The Great Tax Gap Flap

– November 10, 2021 Reading Time: 4 minutes

The US Treasury claims that every year about $600 billion in taxes owed to the federal government, about 15 percent of the total, go unpaid. This so-called “tax gap” refers to taxes that should have been paid, but were not, not to taxes lawfully avoided via loopholes and such.

Calculating the tax gap is fraught with difficulty, as one might imagine, but trying to reduce the amount, whatever it is, wins politically. More money for government programs without raising taxes is always popular, as is the notion of Caesar collecting what he, and essentially other taxpayers, are “owed” by sundry scofflaws and tax cheats.

Liberty lovers who dutifully try to pay their outrageously high taxes might even get on board with efforts to reduce the tax gap, because they dislike free riders and, more importantly, because they want powerful people to suffer the full brunt of their increasingly authoritarian government. This might, they seem to hope, finally do something about limiting government power.

Most of the unpaid taxes, however, stem from self-employed small business owners underreporting income and overreporting deductions. That big corporations are not responsible for the tax gap makes sense intuitively. They can afford fancy accounting firms that help their clients legally to avoid taxes. Individuals running their own businesses, from side hustles to small shops, by contrast, often wing it at tax time.

Interestingly, a nontrivial amount of the tax gap appears to be due to low-income people gaming the Earned Income Tax Credit. That, apparently, was the reason for the $600 threshold on bank account reporting initially requested by the Biden administration.

Surely some taxpayers, rich and poor, do a cost-benefit analysis before sticking it to the tax man. The best way to decrease such activity is not to increase enforcement efforts, but for the government to stop wasting money on stupid things that most Americans dislike, like cruel experiments on puppies. But since wasting money appears to be the government’s core business, any improvement in that direction seems unlikely.

I would wager that a lot of the tax gap stems largely from the mind-numbing complexity of the tax code. But if I win the wager, do I have to pay taxes on it? Can I deduct gambling losses then too? What form does that go on? Does the amount matter? Maybe it was just a gift? You get the idea.

Undoubtedly, a lot of the presumed underpayment is inadvertent, attributable directly to the complex and ever changing tax code. The IRS admits that it answers only 30 percent of the questions taxpayers pose to it. Tax software is a nontrivial expense in terms of money and lost time. Hiring a real human tax expert could easily wipe out the profits of a marginal nano-enterprise.

The overall cost-of-doing-business in many states is already high. Why does Treasury want to make it higher? Maybe before trying a bunch of intrusive things to lower the tax gap, further traumatizing the beaten down small business sector, the government ought to try simplifying the tax code first. Perhaps down to a postcard, like real estate taxes. I don’t hear any complaints about a tax gap there! Or is destroying small business its real goal?

Steve Forbes called it a flat tax; others friendlier to progressive taxation have called it tax simplification and such. Call it what you will, the core idea is to reduce the tax rate in exchange for getting rid of deductions, exceptions, and exemptions. Simplification would increase economic efficiency by eliminating incentives to take people to lunch on the pretext of business and such, and also allow sole proprietors and other small businesspeople to concentrate on accurately tracking their income.

Tax accountants would lose income were tax simplification to occur, but most have mad accounting skills and will get on just fine without the annual April crush. If you think doing your own taxes is a pain, imagine the horror of doing other people’s taxes. Personally, I would resort to decriminalized SW before putting my hand in some stranger’s tax receipt drawers!

Seriously, even a major accountant professional association, the American Institute of CPAs (AICPA), has pushed for tax simplification. It too argues that tax simplification would likely reduce the tax gap. The Trump Administration made some headway on the issue by doubling the standard deduction, but the Biden Administration wants to move in a more totalitarian direction by increasing the budget and reach of the IRS, and locking in its growth over the next decade.

Biden has even formed a tax task force that includes economist Natasha Sarin, the Treasury’s deputy assistant secretary for economic policy and an assistant professor at UPenn Law. In a Zoom presentation for the Committee for a Responsible Federal Budget, she said she wants to increase the number of “heroic” tax police and to give them easier access to Americans’ bank accounts in order to reveal what she calls “opaque income streams.”

Sarin claims that Treasury only wants to target “wealthy tax cheats” and that “compliant” taxpayers will have nothing to worry about. After the events of the last 18 months it is difficult to find such claims credible. Most importantly, it isn’t clear that increasing the IRS’s budget is the best route. Its ancient computer system and current staff levels are already more than sufficient to handle a flat tax.

Moreover, I suspect that beefing up the IRS will simply induce Americans to chant “Let’s go Brandon” with even greater alacrity. Despite Tony Gill’s 2019 reminder that anyone can voluntarily donate to the US Treasury, most Americans want to pay Uncle Sam precisely what they owe, provided they can figure out what that is without breaking the bank, and no more. Americans do not want to return to the days when they deliberately overpaid their taxes in order to avoid a nasty audit. And certainly any hint that the IRS was auditing middle class Americans for partisan reasons would be revolutionary in more ways than one.

Robert E. Wright is the (co)author or (co)editor of over two dozen major books, book series, and edited collections, including AIER’s The Best of Thomas Paine (2021) and Financial Exclusion (2019). He has also (co)authored numerous articles for important journals, including the American Economic Review, Business History Review, Independent Review, Journal of Private Enterprise, Review of Finance, and Southern Economic Review. Robert has taught business, economics, and policy courses at Augustana University, NYU’s Stern School of Business, Temple University, the University of Virginia, and elsewhere since taking his Ph.D. in History from SUNY Buffalo in 1997. Robert E. Wright was formerly a Senior Research Faculty at the American Institute for Economic Research.