How Financial Reporting Helps American Workers and Ensures that Top Earners Pay Their Fair Share
October 14, 2021 / Source: Treasury
By Natasha Sarin, Deputy Assistant Secretary for Economic Policy
A centerpiece of the Administration’s tax compliance agenda includes an important reform proposal, known as financial reporting, which would expand the information available to the Internal Revenue Service (IRS). This information will help the IRS determine whether taxpayers with opaque sources of income are meeting their tax obligations.
Congressional consideration of this proposal has been marred by misinformation, as opponents have elevated the pernicious myth that banks will have to report all individual customers’ transactions to the IRS. This is unequivocally false, and an incorrect representation of the proposals under consideration. Simply put, the financial reporting proposal in front of Congress does not mandate that individual transactions of any amount be reported to the IRS.
Instead, the proposal would direct banks to report basic, high-level information on aggregate account inflows and outflows. Banks would add just a bit of additional data to information that they already supply to taxpayers and the IRS: how much money went into the account over the course of the year, and how much came out.
Why is aggregate information about account inflows and outflows useful? Because currently the IRS has no knowledge about whether taxpayers who earn income in hard-to-track ways are making good on their annual tax obligations. Taxpayers who want to shirk their tax obligations know about and exploit this information shortfall. With very low audit rates for many types of taxpayers—rates that have decreased in the last decade as IRS resources have been gutted—tax cheats play the “audit lottery,” and wager that their noncompliance is unlikely to be detected. Providing slightly more information to the IRS—as the financial reporting proposal would do—will significantly increase compliance because the odds of evasion being detected will rise.
For example, suppose a taxpayer has $1 million of deposits flowing into their checking account in a year, but reports only $100 of income to the IRS. There may be a benign explanation for this, but it is suspect—and something the IRS can prioritize looking into when selecting returns for potential audit scrutiny. Yet today, the IRS doesn’t have this information, so it is often left to guess when it makes enforcement decisions, resulting in too much scrutiny of American workers who already pay what they owe—and too little scrutiny of evaders.
The financial reporting proposal strikes at an unfortunate truth with today’s tax system, where how people are paid is a major determinate of whether they pay their taxes. Most working Americans who are paid wages or salaries, like firefighters and teachers, are making good on their tax obligations. For these workers, the compliance rate on reporting their wages is 99 percent. This is because wage earners get a W-2 in the mail each year, detailing what they’ve earned from their employers, and that same information goes to the IRS as well. Taxes are automatically deducted from paychecks, and employees pay what they owe.
High-income earners, however, often accrue business or pass-through income that is not reported by a third-party to the IRS, so taxes are less likely to be appropriately paid. For these types of income, compliance rates can be under 50 percent in the absence of any third-party reporting. That is a large part of the reason why, in 2019, the top 1 percent of earners in the United States were responsible for an estimated $163 billion in unpaid taxes. If we were able to collect the taxes that were due from the very wealthiest among us, this revenue would be more than sufficient to support critical initiatives in the Build Back Better agenda—such as an expanded Child Tax Credit that lifts millions of children out of poverty.
The IRS, the Government Accountability Office, and academic experts all agree that third-party reporting is the best way to improve tax compliance. That is why the Biden Administration supports an improved financial reporting regime. These changes can raise hundreds of billions of dollars over the course of the next decade, not by raising taxes or increasing oversight on American wage and salary workers, but by working to ensure that those who accrue income in more complex ways pay the taxes they owe.
Specifically, any additional IRS scrutiny will be focused on the high end of the income distribution, where it belongs, given the distribution of the tax gap. In fact, audit rates will not rise relative to recent years for anyone making less than $400,000 per year.
In recent congressional testimony, Secretary Yellen was asked whether it was necessary for the IRS to know detailed information about what types of purchases taxpayers make each day. The answer is simple, and it bears repeating: No. The financial reporting proposals under consideration do not include any information about specific transactions or what taxpayers buy. The IRS will receive no information whatsoever, and will have no ability whatsoever, to track specific transactions under this proposal.
Ultimately, the President’s proposal seeks to pare back tax evasion by shedding some light on opaque sources of income that accrue disproportionately to the top 1 percent of earners. As such, it is unsurprising that substantial resources are being deployed to defeat these efforts, because many tax cheats stand to lose from a fairer tax system. But the American people stand to gain much more. A robust attack on tax evasion will raise substantial revenue to fund necessary investments in American families, increase the efficiency and fairness of the tax system, and create a more just society.