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U.S. Department Of Treasury: The Case For A Robust Attack On The Tax Gap



US Department Of Treasury

A well-functioning tax system requires that everyone pays the taxes they owe. Today, the “tax gap”—the difference between taxes that are owed and collected—totals around $600 billion annually and will mean approximately $7 trillion of lost tax revenue over the next decade. The sheer magnitude of lost revenue is striking: it is equal to 3 percent of GDP, or all the income taxes paid by the lowest earning 90 percent of taxpayers.

The tax gap can be a major source of inequity. Today’s tax code contains two sets of rules: one for regular wage and salary workers who report virtually all the income they earn; and another for wealthy taxpayers, who are often able to avoid a large share of the taxes they owe. As Table 1 demonstrates, estimates from academic researchers suggest that more than $160 billion lost annually is from taxes that top 1 percent choose not to pay.1

Table 1: Distribution of the Tax Gap

Distribution of the Tax Gap

1These estimates for the distribution of unpaid taxes are based on DeBacker, Jason et al., 2020. “Tax Noncompliance and Measures of Income Inequality,” Tax Notes Federal, 17 February. Estimated unpaid taxes are calculated by applying these percentages to TY 2019 tax gap estimates. The distribution of the tax gap across the income spectrum is difficult to estimate, especially at very top incomes. Ongoing work by IRS researchers and outside academics suggest the concentration of the tax gap is even more skewed toward the top of the income distribution. Guyton, John, et al., 2021. “Tax Evasion at the Top of the Income Distribution: Theory and Evidence,” NBER Working Paper No. 28542 These estimates are based on imputations of undetected evasion using multipliers developed from earlier audit data. The advisability of so-called “detection-controlled estimation” (DCE) adjustments are debated in the literature, especially with respect to understanding the distribution of noncompliance.

The United States collects less tax revenue as a percentage of GDP than at most points in recent history, in part because owed but uncollected taxes are so significant. The tax gap also has meaningful implications for fiscal policy. These unpaid taxes mean policymakers must choose between rising deficits, lower spending on important priorities, or further tax increase to compensate for lost revenue—which will only be borne by compliant taxpayers.

Currently, an under-staffed IRS, with outdated technology, is unable to collect 15 percent of taxes that are owed, and a lack of resources means that audit rates have fallen across the board, but they’ve decreased more in the last decade for high earners than for Earned Income Tax Credit (EITC) recipients. For the IRS to appropriately enforce the tax laws against high earners and large corporations, it needs funding to hire and train revenue agents who can decipher their thousands of pages of sophisticated tax filings. It also needs access to information about opaque income streams—like proprietorship and partnership income—that accrue disproportionately to high-earners.

The Administration’s proposals call for significantly increasing the IRS budget, specifically $80 billion of investment over the coming ten years in enforcement, IT, and taxpayer services generating an estimated $320 billion in additional tax collections over the next ten years.

To further ensure that everyone pays their fair share, the Administration also calls for using information that financial institutions already possess—without imposing any burden on taxpayers whatsoever—so the IRS can deploy these additional resources to audit more sophisticated tax evaders. These changes to the third-party information reports are estimated to generate $460 billion over a decade.

In the subsequent decade, once the overhaul of the IRS is complete, these proposals combined will generate even more revenue: an estimated $1.6 trillion in additional tax revenue, just from improved collection of the taxes that are already due.

This revenue will be collected in a highly progressive way, as the tax gap is more concentrated toward the top of the income distribution.

Why does misreporting rise with income? In part, tax evasion is concentrated toward the top of the income distribution because higher-income taxpayers have the ability to tap into the services of accountants and tax preparers who help shield them from bearing their true income tax liability. Because these individuals know enforcement authorities lack the resources needed to pursue them, the consequences of their underpayments are viewed as minor, and so voluntary compliance rates tend to be lower.

But the distribution of the underreporting tax gap is also the natural byproduct of the current information reporting regime. There is a direct relationship between the information the IRS has at its disposal to verify that a taxpayer has properly paid her tax liabilities, and her voluntary compliance rate. For ordinary wage and salary income, compliance with income tax liabilities is nearly perfect (1 percent noncompliance rate). In stark contrast, for opaque income sources that accrue disproportionately to higher earners—like partnership income, proprietorship income, and rental income—noncompliance can reach 55 percent.

Misreporting by Income Category

In fact, about half of the individual income tax gap accrues to income streams from proprietorships, partnerships, and S-corporations, where there is either little or no information available to the IRS to verify the veracity of tax filings. As Table 2 makes clear, a significant share of this income accrues to those at the very top of the distribution.

Table 2: Distribution of Proprietorship, Partnership, and S-Corporation Income

Corrected Adjusted Gross Income Proprietorship income2 Partnership and S-corporation income3
Less than $0 0% 0%
$0 to $50,000 13% 3%
$50,000 to $100,000 20% 14%
$100,000 to $200,000 26% 27%
$200,000 to $500,000 17% 22%
$500,000 and over 24% 35%
2From individual income tax returns that report or should have reported Schedule C income.
3From individual income tax returns that report or should have reported Schedule E income.
NOTE: The underlying data for the table below is individual audit outcomes based on random audits done by the IRS National Research Program for tax year 2014 (the most recent year available). Income is adjusted for economic growth to current dollars, and the underreported income and self-employment tax is estimated through a tax calculator. Crucially, the table presents results by taxpayers’ corrected income, defined as the sum of reported and misreported income. Distributing unreported income in this manner appropriately adjusts for the fact that taxpayers who misreport income will appear to have lower incomes, when in reality they may well be higher-income taxpayers. Indeed, the difference between reported and corrected income is precisely what results in a substantial misreporting tax gap.

It is important to understand what this improved information reporting proposal is not: It is not about using new financial account information reports to increase enforcement scrutiny on lower-income taxpayers. The Administration has been clear that audit rates will not rise relative to recent years for those with under $400,000 in actual income.  Instead, these proposals are about targeting enforcement actions where they belong: on higher earners who do not fully report their tax liabilities.

These estimates understate the distributional tilt of the Administration’s proposals. For one, these reported estimates of underreported partnership and S-corporation income are based on audits that are frequently limited to individual tax returns as opposed to returns at the passthrough business level. This distribution therefore can miss much of the reporting noncompliance at the passthrough business level, especially important for complicated business entities. The owners of these entities are concentrated in the top of the income distribution.4 For example, IRS estimates suggest that medium-to-large S corporations with over $200,000 in assets are responsible for nearly 50 percent of S-corporation underreporting.

Overall, the Administration’s compliance initiatives are guided by a singular objective—bringing about an end to a two-tiered tax system, where ordinary Americans comply with their tax obligations, but many high-end taxpayers do not. Giving the IRS the information and resources that it needs will generate substantial revenue. But even more importantly, these reforms will create a more equitable, efficient tax system.

4Smith et al. (2019) found that those in the top 1 percent of the income distribution are much more likely to own medium and large passthrough businesses. Smith, Matthew et al., 2019. “Capitalists in the Twenty-first Century,” The Quarterly Journal of Economics.
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