Estimating Tax Noncompliance with Evidence from Unaudited Tax Returns

Abstract

This article estimates the degree of tax noncompliance using evidence from unaudited tax returns. Measurements of noncompliance are derived from the relationship between reported charitable contributions and reported income from wages and salary as compared to alternative reported income sources such as self-employment, farm and other small business income. Assuming that the source of one's income is unrelated to one's charitable inclinations and that the ratio of true income to taxable income does not vary by income source, any difference in the relationship between charitable contributions and the source of income can be attributed to (relative) underreporting by the individual. We find that the implied amount of noncompliance is significant and that it varies by source of income, as well as between positive and negative values of each type of income. Tax evasion creates horizontal inequity and, if opportunities for evasion are correlated with income, complicates the attempt to achieve vertical equity. Evasion also imposes economic costs because taxpayers expend resources to facilitate evasion and the tax agency expends resources to contain it. The equity and efficiency implications of tax evasion, and optimal policy to address it, depend on its magnitude and nature which, for obvious reasons, is difficult to ascertain. This article contributes to that effort by developing a new method for estimating the extent and nature of tax noncompliance based on evidence from unaudited tax returns. This evidence is derived from the relationship between reported charitable contributions and reported taxable income from various sources such as wages and salaries, selfemployment, nonfarm small-business and farm income, and is based on the assumptions that the source of one's income is unrelated to one's charitable inclinations and that the ratio of true income to taxable income does not vary by income source. We find that the implied amount of noncompliance on non-wageand-salary income is substantial and that it varies among these sources of income as well as between positive and negative values of each type of income. On average, reported positive self-employment, nonfarm small-business and farm income must be multiplied by a factor of 1.54, 4.54 and 3.87, respectively, in order to obtain true income. Even those individuals who report zero income for a specific income source, but file the schedule for that source, are estimated to have true positive income. Finally, those households that report negative schedule income may actually have greater true income than those households that report positive income.