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The end of January brings an annual blizzard of little scraps of paper to everyone’s mail box: income tax documents from employers, banks, pension funds, mortgage lenders, and governments. The income tax relies on one of the most complex systems of information reporting ever devised. Billions of documents are printed and mailed, filed electronically, and cross-referenced. The Internal Revenue Service and all the state departments of revenue receive copies of all of them, in order to do a computer “audit” of everyone who files a tax return.

The income tax has been described as a system of voluntary self-reporting, but that misleading idea is based only on the final tax return each taxpayer signs and submits by April 15. The taxman already knows what your income is, from the little scraps of paper other people send in about you; but the information is not compiled into a coherent financial profile until you submit the tax return.

It takes the IRS from six to twelve months to digest the flood of tax documents submitted in January each year. All that info has to be entered into the central computer and cross-tabbed by employer or payer identification numbers and social security numbers.

Imagine what this system of information collection must have been like in 1943, the first year the payroll withholding tax was in effect. There were no computers; everything had to be done by hand. The IRS had to maintain acres of warehouse space just to store the file cabinets and index cards. It would never have been possible if Social Security had not become law six years earlier. In 1937, the federal government had started giving numbers to every worker. Employers had started sending payroll data in to the Social Security Administration and money to the U.S. Treasury. The financial information reported to Social Security became the basis for our current tax system.

The income-reporting system also provides a rich field for mischief. Anyone can obtain a tax-reporting number, as a potential employer or payer of money to individuals. With that nine-digit number you can then file such reports on little scraps of paper. A cruel practical joke would only require someone to get a number for a fictional company, write up a 1099-Misc form, obtain an individual’s Social Security number, and report to the IRS that the person was paid a few thousand dollars.

The law says both the IRS and the individual should get a copy of every 1099 form, but this is a practical joke, remember, so the victim doesn’t get a copy. About two years later the IRS will match up the false 1099 with the victim’s tax return and send the victim an audit letter, demanding payment of taxes on the “unreported income,” which of course the victim knows nothing about until the threatening letter from the IRS arrives. This is exactly what computer virus hackers and pranksters do just for fun to your computer over the Internet and by e-mail.

How can the victims disprove the accusations from the IRS that they did not actually receive any income from the fictional employer you have created? Nobody can prove a negative claim, which is why traditional law says you are innocent until someone proves you are guilty. But in our tax law, it is just the reverse.

Just fighting off the IRS for several years would cause the victim some distress, and to make the problem go away, the person might actually send money to the government.

Such pranks are against the law, of course. Nobody should break the law. But bad people do bad things all the time, which is why we have anti-virus programs and firewalls on our computers. Government ought not to set up a tax system based on little scraps of paper, which opens the door for hackers and pranksters to submit “virus” tax documents into the IRS computer. And in rethinking that reporting system, maybe government should rethink the whole idea of having an income tax to begin with.

This entry was posted on Tuesday, January 23rd, 2007 at 11:40 am and is filed under Economics. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.