Phantom income helps poor children

The number of informal businesses in the United States is growing robustly, but the average size of these enterprises is shrinking fast, my analysis of official government data from 1988 to 2012 shows.

Given the millions of people who have lost a job, cannot find work or kept working but at reduced pay, it’s not surprising that many of them are starting small businesses to make ends meet. If you cannot get a job, make one for yourself — sell homemade goods, wash windows, edit articles.

The trends in what government calls sole proprietorships — any unincorporated business that files a Schedule C with the owner’s personal tax return — open a window on how Americans are adapting to an economy that for decades has been glorious for those at the top but hard on the vast majority.

This is a story not of prosperous entrepreneurship but of desperate struggles to swim against powerful economic currents. A much darker story lies hidden in the official numbers, a story of crushing poverty alleviated by a strange amalgam of thieving tax preparers, ignorant parents and Congress’ failure to focus on making government policies work as intended.

In analyzing the official data, I saw hints that many of these informal businesses either are bogus or inflate their profits. It may appear bizarre that anyone would tell the Internal Revenue Service that they made more money than they actually did. But doing so can be lucrative for unscrupulous tax preparers and their poorest clients.

The rising number of sole proprietorships makes sense, considering that the last five decades have been a disaster for most Americans. Adjusted for inflation, the average income of the bottom 90 percent in 2013 was smaller than in 1967. The $31,652 average income on 2013 tax returns was lower by $566, or 1.8 percent, the equivalent of one less week’s pay for the year.

But the tax returns of sole proprietors do not follow the overall pattern of businesses, where revenues and profits ebb and flow with the economy. In the 25 years from 1988 to 2012, the number of sole proprietorships grew by almost 10 million, to more than 23.5 million. That 72 percent increase was two and a half times population growth.

Yet total revenues were flat. Sole proprietors took in a tad more than $1.3 trillion (in 2012 dollars) in both years, with revenues rising a scant 1.5 percent. Even in 2007, the best year for sole proprietors, total revenues were up just 12 percent from 1988, lagging the 76 percent real growth in the economy.

With many more businesses divvying up the same-size pie, revenue per business plunged from $95,400 to about $56,200. That’s a 41 percent decline from 1988 to 2012.

Curiously, even as businesses have gotten smaller, profit margins have been rising, according to my analysis of the published statistics. In 1988 proprietors kept 19 cents out of every dollar of revenue as profit before taxes. In 2012 they kept a record 23 cents.

Profit margins rose because costs of running these businesses fell more than revenues, down 44 percent. Generally as businesses grow, they become more efficient, thanks to economies of scale. But these businesses are, on average, shrinking. The data shows that 1988 was the peak year in profits per proprietor, averaging $17,922. Profit fell nearly $5,000, or 28 percent, to $12,945 in 2012.

So what’s going on here? More sole proprietors split the same total revenue and yet somehow profit margins are rising? Really? 

One logical inference is that some of these new businesses exist only on tax returns. That brings us to the incentives Congress has created to fabricate sole proprietor profits because of rules governing the earned income tax credit.

That credit is a form of negative income tax devised by Milton Friedman, the Nobel Prize–winning economist and libertarian. President Ronald Reagan embraced Friedman’s idea, calling it the best welfare program ever. It is by far the most important source of money to ease our disgracefully high rates of childhood poverty.

Friedman came up with the idea to address a logical problem with 1970s welfare: Getting a job could make you worse off than staying on the dole. That was because the intersection of work, tax and welfare rules could produce marginal tax rates greater than 100 percent. 

Congress designed the credit to remove this disincentive and encourage work. But its design has serious flaws — which liberals avoid discussing, lest they hurt poor children, and conservatives avoid because their supporters tend to vote out of office anyone who works for actual improvements in our tax system.

The problem with the tax credit is that its sweet spot is about $12,000. Make more or less and your benefits diminish fast.

Now imagine you are a single parent among the 49 million workers — almost 1 in 3 — who averaged $6,200 in income in 2013. You walk into a tax preparation service with your W-2 forms hoping to get the earned income tax credit.

The tax preparer knows that you qualify for less than $3,000 of the tax credit. But he also knows that by inflating your income so it doubles, the benefit will also double, to nearly $6,000. The tax preparer also knows that you understand next to nothing about taxes or you would not be paying him $50 or so to fill out a few pages of forms.

So the pitch you get goes like this: I can get you a refund of close to $6,000 because of my knowledge of these very complicated tax rules that befuddle you, and all it will cost is $500, which I’ll take out of your refund.

Who would say no?

The tax preparer then fills out one extra page, a Schedule C, showing about $6,000 of nonexistent income with no expenses. Maybe he puts down that you were paid cash for cleaning houses or doing laundry.

Ohio entrepreneur Fesum Ogbazion created a nationwide chain, Instant Tax Service, that did just this. A 2012 Justice Department lawsuit said Ogbazion ran an “extensive and pervasive tax fraud.”

According to the Justice Department, the firm often charged $1,000 for 15 minutes of tax preparation work. A separate lawsuit by the San Francisco city attorney accused an Instant Tax franchise of surreptitiously taking a $4,400 fee on a $6,000 tax refund, a fee that the tax preparer says in court papers was justified.

After a trial, a federal judge shut down Ogbazion’s business. Last November a federal appeals court upheld that ruling. But thousands of individual tax preparers continue in this unregulated business. Given the IRS budget cuts, the chances that the tax police will catch any crooked tax preparers are small; the chance of criminal prosecution is near zero.

In 1998 Congress created the office of IRS taxpayer advocate. Nina Olsen, the advocate since day one, has repeatedly urged Congress to regulate all tax preparers to stop such misconduct. Congress ignores her advice.

My analysis shows a revealing trend in sole proprietor tax returns for 2000 and 2012. The number of such returns and the share of total income from proprietorships increased most at the income levels that qualify for the biggest earned income tax credit.

There’s also a hint to be found in unpublished tax data. In the 1990s, I am reliably informed, fewer than 9 percent of the sole proprietorships reported income but no expenses. In 2012 that rose to 13.7 percent.

A business that is pure profit is unusual. It is possible that random checks for freelance gigs explain this phenomenon. It’s more likely that a significant share of the increase is from businesses that exist only on tax returns — the imagined income producing tax benefits worth a lot to America’s growing armies of very poor children.

Congress needs to investigate. It needs to change rules that encourage criminal conduct and entice poor parents to lie so their children suffer less. The way for liberals and conservatives to join hands on this is to begin with the premise that no rule should encourage tax cheating and any reform will be matched by increased funds to make sure reform does not take food from the mouths of poor children or their parents.