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Three Steps to Help Close the Tax Gap

Americans paid about 82 percent of the federal taxes they owed for tax years 2008-2010 voluntarily and on time, according to new IRS data.  Including enforcement and late payments, that number rises to 84 percent.  But this means that the government didn’t collect an annual average of about $406 billion of owed taxes over that period. 

While this share of uncollected taxes was about the same as in the previous 2006 estimates, this large sum of annual lost revenue shows that there’s a lot of room to improve tax collection, and that honest taxpayers deserve more than they’ve been getting from Congress.  Here are three places to start.

  1. Increase — don’t cut — the IRS enforcement budget.  The final year of this new data, 2010, was also the last before House Republicans began targeting the IRS budget for deep budget cuts.  The enforcement budget has been hit hard: IRS enforcement personnel have been cut by 23 percent since 2010 (see chart).  Nearly one in every four IRS staff charged with pursuing tax cheats is no longer on the job.  Audits, criminal investigations, and convictions are down.  This sends a risky message to both honest and dishonest taxpayers.  It also undermines a basic and necessary function of government.  Policymakers should reverse this downward trend.

  2. Focus on the biggest source of the tax gap: the under-reporting of business income on individual tax returns.  So-called pass-through businesses — S corporations, sole proprietors, and partnerships — underreported their business income enough that they failed to pay $125 billion in individual income taxes on average between 2008 and 2010, according to the IRS data.  This was the largest single source of the tax gap.  Sole proprietors, for example, underreported their income by 63 percent. Moreover, small businesses underpaid self-employment taxes by another $65 billion.  Combined, these two pieces account for 41 percent of the tax gap.

    In contrast, IRS data show that all individual tax credits combined, including the Earned Income Tax Credit (EITC), account for less than 10 percent of the tax gap.  That may surprise those following congressional debates on tax compliance, which focus far more on issues related to the EITC than to small businesses.  Indeed, Congress has strengthened EITC tax compliance, including as part of last year’s tax deal, but it’s made little effort to address poor small business compliance.   This double standard is both inefficient and unfair — particularly in light of the new IRS data.

    The IRS report highlights the lack of third-party information on this small business income.  (The Government Accountability Office has reported this in the past, too.)  The best way to encourage people to comply with the nation’s tax laws is to create a paper trail, such as the W-2 forms that employers send the IRS regarding their workers.  Policymakers took a step in 2009 to require more such reporting for small businesses but they repealed the requirement in 2011 before it even took effect.  We need to strike a balance between encouraging tax compliance and not requiring excessive paperwork, as I’ve noted in the past, but these figures show the need for action.

  3. Require paid tax preparers to be competent.  Most people use a paid preparer to file their taxes.  These preparers should know what they’re doing.  Senate Finance Committee Democrats recently advanced an amendment to require paid tax preparers to meet a basic level of competency.  Some Republicans have suggested that they understand the importance of the issue, and lawmakers should attach such an amendment to identity theft legislation as it moves forward.
Chuck Marr
Vicepresidente de Política Tributaria Federal