The Tax Gap: Measuring the IRS's Bottom Line
Blanthorne, Cindy, Yancey, Kristen Selvey, The CPA Journal
The IRS recently reported that the gross tax gap is estimated to be approximately $345 billion (see "IRS Updates Tax Gap Estimates," IR-2006-028, from www.irs.gov/newsroom/).
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.eov/newsroom/).
First, the nonfUing 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.
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 Puiliam 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. …