti’s clever proposal is to obtain that information from banks. Under his plan, the government would require banks to produce an annual account statement totaling inflows and outflows, like the 1099 tax forms that investment firms must provide to their clients.

Individuals would then have the opportunity to reconcile what Mr. Rossotti dubs their “1099New” forms with their reported income on their individual tax returns. One might, for example, assert that a particular deposit was a tax-exempt gift.

Offhand, that strikes me as burdensome. One presumes banks could more-or-less automate this process but it would seem to require an inordinate amount of record-keeping for individuals to have to keep track of the source of every debit and credit throughout the year. But I guess that’s what accountants are for.

Mr. Rossotti has proposed that the I.R.S. require the new forms only for people with taxable income above a generous threshold. A bill including Mr. Rossotti’s plan, introduced by Representative Ro Khanna of California, sets that threshold at $400,000, to minimize the burden on small business. The money is undoubtedly in chasing wealthy tax cheats, but equity argues that business income, like wage income, should be subject to a uniform reporting standard. Small businesses ought to pay their taxes, too.

I’m not sure when $400,000 replaced $250,000 as the threshold for “rich” but it is indeed pretty high–roughly the top 1.5% of all earners. Regardless, sure, people who own small businesses ought to have to pay taxes on their income just like the rest of us. (Whether the businesses themselves should have to pay is a separate question altogether but almost all countries have answered it in the affirmative.)

The proposal would not increase the amount anyone owes in taxes. It would, instead, increase the amount paid in taxes by those who are currently cheating.

It would have the immediate benefit of scaring people into probity.

My guess is that very rich people who are currently cheating will figure out how to avoid this accounting, likely by offshoring their banking. In principle, though, it seems reasonable. And their anecdote is powerful:

Consider what happened after Congress passed legislation in 1986 to require taxpayers to list a Social Security number for each person claimed as a dependent. The government could not easily crosscheck all of those claims then, but the requirement itself caused a sharp drop in fraud. The next year, seven million children abruptly disappeared from tax returns.

That was a 9 percent drop in claimed dependents! (Although the IRS estimated that “20 percent of the vanished dependents were children who had been claimed as dependents by both parents after a divorce,” so it wasn’t so much phantom children but double-counting.) The same legislation, part of the Reagan tax reforms, also required giving the name and Social of claimed child care providers, substantially reining in off-the-books babysitting.

Alas, remember the aforementioned resource gap?

To realize the full benefit of the new data, however, Congress does need to make a significant investment in upgrading the I.R.S.’s outdated computer systems, and in hiring enough qualified workers to examine suspicious cases and to hold accountable those who cheat.

In 2008, for example, Congress passed a bill to require credit card processors to report payments processed on behalf of online retailers on an annual form called a 1099-K so the I.R.S. could verify the income reported by those retailers. But in December, the Treasury Department’s inspector general reported that “resource limitations” had prevented the I.R.S. from investigating more than 310,000 cases in which individuals and businesses failed to report more than $330 billion in income documented on 1099-Ks.

Despite the NYT editorial being a couple of days old and Rossotti’s plan having been floating around quite a while, I’m not seeing much new commentary on it. The website where the plan was launched has collected a large number of comments, not surprisingly all favorable, but from across the political spectrum.

It’s certainly worthy of discussion. But, absent substantially improving the IRS’ resources vis-à-vis those with the most money to hide, it’s going to be very difficult, indeed, to close that gap.

FILED UNDER: Economics and Business, Taxes, US Politics
James Joyner
About James Joyner
James Joyner is Professor and Department Head of Security Studies at Marine Corps University's Command and Staff College and a nonresident senior fellow at the Scowcroft Center for Strategy and Security at the Atlantic Council. He's a former Army officer and Desert Storm vet. Views expressed here are his own. Follow James on Twitter @DrJJoyner.

Comments

  1. Sleeping Dog says:

    Saw that Sunday and the idea should be implemented. My favorite taxation hobby-horse is a financial transaction tax. Even if applied to all financial transactions, a low rate would make it invisible to most, but still deliver a great revenue stream from Wall St and banking actives.

    Saw this the other day;

    Another Blow to Tax Evasion and Money Laundering: UK Targets Art Market After US Goes After Anonymous Shell Companies

    Tax evasion is a problem for all government and it seems, that they are finally beginning to address it on a global basis. Biden has a proposal for a worldwide, minimum corporate tax rate that will cut into evasion.

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  2. Just Another Ex-Republican says:

    Tracking all debits and credits going through an account is burdensome? Like…balancing a checkbook?

    Though it should also be pretty easy for banks to identify personal vs business accounts, and exempt personal accounts from the new approach since they have W2’s.

    Bigger issue I see is around forcing foreign banks to provide the new form to US tax authorities for US businesses. If we could do that the push against anonymous shell companies and money laundering wouldn’t be so important.

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  3. gVOR08 says:

    Wouldn’t a European style Value Added Tax be just as effective and a lot simpler?

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  4. Scott F. says:

    And, as I have noted more than once before, they’re simply outmatched by the very wealthy in terms of lawyering and resources.

    The very wealthy’s advantage is in terms of politicians they have bought. Without campaign finance reform there will be no increase in enforcement against the very wealthy’s taxation freeloading.

    Unreported income is the single largest reason that unpaid federal income taxes may amount to more than $600 billion this year, and more than $7.5 trillion over the next decade.

    Tax rates on the very wealthy are at historical lows, while the super rich get more and more sophisticated in their tax avoidance schemes. Wealth and income inequity are unprecedented. On the same day, there’s an OP that questions how we could possible afford $3T to build out our infrastructure for the 21st century.

    Imagine how differently this country would operate if this tax reporting from the NYT found broader sympathetic commentary – if we spent time focusing on tax cheats that was proportional to the cost to the country as we do on the costs of welfare cheats.

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  5. Jen says:

    I don’t get what’s being alleged. I am self-employed, I have an LLC and a business bank account. My clients make their payments out to the LLC (most direct-deposit right into the business bank account). I pay some of my taxes/fees/expenses using the business bank account, but for things that require a credit card, like my website and hosting fees, I use a personal credit card. I keep track of all of my business expenses and credits and those all get sent to our accountant when it’s time to do taxes. He tells me what my quarterly estimated taxes are, and I pay them.

    I don’t have a criminal mind because I don’t even understand how people are avoiding taxes–are they taking money under the table or something?

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  6. James Joyner says:

    @gVOR08:

    Wouldn’t a European style Value Added Tax be just as effective and a lot simpler?

    My longstanding preference is for taxation to focus on spending rather than earning, with some sort of carveouts for daily necessity or UBI to mitigate against it hurting the poor.

    @Scott F.:

    On the same day, there’s an OP that questions how we could possible afford $3T to build out our infrastructure for the 21st century.

    The post is mostly musing about the vagueness of the early trial ballooning and questioning whether particular measures make much sense. On affordability, I don’t think “tax the rich more” covers the cost, but I acknowledge here and elsewhere that we’re not doing a great job of collecting the taxes the rich already owe.

    I’m skeptical of this:

    The very wealthy’s advantage is in terms of politicians they have bought. Without campaign finance reform there will be no increase in enforcement against the very wealthy’s taxation freeloading.

    We’ve been trying to “reform” campaign financing since 1974 with little to show for it.

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  7. DrDaveT says:

    While I’m a wee bit skeptical that the IRS can reliably estimate how much unpaid taxes it is getting screwed out of and yet not collect it, one presumes they have a reasonable supply of expertise.

    You have apparently not been paying attention to the progressive and egregious underfunding of the IRS by Congress. GAO, usually no friend of federal agencies, has repeatedly reported that simply funding the IRS to collect the taxes they already know about but can’t afford to pursue would return somewhere between $10 and $20 to the treasury for every dollar spent.

    Guess which political party has blocked all attempts to do that…

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  8. James Joyner says:

    @DrDaveT:

    You have apparently not been paying attention to the progressive and egregious underfunding of the IRS by Congress.

    I’ve not only been paying attention, but I’ve written about it at length, link to one of said posts in the OP, and close the OP with another reference. I’m just dubious that the IRS can reliably estimate the amount it’s undercollecting but am sure that it’s quite a lot.

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  9. DrDaveT says:

    @Scott F.:

    The very wealthy’s advantage is in terms of politicians they have bought.

    Seriously. When was the last time you heard Congress even musing about taxing capital gains at the same rate as wages?

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  10. James Joyner says:

    @Jen:

    I don’t have a criminal mind because I don’t even understand how people are avoiding taxes–are they taking money under the table or something?

    They’re simply not reporting the income. When I was making a decent amount from blogging (mostly owing to the Gone Hollywood site rather than this one), I just filed as a sole proprietor along with my regular wage income. Some of the ad partners supplied 1099s but many did not. I was scrupulous in claiming all income I could document (through bank or PayPal deposits, mostly) but I suspect I could have gotten away with reporting only that for which the IRS had a record.

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  11. DrDaveT says:

    @James Joyner:

    I’m just dubious that the IRS can reliably estimate the amount it’s undercollecting but am sure that it’s quite a lot.

    I don’t understand why you think this is hard. The volume of transactions in the economy is extremely well-documented, and economists spend enormous effort estimating the parts that aren’t reported directly. How much tax liability those transactions should generate is easy to estimate with reasonable precision. Compare that against actual tax revenues, and you know the gap.

    What am I missing?

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  12. Stormy Dragon says:

    While I’m a wee bit skeptical that the IRS can reliably estimate how much unpaid taxes it is getting screwed out of and yet not collect it, one presumes they have a reasonable supply of expertise.

    When you have a detailed macro view of the economy, you can see things like how much money is in banks, the stock markets, etc. and figure out roughly how much tax should be being paid and how much actually is and come to an accurate conclusion that a specific amount is missing without knowing who specifically was responsible for it.

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  13. Scott F. says:

    @James Joyner:

    We’ve been trying to “reform” campaign financing since 1974 with little to show for it.

    Skeptical of what is or what ought to be? Our government’s ability to accomplish a thing politically and the value to the nation of that thing are not correlated.

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  14. gVOR08 says:

    @James Joyner:

    with some sort of carveouts for daily necessity or UBI to mitigate against it hurting the poor.

    Yes. The usual criticism of a VAT is that it’s regressive. But the system we’ve got is de facto regressive. As you point out, the regressiveness of a VAT is easily fixed. And we’d still get to keep some sort of reduced income tax, and maybe make it actually progressive.

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  15. James Joyner says:

    @DrDaveT: @Stormy Dragon: As I noted, I don’t have time to read through the report and study its methodology. It makes sense, though, that we can do macro but not micro.

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  16. Jen says:

    @James Joyner: Ahh, thanks. All of my clients are diligent about W9s and 1099s, so the idea of unreported income is completely foreign to me, but thank you for explaining that.

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  17. James Joyner says:

    @Jen: I would think it even easier to hide money in retail or other direct-to-consumer businesses. And that’s where this proposal would help, as banks, credit card companies, and the like are tracking all but the non-cash transactions in some manner.

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  18. Stormy Dragon says:

    My solution to the under taxation problem: a federal escheat law. Right now if there’s money sitting around and it’s not clear who owns it or if taxes have been paid on it, we expect the federal government to prove who it belongs to before it can go after them. Not surprisingly, this doesn’t work because it’s easier for the cheats to hide than for the government to find them.

    So reverse the process: if there’s money sitting around without on obvious owner, declare it abandoned property and put it in escrow until the true owner can be determined. Now the owner will have to show up and prove they own it.

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  19. DrDaveT says:

    @gVOR08:

    The usual criticism of a VAT is that it’s regressive.

    It’s not just that it’s regressive; it’s that it doesn’t do anything about wealth inequality.

    As best I can tell, taxes have two purposes:
    1. Raise money to run the government
    2. Counteract the steady increase in wealth inequality caused by capitalism

    Everyone talks about #1, but #2 is also very important. And some of our taxes, such as inheritance taxes, are clearly focused on that goal. VAT only applies to consumption, and you really don’t have to be all that rich for your income to outstrip your consumption. For normal people, we call that “saving” and think it a good thing. For the wealthy, it’s just hoarding. No VAT you can propose would ever come close to taxing the wealthy at a rate that would curb wealth inequality growth.

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  20. Stormy Dragon says:

    @DrDaveT:

    MMT would say that for a country that can finance debt in its own currency, the purpose of taxes isn’t to raise money to run the government, but rather control inflation by reducing the monetary base.

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  21. Michael Cain says:

    @James Joyner:

    …but I suspect I could have gotten away with reporting only that for which the IRS had a record.

    One of the fascinating things that came out of the Deepwater Horizon oil spill and federal payments for resulting loss of income, is just how much of the sport fishing industry there was happening completely off the books. Men in their 40s and 50s who, while they had an SS number, had no contributions made towards that, and who had never filed an income tax return. Cash, their entire life, never reported.

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  22. DrDaveT says:

    @Stormy Dragon:

    MMT would say that for a country that can finance debt in its own currency, the purpose of taxes isn’t to raise money to run the government, but rather control inflation by reducing the monetary base.

    I’ve heard that. Does that mean that wealth redistribution is inflationary, but giving money to the rich to stuff into mattresses is not? I could believe that. It sets up an interesting set of conflicting purposes.

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  23. Stormy Dragon says:

    @DrDaveT:

    If I can be pardoned for oversimplifying, MMT is based on several propositions, most of which are not controversial, leading to a conclusion that is controversial:

    1. There are two types of countries, ones that can finance debt in their own currency and countries that can’t.
    2. A country that can finance debt in its own currency can never be forced to default since it could just print enough money to pay off the debt
    3. The only practical limit on how much money a country can print is that if the money supply grows too fast it causes inflation
    4. Governments have two mechanisms to reduce the size of the money supply: taxation and issuing debt
    5. Government issued debt is bad because it crowds private debt out of the market
    6. The controversial part: therefore governments like the US should stop issuing debt, just print whatever money they need for their operations, and then uses taxes to control inflation

    In practice this wouldn’t look much different then what we’re already doing, we kinda backed into MMT by accident, only change our understanding of why we do it. It also provides a reason for why the wealthy should pay more taxes: people with large amounts of savings are the ones who benefit most from low inflation so they should pay the most for the privilege of maintaining it.

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