closing-tax-gap.pngLast year’s Capitol Hill battles over reducing federal budget deficits and our $15 trillion public debt centered around rival plans either to cut government spending or raise taxes.

Democrats and Republicans presented the issue as a stark binary choice: cut government entitlements like Medicare or increase income taxes. No wonder the Congressional “Super-committee” failed to reach consensus.

Now comes word from IRS, on January 6, 2012 to be exact, that there’s a third choice: close what’s known as the “Tax Gap.” Read more.

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Closing the Tax Gap: It Beats Raising Taxes

Wed Jan 18, 2012

closing-tax-gap.pngLast year’s Capitol Hill battles over reducing federal budget deficits and our $15 trillion public debt centered around rival plans either to cut government spending or raise taxes.

Democrats and Republicans presented the issue as a stark binary choice: cut government entitlements like Medicare or increase income taxes. No wonder the Congressional “Super-committee” failed to reach consensus.

Now comes word from IRS, on January 6, 2012 to be exact, that there’s a third choice: close what’s known as the “Tax Gap.”

IRS defines the “gross tax gap,” $450 billion in tax year 2006 (the latest year for which data are available), as “the amount of true tax liability faced by taxpayers that is not paid on time.” Subtracting out subsequent voluntary or involuntary tax collections yields an estimate of the “net tax gap,” or the “amount of tax liability that is never paid” — a whopping $385 billion in 2006 alone!

While obviously easier said than done, more aggressive efforts to close this gap would alleviate pressure to reduce budget deficits either by cutting spending or raising taxes.

As part of its analysis IRS offers a fascinating chart, distinguishing among three components of the gross tax gap: non-filing, underpayment and under-reporting, with the latter accounting for fully 84% of the total gap. (Tax Gap Map)

Of the total under-reported tax of $376 billion, 63% or $235 billion, is attributable to individual income tax under-reporting, with half of that due to business income tax under-reporting of $122 billion in 2006.

Summing up, the heart of the tax noncompliance problem appears to be not with non-filing ($28 billion) or underpayment ($46 billion) of taxes due, though these amounts are still mammoth, but with under-reporting; and not of employment taxes ($72 billion) or corporate income taxes ($67 billion) but of individual income taxes, particularly business income taxes. Moreover, IRS estimates that between 2001 and 2006 the under-reporting portion of the gross tax gap exploded by 32%, meaning that more and more taxpayers were under-reporting their tax liability.

The good news is that voluntary tax compliance is at an all-time high—about 85%. The bad news, of course, is that this means, according to IRS, that almost 15% “of the estimated total tax liability for 2006 will never be paid.”

What can be done to reduce the size of the tax gap? The answer, says IRS, is that “compliance is far higher when reported amounts are subject to information reporting and, more so, when subject to withholding.” In other words, as President Reagan famously said of a pending nuclear weapons treaty with theSoviet Union, “Trust, but verify.”

Commenting on the IRS report, Senator Max Baucus (D-MT), chairman of the U.S. Senate Finance Committee, urged that the tax gap be addressed with reform of the tax code:

“This report shows that closing the tax gap needs to be a major focus of tax reform.  An improved tax code that’s simple and fair to all Americans will help close the tax gap, boost our economy and create jobs. In an era when we’re squeezing the federal budget for every dollar of savings, we have to make every effort to recover these lost funds.”

What are we to conclude about the new tax gap analysis? First, we can wish the news media had given more attention to the January 6 IRS report. Public support for more aggressive efforts to close the tax gap might take some pressure off the alternatives of raising taxes and cutting government spending. That’s not going to happen if the public isn’t better informed about this issue.

Second, we can expect more initiatives to expand the scope of information reporting and withholding as Congress and the IRS step up efforts to collect more of what’s owed and not paid. To be sure, requiring more reporting isn’t popular, as Congress learned when it enacted, and later had to repeal, expanded Form 1099-MISC reporting as part of the 2010 healthcare reform law.

Still, it’s likely that IRS will continue to examine ways to cast a wider net of reporting or withholding over financial transactions in an effort to close what is no doubt now at least a $400 billion annual net tax gap. 

In this electronic age, with our gross public debt now soaring above $15 trillion, or over 100% of GDP, and yearly budget deficits over the next ten years forecast to total more than $4 trillion, it’s in everyone’s interests that the $400 billion annual tax gap be closed. Surely that would be better than raising taxes!