March 19, 2007

The Cost of Closing the Tax Gap

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 children from drinking.

The report estimated the number of kids who would stop buying beer because of such a tax, but made no estimates on the burden such a tax would place on responsible adults and legal drinkers.

The Tax Foundation calculated the cost 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 am reminded of this study by the current debate over the so-called “tax gap” – the difference between what the IRS says taxpayers owe and what they pay. The IRS estimates the tax gap to be roughly $300 billion and the thought of recouping even a small portion of that amount has some Congress members in a tizzy.

The question missing in this debate is, 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?

Compliance cost is no small matter. According to the most recent Tax Foundation estimates, the total compliance cost to individuals and businesses of the current income tax system is roughly $275 billion and rising. The cost of this huge dead-weight loss to the economy should not be ignored.

A 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. Employment taxes added another 229 hours – another week of paperwork.

Even the best IRS estimates suggest strict reporting will only recoup a small portion of the tax gap. How much higher do we push that compliance burden in order to collect an indeterminate amount of tax revenues?

Further, hastily proposed legislation could make the cure worse than the disease and hinder our ability to manage future challenges.

The National Taxpayer Advocate identifies complexity in the tax code as a significant contributor to the tax gap. Indeed, ninety-four percent of non-compliance is attributed to mistakes made by people trying to follow the rules. A higher burden on taxpayers increases the likelihood of mistakes. If Congress wishes to see compliance rates rise, the evidence points to simplifying the tax code, not making it more complex.

Lawmakers have argued that closing the tax gap makes us fiscally responsible. But the tax gap is a problem not because it threatens our long-term fiscal outlook; rather, it is a symptom of a burdensome and complex tax code that few understand. To improve fiscal responsibility and close the tax gap, the only long-term solution is tax simplification and fundamental reform.

Today we are increasingly asking the tax code to direct all manner of social and economic objectives. The result is a Swiss cheese-like tax code rife with numerous preferences and special carve-outs for politically favored groups. As difficult challenges emerge, such as entitlement reform, the ability to collect revenue through a simple and efficient process will become crucial.

It is easy to look at the tax gap and see a pot of gold. But it will hardly be worth it if it means a mountain of costly paperwork for compliant taxpayers and making future tax reform significantly more difficult.

Scott Hodge is President of the Tax Foundation (

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