Saturday, April 23, 2011

The Motley Fool: The Most Sensible Way to Solve the Budget Deficit

The Most Sensible Way to Solve the Budget Deficit

Morgan Housel
April 21, 2011

I'm about to cure over half of the projected budget deficit over the next decade. Theoretically, at least.

This doesn't involve tax hikes. We won't even need to decrease spending. We might actually raise spending a little. In the end, we'll shave the deficit by several trillion dollars over the next 10 years.

Sound impossible? It's not. Unlikely, yes, but keep reading. This should start to make sense.

Tax evasion added $3 trillion to the deficit over the past decade alone, an average of $300 billion a year, according to IRS data. This isn't revenue lost from legal tax write-offs, like the mortgage interest deduction. It's not even, as the IRS notes, "taxes that should have been paid on income from the illegal sector of the economy." That $300 billion represents the amount of revenue lost from people deliberately cheating on their taxes every year. This includes underreporting income, hidden offshore bank accounts, sham trusts, and other ways to illegally stiff the IRS.

Put that money in perspective. Tax evasion in the last decade cost an amount roughly equivalent to the Bush tax cuts, the Obama stimulus, and the wars in Iraq and Afghanistan ... combined. That $300 billion is more than four times the Department of Education's budget and 10 times what we spend on science and technology. It's amazing more people aren't outraged about this stuff. Rather, they likely would be if they knew about it.

Some more figures: According to the Congressional Budget Office, the cumulative projected budget deficit over the next 10 years is $6.97 trillion. That's how much additional debt we'll rack up if current laws are left unchanged.

Now extrapolate last decade's tax fraud into the next, and adjust it for inflation and economic growth. We're probably looking at $4 trillion in tax fraud over the next 10 years.

And there it is. Without raising tax rates or reducing spending, we could eliminate more than half of our projected deficit over the next 10 years by simply eliminating tax cheats.

That's irrational, of course. It will never happen. Like I said, this is theoretical. There will always be tax cheats. But pointing these numbers out is important for a few reasons.

1. Prioritizing
I've often said that any politician serious about tackling the deficit should focus on just one issue: health-care costs. That's where essentially all the long-term budget pressures are. But after reviewing tax-cheat data, I think there's a new qualifier: cracking down on tax evasion should be a top priority in the short run. Areas that have been getting deficit-reduction attention lately pale in comparison to what could be saved by ramping up tax enforcement. Cracking down on tax cheats is also probably the most politically feasible way to reduce the deficit. It's simply enforcing existing rules, rather than setting up a fight by changing rules in ways someone will find biased and unfair.

2. Investing
A deficit-reduction plan earlier this year proposed cutting $603 million from the IRS's budget. The cut was eventually scrapped, and for good reason: IRS commissioner Douglas Shulman noted that the cuts would reduce tax collections by $4 billion annually, increasing deficits by a factor of six-to-one. This stressed an important point. IRS agents can be very good investments for taxpayers. An enforcement agent making $60,000 a year who cracks one big case pays for his entire career. Any comprehensive deficit-reduction plan should increase the IRS's budget.

3. Learning from others
Greece is a good example of what happens when tax evasion is ignored. Greece's current status as a near-bankrupt slave grasping at its creditors was caused by many factors, but one of the largest was an endemic culture of tax cheating. Only chumps followed the rules. Emphatic disregard for the tax man became the norm.              

Michael Lewis did a wonderful job exposing this culture in an essay published last year in Vanity Fair. "Somewhere between 30 and 40 percent of the activity in the Greek economy that might be subject to the income tax goes officially unrecorded," Lewis writes.

He continues: "The scale of Greek tax cheating was at least as incredible as its scope: an estimated two-thirds of Greek doctors reported incomes under 12,000 euros a year -- which meant, because incomes below that amount weren't taxable, that even plastic surgeons making millions a year paid no tax at all."

In one Greek town, 324 residents admitted to having swimming pools -- an asset that increases property taxes. A satellite photo showed the actual number of pool owners was 16,974. Small wonder Greece found itself where it is today when 98% of the population cheats on their taxes.

Could we be next?

Check back every Tuesday and Friday for Morgan Housel's columns on finance and economics.

Fool contributor Morgan Housel doesn't own any of the companies mentioned in this article. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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