IRS Tax Compliance - A Costly Business

Updated September 2017

For millions of American individuals and businesses, the IRS tax code is becoming increasingly complex, largely because of its massive size.  Federal tax law has grown from 400 pages in 1913 to a staggering 73,954 pages in 2013 as shown on this diagram from Wolters Kluwer, CCH:

As you can see, over the past two decades alone, the tax code has risen from 40,500 pages in 1995 to its current level of 73,954 pages, an increase of 82.6 percent.  Interestingly as well, the federal tax code stood at 409,000 words in 1955 and has expanded to its current 2.4 million words, almost six times as long as it was sixty years ago.  That said, the Congressionally-passed tax statutes are only part of the tax paperwork mountain; if one includes the words that clarify how the U.S. tax code actually works, the number of words increases to 7.7 million.  When tax-related case law is included, it adds an additional 60,000 pages.

An analysis by the Tax Foundation shows us the high cost of the massive U.S. tax code to the American economy.  Obviously, the complexity of the tax code has real costs for both American households and businesses.  The Office of Information and Regulatory Affairs estimates that Americans will spend more than 8.9 billion hours complying with IRS tax filing requirements in the 2016 tax year.  This is equivalent to 4.3 million workers doing nothing but tax return paperwork with 2.6 billion hours being affiliated with individual income tax returns and 2.8 billion hours being affiliated with business income tax returns.

Here is a table showing the estimated hourly and compliance costs of IRS paperwork in 2016:

The authors of the study used two different hourly compensation costs:

1.) for large business forms and complex forms including estates, an hourly compensation cost of $52.05 was used for professional and related workers.

2.) for all other forms, an hourly compensation cost of $37.28 was used since it is the average compensation for all full-time private sector workers.

In total, the 8.906 billion hours spent to ensure tax compliance are estimated to cost $409,241,340,626.  This is greater than the gross economic product of 36 states.

There is a high cost for businesses who want to stay on the right side of the IRS.  The cost of business compliance stands at $147 billion or 36 percent of the total.  Businesses that become S corporations to avoid the additional taxation that is applied to C corporations have total compliance costs of $46 billion annually.  It costs individuals who wish to keep the IRS happy $99 billion annually.  When you think clearly about this, particularly in the case of businesses, spending on tax code compliance means that spending on other items like capital goods and hiring more employees is reduced.  As the tax code has become more complex, businesses have had to set aside more and more of their profits to ensure that the multitude of tax forms that must be filled out annually are filled out correctly, particularly given the rapid evolution of the tax code.

A 2008 study by the Taxpayer Advocate Service for the 2006 tax year showed that if tax compliance were an industry, it would be one of the largest in the United States.  That study showed that it took an average of 26.4 hours for an individual to complete their tax return and other reporting documents.  Corporations required 193.77 hours for the corporation income tax return (Form 1120) and other types of returns and information reporting documents required a widely varying number of hours as shown here:

Obviously, the complexity of the IRS tax code has passed the point of reason.  When it takes highly paid tax professionals to ensure that taxpayers are compliant with every aspect of the tax code, there is something wrong with the tax system.  Oddly enough, even though politicians often campaign on simplifying the tax code, reality shows that this is one promise that has never been kept.

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.