The Tax Gap: Measuring the IRS’s Bottom Line

By Cindy Blanthorne and Kristen Selvey Yance

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The primary purpose of the tax system is to raise revenue for the U.S. Government. According to the U.S. Budget, tax receipts represent 58.8% of federal revenue; the federal deficit is projected to be $364 billion and $521 billion for the years 2005 and 2004, respectively. Therefore, the $345 billion tax gap has a considerable effect on the federal budget (see “Analytical Perspectives: Budget of the United States Government, Fiscal Year 2005,” from www.whitehouse.gov).

While measuring the magnitude of the tax gap is important, from an economic standpoint identifying the source of the tax gap is a necessary precursor to developing a structured plan to reduce the gap. To guide enforcement efforts, policymakers must identify who is cheating as well as how they are cheating. Identification of tax-gap sources also matters from a psychological standpoint, because tax evasion has been linked to the perceived fairness of taxpayer burden. That is, taxpayers are more likely to cheat if they perceive others in similar situations (occupation, education, income) are cheating:

The United States has long been proud of the “taxpayer morale” of its citizens—the willingness to pay voluntarily the income taxes necessary to finance government activities. Taxpayer morale ultimately depends, however, on the belief that taxes are fair. If the basis for this belief comes under suspicion, voluntary compliance with the tax laws is jeopardized. ... Taxpayers resent paying substantially more than their neighbors who have equal or higher incomes. (“Tax Reform for Fairness, Simplicity, and Economic Growth,” U.S. Department of the Treasury, 1984; www.treas.gov/offices/tax-policy/library/tax-reform).

The Tax Gap Defined

The gross tax gap is the difference between the amount of tax that should have been paid, on a timely basis, and the amount actually received by the government for a specific tax year. In essence, it is the “bottom line” of the U.S. system of taxation. The amount received is relatively easy to quantify, but how much should have been paid if taxpayers were completely compliant requires estimation. The tax gap has three components: nonfiling, underreporting, and underpayment (“Understanding the Tax Gap,” FS-2005-14, www.irs.gov/newsroom/).

First, the nonfiling component is made up of taxpayers who do not file a tax return even though they are required to do so. It follows that taxpayers who do not file do not pay their tax liability. Second, the underreporting component is made up of taxpayers who file their tax returns but understate their tax liability. Underreporting can result from understated income or overstated deductions, exemptions, and credits. Third, the underpayment component is made up of taxpayers who file their tax return but do not make the required payment.

Tax-Gap Measurement

Surprisingly, detailed research on tax evasion has not been conducted in 17 years. All estimates of the tax gap reported in the last decade and a half have been based on data from the 1988 tax year. The 1988 data were gathered through an extensive audit process called the Taxpayer Compliance Measurement Program (TCMP). Data collection was halted in 1988 because of budget cuts and the belief that the program was too intrusive. TCMP audits required randomly selected taxpayers to provide documentation for every item on their tax return. Information collected during the TCMP audit period was analyzed and then used to score subsequently filed returns. A high score indicated a higher probability of noncompliance and, therefore, IRS scrutiny (see Darlene Pulliam Smith, “The IRS Market Segmentation Specialization Program,” The CPA Journal, February 2001).

A revised system of measuring tax compliance, the National Research Program (NRP), has been launched. The number of tax returns audited under the NRP does not differ substantially from the past program. However, the manner of selection and the actual review have been refined. The NRP randomly selects tax returns for review, with an oversampling of high-income tax returns. The sample-selection procedure facilitates analysis of important subcategories of taxpayers. For example, 6% of all individual income tax returns reported a profit or loss from business activities (i.e., Schedule C). Of the tax returns selected for review by the NRP, however, approximately 46% included a Schedule C (FS-2005-14).

The audit process of the NRP is less intrusive for taxpayers than TCMP audits were. The IRS shifted most of the burden onto itself through the use of information already available to the IRS. For instance, the TCMP required all audited taxpayers to provide line-by-line documentation of the amounts reported on their tax returns. Instead, only a small fraction of the tax returns selected for review through the NRP require line-by-line auditing. Furthermore, the IRS attempts to verify as many line items as possible before requiring the taxpayer to substantiate the amounts reported (“IRS Sets New Audit Priorities,” FS-2002-12, www.irs.gov/newsroom/).

Tax-Gap Estimate

The tax gap for the first NRP sample year—comprising approximately 46,000 individual income tax returns from 2001—was recently reported by the IRS. As shown in the Exhibit, the gross tax gap is estimated at $345 billion. The NRP estimate is higher than the related estimate based on the 1988 TCMP data, which was $311 billion. The NRP reported a noncompliance rate of 16.3% of the true tax liability.

As discussed above, the gross tax gap is broken down into three components: nonfiling, underreporting, and underpayment. The Exhibit shows that the majority of the tax gap is the result of the underreporting component. It is estimated that at least 80% of the gross tax gap, $285 billion, stems from taxpayers who underreport taxable income rather than taxpayers who do not file tax returns or who underpay their tax liability when they do file.

Individual income tax is by far the largest contributor, in terms of the type of tax, to the gross tax gap and the underreporting component of the tax gap. NRP estimates that $197 billion of underreporting is the result of noncompliance by individual taxpayers. Furthermore, tax evaders are much more likely to understate income than they are to overstate deductions, credits, and exemptions. Understatement stems from income invisibility and the lack of a paper trail. Income that is not reported by taxpayers is difficult for the IRS to discover. But deductions, exemptions, and credits must be substantiated by the taxpayer. Income from business activities makes up the majority of underreported income. In comparison to business income, income from other sources, such as wages or investment income, is more likely to be directly reported to the IRS by third parties, such as employers. Furthermore, income taxes owed on wage income are withheld by employers and remitted directly to the IRS, making the opportunity for underreporting minimal.

In the extreme, underreporting business income entails neglecting to report the existence of a business activity. It is difficult for the IRS to identify income from businesses that they do not know exist. In addition, this type of underreporting has the potential to lead to a second layer of evasion called the shadow economy. Cash payments for wages or supplies are less likely to be reported as income by recipients. Increased tax and Social Security obligations create incentives to work in the underground economy, where earnings go unreported. (For more detail, see F. Schneider and D.H. Enste, The Shadow Economy: An International Survey, Cambridge University Press, 2002.)

Negative Effects of the Tax Gap

As the primary source of revenue for the U.S. government, a tax system with a significant gap between what it collects and what it is owed negatively affects the government’s finances. With rising healthcare costs and the baby boom generation entering retirement, federal spending on Medicare, Medicaid, and Social Security programs is projected to grow dramatically in the coming years. Budget simulations completed by the Government Accountability Office (GAO) predict an unsustainable fiscal path that is likely to “erode … our economy, our standard of living, and ultimately our national security” (statement of David M. Walker, Comptroller General of the United States, “Tax Gap,” Testimony Before the Committee on the Budget, U.S. Senate, GAO-06-453T, available from www. gao.gov).

The magnitude of the tax gap has serious financial ramifications for the U.S. federal budget and imposes a significant and unnecessary financial burden on individual citizens who honestly comply with the tax law. Yet it is unrealistic to expect the tax gap to ever be zero. An effective system must measure the tax gap and identify its sources in order to direct monitoring and enforcement efforts. The NRP is the IRS’s attempt to accomplish these goals with minimal intrusion to taxpayers.