Question

How is Benford's Law used in detecting possible cheaters on income tax returns?

Answer 1

Benford's law states that the first real digit of numbers tend to start with lower digits (like 1 or 2), rather than with higher digits.

You see that 30% of all numbers should start with `1`
And this not only goes for tax returns: Just take a random page from a newspaper or magazine, and count the first digits of all the numbers you see, whatever they are about.

If you're 'cooking the books' on your tax returns, you tend to use more or less random numbers, so you tend to get more higher first digits than according to Benford.

Another reason may be that there are boundaries set for authorisation in financial transactions. Say you are allowed to make transfers up to $1000 without consulting anyone. In that case you might make transactions in the region of $800-$900.

Using Benford's law, or rather great deviations from it, auditors can - through a quick glace - find reason for further investigation. Or, if there is no abberation, check more tax returns in the same time.