Searching for Tax Fairness

Lack of regulation on capital-gains tax invites non-compliance

by Gerald E. Scorse

If you haven't read James Surowiecki's The Wisdom of Crowds, get ready for a surprise. In a book that's part math, part psychology and part common sense, Surowiecki upends the popular belief that individuals are smarter than groups. When it comes to solving problems, look to the group for dead-on answers, he says.

Paying taxes, Surowiecki states, "is a classic example of a cooperation problem". Everyone benefits from the services that taxes provide, but this is true whether or not they pay any taxes. Therefore, why pay?

In Surowiecki's view, taxpayers ante up in large part because they believe that others are doing likewise. Americans, according to historian Margaret Levi, are "contingent consenters". Few of us are thrilled to pay taxes, but we don't mind paying our share as long as we're sure that the folks next door are paying theirs.

But hold on. What makes us believe that our fellow citizens are giving the taxman his due? Are we being chumps, or does something in the system give us the assurance we need?

The answer arrives like clockwork every tax season. It's the blizzard of W-2s and 1099s sent out by employers, banks, brokerage houses and mutual funds, telling us how much we made the year before in wages, interest, dividends and other forms of income. Each bears the reminder, "This information is being furnished to the Internal Revenue Service."

It's this third-party reporting that forms the linchpin of our "voluntary" tax system. It is the lodestar that keeps us on the straight and narrow, and tells us that we're all in the same boat.

But hold on one more time. There's a goldmine of unearned income that has its own set of rules, that isn't "furnished to the Internal Revenue Service." This rich vein is capital gains income from the sale of stocks, bonds and mutual funds. None of this income is reported by a third party to the IRS, though you could easily think it is. (Capital gains distributions by mutual funds are treated differently; they are the only capital gains reported by a third party.)

To explain: The IRS does get reports of proceeds from stock and bond sales. But the agency isn't told what these holdings cost to begin with, or when they were bought. In tax-speak, income from these transactions is "self-reported"; the figures don't come from a third party, they come from the taxpayer.

This is unfair on its face, and porous tax policy besides.

A major IRS study found that misreporting rises sharply with self-reporting, climbing to more than 12 times the rate for income reported by third parties. Other government and scholarly studies have produced similar results. Kim Bloomquist, a senior economist with the IRS, makes the point the other way around: "One of the few generally accepted facts in the literature on tax compliance economics is the existence of a positive relationship between transaction visibility and reporting compliance."

There's no question that the self-reporting of capital gains costs the U.S.

Treasury; the only question is how much. Unless we're a nation of angels, the figure likely hits the double-digit billions every year. On top of that there's the multiplier effect: states and cities which simply plug federal totals into their tax returns get short-changed as well.

The solution is only half a step away, staring us in the face and daring us to put it in place.

Brokerage houses and mutual funds routinely track their customers' basis prices, purchase dates and realized capital gains, and report the information to them. With little more than the click of a mouse, the same data could be reported to the IRS at tax time.

Circle back to Surowiecki: "Getting people to pay taxes is a collective problem. We know what the goal is: everyone should pay their fair share."

IRS Commissioner Mark W. Everson sounded a similar note when he told the National Press Club, "Average Americans pay their taxes honestly and accurately, and have every right to be confident that when they do, their neighbors are doing the same."

It's time to put more reality into Everson's rhetoric. It's time to treat capital gains income the same as wage income, and have it reported by third parties.

Just ask any crowd.

SOURCES

Bloomquist, Kim M. "Trends as Changes in Variance: The Case of Tax Noncompliance," presented at the IRS Research Conference, June 2003. Bloomquist is Senior Economist, Office of Research, IRS. His paper cites the agency's major study, and several others, on the relationship between tax compliance, third-party reporting ("matchable income") and self-reporting ("nonmatchable income"). The article is accessible online.

Everson, Mark W. Speech at the National Press Club, Washington, D.C., March 15, 2005.

Surowiecki, James M. The Wisdom of Crowds: Why the Many Are Smarter Than the Few and How Collective Wisdom Shapes Business, Economies, Societies and Nations. Doubleday, 2004.