Some of the best ideas are the most simple.
This dawned on me while chatting with a fellow tax pro at a recent networking event (okay, it was a cocktail party, same thing). The two of us spent a few minutes talking about tax fraud and the child tax credit (yes, that’s what tax professionals talk about at events like these). That’s when I told him my great idea. It’s crazy simple. And I think it would significantly reduce instances of modern tax fraud. I get that we’re always going to have under-reporting and over-deducting. But tax fraudsters today have learned that they can make big money by inflating tax credits and using stolen identities to collect even when they don’t pay into the system. In some instances, all they need is a Social Security Number.
So here’s my great advice: eliminate refundable tax credits. So simple. So easy. And I am sure that it would reduce tax fraud.
And here’s why.
Deductions – which are what most people think about when they think about tax fraud – are reductions in taxable income. Credits are dollar for dollar reductions in tax due. If you “over-deduct,” the most that can really happen is that you can bring your taxable income – and thus, your tax obligation – down to zero. Your taxable income is the number you’ll see on line 43 of your form 1040.
You figure your tax based on that number. If you’ve paid into the system, you can get a refund as a result of over-deducting, but you have to work at it pretty hard.
However, if you claim a number of credits, you can easily reduce your tax obligation to zero. In most instances, you can’t bring your obligation below zero – that’s the number at line 46 of your form 1040.
But here’s where refundable credits come into play. With refundable credits, you can get a tax refund even if you didn’t have any tax obligation and even if you didn’t pay into the system. Those credits include:
- Adoption Credit (not refundable for 2012)
- Additional Child Tax Credit
- American Opportunity Tax Credit – (up to 40% refundable)
- Earned Income Credit (EIC) or Earned Income Tax Credit (EITC)
- First-time Homebuyer Credit (not applicable for 2012)
- Health Coverage Tax Credit
- Making Work Pay Credit (not applicable in 2012)
Notice anything interesting?
A number of those credits have been singled out by the IRS, The United States Treasury Inspector General for Tax Administration (TIGTA), and/or Congress for abuse.
Tops of the list is, of course, the EITC, which has been a constant source of tax fraud. How much fraud? The IRS believes that between 23 and 28% of EITC claims are paid in error. The result is estimated fraudulent payouts each year of more than $10 billion.
With respect to the first-time homebuyer credit, officials from the IRS testified before Congress that as much as $600 million of those credits were “suspicious.” Of those, the IRS suspects that 73,799 claims totaling almost $504 million were distributed to individuals who would not qualify as first-time homebuyers. Most striking, 582 taxpayers under the age of 18 years old, including several 4-year-olds, applied for and received the credit.
With respect to the adoption credit, TIGTA chief J. Russell George testified before the oversight subcommittee of the House Ways and Means Committee on May 25, 2011 (downloads as a pdf) that more than half (58%) of the claims for adoption credits received in 2011 either had no required documentation or the documentation was invalid or insufficient.
TIGTA also reported “significant improper payments” made to taxpayers claiming the American Opportunity Tax Credit with ineligible students (often, those that did not even attend school).
The IRS has also reported a “substantial” uptick in Additional Child Tax Credit claims by taxpayers who were unable to obtain a Social Security Number or were not eligible to receive a Social Security Number. That problem was highlighted recently by a viral video that improperly painted the credit as a loophole.
Notice a pattern? It’s clear that refundable tax credits are synonymous with increased instances of taxpayer fraud. So why not ditch them? I’m not saying that it will eliminate all tax fraud. But when you look at the numbers of fraudulent claims and the continuous opportunities available to commit fraud and get easy money, it would seem that eliminating refundable credits is smart policy.
I know that it’s politically dangerous: refundable credits are vote-getters. They were designed to help low-income individuals reduce their tax burden or to provide incentives for… something. But what it’s really doing is creating an underground welfare system out of the Tax Code and providing an incentive for fraud.
To be clear, I’m not suggesting that all of the refundable credits should be eliminated in full. But I think all of them deserve a second look. And I would suggest that any that remain after a second look should be made nonrefundable.
I happen to believe that, as a taxpayer, you need some skin in the game. If you’re filing a return simply to get money back from the government that you didn’t pay in, I don’t know if that’s the best use of our country’s limited resources (there are other, better ways for those folks to receive benefits and assistance). And if you’re filing a return to get money back fraudulently from the government that you didn’t pay in, that’s illegal and wrong. The problem is that I don’t know how much more resources I want to see thrown at enforcement for those taxpayers. Wouldn’t it be easier for Congress to simply start saying no?
