As Honest As The Day Is Long

In Casablanca, Rick fixes the roulette game to allow a young Bulgarian refugee to win enough money to buy an exist visa. His croupier, Carl, is challenged by another customer who was watching:

Customer: Say, are you sure this place is honest?

Carl (fervently): Honest! As honest as the day is long!

Only fools will believe the Bush Administration's explanation for eliminating over half of the lawyers in the IRS who audit estate and gift tax returns. The story is reported by the NYT here.

Bush Administration apologist spokesman Kevin Brown "dismissed as preposterous any suggestion that the I.R.S. was soft on rich tax cheats. He said that the money saved by eliminating the estate tax lawyers would be used to hire revenue agents to audit income tax returns, especially those from people making over $1 million."

Right. The Bush Administration is as honest as the day is long.

First, according to the article, citing the aforesaid Brown as the source, "estate tax lawyers are the most productive tax law enforcement personnel at the I.R.S. . . . For each hour they work, they find an average of $2,200 of taxes that people owe the government." While Brown argues that:

[C]areful analysis showed that the I.R.S. was auditing enough returns to catch cheats and that 10 percent of the estate audits brought in 80 percent of the additional taxes. He said that auditing a greater percentage of gift and estate tax returns would not be worthwhile because "the next case is not a lucrative case" and likely to be of relatively little value.

This may be technically true, but it is also irrelevant. After all, it only follows that one can gut the enforcement staff without any diminution in audit revenue if one is assured that the remaining staff will only focus on those estates that owe taxes. In reality, this is not likely to be the case, since it is not certain before an audit is conducted whether or not any tax is due.

To illustrate this point, assume that every police speed trap picks up one speeder for every 100 cars that pass by. Assume further that there are 100 speed traps and each picks up 1 speeder (i.e., 100 total speeders).

Using Brown's logic, we could reduce the number of speed traps by 99% since only 1 in 100 drivers are actually exceeding the speed limit. Of course, what actually will occur is that the last remaining speed trap will only pick up 1 speeder, since that speed trap's percentage is still only 1 in a hundred. Thus, the reduction in the total number of law enforcement personnel causes a similar reduction in the number of speeders apprehended.

Second, as a practical matter, the loss will be even greater than the percentage reduction in enforcement since the reduction in audits will embolden those who want to "game" the tax system. Assume that drivers knew that the number of speed traps had been dramatically reduced. Over time, because they would have a lower incentive to monitor their speed, we could expect that there would be a greater number of speeders on the road. The same thing happens in tax law.

In fact, practitioners actually refer to this behavior as "audit roulette." Specifically, taxpayers willingly take positions that they know the IRS can probably successfully challenge because (i) they may not get audited at all or (ii) even if audited, they can settle the case for less than 100 cents on the dollar. This tendency is especially pronounced in estate planning with taxpayers taking positions using aggressive property valuation appraisals.

Any practitioner in the area knows that John Hruska, an IRS estate tax lawyer in New York who is active in the National Treasury Employees Union, which represents IRS workers, is correct when he says that "This [the gutting of the estate tax audit division] is not a game the poor will win, but the rich will."

Some readers of this blog have taken exception to my constant reference to the Bush Administration's tax policy makers as "knaves." Only fools would take exception now.