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. Last Updated: 07/27/2016

Taxpayer Inequality May Equal Cheating

WASHINGTON -- Economists have long known that there are two reasons people cheat on their taxes. One is they are poor and need the extra cash so badly they are willing to risk getting caught. The other is that they are rich and have lots of "nonmatchable" income -- mostly investment income not directly reported to the government -- which makes it less likely they will be caught.

Taxpayers in the middle class are the least likely to cheat: They are not struggling to make ends meet and their income is mostly wages, which are directly reported to the tax authorities. If you measured the likelihood of tax evasion by income level, in other words, it would look like a giant U.

What economists missed seeing until recently, however, is that both these explanations are really part of a single, larger theory.

Essentially, said Kim Bloomquist, an economist at the U.S. tax agency, the Internal Revenue Service, the more people you have at the upper and lower ends of the income spectrum -- at the ends of the U -- the more tax evasion you are likely to see. A central cause of cheating, in other words, might be inequality.

Bloomquist tested his hypothesis. In 1980, Americans underreported 3.6 percent of their income. In 2000, Bloomquist estimated they underreported about 5.6 percent of income -- based on increases in the kinds of income not reported to the government.

In the same period, the nonmatchable portion of the income of the wealthiest 5 percent of Americans rose by 9.2 percent per year. In 1980, about 19 percent of the income of the wealthiest 5 percent Americans was nonmatchable. By 2000, it was 37.9 percent.

The IRS economist also compared underreported income with other inequality analyses. University of California economists Thomas Piketty and Emmanuel Saez found that in 1970, the wealthiest 10 percent of Americans had 31.5 percent of all reported income. By 2000, they had 43.9 percent.

"Empirical results show a statistically significant relationship between a measure of pre-tax income inequality ... and U.S. wage and salary reporting noncompliance for the period 1947 to 2000," Bloomquist concluded.

The economist said he has found only a flag, not proof, that inequality causes tax evasion. What would settle the question is better data on tax evaders.

But another line of evidence suggests the economist is on to something. International data suggest that the size of a country's shadow economy -- income not reported to authorities -- appears to be linked to income inequality.

In a study of 23 countries, in which nations got inequality ratings from zero to 100, the Netherlands had an inequality score of 29.6 and Mexico had a score of 54.98 -- meaning Mexico is far more unequal than the Netherlands. The shadow economy in the Netherlands was 13.4 percent of the legitimate economy, but 49 percent in Mexico. Thailand had an inequality score of 48.8 and a shadow economy that was 71 percent of the legitimate economy.

The United States had an inequality score of 37.8 and a shadow economy that was only 10.5 percent the size of the legitimate economy, which suggests that better monitoring of income might be compensating to some extent for the effects of inequality on tax evasion.