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Employers eyed to close tax gap: A bridge too far?

By Rob Smith, Ceridian manager of Government Relations

Ahh, tax day, the nation's foremost "anti-holiday " that everyone loves to hate. On April 15th, we were once again reminded that nothing in life is certain but death and taxes -- or perhaps death by taxes for those who habitually wait until the last minute to file. Another certainty is that nobody enjoys paying taxes. And few would suggest that they don't pay enough money to the government.

However, the difference between what the IRS estimates it should receive in tax payments and the amount that actually comes in to the U.S. Treasury is known as the tax gap. According to recent IRS data, a large section of the U.S. economy pays less than half of what it owes on its returns, which is quite a substantial gap. And that's happening every year to the tune of approximately $345 billion.

Someone has to pay to make up for this noncompliance. This means law-abiding taxpayers end up footing the bill with what amounts to a $2,680 per household "surtax" for those who don't pay the taxes they should.

To put the $345 billion gap in perspective, every man, woman and child in the United States would have to contribute $1,160 to close the gap. And $345 billion is about $100 billion higher than the entire national deficit.

Source of the gap
According to the Government Accounting Office, most of the tax gap comes from individual income taxes. The last time the IRS measured the tax gap was in 2001. That year, individual taxpayers underreported $166 billion of income. Underreported nonbusiness income, such as wages and tips, contributed another $56 billion, which led to another $54 billion in uncollected FICA and unemployment insurance taxes.

Noncompliance by the "cash economy" and self-employed individuals are the biggest overall source of the gap. The cash economy is mostly comprised of contractors and workers who receive tips and other cash payments as a large portion of their salaries. Payments to cash economy workers are not subject to withholding or third-party reporting -- unlike businesses that send W-2 data to the IRS to report wages paid and banks that send 1099 forms reporting interest, dividends and various other types of income -- which makes it relatively easy to pass this money around under the IRS's radar. All told, the IRS estimates that this cash economy noncompliance makes up more than $100 billion of the tax gap.

The United States is waging two financial wars, our gross national debt tops out at around $9 trillion, and we are coming up on more than $50 trillion in unfunded Medicare and Social Security promises. Clearly, America needs to close the tax gap, and the government is considering several options to ensure that taxpayers make good on the money they owe the U.S. Treasury.

Reporting and withholding
Tax Payer Advocate Nina Olson spoke in a House Ways and Means hearing in March on the tax gap. Olson outlined steps the government could take to substantially close the tax gap, starting with the cash economy. One would think a comprehensive effort to crack down on taxpayers who shirk the system would mostly affect taxpayers themselves, but it appears a lot of these changes will be handled by employers.

According to Olson, "where taxable payments are reported to the IRS by third parties, taxpayers generally report well over 90 percent of their income. By contrast, where taxable payments are not reported to the IRS by third parties, reporting compliance drops below 50 percent."

It's not hard to see where the government may be going with this. More reporting equals more compliance, more compliance equals more taxes paid, and more taxes paid equals a smaller tax gap. While this equation is fairly simple, it will be up to employers to comply with new reporting requirements once they are enacted into law, which certainly won't be easy, especially for small businesses.

In early 2008, the U.S. Treasury submitted a proposal to Congress asking it to enact legislation requiring businesses to file a Form 1099 to report payments of $600 or more they make to other corporations for services or materials. Businesses are currently required to issue 1099 forms for contractors but are exempted from generating them for payments to corporations.

A report produced by IBM Business Consulting Services for the IRS in 2005 shows that small businesses had spent 214 hours and $1,839 per year complying with the income tax. Another 127 hours and $436 were spent on complying with the employment tax (http://www.irs.gov/pub/irs-soi/05deluca.pdf). The National Federation of Independent Business estimates that ending the current Form1099 corporate payment exemption would double or triple this paperwork for small businesses.

The government also is examining changing withholding obligations to boost tax compliance. Last year, Congress passed a little-known provision in the FY 08 budget that will require federal, state and local agencies to withhold taxes on payments to contractors starting in 2011. This amounts to these agencies issuing W-2 forms for each contractor they deal with. The next logical step is to extend that withholding requirement to private businesses. Politicians are loathe to attach their names to measures that could be construed as tax increases in election years, but it would not be surprising to see this happen in the near future as the tax gap continues to grow.

Congress and the U.S. Treasury seem to be on a straight course toward requiring employers to abide by the same reporting and withholding requirements for contractors and other corporations they do business with as they do for their employees. Combining or merging accounts payable and payroll departments would be very difficult for employers to manage, and many small businesses have neither the staff nor the resources to make these changes.

Small price to pay?
While closing the tax gap is frightening, it could also have a silver lining. Our tax code is enormously complex and grows more so each year. Much of the underreporting and other noncompliance can be attributed to businesses and the self-employed lacking the understanding to navigate the system. The Form 1040, the most used individual tax form, is an example of a growing tax complexity. In 1945, the form had five pages of instructions. By 2001, the instructions increased to 117 pages, and in 2007, they comprised a massive 155 pages.

Even Congress is having a harder time explaining the tax laws it passes. The Congressional Joint Committee on Taxation's explanation of tax legislation enacted in the last session of Congress took 852 pages, an increase of 593 pages over the previous session.

The House and Senate have given lip service to reforming the tax code, but they have yet to take up a serious effort to both increase tax compliance and reduce tax code complexity. Sadly, major tax reform is most likely off the table until the next president is in office. Even then, that president will most likely focus on eliminating the hated alternative minimum tax, as all of the candidates have promised.

In recent years, however, Congress and the IRS have taken positive steps to increase electronic filing, which greatly reduces taxpayer errors and errors by the IRS. According to the National Commission on the IRS, processing paper returns yields an error rate of approximately 20 percent. This costs both the IRS and taxpayers' time and resources to correct. In contrast, electronic filing, with its built-in system of checks, only has an error rate of 1 percent. Several measures are currently pending in Congress to provide more incentive for businesses and individuals to file electronically, and the IRS has undertaken several initiatives to make the process easier.

Money matters
In the meantime, the government is in real need of money. Government spending can only be cut so much, and there is nothing voters hate more than tax increases. On the other hand, few would argue that businesses and individuals who don't pay their fair share of taxes should be able to do so while everyone else picks up their tabs.

Closing the tax gap is by far Congress's easiest and most attractive option for putting money in the federal treasury. It is common for Congress to attach revenue-raising provisions to legislation to offset the amount it will cost the government to implement the bill once it becomes law. In fact, these offsets are required under the "pay as you go" budgetary rules of the House of Representatives, which makes the $345 billion all the more enticing.

The IRS recouped $55 billion of the tax gap last year through more aggressive auditing. But going after the tax gap's main source -- with employers' help -- through increased withholding and reporting for the cash economy would be a more direct and less expensive approach for the financially strapped federal government.

Some readers may remember commercials for the GAP clothing stores that urged shoppers to "fall into the GAP." While this slogan was aimed at selling khakis and sweater vests, it could also ably describe what the government is on the verge of asking employers to do. Watch your step, it's a long way down.