Understanding the Federal Tax Gap
An enduring concern of the IRS is the “tax gap” – the difference between the full amount of income taxes owed and the amount taxpayers voluntarily pay on time. As the IRS states, the tax gap is essentially, “…the sum of non-compliance with the tax law.” And it is a large sum indeed. While the latest IRS report on the tax gap in July 2009 estimates an 84% voluntary tax compliance rate in the United States, the same report estimated the gross tax gap to be roughly $345 billion. Even after deducting revenue obtained from late payments and by prosecuting delinquent taxpayers, the net tax gap was still clocked at $290 billion. Furthermore, both numbers are likely to be higher by now because the IRS admits that these estimates (which remain “…the most recent estimates available”) were calculated in 2005 based on data collected in 2001. Admittedly, the tax gap in the United States is likely smaller than in many other industrialized nations. An academic paper comparing the differences in “tax morale” – that is, propensity to voluntarily pay taxes – between the U.S. and fourteen European countries concluded that, “…individuals in the United States have the highest tax morale across all countries, followed by Austria and Switzerland.” However, in light of the country’s growing federal deficit, a small tax gap by international standards is still highly consequential. Additionally, recent tax increases have arguably created greater incentives to not to pay.
Today, We’ll analyze the tax gap in greater detail, including its main causes and its special consequences during recessions.
Three Main Causes
At first glance, it might seem fairly easy to explain the existence of a tax gap: brazen refusal to pay taxes. However, the IRS actually breaks this phenomenon down into three distinct categories:
- Under-reporting of income
- Underpayment of taxes
- Non-filing of returns
According to the IRS, the vast majority of the tax gap is not, as one might expect, pure failure to report or pay any taxes. Rather, their estimates show 80% of the tax gap as consisting of under-reported income. In other words, most tax cheats prefer to give the allure that they are paying something and gamble that the IRS wont investigate any further. The IRS drills even deeper into this category, determining that everything from understated income to improper deductions to overstated expenses and erroneously claimed credits all fall under the label of “under-reporting.” From a tax cheat’s perspective, it is easy to understand why under-reporting is the preferred method of dodging the IRS. Both underpayment of taxes and non-filing of returns are automatic red flags. In both cases, a certain amount of taxes have been admitted by the filer and failing to pay them makes enforcement an essentially open and shut case. Under-reporting, on the other hand, injects ambiguity and human judgment into the equation. Filing a return and paying what it says ought to be paid bypasses initial IRS scrutiny. Whether or not all the dubious deductions, exemptions and crafty explanations stated in that return will ultimately be discovered (much less investigated and punished) is far from certain. Indeed, the fact that the IRS loses over $270 billion per year to precisely this activity suggests that many who under-report do get away with it, at least temporarily.
Economists and professors have also offered proximate explanations for the tax gap beyond these three categories. Villanova Professor James Maule, for instance, sees the complexity of the tax code as a major contributor. The Tax Foundation quotes Maule as saying, “…tax simplification is essential if rates of noncompliance are to be reduced” and citing, “…a direct correlation between noncompliance and complexity.” In a separate report from 2007, the Tax Foundation clocks the cost of tax compliance to individuals and businesses at, “…roughly $275 billion and rising” – nearly the entire net tax gap in itself, and a, “…huge dead-weight loss to the economy.”
Who Doesn’t Pay
It is often assumed that ultra-wealthy corporations make up the majority of illegal tax dodging in the United States. Interestingly, however, the IRS data on the subject unambiguously states that individuals are, “…the single largest source of the annual tax gap” – nearly two-thirds, to be exact. In a graph comparing different sources of the tax gap, individual income taxes are shown to make up over $200 billion of each year’s tax gap. Unpaid employment taxes, by contrast, account for between $73-$78 billion of the gap, while corporate taxes account for just $32 billion. In fact, the IRS shows, the majority of the tax gap appears to come from the under-reported small business activities of individuals. Breaking it down even further, roughly $59-$65 billion of the gap comes from non-farm sole proprietors, while partnerships, S-Corps and estates account for $16-$24 billion in unpaid taxes. Furthermore, the same data shows that 80% of individual under-reporting takes the form of understating how much income was earned, rather than claiming overstated or erroneous deductions.
The Tax Gap & The Recession
Logic implies that the tax gap should grow larger during recessions, when money is tight and the incentive to cheat the IRS is greater. In actuality, this does not appear to be the case. According to the Heritage Foundation (who also states that the current tax gap is not large by historical standards), “…over the last several decades, the United States has collected between 81 percent and 84 percent of taxes due before compliance efforts.” This includes the July 1981-November 1982 recession, as well as July 1990-March 1991 and March-November 2001 downturns. In fact, Heritage also reports that while the IRS “…set a goal of increasing taxpayer compliance to 90 percent by 2001″ in 1993, this effort failed, as, “…the compliance rate remained within its historical range of 81 percent to 84 percent.” Data is not yet available on the tax gap during the current recession, but one unique variable could change the outcome: a substantial tax increase on high income earners. Harvard MBA John T. Reed contends that the higher tax rates on high income earners are raised, “…the greater the incentive to cheat and the greater will be the incidence and amount of the cheating.” In concluding this, Reed ignores the ideology of raising taxes and focuses entirely on the cause and effect relationship between it and tax cheating. Reed writes, “…the greater the incentive to cheat, the greater the cost of stopping cheating.”
Howard Gleckman of the Tax Policy Center refers to a similar phenomenon that occurs when cigarette taxes go up. Raising cigarette taxes too high, Gleckman points out, encourages, “… smuggling, Internet purchases, and—if neighboring states don’t raise their taxes too–a quick drive across the border to stock up on smokes.” Keeping this in mind, it will be interesting to see whether the income tax rate hikes in the current recession inflated the tax gap the next time data is compiled.
To recap, we have learned that the United States tax gap, while modest internationally, encompasses at least $345 billion per year ($290 million after enforcement and late payments.) Additionally, we learned that under-reported income comprises 80% of the tax gap, and 80% of under-reporting is, in turn, comprised of understated income. Complexity of the tax code is also a known obstacle to full tax compliance. The primary group engaging in illegal tax avoidance is individuals, largely as regards their small business income. And while the tax gap has hovered rather consistently between 81%-84% throughout the last few recessions, the income tax hike unique to this recession (coupled with a lack of increased enforcement) is cause for suspicion that the gap could rise.