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Cracking down on the tax gap would not only introduce more fairness into the system, but it could be a big help for our nation’s fiscal imbalance — to the tune of hundreds of billions of dollars every year.
The tax gap is the difference between taxes owed and taxes paid on time, and the Internal Revenue Service (IRS) estimates that it averaged $496 billion per year between 2014 and 2016. Estimating the tax gap is a useful way to gauge the level of noncompliance with federal tax obligations and to inform the IRS’s formulation of tax administration strategies. While policy gridlock and a lack of leadership in Washington has made it difficult to make progress on our debt challenges, the magnitude of the tax gap suggests a path through improved tax administration for the federal government to collect additional revenues to narrow the budget deficit.
The tax gap is the difference between the total amount of taxes that are estimated to be owed and the amount actually collected on time. In their most recent analysis, the IRS reported that the tax gap averaged $496 billion per year between 2014 and 2016, or about 15 percent of total taxes due. Individual income taxes made up the largest share of unpaid taxes, followed by employment and corporate income taxes.
According to the IRS, most of the unpaid taxes (80 percent) resulted from taxpayers underreporting their income or overstating credits, deductions, or other adjustments. The remainder of the gap stems from underpaying taxes or not filing a return.
The size of the tax gap is affected by factors including whether the IRS can verify reported incomes, the complexity of the tax code, and the agency’s operating budget.
When the IRS can verify reported incomes through a third-party source, such as employers and financial institutions, taxpayers are less likely to underreport earnings. For example, employers report wages and salaries on W-2 forms, which makes it easier for taxpayers to maintain accurate records. For the largest source of the tax gap — the individual income tax — underreporting is less of an issue when income is also subject to withholding. Transactions that are less visible, such as business expenses for which the IRS does not receive independent information, enable taxpayers to more easily minimize their tax liability.
The tax code contains complex provisions designed to promote policy goals, including providing benefits to specific groups of taxpayers that sometimes lead to errors on tax returns. Among such provisions are more than 200 tax expenditures, which can take the form of exemptions, deductions, credits, and preferential rates. Consequently, about half of taxpayers seek paid tax preparers to assist them with compliance; however, tax preparers can introduce their own errors and are not regulated by the IRS. In 2020, tax expenditures totaled $1.8 trillion. To put that in perspective, that is more than the government spends on Social Security, defense, or Medicare.
The IRS’s operating budget affects the number of enforcement staff dedicated to reducing the tax gap through audits, collections, criminal investigations, and appeals. In 2021, the agency’s budget totaled $11.9 billion, a decline of $2.5 billion in real (inflation-adjusted) dollars from its peak in 2010. The decline in funding resulted in a loss of about 16,000 employees; enforcement staff comprised 96 percent of those losses.
As the number of staff declined, so did the taxes collected through enforcement activities. In 2021, the total amount of additional tax required after audits was nearly $27 billion, three-fifths of the amount assessed in 2010. In 2020 and 2021, the agency was responsible for administering the three rounds of Economic Impact Payments from COVID-related legislation, which likely both reduced the ability of the IRS to enforce tax laws and presented new challenges for taxpayers in complying with tax laws.
The IRS will soon be receiving additional funding, though. The Inflation Reduction Act of 2022, allocated an additional $80 billion to the IRS through 2031 to bolster enforcement and help reduce the tax gap. Of that amount, $46 billion was dedicated to tax enforcement activities, including hiring additional auditors as well as investing in investigative technology. Such increased funding for enforcement represents a two-thirds increase relative to previous budget projections over the next 10 years.
Multiple strategies are needed to reduce the tax gap. Many economists believe that simplifying the tax code by eliminating expenditures, deductions, exemptions, and preferential rates would lessen the burden of compliance and close the tax gap. A compelling approach to diminish the tax gap, proposed by former IRS Commissioner Charles Rossotti, involves creating a third-party verification system for income that is less visible. Through that system, the IRS could recover an estimated $1.6 trillion over the first 10 years.
Devoting additional resources to IRS enforcement without a new verification system could also narrow the tax gap to a lesser extent. In fact, CBO estimates that the increases in outlays for the IRS through the Inflation Reduction Act will increase revenues by $180 billion over the next 10 years. The IRS also estimates that between 2014 and 2016, an average of $68 billion per year of unpaid taxes was recovered through enforcement activities, resulting in an average net tax gap of $428 billion per year. Additional IRS appropriations could be targeted to enhance automated enforcement activities as part of a broader IT modernization effort to improve information reporting and review, as recommended by the Government Accountability Office. Enforcement ability may also affect new tax policies; for example, a wealth tax, would likely not be effective unless coupled with adequate enforcement.
Others argue that increased investment in technology modernization could help reduce the tax gap by making it easier for taxpayers to file returns and for the IRS to administer them. The IRS has frequently been criticized for failing to replace its outdated computer systems and heavy reliance on paper-based processes that cause significant delays in processing tax returns. Although the IRS has spent $5.3 billion since 2006 to replace its outdated systems and increase automation, that amount represents only 3 percent of its total budget over the past 15 years.
Reducing the tax gap could bring in additional revenues to the federal government, and it represents one approach to help address the structural mismatch between spending and revenues. Increasing appropriations to the IRS may lead to a smaller tax gap, and there are other approaches to properly enforce existing tax laws that could make a significant impact as part of an overall strategy to put our national debt on a more sustainable path.
Related: Infographic: How the U.S. Tax System Works
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