The American scheme: pushing the tax envelope

For tax attorney Jackie Perlman, a college student's recent question sums up a major shift in Americans' attitudes on the federal income tax. The student's sincere query: "Do I really have to pay taxes?"

Ms. Perlman, a senior tax analyst with H&R Block, says most customers she works with are honest and straightforward in paying their taxes.

But over the past five years, she's observed more Americans beginning to take taxes less seriously. At the root of the change: A widespread perception that the government isn't paying attention. "I think people fear the IRS much less," says Perlman. Her suspicion is supported by data.

A 2001 government survey found that 24 percent of taxpayers think it's OK to cheat on their taxes - up from 13 percent in 1999. And the fiscal consequences are huge: If all Americans had paid their taxes last year, according to IRS estimates, an additional $207 billion would have poured into federal coffers - enough to pay the projected federal deficit for 2003, and have $7 billion to spare.

The shift toward noncompliance, say experts, has likely resulted from the IRS's five- year effort to mend its reputation as an intrusive, bullying bureaucracy. Many tax-policy experts applaud the IRS's attempt to burnish its image. But the public- relations campaign has surpassed expectations - and the drive toward a kinder, gentler enforcer of the tax code may have gone too far.

Now, even middle-class Americans are bending the rules on their returns, using tax schemes that were once solely the province of those who munch pâté de foie gras on private jets.

"I think that people have come to see paying income tax as driving 55 m.p.h: Only a fool would do it," says Deborah Schenk, a law professor at New York University. "If the attitude spreads, the whole system will collapse."

Because of a series of recent budget cuts, the IRS's number of full-time personnel declined by 16 percent between 1992 and 2001. The result: the average taxpayer's chances of being audited dropped dramatically. Five years ago, the IRS audited 1 of every 78 tax filers. Last year, the fraction shrank to about 1 in 170. That steep decline in audits, experts say, has emboldened brash millions to try to pay less. "It's not a secret that the IRS is understaffed and it can't enforce as much as it would like," says Perlman.

According to a report released earlier this month by the General Accounting Office, the IRS has resources to track down only 20 to 30 percent of the people it has identified as likely tax evaders.

But prosecutions are critical to building faith in the IRS, according to former agency chief Charles Rossoti. Like an authoritative parent, the IRS must walk a fine line between maintaining respect and instilling fear. "If these problems and conditions are left unaddressed, we could face an enormous crisis in confidence in the tax system," Mr. Rossoti wrote in a report last year to the IRS Oversight Board.

There are signs that the system is already beginning to crack. Experts point to a huge proliferation of tax-shelter schemes over the past five years that increasingly push the envelope of legality. Among the most recent: efforts on the part of an estimated 2 million Americans to hide income in overseas credit-card accounts.

Creative circumvention of tax codes has become especially prevalent among corporate executives. A variety of accounting and tax laws restricting executives' pay have prompted many companies to find ways of supplementing their employees' income. "Companies are trying to be very artful in how they design programs to get around tax and accounting rules," says Paul Dorff, managing director of the consulting firm Compensation Resources.

More troubling, though, is the possibility that mainstream America has adopted an increasingly casual attitude about taxes, with middle-class taxpayers taking ever-greater risks to hide their income. In the past five years, say experts, many more companies have begun marketing offshore account services at prices affordable to those living in places like Milwaukee, not Monaco.

Their target customers are upwardly mobile professionals, like doctors and lawyers, who minimize their tax liabilities by investing in companies located in havens like Gibraltar, the Seychelles, and Bermuda. "Tax shelters have worked their way down the income ladder so that the middle-class can now afford them," says Professor Schenk.

There are signs that Congress and the IRS are responding to the abuse. The government is exerting more pressure on US corporations attempting to relocate to tax havens. And the Bush administration has called for a $133 million budget increase to boost by one-third the number of audits of unreported income, offshore accounts, and erroneous exemption claims. "Congress has suddenly realized the system doesn't work unless you enforce it," says Donald Alexander, who headed the IRS from 1973 to 1977.

Still, observers say the agency's greatest challenge could be convincing Congress to simplify the tax code itself. Many critics believe Americans increasingly are flouting the IRS because of their feeling that the code is too elaborate to be taken seriously. Daunted by official procedures, they invent their own. "The complexity of the code encourages noncompliance," says Walter Hellerstein, a law professor at the University of Georgia. "Things have to be made easier."