Tax Evasion Incentives and the Earned Income Tax Credit

Robert Halperin
University of Illinois at Urbana–Champaign

Shelley C. Rhoades-Catanach
Villanova University

Abstract: This paper considers taxpayer reporting incentives and IRS audit strategy related to the earned income tax credit (EITC). This credit accounts for over $20 billion of annual tax outflows, of which some observers estimate 20% of such benefits are claimed in error. Erroneous benefits may result first by claiming ‘qualifying children’ to whom the taxpayer is not entitled. A second source of erroneous benefits is more subtle, and results from misreporting of taxpayer income on which the amount of the allowable credit is based. The EITC is a refundable credit, and for some taxpayers results in a negative effective tax rate. Thus, these taxpayers can increase their tax refund by reporting higher income and thus higher EITC. While a number of empirical studies consider taxpayer claims of the EITC, no prior theoretical work addresses the impact of the credit on taxpayer reporting of income, qualifying children, and resulting tax liability. We also consider IRS audit strategies to detect misstatements of income and qualifying children for purposes of the EITC. Our results show that the benefits of the EITC provide considerable incentive to overstate claims of qualifying children. However, not all taxpayers with such incentive will over-report. In equilibrium, tax authority strategies to detect evasion also successfully deter some taxpayers from misreporting both claimed dependents and reported income. Interestingly, some taxpayers in our model choose to over-report income in order to increase the EITC, while others choose to under-report income. Because of these reporting strategy differences, IRS audit sequence is important. In our model, the tax authority audits reported exemptions first, then decides whether to audit income depending on whether reported exemptions were misstated and on the level of reported income. Hopefully, these results give some insight for improving IRS audit efficiency and increasing taxpayer compliance.

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