The Effects of Communication Among Taxpayers on Compliance

T axpayer audits are a central feature of the voluntary compliance system in the United States Federal individual income tax. Audits are thought to have a direct deterrent effect on the individuals actually audited. In addition, audits are believed to have an indirect deterrent effect on individuals not audited, and there is some empirical evidence that suggests that changes in audit rates affect compliance beyond the audited individuals themselves. For example, in an econometric study using U.S. State-level reporting data for the years 1977 to 1986, Dubin, Graetz, and Wilde (1990) find that, for every $1 of revenue produced because of taxpayer audits, an additional $6 of revenue were generated from the indirect or " ripple " effects. Tauchen, Witte, and Beron (1989) use taxpayer audit data from the 1969 Taxpayer Compliance Measurement Program (TCMP) and find that raising the audit rate had overall a smaller impact, and one mainly felt on high-income wage and salary workers ; for this group of taxpayers, they estimate an indirect effect of audits that is almost three times the direct revenue effect. Given the importance of audits in the voluntary compliance system of the U.S., it is significant that taxpayer audit rates have fallen dramatically since the 1960's and have continued their decline in recent years. In the early 1960's, the percentage of individual tax returns that were audited by the Internal Revenue Service (IRS) was about 6 percent, and this percentage fell to 2.5 percent by the mid-1970's. Over the next decade, the audit rate fell further to roughly 1 percent. According to the Inspector General for Tax Analysis (2002), taxpayer audit rates have fallen another 56 percent between 1997 and 2001. As a result, at present, less than 1 percent of all individual tax returns are audited. Seen in the context of the Dubin, Graetz, and Wilde (1990) and Tauchen, Witte, and Beron (1989) studies, the effect of declining audit rates is not confined to the direct effect due to fewer audited taxpayers. Rather, there is an indirect effect that extends to taxpayers in general, who respond to the reduced overall probability of audit by lowering their compliance. It, therefore, seems likely that the decline in audit rates since the 1960's has affected voluntary compliance. For example, it is estimated that Government coffers have been shortchanged by $7.2 billion of " real money " as a