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The “Tax Gap,” Reporting, and Withholding

2 min readBy: Joseph Bishop-Henchman

At the New York Times blog, economist Bruce Bartlett reviews IRS data indicating that Americans pay about 83.1 percent of the federal taxes they owe (the number rises to 85.5 percent after IRS enforcement actions). That leaves a “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. ” of $385 billion, in 2006.

He makes the case that information reporting (1099 forms and employer reporting) and 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 of the employee requests. make a big difference.

In areas the require both reporting and withholding (wages and salaries), only about 1 percent of income ($11 billion) goes unreported. For items that require information reporting but not withholding (pensions, Social Security and unemployment benefits, interest, and dividends), about 8 percent ($12 billion) goes unreported. For items that involve little or no information reporting (small business income, rents and royalties, etc.), the IRS estimates that 56 percent ($120 billion) goes unreported.

Bartlett argues that this is reason to spend more on enforcement but I’m not so convinced. After all, the IRS’s 84,000 employers were able to boost collections by only 2.4 percent, or $65 billion. Those were probably the easier enforcement cases, so it’s hard to say significantly increasing the IRS’s army of 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. collectors would bring in a big chunk of uncollected taxes. (The IRS budget is about $13 billion a year.)

Bartlett is also critical of the idea that high tax rates lead to high evasion, citing data that show tax compliance not changing much after the Bush tax cuts were enacted in 2001-03. I could note that those tax reductions did not involve significant reform to 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. , as did the 1986 reform. (I don’t have the data but I’m guessing noncompliance dropped after the 1986 reform.) There are doubtlessly other data points out there that would undermine Bartlett’s point. I’m often told that Russia moved to a flat taxAn income tax is referred to as a “flat tax” when all taxable income is subject to the same tax rate, regardless of income level or assets. in part to reduce noncompliance, though I don’t spend much time on international tax issues and can’t verify it for this short post.

Bartlett’s post is worth the read, as is the underlying IRS report.