Mind the (Tax) Gap
It's a federal budget fix-all... but what is it?
I’m excited to announce Robert Kerr, the former Executive Vice President of the National Association of Enrolled Agents, will be contributing occasional articles related to tax policy and administration. Welcome, Bob, and I look forward to your opinion on important tax issues. -Tom
The tax gap has been everywhere in recent months. In fact, I would argue “tax gap” is a contender for Tax Word of the Year (note to self: this would be *so* cool), in a year in which that title will be difficult to secure (other contenders: “stimmy,” “advanced Child Tax Credit,” and “Error Resolution”). Even today, the new, compromise infrastructure bill includes reducing the tax gap as a significant ‘pay-for.’
But what is the tax gap? Put simply, the tax gap is the difference between the amount of tax imposed on taxpayers for a given year and the amount paid voluntarily and timely.
Before we go further on the Tax Gap, back up for a moment. When I was a baby bureaucrat, I worked in the IRS National Office Research Division, which was (and still is) responsible for measuring the Tax Gap (it’s also responsible for the DIF score, but that’s another story unto itself). In the 1990s (and for years prior to then), the Research Division managed tax gap measurements through the Tax Compliance Measurement Program (or TCMP).
If losing audit lottery is terrible, selection for a TCMP audit was heinous. How heinous? A TCMP audit was a full, line-by-line defense of one’s return. For instance, for a MFJ return, IRS asked the taxpayers to prove they were married.
I read repeatedly a TCMP audit was akin to an autopsy without the benefit of being dead first. In 2006, then-Commissioner Mark Everson testified as such. The testimony also provides great background on the bad old days of how IRS used to measure the tax gap and, the agency’s transition to a kinder, gentler process, the National Research Program (NRP). If you’re looking for something to accompany your Saturday rosé, I recommend reading at least the first few pages of Commissioner Everson’s testimony.
One important takeaway: an NRP audit cycle takes years to complete, is (generally, at least in my experience) focused on a particular tax type (e.g., individual Forms 1040 or partnership returns or estate taxes) and IRS does not perpetually conduct NRP audits. As a result, the most current NRP results, which underpin IRS estimates of the size of the tax gap, are roughly 10 years old.
IRS has over the course of many decades given serious thought and expended serious resources in attempting to measure the tax gap and I devote a few paragraphs to this because it underpins the entire conversation.
So now on to Tax Gap 101. We should each understand at least three fundamental issues when it comes to the tax gap:
IRS considers three compliance measures, filing compliance, reporting compliance, and payment compliance. In other words,
Did the taxpayer file her/his required returns timely?
Is the filed return an accurate representation of income from whatever source derived and allowable expenses?
Did the taxpayer make complete, timely payment of all taxes due?
IRS also categorizes the tax gap by five different tax types:
Individual income tax
Corporate income tax
Employment taxes (FICA and FUTA, or payroll taxes)
IRS considers two types of payments:
Voluntary (through withholding or estimated payments)
Enforced (through IRS enforcement—exam and/or collection) or late
The tax gap, therefore, is measured by periodically NRP audits which are also periodically updated (or, I would argue, re-estimated) by IRS researchers, and, according to the Service (in Publication 5364, updated 9-19), “provides a rough gauge of the level of overall noncompliance and voluntary compliance given all the events that occurred during the relevant tax periods and the…IRC provisions in effect at the time.”
IRS in 2019 released its latest estimate, for tax years 2011, 2012, and 2013. While Commissioner Chuck Rettig a few weeks ago during a Senate Finance Committee hearing conceded the tax gap today might be as large as $1 trillion annually, the last official estimate of the gross tax gap (that is the gap before IRS enforcement efforts and other late payments) was $441 billion annually, and after late payments and enforcement efforts to the tune of $60 billion, the net tax gap was estimated at $381 billion (or a rate of approximately 85.8%).
For those who are visual learners, IRS provides Publication 5365.
There’s a lot to unpack here, but I’ll limit myself to two political observations:
The recent excitement in DC with respect to the tax gap is entirely focused on the difference between the gross tax gap and the net tax gap, the bulk of which legislators assume (not unreasonably IMHO) is wrested from noncompliant taxpayers through IRS enforcement efforts, either through audit or collection.
More specifically, the long-held (and again IMHO not unreasonable) operating assumption is every dollar provided to IRS for enforcement yields much more than one dollar in revenue…without raising taxes.
Also important to keep in mind, and I’ve heard IRS officials state as much: IRS is not going to make a serious run at closing the tax gap through audits (and enforced collections) alone. A system based on voluntary compliance requires the agency both to inform, educate, and assist taxpayers who are attempting to meet their filing, reporting, and payment requirements and to compel through enforcement efforts those who are tempted not to meet those requirements.
As we look at efforts to lessen the tax gap by increasing IRS resources, we are well advised to look at the full scope of increased funding and staffing. Where is that funding going? Will it make tax administration more effective and efficient, and will it meet the 21st century expectations of a public accustomed to Amazon and Fidelity levels of service?
And finally, something I’ve been saying for decades: no one wants to live in a world in which the tax gap is zero. The system leaks. It always has. It always will. The goal is to create a system in which those who would like to comply (and their representatives/ preparers) can count on IRS assistance and those who are inclined not to comply think twice about the wisdom of that approach.