Underreporting of farm income to avoid taxes

One of the largest benefits of owning a small business is that a small business can easily hide income and thereby avoid taxes.

How large is this problem? That's very hard to tell.

Here's John Berry from Bloomberg:

According to Internal Revenue Service research, the tax gap isn’t the result of high-rollers hiding income in offshore accounts. Most of it is the underreporting of income by proprietors of small businesses and farmers and the failure to pay employment taxes related to that income. Also not reported: an estimated half of all income from rents and royalties.
...

In 2006, the IRS reported the results of a three-year study of individual income tax returns for 2001. It found a gross tax gap of $345 billion, or 16 percent of taxes due. Enforcement activity plus other late payments recovered $55 billion of that, leaving a gap of $290 billion.

That figure, as large as it is, doesn’t include income of the deeply underground economy, including most criminal enterprises. That’s certainly hundreds of billions more, and no tinkering with the tax code is going to bring it into the light of day.

...

In 2001, according to the IRS review, only about one-fourth of farm income was acknowledged. For 2006, only 550,000 farmers reported positive net income, totaling $7.7 billion, while 1.4 million farmers reported losses of $23 billion, according to the latest figures available.

Well, it's hard to assess those IRS reviews. My understanding is that these numbers come from an extrapolation of audits selected at random (most audits target returns with likely errors or underreporting).

Also, with regard to Berry's last commentary, keep in mind that in 2006 there were probably only about 550,000 farms where anyone was trying to make a living from the farm income. The other farms are mostly hobby farms, not intended for profit at all. But they do make for a nice occasional tax deduction, not necessarily illegal.

Anyway, John Berry is writing about Obama's efforts to close loopholes. I think this one will be a tough to enforce without more auditing, which is expensive. Audits may be worth the cost if underreporting is becoming more prevalent. I haven't seen data showing a clear trend up in underreporting, but I wouldn't be surprised.

Quantifying the "Geithner Put"

The plan is out. The Treasury will buy the toxic assets in an auction, but will allow participants to leverage their investment with non-recourse loans from the FDIC on a six-to-one basis. The taxpayer gets some of the upside because the Treasury invests equity dollar-for-dollar with the bidders. But, because of those non-recourse loans, the taxpayer gets all the downside below the 14% of the purchase price and shares losses dollar-for-dollar with private investors up to 14%. I like the clear way Nemo spells it out.

Is it a good idea? Will it work?

Brad DeLong says 'Yes', Paul Krugman says 'No'. There are many other views, but these two guys usually see eye-to-eye. No ideological wrangling here. Hmmmm.

Let's do the math.

We can only answer this question with some measure of uncertainty about true value of the underlying asset. If uncertainty were small, say a standard deviation (SD) equal to 6% of the purchase price, then the subsidy implicit in those non-recourse loans is pretty small. The odds the price falls below the 14% public/private-equity skin in the game is small, t-stat of 7/3. That's less than a 1% chance of FDIC losing some of its principal.

Nemo has an extreme case where the SD = 50% of the face value and nearly 60% of the purchase price. THAT's a lot of uncertainty. But he also takes the price as fixed.

A 7% SD seems too small to Paul Krugman. It doesn't seem altogether crazy to me.

But suppose the SD is actually much greater than 7%. That risk means the upside potential is huge. With all that government-financed leverage and protection from the downside, investors will bid up the price.

Let's look at a range of possibilities. In this exercise I consider the expected return on the underlying assets assuming the marginal investor's return is fixed at 10% (due to competitive bidding). I'm assuming a normal distribution (no fat tails) and no risk premium

SD : (Expected Return Payoff/Price - 1) x 100%

6% : 1.4%
9% : 1.3%
12% : 0.8%
15% : 0.05%
18% : -1.0%
21% : -2.2%
24% : -3.8%
27% : -5.5%
30% : -7.4%

Expected returns of the underlying asset go down with risk. Expected returns for the taxpayer would be somewhat less than that of the underlying asset since the investor gets 10% in expectation. A seriously raw deal for the taxpayer kicks in around an SD of 15% of the purchase price.

I don't know how much uncertainty there is. But my guess is it's less than an SD of 15%.

Krugman, as usual, has a good point. But I think Krugman may be a little too pessimistic on this one.

Update: I realize this is a bit abstract. I'll try to be clearer. The figure on the right-hand-side is an estimate for the expected return of the toxic assets (aka, mortgage-backed securities) starting from the market-clearing auction price. The SD is a measure of uncertainty around that expectation. In words, the SD is a "typical" deviation from the expected return, whether positive or negative. Expected returns go down as the SD increases because private investors are protected from downside risk from non-recourse loans ("Geithner's put"). Private investors determine the price of the assets at auction such that they always earn a 10% return in expectation. The taxpayers' returns are expected to be slightly less than the number on the right-hand-side of the column.

Confined Livestock and Zoonotic Diseases

When I worked at USDA I remember a few meetings with folks at the Animal Plant Health Inspection Service (APHIS). They were worrying out loud about zoonotic diseases (that was a new word for me at the time). Mad cow was in the press but they were far more worried about other things (I don't recall the details). I think I was trying to make suggestions for how they might try to quantify the social benefits of their monitoring efforts (value of information stuff).

Today we have this breaking story by Nicholas Kristof at the New York Times.

The late Tom Anderson, the family doctor in this little farm town in northwestern Indiana, at first was puzzled, then frightened.

He began seeing strange rashes on his patients, starting more than a year ago. They began as innocuous bumps — “pimples from hell,” he called them — and quickly became lesions as big as saucers, fiery red and agonizing to touch.

They could be anywhere, but were most common on the face, armpits, knees and buttocks. Dr. Anderson took cultures and sent them off to a lab, which reported that they were MRSA, or staph infections that are resistant to antibiotics.

MRSA (methicillin-resistant Staphylococcus aureus) sometimes arouses terrifying headlines as a “superbug” or “flesh-eating bacteria.” The best-known strain is found in hospitals, where it has been seen regularly since the 1990s, but more recently different strains also have been passed among high school and college athletes. The federal Centers for Disease Control and Prevention reported that by 2005, MRSA was killing more than 18,000 Americans a year, more than AIDS.

Dr. Anderson at first couldn’t figure out why he was seeing patient after patient with MRSA in a small Indiana town. And then he began to wonder about all the hog farms outside of town. Could the pigs be incubating and spreading the disease?

“Tom was very concerned with what he was seeing,” recalls his widow, Cindi Anderson. “Tom said he felt the MRSA was at phenomenal levels.”

By last fall, Dr. Anderson was ready to be a whistle-blower, and he agreed to welcome me on a reporting visit and go on the record with his suspicions. That was a bold move, for any insinuation that the hog industry harms public health was sure to outrage many neighbors.

So I made plans to come here and visit Dr. Anderson in his practice. And then, very abruptly, Dr. Anderson died at the age of 54.

There was no autopsy, but a blood test suggested a heart attack or aneurysm. Dr. Anderson had himself suffered at least three bouts of MRSA, and a Dutch journal has linked swine-carried MRSA to dangerous human heart inflammation.

The larger question is whether we as a nation have moved to a model of agriculture that produces cheap bacon but risks the health of all of us. And the evidence, while far from conclusive, is growing that the answer is yes.

A few caveats: The uncertainties are huge, partly because our surveillance system is wretched (the cases here in Camden were never reported to the health authorities). The vast majority of pork is safe, and there is no proven case of transmission of MRSA from eating pork. I’ll still offer my kids B.L.T.’s — but I’ll scrub my hands carefully after handling raw pork.

Let me also be very clear that I’m not against hog farmers. I grew up on a farm outside Yamhill, Ore., and was a state officer of the Future Farmers of America; we raised pigs for a time, including a sow named Brunhilda with such a strong personality that I remember her better than some of my high school dates.

One of the first clues that pigs could infect people with MRSA came in the Netherlands in 2004, when a young woman tested positive for a new strain of MRSA, called ST398. The family lived on a farm, so public health authorities swept in — and found that three family members, three co-workers and 8 of 10 pigs tested all carried MRSA.

Since then, that strain of MRSA has spread rapidly through the Netherlands — especially in swine-producing areas. A small Dutch study found pig farmers there were 760 times more likely than the general population to carry MRSA (without necessarily showing symptoms), and Scientific American reports that this strain of MRSA has turned up in 12 percent of Dutch retail pork samples.

Now this same strain of MRSA has also been found in the United States. A new study by Tara Smith, a University of Iowa epidemiologist, found that 45 percent of pig farmers she sampled carried MRSA, as did 49 percent of the hogs tested.

The study was small, and much more investigation is necessary. Yet it might shed light on the surge in rashes in the now vacant doctor’s office here in Camden. Linda Barnard, who was Dr. Anderson’s assistant, thinks that perhaps 50 people came in to be treated for MRSA, in a town with a population of a bit more than 500. Indeed, during my visit, Dr. Anderson’s 13-year-old daughter, Lily, showed me a MRSA rash inflaming her knee.

“I’ve had it many times,” she said.

So what’s going on here, and where do these antibiotic-resistant infections come from? Probably from the routine use — make that the insane overuse — of antibiotics in livestock feed. This is a system that may help breed virulent “superbugs” that pose a public health threat to us all. That’ll be the focus of my next column, on Sunday.

I'm sure they were scrambling back at APHIS today...

I think this is a potentially huge issue. They use so many antibiotics in modern confined livestock operations we have to wonder what kind of super diseases we may be breeding. This seems like a good area for more empirical work in a style similar to the Currie et. al piece below. And beyond econometrics, there are so many public good aspects to this problem screaming for serious economic analysis. I think it would be a good disertation topic.

The Effect of Fast Food Restaurants on Obesity

An abstract from new working paper by Janet Currie, Stefano DellaVigna, Enrico Moretti, and Vikram Pathania. (I went to grad school with Moretti.)

We investigate the health consequences of changes in the supply of fast food using the exact geographical location of fast food restaurants. Specifically, we ask how the supply of fast food affects the obesity rates of 3 million school children and the weight gain of over 1 million pregnant women. We find that among 9th grade children, a fast food restaurant within a tenth of a mile of a school is associated with at least a 5.2 percent increase in obesity rates. There is no discernable effect at .25 miles and at .5 miles. Among pregnant women, models with mother fixed effects indicate that a fast food restaurant within a half mile of her residence results in a 2.5 percent increase in the probability of gaining over 20 kilos. The effect is larger, but less precisely estimated at .1 miles. In contrast, the presence of non-fast food restaurants is uncorrelated with obesity and weight gain. Moreover, proximity to future fast food restaurants is uncorrelated with current obesity and weight gain, conditional on current proximity to fast food. The implied effects of fast-food on caloric intake are at least one order of magnitude smaller for mothers, which suggests that they are less constrained by travel costs than school children. Our results imply that policies restricting access to fast food near schools could have significant effects on obesity among school children, but similar policies restricting the availability of fast food in residential areas are unlikely to have large effects on adults.

This seems like really important work and I find it amazing that it hasn't been done already. It must be getting the detailed data that's so difficult.

Anyhow, a couple small quibbles:

(1) Please do not report percent changes in obesity rates. Instead, write "a fast food restaurant within a tenth of a mile of a school is associated with average increase obseity from X to Y among 9th graders." I am sure at least half your readers will misread "5.2 percent" as "5.2 percentage points" and those two things are WAY different.

(2) The title suggests findings more sweeping than what you can identify with the data and empirical strategy you have. Another title more well-suited to the actual findings would be nice. I kind of like the way natural scientists write titles in journals like science and nature; that is, typically with a statement of findings. I don't know why this doesn't seem to fly in economics journals. In this case, the title might be: "Fast-Food Restaurants Very Near Schools Increase Obesity in 9th Graders."