Annette Nellen
Narrowing the tax gap for tax reform

Comprehensive tax reform should not ignore the $450 billion annual tax gap.

March 14, 2013
by Annette Nellen, Esq., CPA

Comprehensive tax reform is clearly an agenda item for lawmakers in 2013. In February, House Ways and Means Committee leaders established 11 working groups to study various aspects of tax reform and announced an email address to allow for public input on tax reform (tax.reform@mail.house.gov). (Committee press release of 3/1/13). To signal his commitment, House Speaker John Boehner, R-Ohio, reserved high-profile bill number H.R. 1 for anticipated comprehensive tax reform legislation.

In his 2013 State of the Union address, President Barack Obama stated: “Now is our best chance for bipartisan, comprehensive tax reform that encourages job creation and helps bring down the deficit.” One element of tax reform—reducing the tax gap—could provide a revenue source. Politicians need to resolve whether that revenue is used for tax reductions (revenue-neutral tax reform) or also for deficit and debt reduction. This article reviews tax gap data, proposals for reducing the gap, and the prospects for change.

The tax gap

The tax gap is the amount of tax dollars that go uncollected due to both intentional and unintentional errors. The IRS defines the tax gap as the amount of taxpayer liability that is not paid on time (IRS Tax Gap). The most current data from the IRS show that the gross annual tax gap was approximately $450 billion for 2006. Enforcement activity brings this down to a net annual gap of $385 billion, which equates to a compliance rate of roughly 86% (IR-2012-4).

How significant are these numbers? The National Taxpayer Advocate (NTA) translates the tax gap into a “surtax” paid by compliant taxpayers. Using the existence of 116 million U.S. households, the NTA states that the tax gap results in households each “effectively paying a ‘surtax’ of some $3,300 to subsidize noncompliance by others” (NTA, 2012 Annual Report to Congress, Vol. 1, page 7).

For additional perspectives on understanding the significance of the size of the tax gap, consider the following:

  • Per the Office of Management and Budget (OMB), the deficit for fiscal year 2011 was $1.3 trillion. The net tax gap represented about one-third of that amount (OMB, Table 1.1).
  • Per IRS data, for FY 2011, the net tax gap exceeded net tax collections for the corporate income tax and tax-exempt unrelated business income tax ($175 billion), excise taxes ($47 billion), and estate and gift taxes ($7.3 billion) combined (IRS, Data Book, Table 1).

IRS data on the tax gap, illustrated in the IRS Tax Gap Map, indicate that the largest sources of the gross tax gap are underreporting of business income on individual returns, consisting of $122 billion of income tax, and $57 billion of self-employment tax.

GAO suggestions

Over several decades, the U.S. Government Accountability Office (GAO) has issued reports on ways to reduce the tax gap (see Nellen, “Closing the Tax Gap,” Tax Insider, Aug. 14, 2008.) Listed below are GAO recommendations from a February 2013 report (GAO, High Risk Series, Feb. 2013, GAO-13-283, pages 230–234). An analysis of the feasibility of these suggestions follows:

Expand information reporting: The GAO notes that when income information is reported to the IRS and the recipient, such as by Form 1099, compliance is improved. Thus, a logical tax gap measure is to increase information reporting. The GAO suggests expanding information reporting to include payments made by businesses to corporations and for payments made by landlords. The GAO observes that, per Joint Committee on Taxation estimates, these changes would raise $3.4 billion and $2.5 billion, respectively, over 10 years.

The information reporting suggested by the GAO has already been enacted and repealed by Congress because it is unduly complex (see Bernard, “Expansion of 1099 Reporting Requirement Repealed,” Corporate Taxation Insider, April 28, 2011). Some of the complexity stems from tracking the payment data and its interaction with Sec. 6050W, which already requires information reporting for certain credit and debit card payments on Form 1099-K, Payment Card and Third Party Network Transactions. For example, ABC, a small business, purchases office supplies from X, a corporate supplier. If ABC uses a credit card, the sales will already be reported on a Form 1099-K issued by the credit card processor. Thus, ABC should not also issue a Form 1099 for credit card purchases. There are also costs of issuing Forms 1099. To require a small business to issue a Form 1099 to a large corporation that is likely already in compliance is not a good use of resources.

If any expansion of Form 1099 reporting as suggested by the GAO is enacted, Congress should consider the following issues:

  • Not require issuance of Forms 1099 to publicly traded corporations.
  • Simplify the Form 1099 issuance process for small businesses and landlords such as by creating a website where the data can be entered and the Form 1099 generated and mailed by the IRS to the payee. This process could also be made part of the pre-populated return idea former Commissioner Douglas Shulman promoted (IR-2011-38).
  • Repeal Sec. 6050W to simplify recordkeeping. While this would eliminate an information source for the IRS, the IRS has not yet been fully using Form 1099-K to gather information. For 2011 returns, the form was noted on the gross receipts line of income tax forms for businesses with the instruction to enter zero (rather than the Form 1099-K amount). For 2012 returns, there is no reference to Form 1099-K (also see the IRS’s “Third Party Information Reporting Center”). Alternatives should be explored for finding businesses that might not be reporting sales, such as perhaps those selling through third-party websites. Other alternatives include information sharing with states and IRS examinations targeting individuals selling goods and services via the web.
  • Connect tax rules with information reporting where feasible and appropriate. For example, if an individual claims an energy credit, he or she should be required to provide the name and address of the vendor who sold the energy equipment. That information can be reported on the form for claiming the credit.

Expanded math error authority: The GAO suggests that Congress grant the IRS greater “math error authority” to enable it to address more mistakes prior to issuance of a refund. The NTA has pointed out, though, that expanded math error authority might harm taxpayer rights in some instances (NTA, 2011 Annual Report, pages 74–92). The IRS should work with Congress to reconcile greater math error authority while protecting taxpayer rights.

Regulating paid return preparers: The 2013 GAO report notes that in generating “approximately 60 percent of all tax returns filed, paid preparers have an enormous impact on IRS’s ability to administer tax laws effectively.” It also notes that the program has been limited by the district court’s decision in January 2013 that struck down the IRS’s registered tax return preparer program (Loving, No. 1:12-cv-00385-JEB (D.D.C. 1/18/13)) (The IRS is pursuing an appeal of that decision.)

The IRS should pursue its return preparer regulation program that reaches more than 300,000 preparers who are not otherwise subject to Circular 230, Regulations Governing Practice Before the Internal Revenue Service (31 C.F.R. Part 10), requirements such as for due diligence. While preparers are subject to various penalty provisions, such as Sec. 6694, the conduct rules in Circular 230 are more specific, and the requirement in the return preparer program for continuing education makes sense given the frequent changes in the tax laws and the different transactions preparers must handle on returns. To be certain regarding IRS authority to regulate all paid preparers, Congress should amend Section 330 of Title 31, which allows the IRS to regulate representatives who practice before it, to ensure that it unambiguously authorizes the IRS to regulate return preparers.

Simplification: The GAO notes that simplification of the tax system can reduce the tax gap. No doubt, complexity of the federal tax system leads to unintentional errors and disrespect for the system. The GAO report states:

A broader opportunity to address the tax gap involves simplifying the Internal Revenue Code, as complexity can cause taxpayer confusion and provide opportunities to hide willful noncompliance. Fundamental tax reform could result in a smaller tax gap if the new system has fewer tax preferences or complex tax code provisions, reducing IRS’s enforcement challenges and increasing public confidence in the fairness of the tax system (GAO, supra, page 232).

Homing in on the big dollars

As shown in the IRS Tax Gap Map, the most significant way to generate revenue from the tax gap would be to reduce its largest piece—underreporting of business income. Here, the GAO has also issued suggestions (see Rep’t No. GAO-07-1014, Table 2, pages 30–31).

New information to help reduce this portion of the tax gap was generated by the NTA in its 2012 annual report. That report includes the results of an independent survey to identify factors that influence voluntary compliance by small businesses (Compliance Study). Taxpayers in the high-compliance group had greater trust in the government and were likely to rely on preparers. Those in the low-compliance group tended to be suspicious of government, view the tax system as unfair, and were less likely to follow the advice of their preparer. Both compliance groups viewed the tax system as complex and cheating as wrong.

This additional information should be considered along with information from the IRS, the GAO, and others to develop administrative and legislative proposals to reduce the largest portion of the tax gap.

Looking forward

Comprehensive tax reform should yield a better tax system. That system should be simpler with greater collection of the dollars owed by all taxpayers, that is, a smaller tax gap. There are many suggestions available for Congress and the IRS to consider. Given the size of the net tax gap, reducing it will help achieve revenue-neutral reform and perhaps also dollars for deficit reduction. It will take more than requiring landlords to issue 1099s, though (estimated to generate about $250 million per year). Tackling the larger elements of the tax gap will likely require new withholding requirements, an improved worker classification system (which will increase self-employment tax collection), and increased funding for the IRS to help small businesses with their compliance obligations and to find noncompliant taxpayers. Have a suggestion? The House Ways and Means Committee is interested in hearing it by April 15.

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Annette Nellen, Esq., CPA, is a tax professor and director of the MST Program at San José State University. She is an active member of the tax sections of the AICPA, ABA, and California State Bar. She is the immediate past chair of the AICPA Individual Income Taxation Technical Resource Panel. She has several reports on tax policy and reform and a blog.