Tax Policy - Minimizing the Tax Gap

The "tax gap" is the difference between taxes owed and taxes collected. The amount not collected is due to both intentional and unintentional errors. Unintentional errors can be due to inadequate recordkeeping, posting errors and confusion over the law. Intentional errors include purposefully omitting income from one's return, and claiming deductions and credits one is not entitled to.

Principles of good tax policy include that the system should be designed to minimize both intentional and unintentional non-compliance (see AICPA Policy Concept Statement on Principles of Good Tax Policy).

The federal tax gap is at least $345 billion per year. States also have gaps in their tax systems as well.

Two events of this week illustrate problems in drafting provisions to minimize the tax gap.

1. Smith v. Commissioner, 133 T.C. No. 18 (12/21/09) - a case involving excessively large tax shelter penalties that are poorly designed to address non-compliance.
2. A report, Evaluation of the Internal Revenue Service’s Capability to Ensure Proper Use of Recovery Act Funds, by the Treasury Inspector General for Tax Administration, released on 12/22/09, notes that the "IRS is unable to verify taxpayer eligibility for the majority of Recovery Act tax benefits and credits at the time a tax return is processed. This includes 13 of the 20 benefits and credits for individual taxpayers and 26 of the tax provisions benefiting businesses."

Details ...

Section 6707A: In the Smith case, the taxpayer and his corporation were each assessed a penalty under Internal Revenue Code Section 6707A for failure to report a "reportable" transaction that was also a "listed" transaction. This penalty was designed to reduce tax shelters. The penalty is basically a strict liability one. For individuals, it is $100,000 and for corporations it is $200,000. For three years of assessment, the individual faced a $300,000 penalty and his corporation $600,000. The Tax Court ruled that it was not allowed to review the penalty (although the taxpayer had other options beyond the Tax Court).

The Section 6707A penalty has come under scrutiny because of its size and because it allows the IRS no leeway to consider the taxpayer's intent related to the violation and the size of the related tax deficiency (or if there even is a deficiency). While Congress could enact changes to the provision (for example, S. 2771), it has not done so. In introducing S. 2771, Senator Baucus noted that sometimes this penalty results in an assessment 20 times greater than any taxes saved by the particular investment that is a "listed transaction." He also noted: "Many of these businesses thought they were putting their money into sound investments for the benefit of their employees and learned only after they were audited by the IRS that they instead had invested in something the IRS considers to be a tax shelter." He also notes that while he is not soft on tax shelters, he realizes that the penalty structure is harming many small businesses [Congr. Rec. 11/16/09, S11384]

In 2009, IRS Commissioner Shulman twice issued a statement that the IRS would not pursue collection efforts on the penalty in light of the bipartisan in Congress to modify the penalty. He extended that commitment to 12/31/09 (see first letter of 7/09).

The design of this penalty does not improve compliance and is way too intrusive (putting a taxpayer into financial ruin when they did not do anything evil or clearly abusive, is the wrong approach).

TIGTA Report: TIGTA points out that it is much more efficient for the IRS to verify whether a taxpayer is entitled to a special deduction or credit in processing the return rather than having to audit the return and then seek a refund. But for this to occur, the IRS needs "math error authority" and documentation on the return. It doesn't always have this power - it needs help from Congress.

Comments: In drafting any tax rule, all principles of good tax policy should be considered including ways to minimize non-compliance. Sometimes, just asking for information on the return itself would help. For example, include questions about the address of rental property, the details of a home purchase (such as for the first-time homebuyer credit).

As noted by the GAO in a 1995 report (p. 13), efforts to minimize the tax gap must strike a balance between the desired level of compliance and the intrusiveness of the tax system.

Considering other principles of good tax policy, such as simplicity, neutrality and economic growth and efficiency, it is usually best to not keep adding special rules to the tax law! Alternatives include rate reductions or modifications to rules that already exist, such as the standard deduction or the Earned Income Tax Credit.

I've got more on the tax gap here. The short articles noted there have links to government reports on the tax gap and its causes.

For an overview to 10 principles of good tax policy from a recent presentation I made to the National Conference of State Legislatures - click here (ppt).

What do you suggest for reducing the tax gap and not legislating more changes that just make it worse?