Trust But Verify

David Clay Johnson

New data, not yet published by the IRS, establish beyond a doubt that America has two income tax systems, separate and unequal. One system effectively taxes people with wages, while the other system is a sieve of untaxed income for investors and business owners.

The data show that 99% of wages people report on their income tax returns matches what employers list in verification reports. In contrast, the share of actual income from capital gains and business, which is not independently verified, is much less. Only about half of Schedule C profits show up on tax returns. And the new IRS data show that only 88% of capital gains is reported, a figure that almost certainly understates reality by a substantial degree. ...

Now, how do we have two systems, separate and unequal?

Congress treats Americans who work for wages, claim deductions for spouses and children, collect interest and dividends, and withdraw from pension and retirement savings accounts the way Ronald Reagan said we should treat the Soviets on arms reduction: Trust, but verify. Congress does not trust this vast majority of citizens to report their incomes honestly and, with good reason, demands verification by employers, banks, brokerages, and mutual funds. Congress also requires Social Security numbers for all dependents.

Business owners and investors are another story. Congress trusts them to fully and accurately report their revenues, their profits, and their capital gains and not to charge personal expenses as tax-deductible expenses. For these favored citizens, there is no independent reporting, except for capital gains, in which only the amount realized at sale is reported and the individual is trusted to accurately report basis. Except for requiring audits, which are rarely performed today compared to two decades or more ago, Congress assumes that these taxpayers keep their books the same way Rome's vestal virgins retained their privileged status. ...

Now if political reporters on the campaign planes would just ask hard questions about taxes and spending instead of hunting for gaffes, the next president and Congress could be pressured to weed out officially enabled tax cheating for business owners and investors through verification and withholding, which encourages tax return filing.