OF ALL the ways to reduce the deficit, none should have more appeal than making it harder for people to cheat on their taxes. Yet no proposal made by the Reagan administration has met with a colder reception on Capitol Hill than the plan to withhold taxes on interest and dividends. Why?
The standard argument against this plan--over the four decades in which it has been discussed--is that it would impose an intolerable burden on financial institutions (never mind that employers manage somehow to withhold taxes on wages paid employees). Now that automation has made that argument more or less obsolete, a new line of attack is being pursued. Withholding taxes on interest and dividends is a bad idea, it is argued, because that would cut the effective yield on investments and discourage saving.
Requiring financial institutions to forward withheld taxes to the Treasury quarterly would, it is true, slightly reduce the effective return on savings to those taxpayers with relatively small amounts of property income who are not already required to file quarterly returns. But the real losses would come to the maddeningly large number of people who now fail to report their interest and dividend income at all. What this argument comes down to is the essentially preposterous claim that in order to encourage savings it is necessary to condone cheating.
A more respectable argument is that, since payers of interest and dividends already file information returns with the government, the IRS should simply compare them with taxpayer returns and go after the cheaters. IRS, however, has already stepped up computerized cross checking and still an estimated $20 billion a year in interest and dividends goes unreported.
Cheating persists because, as a recent study in the journal "Tax Notes" points out, it is very expensive for the IRS to track down millions of tax evaders and collect typically small amounts from each of them. Not only are the chances of detection relatively low, but throughout the process of adjudication the odds favor the adroit cheat. For many tax evaders the risk is well worth the possible penalty they might have to pay if the IRS succeeds--after protracted administrative and, perhaps, judicial proceedings--in proving they really meant to defraud the government.
Neither increased audits nor larger penalties are likely to do much to remedy this unsavory situation, the study concludes. There is only one efficient solution and that is the one that the administration now proposes--withholding taxes at the source of income payment. If it's acceptable to do this with wages, why not with investment income as well?