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Monday, January 9, 2012

IRS Now Estimates Annual Tax Gap at $450 Billion

On Friday (1/6/12), the IRS released updated tax gap data showing that the annual tax gap is $450 billion (based on 2006 liabilities). The prior estimate based on 2001 liabilities was $345 billion. They describe this as the gross tax gap meaning that after additional enforcement efforts, it drops to $385 billion (and old net tax gap was $290 billion).

The tax gap is the amount of tax that should be collected if all taxpayers determined and paid their tax liability correctly and what is actually collected.

The IRS notes though that compliance rates have not really changed much. Per the IRS new release: "The voluntary compliance rate — the percentage of total tax revenues paid on a timely basis — for tax year 2006 is estimated to be 83.1 percent. The voluntary compliance rate for 2006 is statistically unchanged from the most recent prior estimate of 83.7 percent calculated for tax year 2001." So, the larger dollar amount of the gap is due to increased tax liabilities and better estimation methods by the IRS.

The broad reasons underlying the gap are:
  • Underreporting  84%
  • Underpayment   10%
  • Non-filing           6%
There is a "map" with further details on the above percentages.

$450 billion of uncollected tax is a lot of money. While IRS estimates that its efforts bring it to $385, that is still a lot of money and there are costs of collection. Congress has enacted various measures to address the gap, a few of which we'll see on information returns issued for 2011. These two measures, which I don't think will do anything to reduce the gap are:
  • 1099-K issued to businesses that let customers pay via credit or debit card or Paypal (per IRC Section 6050W)
  • 1099-B issued for security sales where some of these forms will show not only the sales proceeds, but the basis of the stock.
Why I say these measures likely won't do much is because these are areas where there is already a paper trail and the 1099-B provision won't show basis for all securities (and the basis amount might be wrong).

I am puzzled why in 2008, the tax gap measure was to have an information report for transactions with a significant paper trail - the credit and debit card processing.  Tax gap measures need to be focused where there is little or no paper trail, such as cash transactions of businesses.

Tax gap measures should also include NOT enacting provisions that are likely to lead to increased tax gap. For example, the first-time home buyer credit led to improper use and education credits have led to people overclaiming them.  These two measures did not need to be in the tax law and could instead have been implemented in a different way where verification could have been made more easily and timely. For example, students in need of financial aid complete a FAFSA form and grants are sent to the university if eligible. The higher education credits funds could have instead been directly through existing structures, such as the Pell grant program. Similarly, the first-time homebuyer credit could have been directed at the state level with the verification done through the escrow process where verification could have been made as to whether the person was a first-time homebuyer (lenders check assets and borrowing history - they know if you owned a home in the past three years).

Simplification of other provisions will also reduce the gap because it will reduce unintentional errors which contribute to the gap.

Benefits of reducing the tax gap, of course, are to help pay down the deficit and debt without raising taxes to do it - collect more within the existing system. Of course, our deficit and debt are greater than $450 billion, but it will help.  A tax gap also means that compliant taxpayers pay more to help fund non-compliance which doesn't bode will for tax system.

What would you suggest to reduce the tax gap?

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