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Roundtable Discussion on the Tax Gap and Ways to Improve Tax Compliance

6 min readBy: Scott Hodge

Roundtable Discussion on the Tax Gap
Sponsored by the Department of the Treasury
March 9, 2007

Testimony by Scott Hodge, President, 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. Foundation

HODGE: Thank you for the opportunity to take part in this important discussion. The 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 1 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 2013, the average net gap was around 1 billion. is certainly one of the thorniest issues in the tax world today.

As I’ve watched this debate unfold over the past months, I’m oddly reminded of the debate over teenage drinking. A few years ago, the National Research Council and the Institute of Medicine produced a headline grabbing report that recommended dramatically higher taxes on beer and alcohol in order to dissuade kids from drinking.

The report was full of estimates of how many kids would stop buying beer because of such a tax. However the report was silent on estimates of what kind of a burden such a tax would place on responsible adults and legal drinkers.

We did that estimate and found the tax would boost the tax burden on every Joe Sixpack by at least $500 per year.

In other words, the tax would have a marginal impact on teen drinking (which is already illegal) but place a substantial cost on law-abiding adults.

I think we are facing the same dilemma in this debate. How much of an extra burden do we place on compliant taxpayers in order to raise a small amount of extra tax revenues from the non-compliant or those who make simple mistakes?

According to the IRS, the net tax gap is around $290 billion per year. But according to the most recent Tax Foundation estimates, the total compliance costs to individuals and businesses of the current income tax system is about $275 billion and rising.

The obvious question is, how much higher do we push that compliance burden in order to collect an indeterminate amount of tax revenues?

Clearly, none of us wants to encourage tax cheats because we know that tax evasion increases the burden on the rest of us. But are honest taxpayers – who already dread April 15th – willing to pay more to comply with the tax code in order to stop a few more tax cheats?

How about increasing the budget for the IRS? Members of Congress may not want to hear this, but even tax law is not immune to the economic law of diminishing marginal returns.

Our current voluntary tax system is generating a compliance rate of around 84 percent. To be sure, pushing the compliance rate to even 86 percent could be worth billions of dollars in new revenues.

But in all of the estimates that I’ve seen of the various plans to close the tax gap, I’ve yet to see a companion estimate of the added compliance cost burden on taxpayers. If we cannot accurately estimate those compliance costs, then we should be very cautious about moving forward with any new enforcement plan.

We should be particularly cautious about adding to the compliance burden of American businesses who already acting as the tax collectors for government. Look at the taxes we ask a typical business to remit:

  • Payroll taxes;
  • Personal income taxes withheld;
  • Unemployment insurance taxes;
  • Corporate income taxes;
  • General sales and excise taxes;
  • Property taxes;
  • Gross receipts taxes;
  • Franchise taxes and other business licenses.

Some might argue that any new reporting costs will be negligible because businesses already have the infrastructure and systems in place to remit all of these other taxes.

Tell that to the small business owner who is trying to make next month’s payroll. The study on small business compliance burdens that IBM conducted for the IRS found that the burden of just the income tax for a firm of 20-99 employees was 450 hours and $4,738. That translates into more than 11 days worth of paperwork (one day longer than my vacation allowance). Employment taxes added another 229 hours – another week of paperwork.

I agree with the General Accountability Office, the National Taxpayer Advocate and others that the only long-term solution to the tax gap it tax simplification and fundamental reform.

We all know the old chestnut that the primary goal of taxation is to pluck the goose so as to obtain the largest amount of feathers with the least amount of hissing. Sadly, we are well past that ideal.

The President’s Advisory Panel on Federal Tax Reform reported that since the 1986 tax reform act, lawmakers made more than 14,000 changes to the tax code – that’s 700 per year over twenty years, or nearly 2 per day.

Frankly, lawmakers are simply asking too much of the IRS and the tax system and neither one is functioning very well. For example, while the IRS is responsible for processing 135 million tax returns each year, Congress has demanded that it also become part of the welfare system by dispensing $50 billion in refundable credits through the EITC and the child credit.

And while the primary purpose of a tax system is to simply raise enough money to fund government programs, we are increasingly asking the tax code to direct all manner of social and economic objectives, such as: encouraging people to buy hybrid vehicles; save more for retirement; purchase health insurance; buy a home; adopt children; put them in daycare; take care of grandma; hire the unemployed, spend more on research; purchase school supplies; take out huge college loans; invest in historic buildings; and the list goes on.

The point is that we have so carved up the tax baseThe tax base is the total amount of income, property, assets, consumption, transactions, or other economic activity subject to taxation by a tax authority. A narrow tax base is non-neutral and inefficient. A broad tax base reduces tax administration costs and allows more revenue to be raised at lower rates. that trying to accomplish more social goals via the tax code will be like pushing on a string. As it stands today, some 43 million tax filers have no income tax liability after they’ve taken advantage of their credits and deductions. That’s one-third of all taxpayers who have now been dropped from the income tax rolls, a 50 percent increase in non-payers since 2000.

This means that we are asking more of those who are paying income taxes. These days everyone wants to pick on the top 1 percent of taxpayers. But these 1.3 million taxpayers shoulder a greater share of the tax burden (37 percent) than the bottom 90 percent of taxpayers combined – representing 117 million returns.

Finally, we need to ask why we want to close the tax gap. If we are trying to reduce the deficit by looking for loose change under the federal seat cushions, then there many other areas we can find money without increasing the compliance burden on honest taxpayers.

For example, last year the federal government wrote off $19 billion in bad loans and expects to write off another $22 billion this year and nearly $24 billion next year. Based on these trends, denying loans to deadbeats could save more than $100 billion over the next five years.

Similarly, the latest Financial Report of the Government tells us that federal agencies made about $42 billion in “improper” payments in 2006, up from $38 billion in 2005. This estimate does not even include high-risk programs such as Medicaid. Fixing this problem could possibly save more than $200 billion over the next five years without increasing the compliance burden on honest taxpayers.

It is easy to look at a $290 billion tax gap and see a pot of gold. But for many taxpayers, efforts to close that gap could become a mountain of paperwork.