Two income tax systems, separate and unequal

By David Cay Johnston
davidcay@mac.com

Q. New data from an intensive IRS study of tax returns shows that at least 12 percent of capital gains are not being reported and, therefore not taxed. What will you do to make sure that all capital gains are reported and taxed?

Q. The same data shows that only about half of the profits earned by sole proprietors and farmers are reported to the IRS. What will you do to make sure these small business owners and farmers pay taxes on all of their profits?

Q. If you do not know at this moment what you will do, then will you please give us an exact date when you will present us with your plan and answer questions about it?

Congress enables massive tax cheating by business owners, investors and farmers  -- while making wage earners pay taxes on 99 percent of their incomes.

That’s the conclusion of my analysis for Tax Notes of new but as yet unpublished research by the Internal Revenue Service. This official government data shows that America has two systems of income taxation, separate and unequal. One system very effectively taxes wage earners, whose incomes can be checked against what employers list in verification reports. The other, lacking independent verification, is a sieve of untaxed income for business and owners and investors.

Just 88 percent of capital gains are reported on tax returns, according to IRS data from a detailed survey of 46,000 taxpayers. But even that figure significantly understates the pervasiveness of the problem. The IRS report shows endemic under-reporting among the 99.9 percent who make less than $2 million a year. (It also shows that among the tiny group making more than $2 million, almost all capital gains are reported, which, as I explain in my column, I do not believe.)

The data also show that only about half of the income taken in by America's 21.5 million sole proprietors is actually reported. These are people from freelance writers and management consultants to restaurant operators who file a Schedule C with their tax return. The IRS Taxpayer Advocate, Nina E. Olson, has for several years called this form of income the last great area of mass tax cheating, but Congress has declined to take any action.

All this and charts of the official data are in my Aug. 4 column in Tax Notes, a nonprofit journal that accepts no advertising and pays for its team of journalists and lawyers through subscriptions. The column is available free, courtesy of the editors, here.

My analysis also finds that many people with big incomes from unreported capital gains show up – incorrectly -- as middle-class taxpayers in the official IRS tables. What does that mean? It means that the huge gains in income going to high earners are even greater than what has been reported.

The new data matter because soon taxes are going to have go up unless Congress dramatically slashes spending. The hard truth is that the next president will face a huge and worsening problem: our federal government is spending far more than it collects in taxes, which is slowly making us all poorer.  A president who began with a nine-figure surplus and promised fiscal restraint turned out to be the biggest spender of all time.

The annual shortfall is projected at $482 billion this year, a record. But the shortfall will actually be about $575 billion because we pay $92 billion or so more in Social Security taxes than are paid out in benefits, a subsidy to the rich from workers making less than $104,000. Just the interest on this $575 billion of borrowing will cost almost $29 billion per year at 5 percent interest. Already interest on the national debt equals all of the income taxes people pay from January into mid-May.

So there will be a big revenue hunt starting next year. The hunt actually began in 2006, when President Bush violated his pledge to never raise taxes and raised them on teenagers with college savings funds.

Presidential and congressional candidates should be asked what they intend to do to end this official unfairness between wage earners and the ownership class and its role in reducing the record budget shortfalls.

David Cay Johnston, a Pulitzer prize winner, is a columnist for Tax Analysts and teaches the law of the ancient world at Syracuse University’s law and graduate business schools. The Fine Print, the third book in his series about the American economy, is scheduled to be published in 2011 by Penguin. E-mail: johnstonstake@tax.org

Comments

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Nice analysis Posted by Bob McKenzie 08/224/2008, 07:11 PM Nice analysis of the 2 tax systems. One solution that I have suggested when interviewed by Congressional staffers is as follows: Require all sole proprietors to have an EIN and to maintain a company bank account. Banks would be required to report gross deposits of all companies to the IRS. Many taxpayers do not even report all of their deposited monies. As far as pure cash payments there are very few ways to track payments to home improvement businesses, restaurants and small retailers. Jump to top of list