Why Tax Enforcement Matters Beyond Revenue

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The Debate over a Smaller IRS

“The IRS Isn’t Going to Catch Me.” The Wall Street Journal’s headline captures an oft-cited concern about recent reductions in tax enforcement: fewer audits could encourage taxpayers to avoid paying what they owe. Recent figures have added urgency to that concern. Revenue from IRS examinations fell 35 percent in fiscal 2025, according to the Treasury Inspector General for Tax Administration, alongside substantial reductions in enforcement staffing.

Much of the discussion regarding the reduction in IRS enforcement capabilities has focused on government revenue and fairness. NPR concluded that cutting the agency’s staff had “backfired” if the goal was to improve the government’s finances. The Institute on Taxation and Economic Policy argued that the richest Americans stand to benefit most when the IRS lacks sufficient auditing staff. And to be clear, these concerns raise important questions about how much tax goes uncollected and whether taxpayers who comply are being treated fairly relative to those who do not.

But recent research by accounting scholars and others shows that enforcement also influences firms’ investment and hiring, their willingness to claim tax incentives, and their ability to obtain bank credit. It can improve the credibility of business information while imposing compliance costs and uncertainty. These broader economic effects deserve attention alongside revenues and fairness when policymakers decide how much enforcement to fund and how to carry it out.

Revenue, Now and Later

Revenue from tax audits is a natural starting point for assessing the consequences of reduced tax enforcement. Tax audits are an important way for tax authorities to uncover unreported income, identify improper deductions, or correct mistakes, each of which can bring additional cash into the government’s coffers. Reducing the resources available for tax enforcement can therefore leave legally owed taxes unpaid, weakening the government’s fiscal condition. For perspective, the IRS collected $93.8 billion from enforcement activities in fiscal year 2025, less than 2 percent of the roughly $5.3 trillion it collected overall (Treasury Inspector General for Tax Administration 2026).

However, even if one focuses narrowly on tax audit revenue, today’s reduced revenue number does not capture the full revenue consequences of reduced enforcement, for two reasons. First, the prospect of an audit can change what taxpayers report before the tax authority ever contacts them. This is the deterrent effect of tax enforcement: a business that believes an audit is more likely has a stronger incentive to report accurately. Second, experiencing an audit—or learning that someone else has been audited—can also influence subsequent tax return reporting. Enforcement can thus affect tax payments both from previously audited taxpayers long after their examinations end and from taxpayers who are never in fact audited themselves.

William Boning, Nathaniel Hendren, Ben Sprung-Keyser, and Ellen Stuart provide evidence of these lasting effects (full academic citations below). Studying randomly selected individual audits in the United States, they find that audited taxpayers make higher subsequent tax payments over a decade after the audit. In present value terms, those additional payments amount to more than three times the revenue collected from the initial audits. Their study provides compelling evidence that the fiscal consequences of an audit can persist long after the audit itself is completed.

Research also shows that the effects of an audit can spill over to other taxpayers. Studying business tax audits in South Africa, Collen Lediga, Nadine Riedel, and Kristina Strohmaier find that unaudited firms report higher tax liabilities when a nearby business is audited. They find a similar spillover effect when a business shares the same tax preparer as an audited firm. These findings suggest that an audit’s influence can spread through taxpayers’ networks, changing behavior beyond the firm directly examined.

Evidence from U.S. public companies reinforces the broader link between enforcement and tax behavior. Studies by Jeffrey Hoopes, Devan Mescall, and Jeffrey Pittman, and by Daphne Armstrong, Stephen Glaeser, and Hoopes, link stronger IRS enforcement to higher cash effective tax rates, which measure the taxes firms pay relative to their pre-tax profits. These findings are consistent with firms scaling back their usage of tax avoidance strategies in the face of greater tax enforcement, which could improve government revenues without involving increased enforcement collections.

Collectively, these studies suggest that reduced tax enforcement will not just impact today’s tax audit revenue number, but also the future tax reporting and payments of individuals and businesses, even those not actually selected for an audit.

How Tax Enforcement Can Help Businesses Borrow

The consequences of reduced enforcement extend beyond revenues and fairness. While business owners may welcome a lower likelihood of an IRS audit, they may overlook a potential cost of weaker enforcement: less reliable tax return information, which lenders often use to assess a firm’s performance and financial condition. In research with Martin Jacob, I examine a potential consequence of this reduced reliability—a reduction in bank lending.

To illustrate our idea, consider a small private manufacturer seeking a loan for new equipment. The banker needs to assess its sales, earnings, and ability to repay. The firm may not have the resources to obtain audited financial statements, making its tax returns an important source of information. Banks can use these returns to evaluate the firm’s financial condition or corroborate information from other sources. Stronger tax enforcement gives firms greater incentives to report accurately, allowing bankers to assess creditworthiness with greater confidence. Weaker enforcement can undermine that confidence, making the banker more reluctant to extend credit.

Consistent with this explanation, Martin and I find that stronger tax enforcement aimed at small and midsized enterprises is associated with greater commercial lending growth at regionally focused U.S. banks. The increase in lending is greater when banks likely know less about potential borrowers. We also find that stronger enforcement is associated with better bank loan portfolio quality, consistent with enforcement helping banks make better lending decisions. Collectively, these findings suggest that tax enforcement can support businesses’ access to credit by improving the reliability of the information lenders use to evaluate them, particularly when lenders have little other information to go on.

The Costs of Enforcement for Businesses

Yet, even if tax enforcement improves the information available to lenders and thus firms’ access to capital, these benefits come with costs. When selected for an audit, businesses must assemble records, pay advisers, and devote employee and management time to responding. Even the prospect of an audit can lead firms to incur documentation and compliance costs. Thus, a business that has paid all the taxes it owes may still devote substantial resources to demonstrating that fact—resources that could otherwise support other parts of its business.

In a second study with Martin Jacob, we examine how these competing forces affect business activity. Better access to financing can support growth, while compliance costs and additional tax payments can leave firms with fewer resources to hire employees or expand their operations. Exploiting differences in IRS audit rates across firm sizes and over time, we find that greater corporate tax enforcement is associated with slower growth in employment and business establishments.

One finding in our study helps illustrate why compliance costs can matter. We find that the negative association between tax enforcement and subsequent corporate growth is stronger in regions with relatively less access to accounting professionals. The idea is that when accounting help is less readily available, businesses may face higher fees or have to devote more of their own employees’ time to preparing for and responding to audits. In short, this finding points to tax enforcement-related compliance burdens making it harder for businesses to grow.

Related research by Andrew Belnap, Jeffrey Hoopes, Edward Maydew, and Alex Turk examines small businesses randomly selected for IRS audits. They find that audited businesses are more likely to close, with the effect concentrated among those that underreported their taxes. They also find some evidence that the administrative burdens of an audit contribute to closures.

These findings suggest a potential benefit of reduced enforcement: lower compliance costs could free up money and employee time for business growth. But they also underscore why those costs must be distinguished from the financial consequences of paying taxes already owed. Both can constrain a business, but they have different implications for policy: collecting unpaid taxes provides government revenue, whereas increasing the time and expense required to demonstrate compliance can tie up a firm’s resources even when a business’s tax bill remains unchanged.

How Enforcement Affects Tax Incentives

Enforcement can also influence whether other parts of the tax code achieve their intended goals. Policymakers use tax credits and deductions to encourage activities such as investment and research. But businesses likely weigh the expected tax savings against the costs and uncertainty of claiming them. The possibility that the IRS will challenge a claim, and the expense of defending it, could thus weaken the incentive these policies provide.

The U.S. federal research and development (R&D) tax credit illustrates this tension. Investments in research can generate innovative new products and processes, supporting greater aggregate productivity and economic growth. The idea behind the R&D tax credit is to encourage more investment in innovation by reducing its after-tax cost. However, the credit has also been a longstanding focus of tax enforcement scrutiny, with the IRS concerned about what activities and expenses qualify for the credit, and whether firms have sufficient documentation to support their claims.

Consider a business deciding whether to spend money to develop a new product. A tax credit for the research and development costs could make the project worthwhile. However, if the business anticipates that it will incur substantial costs documenting eligibility or defending its claim under audit, the expected benefit becomes smaller. If large enough, these potential costs may lead the firm to abandon the project.

Consistent with this idea, Mary Cowx finds that greater expected IRS scrutiny is associated with lower R&D tax credits and lower R&D investment among U.S. publicly traded companies. Her survey of over 100 corporate managers highlights the importance of tax documentation: two-thirds report that their company’s ability to produce the necessary records is at least moderately important to claiming the credit. Together, her findings suggest that the prospect of enforcement can discourage both claiming a tax benefit and undertaking the activity it is intended to encourage, limiting the R&D credit’s effectiveness.

These costs and uncertainties can extend beyond federal R&D tax credits, and beyond tax credits more broadly. In a working paper co-authored with Ed Maydew and Ricky Yao, I examine U.S. state R&D tax credits. We track four decades of credit rules, including which expenditures qualify, how the credit is calculated, and what firms must do to claim it. We find that more generous credits are associated with greater subsequent patenting, but this relationship is weaker when the rules are more complex. Relatedly, in research with Harald Amberger and Jaron Wilde, I examine how tax system complexity affects businesses’ responses to corporate tax rate changes across 28 countries. We find that investment responds less strongly when complying with the tax system takes more time and effort. This dampening effect is particularly pronounced among smaller, private, and domestically owned firms, which generally have fewer resources and less experience navigating complicated tax rules. While these studies do not examine enforcement directly, they suggest why greater scrutiny could further weaken the response to tax incentives: businesses already struggling to interpret complicated rules may anticipate additional costs and uncertainty from having to defend their interpretation in a tax audit.

Collectively, these studies suggest that the effectiveness of a tax incentive depends on both its design and its enforcement. Tax enforcement can facilitate policy effectiveness by preventing ineligible claims, but the costs and uncertainty it creates can also discourage the activities policymakers intend to support. Evaluating tax enforcement therefore requires looking beyond the taxes collected to whether the tax code is achieving its broader goals.

What This Means for Tax Enforcement Policy

To date, much of the debate over IRS enforcement has focused on declining audit numbers and enforcement revenues. Yet research shows that the consequences extend well beyond those figures. Enforcement can shape tax payments years into the future, influence taxpayers who are never audited, and affect businesses’ access to credit, growth, and responses to tax incentives. These effects can work in different directions, creating both benefits and costs that belong in the policy debate.

Evaluating these consequences requires measuring them separately. Additional tax payments reduce businesses’ cash but provide government revenue that can support public programs or reduce borrowing. Compliance costs consume time and resources that could serve other purposes. Changes in lending, hiring, and investment also require direct evidence; they cannot be inferred from the taxes collected or the agency’s budget.

The growing research on tax enforcement suggests that evaluating a smaller IRS requires looking beyond both the revenue lost and the burdens businesses might avoid. The challenge is to determine which enforcement activities justify their public and private costs—and how those activities can be administered more effectively.

AI Usage: I used AI to assist with copyediting and take full responsibility for the essay’s content.

References

  • John Gallemore is an Associate professor of accounting at the University of North Carolina Kenan-Flager Business School. John Gallemore studies how firms’ economic and financial reporting behavior are shaped by corporate tax policy and enforcement. He earned his PhD in accounting, his MBA in finance and his BSBA from UNC Kenan-Flagler.