Five myths about tax evasion

Erin Adele Scharff is an associate professor at Arizona State University’s Sandra Day O’Connor College of Law, where she researches tax and local government law. Kathleen DeLaney Thomas is the George R. Ward Term professor at the University of North Carolina School of Law, where she researches tax law and policy.

With the release of the Pandora Papers, we have a rare glimpse into the financial affairs of the world’s rich and powerful. These documents and the stories they tell confirm some of our worst suspicions about the susceptibility of financial systems to corruption and tax avoidance. For the right price, assets and profits are easy to hide. With the Pandora coverage, the Biden administration’s efforts to strengthen IRS enforcement and ongoing investigations into the Trump Organization’s taxes, tax evasion has been in the news a lot lately. But many misperceptions - about the problem and possible solutions - persist.

Myth No. 1: Tax evaders are just exploiting legal loopholes.

Donald Trump famously said he never broke any tax laws — he merely took advantage of legal tax tricks. Forbes coverage of the Pandora Papers describes the rich using legal strategies to conceal their wealth “through well-connected tax accountants, lawyers, offshore tax havens and exploiting loopholes.” And when the Trump Organization came under fire for failing to report a free condominium given to an employee, Insider described the transaction as falling into “legal grey areas.”

While it is true that there are many legal ways for taxpayers, especially wealthy ones, to reduce their tax bill, not all stunts are created equal. Some strategies are simply legal tax avoidance, like holding on to an asset instead of selling it to avoid generating taxable gain. But others clearly violate laws - and merit the label “tax evasion.” Actively concealing income from the IRS that should be reported, whether through an offshore account or some other method, is tax evasion.

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Moving money to an offshore bank, knowing that bank won’t report interest income to the IRS, isn’t taking advantage of a loophole. Similarly, putting business profits into a trust account doesn’t change the tax owed on such profits; the trust structure just makes it easier to hide such profits from the tax authorities. Many of the ploys discussed in the Pandora Papers are more-sophisticated versions of these illegal strategies.

Myth No. 2: Everyone cheats on their taxes.

There is a lot of incredulity about the honesty of American taxpayers. Trump famously said that not paying taxes made him “smart.” In 2018, FiveThirtyEight ran a piece called “Everyone Tries To Dodge The Tax Man, And It Keeps Getting Easier.” And a 2019 Vox article lamented that “more people are cheating on their taxes, but fewer are going to jail.”

Despite this bleak portrayal of tax compliance, Americans are actually an honest bunch. In a 2020 survey of more than 2,000 taxpayers, 87 percent said that cheating on your taxes is “not at all” acceptable. And even if taxpayers aren’t intrinsically motivated to report truthfully, compliance is enforced by an information reporting system that allows the IRS to know how much most taxpayers have earned. When an employer sends the IRS a W-2, or a bank sends a Form 1099, that income is almost always reported accurately by the taxpayer. Because so much income is tracked this way, the IRS reports an overall compliance rate of more than 83 percent.

Myth No. 3: Only the uber-rich evade taxes.

The tax gap is the difference between what taxpayers owe under the law and what is actually collected by the IRS. As Natasha Sarin, deputy assistant treasury secretary for economic policy, framed the issue, “Today’s tax code contains two sets of rules: one for regular wage and salary workers who report virtually all the income they earn; and another for wealthy taxpayers, who are often able to avoid a large share of the taxes they owe.” Editorials and media reports have echoed this characterization.

It’s true that the uber-rich have access to a variety of tax evasion tools that most of us don’t, and that rising income inequality means they have a greater share of income to hide. But they aren’t the only folks underpaying their taxes.

Ever been asked to pay someone in cash and suspected it wasn’t just to save on credit card processing fees? Folks who run companies, as opposed to those who earn salaries, have more opportunities both to understate their income and to overstate the costs of their business. The non-wage-earners contributing to the tax gap include plenty of mom-and-pop businesses, as the Treasury Department’s data suggests. And such evasion is not limited to income tax. A recent report found 20 percent of California restaurants employing “zapper” software to hide the scope of their sales and reduce their tax burden.

Myth No. 4: Tax havens are all abroad.

Portrayals of tax evasion tend to describe the problem as U.S. taxpayers transferring money overseas. The Tax Justice Network’s list of top tax havens, for example, focuses on countries (the British Virgin Islands, the Netherlands and Singapore, among others) where laws allow corporations to book profits in low-tax jurisdictions. Another list focuses on countries (including Taiwan, Bermuda and Liechtenstein) where foreign investment exceeds expected economic activity.

As the Pandora Papers make clear, however, for foreign nationals the United States can serve as a tax haven. The rich can hide their wealth from local taxing authorities and the origins of that wealth from anti-corruption advocates. U.S. banking and trust laws make it hard to identify the owners of assets. For example, South Dakota allows virtually anyone to create a trust and name themselves as the trust’s beneficiary. The state also provides significant protection of trust assets from creditors and ensures the privacy of trusts.

In fact, the Tax Justice Network ranks the United States just ahead of Switzerland in its Financial Secrecy Index. Of course, this is not the first time a trove of tax documents has shined a light on the United States’ role in hiding foreign assets. At the beginning of this year, Congress enacted new measures requiring more reporting of asset ownership, but states still have exceptional leeway to craft laws that help people avoid paying their share.

Myth No. 5: We can’t reduce tax evasion.

“Pandora Papers show tax crackdowns are no match for the superrich,” a recent Fortune headline reads. And a New York Times op-ed last year was titled “The Wealthy Can’t Stop Not Paying Their Taxes” and pointed out that a grossly underfunded IRS is incapable of doing its job effectively. These and similar claims paint a rather hopeless picture of the battle between tax cheats and the government.

But while it’s true that the IRS is under-resourced and lacks adequate technology, the U.S. tax system has made significant progress over the past decade, particularly in cracking down on offshore tax evasion. For example, the Foreign Account Compliance Act, which took effect in 2014,makes it harder for U.S. account holders to hide money offshore by requiring foreign financial institutions to report information to the IRS.

Recent proposals by the Biden administration would also go a long way toward further reducing tax evasion. First, the plan calls for infusing the IRS with $80 billion in much-needed enforcement resources. Then it would compel third parties (such as banks and online payment platforms) to level with the IRS about their transactions. This is particularly promising because third-party reporting has a proven track record of success, with IRS data showing that it leads to more than 90 percent compliance.

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