The law of unintended consequences applies to all policies and all state systems design, including tax policies, tax laws and tax enforcement. This is a statement of truism. And it works both ways. A well-designed policy to promote income supports and aligned incentives to work, for example, can have an unintended impact of increasing fraud. Conversely, a measure to enforce the policy to prevent fraud can result in undoing some of the positive impacts of the policy which it was designed to deliver. These statements are also a form of truism.
However, rarely do we see research into the unintended consequences of core tax policies delivering a negative view of the perceived wisdom of regulators and enforcers. Instead, we tend to think of tax laws enforcement as an unquestionable good. Fraud and tax evasion prevention are seen as intrinsically important to the society, and the severity of penalties and punishments imposed on non-compliance (whether by error or design) is seen as being not only just, but pivotal to the sustainability of the entire tax system. Put differently, there is an inherent asymmetry in the relationship between tax payers and tax enforcers: the former face potentially devastating penalties for even minor infringements, while the latter face zero cost for wrongfully accusing the former of such infringements. Tax audits are free of consequences to enforcers, and tax audits are of grave consequences to those being audited.
In this environment, tax audits can lead to severe distortions in the balance of intended and unintended consequences of the tax law. Yet, rarely such distortions are considered in the academic literature. The prevalent wisdom that the tax authorities are always right to audit and severely punish lax practices is, well, prevalent.
One recent exception to this rule is a very interesting paper, titled “Tax Enforcement and Tax Policy: Evidence on Taxpayer Responses to EITC Correspondence Audits” by John Guyton, Kara Leibel, Dayanand S. Manoli, Ankur Patel, Mark Payne, and Brenda Schafer (NBER Working Paper No. 24465, March 2018). Five of the six authors work for Uncle Sam in either IRS or Treasury.
The paper starts by explaining how EITC audits work. "Each year, the United States Internal Revenue Service (IRS) sends notices to selected taxpayers who claim Earned Income Tax credit (EITC) benefits to request additional documentation to verify those claims." Worth noting here, that IRS' EITC audits are the lowest cost audits from the point of view of the taxpayers who face them: they are based on email exchanges between IRS and the audited taxpayer and request pretty limited information. In this, the EITC audits should create lower unintended consequences in the form of altering taxpayers' behavior than, say, traditional audits that require costly engagement of specialist accountants and lawyers by the taxpayers being audited.
So, keep in mind, fact 1: EITC audits are lower cost audits from taxpayer's perspective.
The study then proceeds to examine "the impacts of these correspondence audits on taxpayer behavior." The study specifically focuses on the labor market changes in response to audits. Now, in spirit, EITC was created in the first place to incentivise greater labor force participation and work effort for lower income individuals. The authors describe the EITC as "the United States’ largest wage subsidy antipoverty program."
Thus, keep in mind, fact 2: EITC was created to improve labor supply choices by lower income individuals.
As noted by the authors, "because these correspondence audits often lead to the disallowance of EITC benefits for many individuals, we are able to examine how the disallowance of EITC benefits affects individuals’ labor supply decisions." The authors use audits data for 2010-2012 and have accompanying administrative data for 2001-2016, so the "data allow for analysis of short-term changes in behaviors one year after the audit, as well as persistent or longer-term changes in behaviors up to six years after the audit".
The study "results indicate significant changes in taxpayer behavior following an EITC correspondence audit. In the year after being audited, we estimate a decline in the likelihood of claiming EITC of roughly 0.30, or 30 percentage points. The decrease in the likelihood of claiming EITC benefits persists for multiple years after the EITC correspondence audits, although the size of the effect is reduced over time." In year four, the likelihood of audited EITC filers still filing EITC claims is 1/4 of that for non-audited higher risk EITC filers.
Now, logical question is: was the decrease down to audits weeding out fraudulent claims? The answer is, not exactly. "Much of the decline in claiming EITC benefits following an EITC correspondence audit appears driven by decreases in the likelihood of filing a tax return." Authors suggest that 2/3rds of the decline in EITC filings post-audit is down to taxpayers stopping filing any tax returns post-audit. Which means that even some of the taxpayers who continue to file returns post-EITC audit are dropping out of EITC system.
Audits seem to trigger reductions in tax liabilities post-audit for self-employed taxpayers (ca $300 in a year following the audit) and no changes in tax liabilities post-audit for wage earners. This suggests that post-audit reported incomes either fall (for the self-employed) or remain static for those in employment. This, in turn, suggests that EIDC audits do not lead to improvements in income status for those audited by the IRS. In other words, audits do not reinforce or improve the stated objectives of EITC (see fact 2 above).
"For the Self-Employed, we estimate an increase in labor force participation (where labor force participation is defined in terms of having positive W-2 wage earnings), possibly indicating some reallocation of labor supply from self-employment to wage employment. In contrast, for Wage Earners, we estimate a decrease in labor force participation following the EITC correspondence audits."
Thus, we have fact 4: self-employed are likely to switch their income from self-employment to wages post-audit, while wage earners tend to drop their labor force participation post-audit.
The former part of fact 4 suggests can be reflective of fraudulent behavior by some self-employed who might over-state their self-employment income prior to audit in order to draw EIDC tax credits. The latter effect, however, clearly contravenes the stated objective of the EIDC system. On the first point, quick clarification via the authors of the study:"Intuitively, some lower-income individuals may increase reported self-employment (non-third-party verified) income, possibly by choosing to disclose more income, invent income, or not disclose expenses, to claim the EITC, but if they are detected by audit, they may become averse to inventing self-employment income for purposes of claiming EITC and without this income they may not file a tax return. These taxpayers may perceive the payoff from not filing as better than the payoff from filing and correctly reporting income."
Now, one can think of the effect on self-employment to be a relatively positive one. "Following the disallowance of EITC benefits due to an EITC correspondence audit, taxpayers with self-employment income on their audited returns appear more likely to have wage earnings in the next year, perhaps to offset the loss of EITC as a financial resource." But that is only true if we consider self-employment as a substitute for employment. In contrast, if self-employment is viewed as potentially entrepreneurial activity, such substitution harms the likelihood of entrepreneurship amongst lower earners. The study does not cover this aspect of the enforcement outcomes.
In measured terms, if EITC audits were successful in reinforcing EITC intended objectives, post-audits, we should see increases in wages and earnings for EITC audited individuals. Thus, we should see migration of lower earners EITC recipients to higher earners. Put differently, the share of higher earners within EITC eligible population should rise, while the share of lower earners should fall.
This is not what appears to be happening. Instead, we see increase in density (share) of lower earnings and slight decreases in densities of higher earnings:
Unambiguously, however, the study shows the damaging effects of audits: they tend to reduce labor force participation, offsetting the intended positive effects of the EITC program, and they tend to increase income tax non-filing, effectively pushing taxpayers into a much graver offence of income tax non-compliance.
Yet, still, we continue to insist that punitive, aggressive audit practices designed to impose maximal damage on tax codes violating taxpayers is a good thing. There has to be a more effective way to enforce the tax codes than throwing pain of audits around at random.