According to government reports, most individuals with business income fail to pay all their taxes, although some appear to cheat more than others. (1) Underpayment of tax on business income is commonly attributed to the receipt of cash. (2) The owner of a clothing store, for example, might sell a dress for cash and not report the cash. Underpayment of tax by individuals on business income contributes significantly to the federal tax gap--the difference between what taxpayers owe on legal source income and what they pay. (3)
The government estimates that the annual tax gap equals $345 billion. (4) About $109 billion of this is attributable to underpayment of taxes on business income by individuals. (5) Sole proprietors also underpay Social Security and other payroll and self-employment taxes. (6) Additional underpayments are attributable to individuals who operate businesses as partnerships and small corporations. In the aggregate, small business owners report less than half of their income, (7) and their underreporting (including informal workers such as gardeners) is estimated to comprise about half of the tax gap. (8)
This Article attempts to provide a qualitative picture of tax evasion in the small business sector. It provides details from almost 275 field study interviews with cash business owners and with tax preparers and bankers who serve cash business clients. Our research suggests answers to the questions of who evades taxes, what taxes they evade, and why and how they evade taxes.
This Article proceeds in three additional parts. Part II summarizes the main threads of relevant social science research on small business tax compliance. Part III describes the methodology and results of this interview study. Part IV concludes.
II. TAX COMPLIANCE IN THE CASH BUSINESS SECTOR: EXISTING RESEARCH
The standard economic analysis frames a tax compliance decision as a comparison between (1) the cost of paying tax and (2) the difference between the benefit of avoiding the tax and the cost of the imposition of tax, interest, and penalties, risk-adjusted for the possibility that the government will successfully challenge the tax avoidance strategy. (9) But this model does not provide a complete picture of taxpayer compliance or the reasons for variations in taxpayer compliance. Substantial behavioral research, including contributions from sociology and psychology, deepens the analysis, and our research here offers more descriptive detail.
One summary of the behavioral compliance literature lists fourteen factors that may affect tax compliance, including age, gender, education, income level, income source, peer influence, ethics, fairness, complexity, and tax rates. (10) For our purposes, two of these factors, income source and peer influence, are most relevant and are discussed below. We also discuss studies that explore the relationship between tax preparers and tax compliance.
B. Income Source
By far the most important determinant of tax compliance is income source. Taxpayers report cash income less accurately than income subject to third party reporting and/or withholding. (11) As noted in the introduction and accompanying notes, individuals evade business-source income, which is commonly received in cash, at a rate of approximately 50%, (12) although this evasion is not evenly distributed. (13) In contrast, the evasion rate on wage income--which employers report to the government and on which taxes are withheld--is about 1%. (14)
Cash income represents one extreme of an income visibility spectrum while income subject to third-party reporting or withholding occupies the other end. Some studies show, for example, that taxpayers are more likely to report income received in check form than income received in cash. (15) Taxpayer concerns that the government will detect a failure to pay taxes appear closely related to, but not completely dependent on, income source. …