Guest Post - The True Cost of The American Shadow Economy

A policy goal for a good tax system is that it should minimize the tax gap. The IRS estimates that the gross federal income tax gap is $450 billion. Collection efforts brings that down to about $385 billion per year. That's still a lot and it might be a low estimate.

Here is a guest post from Simon Andrus of Wallace & Associates in Los Angeles on a reason for part of the tax gap.

Every year hundreds of billions of dollars owed to the IRS are never paid. That difference in taxes owed and taxes paid is known as the tax gap. Those unpaid taxes come from one of three categories: underreporting, underpaying, and not filing. Between these three, the tax gap is formed.

As you can see below in the infographic describing the shadow economy, which includes activities that are not declared for tax purposes while cash is exchanged (including, but not limited to the black market), the United States brought in $2.449 trillion in tax revenue in 2012. That’s an incredibly large sum of money, but it would have been even larger if it weren’t for the shadow economy. If all owed taxes were paid, it’s estimated that an additional couple hundred billion dollars would be added to the federal government’s coffers.

That’s nothing compared to our expenditures though. You might think additional revenue of that amount would go a long way towards curing our budget mess, but it’s not even close. In 2012, the U.S. government spent just over $3.5 trillion. So even if the IRS were able to accomplish the near impossible task of collecting all owed taxes, the large deficits would continue.

Surprisingly enough, unfiled taxes don’t contribute very much to the tax gap. The IRS estimates that only 7.8% of the gross tax gap is due to individuals and businesses not filing. The real contributor is underreporting, which accounts for over 80% of the tax gap, but underreporting is almost impossible for the IRS to detect and act on, especially when it involves the self-employed. Because of this, the discrepancy in taxes owed and taxes paid isn’t going anywhere.

The tax gap will persist through time as it always has. Even though many offenders are locked up or fined every year, the practice continues on unhindered. In fact, the IRS estimates that it’s stayed very steady over the last 10 years, and there isn’t much they could do to lower that. For the IRS, there is a silver lining: The United States has the lowest tax gap in the world, when measured as a percentage of GDP.

Infographic on Shadow Economy from Wallace & Associates - click here to see larger version.

 This infographic was designed and created by Wallace & Associates APC – CPA, a certified Los Angeles taxation and accounting agency.

What do you think?