By David Cay Johnston
NEW YORK, April 26 (Reuters) - Each year the Internal Revenue Service receives tax returns that show more income than was actually earned, in some cases twice the actual earnings.
That seems bizarre at first blush. After all, why would anyone tell the tax man they made more than they did?
The answer is that Congress has created an incentive for the poorest of the working poor to report more than their actual incomes. Doing so can be worth more than $3,000 to impoverished working parents under a form of negative income tax known as the Earned Income Tax Credit that sends government money to the working poor.
But it is not the working poor themselves who make up phony numbers. The problem is with unscrupulous income tax preparers, the IRS Taxpayer Advocate, Nina E. Olson, and others who work with the poor tell me.
Ginning up nonexistent income lets dishonest tax preparers charge larger fees and helps attract new clients as word spreads of their success at getting big refunds.
Just last month the Justice Department sued to shut down what it characterized in court papers as a nationwide chain of tax fraud mills that reported inflated incomes and often did not tell people it was filing tax returns for them.
Asked about the allegations, Instant Tax Service general counsel Todd Bryant said they were baseless, with a handful of problem cases mischaracterized as the norm.
The IRS and the Justice Department identified a problem with tax preparers inflating incomes years ago.
Abusive tax preparers have been found at big firms as well as underground operations. Failing to get tough on the abusers makes it hard for the vast majority of honest preparers to prosper, as clients who know nothing about the complexities of tax naturally gravitate toward whoever has a reputation for getting the biggest refunds.
Congress could fix the problem of exaggerated incomes and at the same time help end America's shameful No. 1 ranking among modern nations in child poverty. Sadly, I don't expect that, given the focus in both parties on tax cuts for corporations and, among Republicans, on more tax cuts for the rich. Indeed, across the country anti-tax Republicans have called for ending the Earned Income Tax Credit.
Milton Friedman, the Chicago School economist and Nobel Prize winner, devised the negative income tax concept decades ago. Friedman demonstrated that people on welfare who go to work could be worse off because of taxes on their earnings. Properly applied, Friedman's negative income tax idea can ensure that working makes people better off.
President Ronald Reagan hailed the Earned Income Tax Credit as "the best anti-poverty, the best pro-family, the best job creation measure to come out of Congress." He was right. Last year it lifted 3.3 million children, and an equal number of adults, out of poverty.
Now consider a family with three children that earned $6,000 last year. That may seem extreme, but that was the average wage for a third of American workers in 2010, as I reported in October.
This family will get $2,711.
However, the family's check more than doubles, to $5,751, when a tax preparer falsely inflates their income to $12,800, as you can test at this website.
Why does the family making $12,800 get more than twice as much as the $6,000 family? Because Congress set the maximum tax credit for a family with three children at wages of $12,800 to $20,800.
The problem of inflated incomes is not with conniving poor people, but with devious tax preparers, everyone I asked about this said.
Nancy Abramowitz, who runs the American University Washington College of Law's tax clinic for poor people, said she could not recall any individuals who had inflated their own income to increase the tax credit. "It's always unscrupulous preparers," she said.
Since employers verify wages, tax preparers usually inflate incomes by creating a phony Schedule C, the tax form used by many small businesses, because it is not verified except in an audit.
Here are four ways Congress and the IRS can fix this:
* Congress should lower the threshold for securing the maximum credit for families with children from $12,800 to the average wage of the bottom third of workers, currently about $6,000.
* Congress should pay for the prosecution of as many corrupt tax return preparers as it takes to stop this fraud, including $3,000 rewards to taxpayers who turn in corrupt preparers. Any action by the IRS, not just convictions, should generate a reward check. The reward I propose equals the maximum fraud loss from a single case, making it cost-efficient provided Congress requires the IRS to be generous, not stingy, in rewarding whistleblowers.
* Congress should delay tax credit refunds for 45 days after a tax return is filed. Olson, the IRS taxpayer advocate, told me that speeding refunds encourages fraud. The United States is unusual in trying to refund money instantly, instead of taking time to make sure payments are proper before cutting checks.
* For the next few years the 40 percent of IRS correspondence audits that now deal with the Earned Income Tax Credit should concentrate on faked Schedule Cs that inflate incomes.
The focus should be on making work rewarding, not on hurting the working poor.