As Tax Day is upon us, roughly 150 million Americans will file tax returns. However, some won’t, and some will underestimate their tax liability. These tax noncompliance issues lead to the “tax gap,” or the difference between what the government expects to take in in terms of revenue and what it actually receives.
Between 2008 and 2010, the IRS, on average, took in $458 billion less in tax revenue than they were owed, or roughly 18.3 percent less than expected. Taking into account average tax overpayment of $52 billion annually, the IRS faced an average net tax gap of $406 billion. Given the decline in IRS funding over the past decade, it wouldn’t be surprising if the current tax gap was significantly larger.
If you want lower taxes, you should be concerned about the tax gap. If some people don’t comply with tax laws, compliant taxpayers have to bear a larger burden of funding government services. Shrinking the tax gap would generate more revenue that could allow for lower tax rates. Not to mention that increasing tax compliance through better enforcement is a much less economically harmful way to raise revenue than most of the tax hikes currently on the table.
There are a few approaches to reducing the tax gap.
Option 1: Simplify the Tax Code
According to the National Taxpayers Union, the total compliance costs of the whole federal tax code was $303.8 billion in tax year 2017. This estimate includes both $31.9 billion in out-of-pocket spending on tax compliance (paying for software, accountants, office supplies etc.) as well as the opportunity cost of the time spent complying that could have been spent earning an hourly wage.
As AEI economist Aparna Mathur noted, some studies have shown that tax noncompliance increases when the time-cost of compliance is high. Therefore, tax reforms to lower tax compliance costs should also somewhat increase tax compliance and tax revenue. For example, when the Tax Cuts and Jobs Act doubled the standard deduction and curbed several itemized deductions, it led many more taxpayers to switch to the much simpler standard deduction. Changes to the income tax in the TCJA on net saved individual taxpayers between $3.1 and $5.4 billion in terms of lower compliance costs, but those changes might have also helped reduce noncompliance.
There are plenty of simplifications to make to the existing tax code to lower compliance costs. The pass-through deduction that the TCJA created is projected to cost $1.3 billion in compliance costs annually, and is also prone to abuse. Eliminating itemized deductions from the personal income tax would raise a lot of revenue, but it would also save the remaining 18 million itemizers roughly 5.6 hours each by switching to the standard deduction. Assuming an average private sector hourly wage of $37.28, that would reduce the time-cost of compliance by roughly $3.77 billion.
Simplifying the Earned Income Tax Credit could also help. Eliminating itemized deductions would reduce the need for the Alternative Minimum Tax, a poorly designed provision of the tax code designed to rein in tax break abuse among high-income taxpayers, and as a result, eliminate the high compliance costs associated with the AMT.
Option 2: Increase IRS Enforcement
The IRS’s budget has declined by 17 percent after adjusting for inflation since 2010, and as a result, its enforcement staff has shrunk by almost 25 percent. A decline in IRS enforcement has meant fewer audits of high-income tax filers, and the potential for an audit is shown to increase tax compliance.
Strengthening IRS enforcement funding would bring in much more tax revenue than additional spending on enforcement would cost. The IRS’s own estimates found that one additional dollar of general IRS funding would raise $5 in revenue, and that one dollar of additional enforcement spending would raise $12. Meanwhile, the Congressional Budget Office estimated that increasing IRS enforcement funding by $20 billion over the next decade would result in $55 billion in new revenue. And former Treasury Secretary Larry Summers recently asserted that an additional $40 billion in IRS enforcement funds specifically auditing more high-income taxpayers could lead to $300 billion in new revenue over the next decade.
Option 3: Reform Tax Filing
Levels of tax noncompliance vary widely depending on the type of tax. For example, taxes that are withheld by a third party have much higher rates of compliance. The tax gap for taxes on wages, salaries, and tips is only 2 percent, as opposed to the average tax gap of 18.3 percent. However, tax gaps are much larger for self-employment income earned through sole proprietorship businesses.
There are two approaches to consider. One would be shifting to a tax system that relies on taxes with lower evasion rates. Value-added taxes, on average, have smaller tax gaps than the US income tax does. Another option would be return-free filing, where given that the IRS receives a lot of information from employers and banks about many filers’ income streams, the IRS could send a person their tax form pre-filled. According to a 2005 analysis, this would save taxpayers $2 billion a year in tax prep costs and $4.4 billion a year in time-costs in addition to reducing the tax gap. Unfortunately, tax preparation companies like TurboTax and H&R Block have supported a provision of a bill that recently passed the Ways and Means Committee that would permanently ban the IRS from developing its own online filing service in order to protect their business model, which relies on taxes being difficult to comply with.
There Will Always Be a Tax Gap
The tax gap will never be $0, and that’s probably a good thing. There comes a point where spending an additional dollar of taxpayer money is not whatever revenue it would raise. However, the tax gap does not have to be as high as it is. And as deficits have skyrocketed to unprecedented levels, policymakers should look to how to raise revenue in the least economically harmful ways possible. Reducing the tax gap is a great way to do that.
