Tax Audits: Once Bitten, Twice Shy

IMGCAP(1)]It’s no surprise that the experience of going through a random IRS audit affects future behavior. What is surprising is how the expected change in behavior—increased reporting of taxable income, and presumably, increased compliance—differs from corporations to individuals, and from individuals subject to third-party information to those who are not.

Bradley Heim, a professor at Indiana University School of Public and Environmental Affairs and a former economist at the U.S. Treasury Office of Tax Analysis, specializes in the behavioral impacts of tax policy. His research into how tax audits change behavior showed contradictory results for individuals and corporations.

“Audits were extremely effective in reducing individuals’ subsequent tax evasion, but corporations gradually increase tax aggressiveness for a few years following an audit, and then reduce it sharply,” said Heim. “This calls for a reexamination of the theory and policy of legal enforcement.”

“We looked at the behavior of taxpayers after a random National Research Program [formerly TCMP, the Taxpayer Compliance Measurement Program] audit for the period 2006 to 2009 to determine both the short- and long-run effects of audits on taxpaying behavior,” he said.

“We found that corporations were more aggressive after the audit. The thinking was that companies learn something during the audit and get a sense of how quickly they’re going to be audited again, so there’s a window for them to be more aggressive in terms of taxes. These are medium- and smaller-size businesses, not large enough to be audited every year,” he explained.

“With individuals it’s the opposite,” Heim said. “There’s a bump up in the taxable income they report. It fades away, but the speed with which it fades away depends on the kind of income we’re talking about. If it’s wage and salary income, there’s a small bump up in taxable income and it persists for quite a while.”
Self-employment returns are notorious for noncompliance, he noted. “The impact with these is stronger but more quickly diminishes for income not subject to third-party information.”

The IRS budget is often viewed through the lens of the amount of revenue collected from an audit, Heim indicated. But his research found there is a secondary yield from an audit in the aftereffect of reporting more taxable income in the years following an audit. “The amount of revenue that is collected after an audit is about equal to the amount that was received directly from the audit itself,” he said.

Heim’s research also found that individuals with higher income volatility revert to their pre-audit behavior more quickly, “conceivably because of a larger degree of asymmetric information between the filer and IRS.”

Larger and more persistent responses to audits were found among those who are less tax literate, Heim observed.

“Companies’ perception as to how long it will take before they are audited again, based on the experience of themselves and their peers, seems to be accurate,” he said. “The window for noncompliance that this creates closes gradually over the ensuing years. As the window closes they become more careful.”

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