Wednesday, April 10, 2013

The Internal Revenue Service and the Tax Gap

As we are all well aware, Washington certainly seems to have problems with money.  Achieving any sense of fiscal balance is elusive and, while tax revenues are up on a year-over-year basis as shown here...

...a study by the IRS shows that there is a rather substantial "tax gap". 

The IRS defines the gross tax gap as the amount of true tax liability that is owed by taxpayers that is not paid on time.  The net tax gap is defined as the amount of true tax liability that is not paid on time and is not collected subsequently, either voluntarily or as a result of enforcement or, in other words, the amount of tax owing that is never paid.

In 2012, the IRS used data from the 2006 tax year and found that:

1.) The gross tax gap was $450 billion with a voluntary compliance rate of 83.1 percent (down from 83.7 percent in 2001).

2.) The net tax gap was $385 billion with a net compliance rate (NCR) of 85.5 percent (down from 86.3 percent in 2001).

In 2006, the net tax gap (taxes that will never be collected) was up $95 billion from 2001, the last year that an analysis was completed.

Here is a flow chart showing which taxable parts of the economy are responsible for the tax gap and how big the tax losses were in 2006:

Here is a chart comparing the tax gap statistics for both 2001 and 2006:

Between 2001 and 2006, the growth in the tax gap was concentrated in both underreporting of taxes owing which grew by 32 percent and underpayment which grew by 38 percent.  Here is a pie chart showing the breakdown of the gross tax gap by component:

More than one-third of the tax gap related to underreporting was attributed to corporate income tax.  Approximately $28 billion or 6 percent of the gross tax gap in 2006 was attributed to non-filing of tax returns.  

In closing, how well does enforcement work when the IRS attempts to recover missing tax revenue?  Large staffing level increases in fiscal 2009 and 2010 resulted in the examination of the most tax returns in the past five years, however, the dollar yield per hour for examinations increased in 2009 but fell in 2010.  In fiscal 2010, Collection Field function staff collected an average of $462,368, a 19 percent drop from $567,733 in fiscal 2007.  The IRS claims that their Voluntary Disclosure Program implemented in 2009 and 2011 for taxpayers with hidden offshore assets have netted $4 billion in missing tax revenue, a relatively small amount given that $1.132 trillion in individual income taxes was collected in fiscal 2012. 

Keeping in mind that the IRS estimates that for one year alone, tax losses are $385 billion or 27.5 percent of the total tax revenue of $1.398 trillion for fiscal 2006, it is apparent that the tax gap is a relatively significant issue.  Unfortunately, it is a very difficult gap to close and as history has shown, the cost of collecting the taxes owing but not paid is very high.

The most reasonable solution is to simplify the tax code.  Back in 2002, 56 percent of tax returns completed by a paid preparer and 47 percent of returns completed by individuals had errors; at that point, the tax code was 53280 pages.  In 2012, the tax code grew to more than 73000 pages making the entire system too complex for most individuals to comprehend without the help of a chartered accountant.  In case you were curious, here's the link to all 9834 sections and 4 million words of the Internal Revenue Code and here's a link to Section 1 which covers Taxed Imposed on Individuals.  This section alone has over 4400 words on 20 pages.  If you managed to read through it, I'm wondering if your eyes have glazed over yet?

If Washington is really serious reducing the tax gap, a massive simplification of the tax code could go a long way to increasing compliance which could result in a significant increase in revenue.  Sadly though, it seems that, like governments everywhere, those in power would still spend $1.40 or more for every dollar that came in.

1 comment:

  1. The Inspector General was too kind. The situation is far worse. The IRS is "advised" by a number of committees, almost all of which are populated by lawyers and accountants representing the large institutions whose escaped taxes constitute the majority of the Tax Gap. Who appoints these parties? Some, the IRS itself (so you know where its sympathies lie) and some by the President or Treasury Secretary (so you know where their sympathies lie). In fact, I can think of no public-interest individual sitting on any of those committees. It's a wonder some of the staff still has the guts to try and be principled in the face of the tsunami of bad advice that colors the IRS executives' way of thinking.