Playing Tax Games

By John Greenwald. Reported by Christopher Ohgden/Chicago and Bruce von Voorst/New York

Uncle Sam is losing billions to artful dodgers

The income tax has made more liars out of the American people than golf has.

--Will Rogers

Hal is one of a flourishing new breed of tax liars that Will Rogers never dreamed of, and his nose, like Pinocchio's when he lied, should be growing longer and longer. When he files his income tax return next week, Hal will report virtually none of the $25,000 he made last year as a self-employed carpenter in the Boston area. For the past three years, Hal and his wife have filed joint returns listing as income only her $12,000 salary as a social worker and the small amount he is paid by check rather than in cash. The carpenter figures he saves himself as much as $8,000 a year in taxes. Says he: "I feel wonderful about it."

Hal and millions of other Americans have made it a normal practice to bilk large sums of money out of Uncle Sam at tax time. Says William J. Anderson, the director of the General Accounting Office's general government division: "Extensive evidence shows that non-compliance among both corporate and individual taxpayers is a serious problem, and is getting worse." Adds Theodore Hanson, a partner in the accounting firm of Peat, Marwick, Mitchell & Co.: "Both tax avoidance and nonreporting are on the rise. With tax brackets rising so high, so fast, more people have the attitude of evade if you can."

Tax cheating fuels the so-called underground economy, the nether world of business where payments are made in cash for everything from dental care to marijuana. A major purpose of operating in the underground economy, of course, is to avoid taxes.

No one is quite certain how big the hidden economy has become because it leaves little in the way of a recorded paper trail. Peter Gutmann, an economics professor at New York City's Baruch College and a close student of the subject, puts the figure at about $420 billion in 1981, or 14% of the official gross national product. Roscoe Egger Jr., commissioner of the Internal Revenue Service, told a Senate Finance subcommittee two weeks ago that the loss in tax dollars due to the underground economy came to some $97 billion last year, more than twice the level of 1976. Others within the IRS believe that even that stunning estimate is too low. Says one insider: "The real total could be more than $200 billion."

Tax evasion is becoming increasingly commonplace. Says one overwhelmed IRS investigator: "Cheating has replaced baseball as the great American pastime." Tax dodgers include executives who charge personal expenses to their companies; doctors and lawyers who demand cash payments rather than checks for their services; waiters, waitresses and cab drivers who fail to record their tips; members of barter clubs who do not bother to report trades. Some examples:

Mildred, 70, a widow living in northern Georgia, fears that reporting the $30 a week she earns baby-sitting will mean the loss of her Social Security benefits. Says she: "If I'm a criminal, then I guess that's what I am. But I don't see what good it would do for me to starve."

Dan, 29, a Boston computer programmer, does not inform the IRS of the $600 or so a year that he pockets in cash for playing guitar in a band. Says he: "I don't feel that I owe it, and I don't like where it's going--to nuclear missiles and things."

Judith, 37, an Atlanta schoolteacher, fails to report the $300-a-month rent she takes in from two small apartments. Says she: "If I reported that income to the IRS, it would make it very difficult for me to provide for my two children."

Government officials and academic experts are perhaps most disturbed by the growing conviction of people like these that they have a right to cheat on their taxes. Many people insist that it is all right to cut corners because the tax code favors big corporations and wealthy individuals by granting them lucrative tax shelters and other loopholes. Reports that a giant corporation like General Electric Co. (1981 profits: $1.7 billion) is actually getting a Government refund on past returns add powerful fuel to this resentment. Says Thomas Field, executive director of Tax Analysts and Advocates of Arlington, Va.: "Millions of taxpayers are now asking why they should pay when corporations and rich people have so many ways of evading taxes."

Many consumers say that they are resorting to tax cheating because the rates are too high and that steps like last year's tax cut have not reduced the staggering part of a paycheck that goes to the Government. The 1981 cuts immediately dropped the ceiling on dividend and interest income from 70% to 50%. The action was designed to stimulate needed investment, but so far has mainly helped taxpayers who pay the top rate. Many people below the highest brackets now unfavorably compare that break with the 5% reduction in individual income tax rates that they received last Oct. 1.

The IRS complains that its limited manpower and outdated equipment make it impossible to police the exploding underground economy and catch tax cheaters. The service has fewer than 85,000 employees to oversee some 142 million corporate and individual tax returns that Americans will file this year.

The Reagan Administration dealt a blow to IRS morale and effectiveness when it cut the number of service personnel to 84,358 for the current year, down from more than 86,000 a year ago, and far below the 91,519 employees that had been budgeted for the same period by the outgoing Carter Administration. Because of its shrunken ranks, the IRS will audit only some 1.6% of the returns filed this year, compared with 1.8% last year and 5% in 1964. The Administration now wants to add 5,225 employees to the IRS staff next year to help cope with the massive enforcement load.

Understaffed and overburdened investigators count primarily on fear to help bring about public compliance with the law. A few well-publicized tax prosecutions, especially around tax-filing time, undoubtedly bring in millions of dollars of additional revenue. IRS officials bluntly admit that they are trying to create an atmosphere of "paranoia" about taxes. Each criminal case is evaluated not only for the flagrancy of the violation but also for how much publicity the prosecution will create. Last year the agency reaped extensive press clippings for its case against former Secretary of Agriculture Earl Butz, who was convicted of not declaring as income nearly $150,000, mostly from fees earned on the lecture circuit.

The agents rely mostly on shoe leather and the patient combing of stacks of returns, which may at times yield a few unexpectedly bright needles. Says Marilyn Leach, 30, an IRS auditor of small businesses in the Carson, Calif., area: "Sometimes you get there and the person sees you and immediately says, 'I didn't report $100,000 in income last year.' That's a real easy audit."

The IRS gets some of its best help from disgruntled ex-wives, business partners or friends. Many cases begin with a tip to the local IRS office that someone is bragging in neighborhood bars that he is cheating on his taxes.

The service has more than mere luck or tips at its command. IRS computers in ten service centers around the U.S. are programmed to flag all returns of certain types of filers, like those making $15,000 in income while spending more than $2,000 on medical expenses. Other computer programs hunt for unusually large deductions and routinely scrutinize returns reporting income of more than $50,000. The IRS is also expanding its computerized program of matching individual returns against dividend and interest payment statements.

The current maximum penalty for falsifying a tax return is a fine of $10,000 and five years in prison. Republican Senators Robert Dole and Charles Grassley, have introduced a bill that would stiffen reporting requirements and add some large new fines. At present, its prospects look dim.

While some Americans are resorting to illegal means to lessen the tax bite, many others are beginning to search through the tax code in hopes of uncovering some new deduction. Tax collectors have no troubles with that. "Take everything that's due you," advises Bob Ruttenberg, an IRS official in Boston. "We only want our fair share."

Discovering legitimate tax breaks can be a difficult task because the internal revenue code is honeycombed with a plethora of exceptions, deductions and tax credits. As late as 1967, there were only 50 of these perfectly legal provisions, and they cost the U.S. Treasury $36.5 billion in forgone revenue. The number has doubled to 104, and the revenue loss is an awesome $266.2 billion. Government planners estimate that the amount will reach $465.2 billion by 1986.

One of the most widely claimed deductions allows home owners to subtract mortgage interest payments from their declared income. That measure will cost Uncle Sam an estimated $25.3 billion this year. Many liberal politicians and economists have urged limiting the amount of mortgage interest considered tax deductible, but President Reagan last week again repeated his opposition to any such move.

Corporations have long employed small armies of accountants and lawyers to find methods of legally avoiding taxes. These are often very successful. First Chicago Corp. (1981 assets: $33.6 billion) was able to use an array of credits, deductions and tax-exempt investments to eliminate all U.S. taxes on its 1980 income of $48 million. A recent Tax Analysts and Advocates survey sorted 405 major firms into industry groups and found that in 1980 they paid a median tax rate of 24%, well below the corporate ceiling of 46%.

Now more and more individuals are turning to tax preparers in hopes of paring down the amount that they owe the Government (see box). Says Paul D. Koehler, a partner of Touche Ross & Co., one of the leading accounting firms: "I'm up to my neck in tax forms. There's a tremendous amount of demand for us to interpret the new tax laws." Richard W. Earp, a partner in the Minneapolis office of Arthur Andersen & Co., noted that the bulk of new business has come from wealthy individuals, who are the biggest beneficiaries of last year's tax changes.

The most frequently asked questions concern estate and gift taxes, Earp says. The new law, for example, allows a husband or wife to pass an entire estate on to a surviving spouse without any tax burden. Before this year, no more than half of a large estate was tax free. Says Earp: "Anybody who didn't change his will after Dec. 31 could wind up costing his family a lot of money." Changes passed last year also permit someone to give a person up to $10,000 in tax-free gifts. The previous ceiling was only $3,000.

The growth of the underground economy and the more and more common attitude that cheating on taxes is basically all right (as long as you are not caught) could be undermining the very basis of the American income tax system. Says Congressman Benjamin Rosenthal of New York, chairman of the House Subcommittee on Commerce, Consumer and Monetary Affairs: "Our nation's self-asessment tax system is increasingly troubled." A dagerous perception is growing up that the law is not fair because everyone is cheating. A tax system that has assumed that people are fundamentally honest and pay their taxes may unfortunately no longer be appropriate for American society. --by John Greenwald. Reported by Christopher Ohgden/Chicago and Bruce von Voorst/New York

With reporting by Christopher Ohgden/Chicago and Bruce von Voorst/New York

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