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How To Help Close The Tax Gap

Aparna Mathur
This article is more than 5 years old.

In its latest projections, the Congressional Budget Office estimates that over the next ten years, federal government deficits will increase from 2.5% of GDP in 2015 to 4.6% of GDP in 2025. With revenues projected to remain stable over this period, increasing government expenditures on Social Security, Medicare and subsidized health insurance purchases by individuals and small employers will drive these deficits.

How can we make up for this shortfall in revenues? One obvious way to expand revenues is to go after tax evasion, which the Internal Revenue Service (IRS) measures as the tax gap.

As per the report recently released by the IRS, the average size of the tax gap for the years 2008-2010 was $458 billion, marginally higher than the size of the federal deficit in 2015. In other words, had taxpayers voluntarily and accurately reported their incomes and tax liabilities, the size of government deficits would be markedly lower today and projected to be lower going forward. Can we fix this?

What is the tax gap?

The ‘gross tax gap’ arises from three different types of non-compliance. The largest is the underreporting gap which arises because people misreport their tax liability on their tax returns. This cost the U.S. Treasury $387 billion annually over the years 2008 to 2010.

The second source of the gap is underpayment, which refers to taxes that are reported but not paid in time, and this cost about $39 billion. The rest is due to non-filing. The IRS estimates that about $52 billion of this gross tax gap will be recovered through IRS audits or through late payments by taxpayers. Hence the ‘net tax gap’ is estimated to be $406 billion.

What types of income?

The answer, perhaps surprisingly, is that the majority of revenue lost is from the individual income tax, rather than from the corporate tax. The IRS estimates that the net tax gap for individual income taxes is $291 billion while for corporate taxes is $35 billion. Within individual income taxes, the largest gaps in payments come from underreported business income from sole proprietors or business owners, recipients of partnership, S-corporation, royalty or rental income and also self-employment taxes that are not subject to third party reporting or information reporting. Within corporations, larger firms contribute more to the gap in payments than smaller firms. So what is the extent of non-compliance?

On average, over the years 2008-2010, corporate tax revenues averaged $211 billion, and personal income tax revenues averaged $986 billion. If $35 billion dollars was the average corporate tax gap and $291 billion the personal tax gap over these years, the non-compliance rate (as a fraction of true tax liability) was 14% for corporate taxes and 23% for personal income taxes.

How do we make up revenues?

The tax gap is of course an imperfect measure of total tax evasion. As explained in a 2007 National Tax Journal article by IRS economists Mark Mazur and Alan Plumley, it is often hard to determine the exact tax liability of a U.S. multinational company with operations in many countries and complex financial undertakings. Moreover, tax gap estimates are limited to taxes due on legal activities and do not cover illegal gambling, prostitution or drug dealing.

Nevertheless, fixing the tax gap will clearly require more action on non-corporate business income than on corporate business income. This could include more information reporting and more enforcement resources for the IRS. Information reporting or third party reporting matters because the tax gap data show that there is 99% compliance in tax payments for incomes where there is substantial information reporting (or withholding) such as wages and salaries. To this end, Eugene Steuerle at the Urban Institute suggests more reporting of net capital gains by financial intermediaries and expanded reporting of charitable contributions by charities, which could be matched with individual reporting.

Moving towards a simpler tax code is likely to help with issues related to non-filing and over claiming of credits and deductions. A 2003 study finds that noncompliance tends to be higher when the time burden associated with filing and preparing a return is high. Complexity in the Earned Income Tax Credit is a reason why many more filers are relying on professionals. For instance, it is relatively tougher for single, divorced or separated parents to determine EITC eligibility than for married couples. There is evidence to suggest that nearly 50% of EITC-related mistakes were unintentional. Further, 20% of eligible individuals do not claim benefits.

On the corporate side, as I have written earlier, the larger issue appears to be legal tax avoidance rather than tax evasion. An overhaul of the corporate tax code that results in a more competitive tax code is likely to result in increased investments, higher revenues and fewer incentives for firms to attempt to invert to a lower tax country.

The tax gap is a reminder of the revenue potential of the country. It is also a measure of complexity. More complicated rules allow for greater evasion, and also prevent honest taxpayers from meeting their obligations. Success in closing the tax gap might start with a simpler tax code.

I am currently a Resident Scholar in economic policy studies at the American Enterprise Institute in Washington, D.C. I received my Ph.D. in Economics from the University

I am currently a Resident Scholar in economic policy studies at the American Enterprise Institute in Washington, D.C. I received my Ph.D. in Economics from the University of Maryland, College Park in 2005. At AEI, my research has focused on income inequality and economic mobility, tax policy, labor markets and small businesses. I have published in top quality academic journals, testified several times before Congress, including to the Joint Economic Committee, and published numerous articles in the popular press on issues of policy relevance. I have done numerous TV appearances and radio interviews, including the popular Diane Rehm Show on NPR. My work has been cited in leading news magazines such as the Economist, the Wall Street Journal, the New York Times, Financial Times, Forbes and Business Week. Government organizations such as the Congressional Research service and the Congressional Budget Office have also cited my work in their reports to Congress. I have been an adjunct professor at Georgetown University’s School Of Public Policy, and have taught economics at the University of Maryland.