The “Tax Gap,” Reporting, and Withholding

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 gap” of $385 billion, in 2006.

He makes the case that information reporting (1099 forms and employer reporting) and withholding 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 tax 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 base, 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 tax 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.