Compliance Costs: What States Don't Know

LineItemFeb13

State Tax Reform
Options, Challenges & Creativity

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The February/March 2013 edition of ABFM’s newsletter, Line Item, features several articles on the pertinent topic of State Tax Reform. Click here to check out the rest of this special issue, and click here for information on a special webinar featuring contributors to this issue, hosted by AABPA on Wednesday, March 13th (1PM Eastern).

By Philip C. Christian, Georgia Southern University

There are significant compliance enforcement risks associated with the current wave of proposed tax reform efforts in the states, especially those calling for the elimination of the individual and corporate income tax in favor of an expanded sales tax.

The state income tax is relatively easily enforced due to the level of third-party reporting required by the federal government. Consider the data from an analysis of federal individual income tax returns from the year 2007 as presented in Table 1:

Table 1: Percentages of Individual Income Tax Income and Deduction Items Subject to Third-Party Verification – 2007 Data

Category

Total

Verifiable

Percentage

Income Items

$8,793,560,693,000

$7,262,331,438,000

82.59%

Deductions for AGI

$122,922,183,000

$89,313,528,000

72.66%

Other Deductions

$2,930,389,570,000

$1,597,353,028,000

54.51%

The federal compliance enforcement process begins with more than 82 percent of reported income and more than half of all deductions verified through independent third-party sources. There is an incentive for accurate third-party reporting on Forms W-2 or 1099 since failure to report properly will result in lost deductions to the third-party reporter. This verification process automatically benefits those states that use federal adjusted gross income or taxable income as the starting point on state returns. Additionally, federal audit results are automatically reported to the states allowing states to benefit from those compliance enforcement efforts at no cost.

Some argue that the sales tax is collected by third-party business entities, and thus all of the sales tax is subject to third-party reporting. This is, in fact, erroneous. In a retail sales tax system there is no mechanism to verify that all of the sales tax collected has been remitted to the state. Therefore, the issue is not sales tax evasion; it is sales tax theft by the parties that collect the tax as an agent of the state.

Many states boast of voluntary sales tax collection rates of from 95 to 99 percent. It is important to understand that these rates are based on delinquent returns only. Delinquencies arise when a taxpayer has either filed a return without paying the tax, or has not filed a return and the amount of delinquent tax has been estimated based on that taxpayer’s filing history. Nothing in that process addresses those taxpayers who collect tax and report smaller amounts of tax to the state, pocketing the remainder. Further, it is unproductive to look for stolen sales tax among those taxpayers who are delinquent, because those who steal sales tax nearly always file returns on time and pay whatever tax they decide to report. In this manner, they “fly below the radar” and are rarely subject to other enforcement efforts.

I have studied sales tax compliance enforcement extensively within the State of Florida. In one study of 392 companies in a single industryi, I found that 192 companies had committed sales tax theft in the amount of $21,421,312. The delinquency amounts on the books were only $302,226, a difference of $21,119,086. Using chronic delinquency as an indicator of potential sales tax theft, and auditing based on that indicator, would have identified only 30.39 percent of those companies involved in sales tax theft. The correlation between sales tax theft and chronic delinquency (late filing or payment in more than ten percent of filing periods) is only .204 (N = 369, p = .001). A review of the results of nearly ten years of criminal investigations indicated that this issue is not limited to a few specific industries or to any one region within the state.

Instead, the problems reflect overall weaknesses in sales tax compliance.

Figure 1: Focus of Sales Tax Enforcement Efforts in Florida

TaxComplianceGap

Fully 80 percent of all tax personnel are dedicated to making sure taxpayers file a return and pay what is reflected on those returns. They do not verify that amounts reported on the return are correct. Auditors audit 0.39 percent (.0039) of all businesses in the state and criminal investigators investigate another 0.08 percent (.0008). This leaves 99.53 percent of all businesses in the state in the category of trust without verification with no internal review or external third-party reporting in place. It is estimated that 60 percent of these businesses are noncompliant to some extent.

More reliance on sales tax versus income tax means that states will have to address several problems:

  • The absence of third-party verification in the sales tax system will require more expensive verification methodologies. States will no longer be able to rely on verification built in to the federal system in the form of both third-party verification and federal audit activities that benefit states at no cost.
  • Improper assumptions about delinquencies representing the sales tax gap will likely result in budget surprises when revenue goals are not met.
  • Raising the sales tax rate will make more funds available for theft and more incentive to engage in theft.

A better option for reform would be focusing resources on more targeted compliance enforcement within the existing sales tax structure.

Philip C. Christian is an Assistant Professor of Political Science at Georgia Southern University


i Christian, Philip C., “Sales Tax Enforcement: An Empirical Analysis of Compliance Enforcement Methodologies and Pathologies” (2010). FIU Electronic Theses and Dissertations. Paper 335. http://digitalcommons.fiu.edu/etd/335