Tax honesty comes not from altruism but from fear

This is the time of year when American citizens inevitably think about the Internal Revenue Service and, also inevitably, about how deeply they hate it.

And yet most Americans say they are proud to pay their taxes. In an independent poll conducted last year for the IRS Oversight Board, 96 percent of the respondents agreed with the statement ''It is every American's civic duty to pay their fair share of taxes," while 93 percent agreed that everyone ''who cheats on their taxes should be held accountable."

On the other hand, when asked what influences their decision to report and pay taxes honestly, 62 percent answered ''fear of an audit," while 68 percent said it was the fact that their income was already being reported to the IRS by third parties. For all the civic duty floating around, it would seem that most compliance is determined by incentives.

So which of these incentives work and which do not? To find out, the IRS conducted a three-year study during which 46,000 randomly selected 2001 tax returns were intensively reviewed. (The IRS doesn't specify what these 46,000 people were subjected to, but it may well have been the kind of inquisition that has earned the agency its horrid reputation.)

Using this sample, the study found a tax gap -- the difference between taxes owed and taxes paid -- of $345 billion, or nearly one-fifth of all taxes collected by the IRS. This sum happens to be just a few billion dollars less than the projected federal budget deficit for 2007; it also amounts to more than $1,000 worth of cheating by every man, woman, and child in the United States.

But most people aren't cheating. And when you take a look at who cheats and who doesn't, it becomes pretty clear just why people pay their taxes at all. The key statistic in the IRS study is called the net misreporting percentage. It measures the amount that was misreported on every major line item on those 46,000 returns.

In the ''wages, salaries, tips" category, for instance, Americans are underreporting only 1 percent of their income. Meanwhile, in the ''nonfarm proprietor income" category -- think of self-employed workers like restaurateurs or the boss of a small construction crew -- 57 percent of the income goes unreported. That's $68 billion in unpaid taxes right there.

Why such a huge difference between the wage earner and a restaurateur? Simple: The only person reporting the restaurateur's income to the IRS is the restaurateur; for the wage earner, his employer is generating a W2 to let the IRS know exactly how much he has been paid. And the wage earner's taxes are automatically withheld from his every check, while the restaurateur has all year to decide if, and how much, he will pay.

Does this mean that the average self-employed worker is less honest than the average wage earner? Not necessarily. It's just that he has much more incentive to cheat.

He knows that the only chance the IRS has of learning his true income and expenditures is to audit him. And all he has to do is look at the agency's infinitesimal audit rate -- last year, the IRS conducted face-to-face audits on just 0.19 percent of individual taxpayers -- to feel pretty confident to go ahead and cheat.

So why do people really pay their taxes, because it is the right thing to do, or because they fear getting caught if they don't? It sure seems to be the latter. A combination of good technology (employer reporting and withholding) and poor logic (most people who don't cheat radically overestimate their chances of being audited) makes the system work.

And while it sounds bad to hear that Americans underpay their taxes by nearly one-fifth, the tax economist Joel Slemrod estimates that the United States is easily within the upper tier of worldwide compliance rates.

Still, unless you are cheating by one-fifth or more, you should be mad at the IRS -- not because it's too vigilant, but because it's not vigilant enough. Why should you pay your share when the agency lets a few hundred billion dollars of other people's money go uncollected every year?

The IRS itself would love to change this dynamic. In the past few years, it has increased significantly its enforcement revenue and its audit rate, despite a budget that is only fractionally larger.

A main task of any IRS commissioner (the current one is Mark Everson) is to beg Congress and the White House for resources. For all the obvious appeal of having the IRS collect every dollar owed to the government, it is just as obviously unappealing for most politicians to advocate a more vigorous IRS. Michael Dukakis tried this during his 1988 presidential campaign, and, well, it didn't work.

Left to enforce a tax code no one likes upon a public that knows it can cheat practically at will, the IRS does its best to fiddle around the edges. Once in a while, it hits pay dirt.

In the early 1980s, an IRS research officer in Washington named John Szilagyi had seen enough random audits to know that some taxpayers were incorrectly claiming dependents for the sake of an exemption.

Sometimes it was a genuine mistake (a divorced wife and husband making duplicate claims on their children), and sometimes the claims were comically fraudulent (Szilagyi recalls one dependent listed as Fluffy, quite obviously a pet rather than a child).

Szilagyi decided that the most efficient way to clean up this mess was to simply require taxpayers to list their children's Social Security numbers.

''Initially, there was a lot of resistance to the idea," says Szilagyi, now 66 and retired to Florida. ''The answer I got was that it was too much like '1984.' " The idea never made its way out of the agency.

A few years later, however, with Congress clamoring for more tax revenue, Szilagyi's idea was dug up, rushed forward, and put into law for tax year 1986. When the returns started coming in the following April, Szilagyi recalls, he and his bosses were shocked: Seven million dependents had suddenly vanished from the tax rolls, some incalculable combination of real pets and phantom children. Szilagyi's clever twist generated nearly $3 billion in revenues in a single year.

Szilagyi's immediate bosses felt he should get some kind of reward for his idea, but their superiors weren't convinced. So Szilagyi called his congressman, who got the reward process back on track.

Finally, five years after his brainstorm became law, Szilagyi, who earned about $80,000 annually at the time, was given a check for $25,000. By this point, his idea had generated roughly $14 billion.

Which suggests at least one legitimate reason to dislike the IRS: If the agency hadn't been so stingy with Szilagyi's reward back then, it probably would have attracted a lot more of the anticheating wizards it really needs today.

Stephen J. Dubner and Steven D. Levitt are the authors of ''Freakonomics: A Rogue Economist Explores the Hidden Side of Everything." HAVE YOU FILED YOUR TAXES? If not, get help with our tax guide at boston.com/business/taxes.