Compliant Taxpayers May Be Less So After IRS Audit

Source: AccountingWEB

By Terry Sheridan

January 26, 2016

IRS audits don’t have a uniform impact on self-employed taxpayers, and those who were behaving themselves before the audit may not afterward, according to a study released in the National Taxpayer Advocate’s recent annual report to Congress

Every year, about 1.5 percent of self-employed individuals can expect to be audited by the IRS. In fiscal year 2014, the result was more than $3 billion in recommended additional tax assessments, though not all of that will be collected.

The Audit Impact Study aimed to determine the indirect long-term effect of audits on tax reporting. “Depending on risk attitudes, norms, moral perceptions, and, perhaps most importantly, the subjective appraisal of the audit, enforcement activity has the potential to increase or decrease the willingness to comply with the law and to cooperate with the IRS in the future,” the report states.

Researchers compared data for a random group of 2,204 Schedule C tax filers with less than $200,000 in reported taxable income who were audited on their 2007 tax returns with data for a control group of 4,705 who weren’t audited. 
They found that tax evaders who were slapped with tax assessments increased their subsequent reported taxable income by 250 percent after the audit. Three years later, the post-audit income reported increased by 120 percent.

But compliant taxpayers who were audited – and faced no additional tax liability – reported 35 percent less taxable income three years after the audit. 
“Our empirical results provide robust evidence that audits have important long-term revenue implications,” the report states. “However, by differentiating the response of compliant and noncompliant taxpayers, we find that there is scope for improving the revenue efficiency of audits.”

The increased compliance by the former tax evaders is probably the result of “some kind of specific deterrent effect,” the report finds. But understanding the effect on the now not-so-compliant taxpayers “is probably even more important.”

So, why be less compliant after an audit? The study posits several notions.

  • “Coercive enforcement activity” could reduce “tax morale” among honest taxpayers.
  • Even if morale wasn’t affected by the audit, the process might give compliant taxpayers with a “window on potential opportunities for both legal and illegal tax avoidance,” the report states.
  • Taxpayers may figure that because they weren’t assessed for more taxes, the chances of a future audit are low.
  • The decrease in reported income could be by dishonest taxpayers whose noncompliance wasn’t found during the audit, making them more bold in future filings. 

Which one is true? Researchers can’t pinpoint a clear-cut answer. But the reduced compliance by seemingly once-compliant taxpayers suggests room for improving audit efficiency, the report states.

“On the one hand, improved targeting of noncompliant returns and an improved capacity to detect noncompliance would seem likely to improve deterrence among cheaters,” the report states. “On the other hand, a better understanding of the psychological impact of audits on compliant taxpayers may lead to enhanced examination approaches that mitigate the erosion of tax morale and maintain their incentives to comply.”

The IRS audited slightly more than 1.2 million individuals during fiscal year 2015, a 0.84 percent rate, which is down 1.1 percent from 2014 and 22.3 percent from fiscal year 2010.