Study: Deterrence a major factor in bringing in more money from IRS audits

The deterrence effect of IRS audits plays a major role in putting more money in the nation’s coffers, and this effect is especially striking for the highest-income filers, according to a paper by researchers at Harvard University, the University of Sydney and Treasury.

The paper, “A Welfare Analysis of Tax Audits Across the Income Distributed,” published in June, is based on an analysis of about 710,000 in-person audits of individuals from 2010 to 2014. The researchers found that an additional $1 spent on audits of top earners (taxpayers above the 90th income percentile) brings in over $12 in revenue. In comparison, audits of below-median income taxpayers yield $5, the paper said.

“While audit costs rise with taxpayer income, the same is true for audit revenue,” according to the paper. “In fact, the additional costs stemming from the complexity associated with auditing high-income taxpayers are more than offset by additional revenues.”

The study quantifies the audits’ costs and revenues by using IRS data and activity logs that record the enforcement activities of all IRS auditors. The paper employs an approach that researchers say is new to arrive at the cost, which includes not only the pay and benefits of IRS auditors, but also indirect costs, such as the pay of management and support staff.

On the revenue side, auditing taxpayers in the bottom half of the income distribution produces an average of $4,984 in revenue, the paper says, while an audit of a taxpayer in the 70th to 80th percentiles produces $8,270 in revenue. In the highest income brackets, an audit of a taxpayer in the 90th to 99th percentiles yields an average of $14,973, and an audit of a taxpayer in the top 0.1% yields an average of $95,491.

On average, the direct revenues collected by audits surpass the cost by more than 2 to 1, but that ratio varies widely by income. Audits of taxpayers in the bottom 50% of the income distribution do not break even, producing 96 cents for each $1 in cost. Audits in the 70th to 80th percentiles return $1.58 for each dollar in auditing costs; in the 90th to 99th percentiles, audits return $2.18 for every $1, and for audits in the top 0.1%, the return is $6.29.

The researchers get to the figure of $12 in revenue from the highest-income taxpayers by including the effects of deterrence: Following an audit, people pay more taxes for a minimum of 10 years and a maximum of 14 years. The revenue generated is three times greater than what is collected during the initial audit.

When the researchers used audit data from the IRS National Research Program (NRP) to factor in the deterrent effect, they found that each dollar spent on an audit of a taxpayer in the 70th to 80th percentiles produces a return of $9.06, while audits of individuals in the 90th to 99th percentiles yield $12.48.

“We find clear and persistent deterrence effects,” the report says. “As one would expect, the difference in taxes paid between treatment and control is statistically indistinguishable in the years prior to the NRP audit. In the years following the audit, a clear gap emerges. Starting in Year 2, we find a statistically significant deterrence effect.”

In October 2022, the IRS said the annual tax gap — the difference between the estimated total tax liability for the period and the amount that taxpayers pay on time — averaged $496 billion for tax years 2014 through 2016. Based on projections for 2017–2019, the estimated average gross tax gap is projected to be $540 billion per year, the IRS said.

The percentage of tax returns audited dropped by 40% during the study period, the authors said, from 0.92% in 2010 to 0.56% for 2014 tax returns. This coincided with a steep drop in enforcement funding — by 24% in inflation-adjusted terms from 2010 to 2020 with the operations staff numbers dropping by 31% from 2010 to 2018.

Meanwhile, the $80 billion allocated to the IRS over 10 years through the Inflation Reduction Act, P.L. 117-169, was cut by about $20 billion as part of the debt ceiling deal reached in June. Almost $46 billion of that $80 billion was slated to go to enforcement. It is not clear how much of that money will be cut or the effects of any cuts on audits.

More research will provide more insight into the benefits or drawbacks of increasing IRS audits, the paper concludes, from the effects of audits on the deterrence of others, to the costs of hiring and training new auditors and expansion to audits of businesses.

— To comment on this article or to suggest an idea for another article, contact Martha Waggoner at Martha.Waggoner@aicpa-cima.com.