How Much Does the US Government Lose to Tax Fraud?

A recent report by the nonpartisan Government Accountability Office (GAO) estimates the federal government loses $116 billion to $304 billion annually to taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. fraud. That amounts to between two and six percent of federal taxes owed. It also exceeds the entire budget of the Supplemental Nutrition Assistance Program (SNAP), a leading anti-poverty program.

The report adds to the case for a simpler tax code and better-coordinated fraud enforcement at the IRS.

What Is Tax Fraud?

Tax fraud is one component of the larger tax gapThe tax gap is the difference between taxes legally owed and taxes collected. The gross tax gap in the U.S. accounts for at least $441 billion in lost revenue each year, according to the latest estimate by the IRS (2011 to 2013), suggesting a voluntary taxpayer compliance rate of 83.6 percent. The net tax gap is calculated by subtracting late tax collections from the gross tax gap: from 2011 to 2—the gap between estimated federal taxes owed and actual federal taxes paid on time each year. The GAO study is novel in its attempt to formally measure tax fraud within the tax gap; the IRS does not offer a separate estimate of tax revenue lost due to fraud.

Some examples of tax fraud include:

• Tax evasion from inaccurately reporting taxes or not filing taxes
• Return preparer fraud
• Identity theft tax refundA tax refund is a reimbursement to taxpayers who have overpaid their taxes, often due to having employers withhold too much from paychecks. The U.S. Treasury estimates that nearly three-fourths of taxpayers are over-withheld, resulting in a tax refund for millions. Overpaying taxes can be viewed as an interest-free loan to the government. On the other hand, approximately one-fifth of taxpayers u fraud

GAO reports that much of the revenue lost due to tax fraud occurs in the so-called “shadow economy.” The shadow economy, which economic literature reviewed by GAO suggests could equal anywhere from two to nine percent of GDP, includes:

• Workers who earn income in cash and/or pay for goods and services in cash, and do not report that income to the IRS or pay taxes on what they owe
• Businesses that pay workers in cash and fail to pay income taxes or remit payroll taxes to the federal government
• Individuals who gift or transfer cash or assets to family members or friends without reporting them, even if the value of the gift or transfer must be reported to the IRS

Tax Fraud, Tax Gap, and Improper Payments: What’s the Difference?

The larger tax gap measures taxpayer noncompliance through intentional fraud and unintentional errors, and was about $696 billion as of tax year 2022. That amounts to 15 percent of taxes owed and indicates fraud is about 17 to 44 percent of the tax gap—a substantial share.

After the IRS collected late payments and money recovered through audits (about $90 billion), the remaining gap was $606 billion.  

Most of the tax gap, about 77 percent, is from underreporting, with the remainder due to nonfiling and underpayment of tax. Most of the underreporting, about 71 percent, occurs in the individual income taxAn individual income tax (or personal income tax) is levied on the wages, salaries, investments, or other forms of income an individual or household earns. The U.S. imposes a progressive income tax where rates increase with income. The Federal Income Tax was established in 1913 with the ratification of the 16th Amendment. Though barely 100 years old, individual income taxes are the largest source, concentrated in sole proprietorship income, representing $117 billion or 17 percent of the tax gap. The IRS finds that sole proprietorship income and other sources of income with little to no third-party reporting or withholdingWithholding is the income an employer takes out of an employee’s paycheck and remits to the federal, state, and/or local government. It is calculated based on the amount of income earned, the taxpayer’s filing status, the number of allowances claimed, and any additional amount the employee requests. tend to have high rates of noncompliance.

A related issue—and one component of the tax gap—is improper payments associated with refundable tax credits, such as the earned income tax creditA tax credit is a provision that reduces a taxpayer’s final tax bill, dollar-for-dollar. A tax credit differs from deductions and exemptions, which reduce taxable income rather than the taxpayer’s tax bill directly. (EITC) and the child tax credit (CTC). Improper payments are either overpayments or underpayments that the government should not have made or could not verify were made to the correct person in the correct amount. According to the latest estimates by the Treasury Department and the IRS, improper payments in fiscal year 2025 totaled $28.1 billion for four major refundable tax credits.

As with the overall tax gap, not all improper payments of refundable credits are due to intentional fraud. The complex rules and confusing structure of the EITC, CTC, and PTC can lead to unintentional errors—and ultimately overpayments or underpayments—which are all labeled improper payments in government data.

Can Congress and the IRS Reduce the Tax Gap?

It is not possible to eliminate fraud completely, which GAO recognizes, nor is it possible to eliminate the tax gap. However, improvements could be made to reduce fraud and the tax gap.

GAO made two recommendations in its report on tax fraud:

• The IRS should develop an anti-fraud strategy that spans the entire agency; currently, anti-fraud responsibilities are split up by division.
• The IRS should also designate a single entity within the agency responsible for carrying out the anti-fraud strategy and overseeing agency compliance.

And what of the bulk of the tax gap that is not due to fraud? Based on IRS analysis of the tax gap as well as our understanding of the problems associated with tax complexity in the US and other countries, we recommend the following:

• First, Congress should simplify the tax code to reduce taxpayer confusion.
• Second, lawmakers should streamline the tax code to focus tax collections on verifiable streams of income that can be withheld at the source, such as income and payroll taxes on wages.
• Third, Congress and the IRS should tighten verification of taxable incomeTaxable income is the amount of income subject to tax, after deductions and exemptions. Taxable income differs from—and is less than—gross income.  , for instance, by improving third-party reporting, and further expand withholding. Third-party reporting means someone besides the taxpayer, such as an employer or payment platform, also reports the income to the IRS.

Tax complexity is a serious problem. It leads to taxpayer confusion and errors and imposes a significant compliance cost, about $544 billion this year—nearly the size of the tax gap. Much of the tax code’s complexity and compliance cost falls on businesses.

The complexity of the business tax code reflects the challenge of defining business income, including rules that differ by business form (C corporations, S corporations, partnerships, sole proprietorships, etc.), and a multitude of information reporting requirements (such as 1099 forms) that generally serve to bolster compliance across the broader federal tax system. In that sense, it is challenging to streamline the tax code in a way that boosts compliance.

One option is fundamental reform that replaces complicated corporate and other business income taxes with a tax on distributed profits, combined with a simplified individual income tax at the same rate. This approach has been successful in Estonia and other countries, resulting in low compliance costs, a low corporate tax gap, and a competitive tax code with revenues on par with other developed countries. A more piecemeal approach would eliminate unnecessarily complicated deductions, credits, minimum taxes, and other special provisions from the tax code.

Congress can also reduce improper payments of refundable credits by simplifying the tax code and streamlining definitions. For example, the EITC currently differs by filing status and number of children, and parents and guardians must go through a complex set of steps to determine if their child is eligible. The qualifying child rules also differ between the EITC and CTC, adding to taxpayer confusion.

The EITC and CTC could be simplified by consolidating the child benefit in one credit—a reformed child credit—and limiting the EITC to a per-worker incentive regardless of family dimensions. This was proposed by former Sen. Mitt Romney (R-UT), for example.

Another way to reduce improper payments is to expand Treasury’s Do Not Pay system. As noted by Romina Boccia, Treasury has recently bolstered the system and found some success in preventing payments to deceased recipients. However, Treasury lacks statutory authority to expand the system to effectively check improper payments related to employment status, income, and identity.

Big Picture

The federal government loses hundreds of billions of dollars per year to tax fraud, and hundreds of billions more to unintentional noncompliance. While it is impossible for the federal government to eliminate tax fraud or fully close the tax gap, Congress can make improvements to the tax code—and the IRS to tax administration—that reduce the gap and close openings for fraudsters. At the top of the list should be simplifying a Byzantine tax code that contributes to the gap between taxes owed and taxes paid.