Incompetence, Gross Mismanagement & Fraud: 3. The Tax Gap

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The vast majority of US citizens pay the federal taxes that they legally owe. Most people earn a wage and taxes are withheld from their pay. Any interest or dividends they earn are reported directly to the IRS by their banks and brokerage firms. They file a tax return, take the standard deduction and either pay what is due or receive a refund.

Unfortunately, a large number of individuals with business income DO NOT pay the taxes they legally owe. As a result, all the honest taxpayers will ultimately have to pay more tax.

The “Tax Gap” is the difference between taxes owed and taxes paid on time. The Government Accountability Office (“GAO”) estimates the gross Tax Gap to be $458 billion annually. IRS recoveries average $52 billion per year, resulting in a net Tax Gap of $402 billion. So, in the last five years, the federal government missed out on over $2 trillion of tax revenues it should have collected.

There are three underlying causes of the Tax Gap. By far, the biggest problem is underreporting of income, which accounts for 84%. The next 9% of the Tax Gap is from underpayment and the last 7% from non-filing.

About 70% of the Tax Gap occurs in individual income taxes and most of this with business income. Remember that sole proprietors, partnerships, LLC’s and S-Corps all flow income through to owners who then pay the resulting taxes on their individual returns. Unlike wage earners, whose salaries are reported directly to the IRS, there is little or no third party verification of private business earnings. The extent of problem is outlined below:

Source of Income

Net Misreporting Percentage

Wages, Salaries, Tips

1%

Interest, dividends, Tax refunds, Pensions and Annuities

7%

Partnerships, S-Corps, Estates, Trusts, Alimony, Capital Gains

19%

Sale of Business Property, Sole Proprietor, Farm Income, Rents, Royalties, Other

63%

Source: GAO analysis of Internal Revenue Service information, GAO 18-39

To be clear, only 1% of wage, salary and tip earners misreport their income for tax purposes. At the other end of the spectrum, 63% of individually owned businesses (sole proprietors, farmers and landlords…) misreport their income to the IRS.

Another 20% of the Tax Gap ($90 billion per year) occurs in Employment Taxes, like Social Security and Medicare withholding. The culprits are the same: pass-through and individually owned businesses that hire people “off the books” to avoid paying tax.

Underreporting of corporate income accounts for most of the remaining 10% of the Tax Gap. Most of this would be privately owned corporations who don’t need to file audits with the SEC.

The underlying problem is a failure in Washington to provide the IRS with sufficient resources to enforce the countries tax code.

Since 2010, when the Republican Party took control of the House of Representatives, the IRS has been under attack. Its budget has been cut every year and IRS staffing is down 13,000 as a result. Enforcement employees are down 23%. There were twice as many IRS Revenue Officers in 1954 than there are now. The number of audited returns is now at a 14 year low and the number of recommended tax evasion prosecutions has dropped 33% in the last four years.

Ironically, IRS enforcement spending makes money. The IRS recovers about $6 for every $1 spent. Small incremental investments would likely yield great increases in annual tax collections. To the extent greater enforcement led to a greater fear of being caught, the Tax Gap itself might start to shrink.

So, why haven’t our elected representatives done more to close the Tax Gap? A high correlation between tax-cheats and political donors might explain this.

 

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