April 13, 2007 | WebMemo on Taxes
American taxpayers are winding up their annual reckoning with the IRS. Meanwhile, House and Senate Democrats are discussing a number of new tax revenues to pay for their spending agenda, including eking out "free money" from closing the tax gap. The tax gap is the difference between what the IRS estimates it is owed and what it actually collects-purportedly around $290 billion. Closing this tax gap is not a simple matter, nor is it cost free. The three types of proposals to close the tax gap are (1) making reporting to the IRS more extensive, (2) increasing withholding, and (3) giving the IRS more power. Each of these would be a nightmare for American taxpayers.
What is the "Tax Gap"?
The tax gap is really a compliance gap, arising when taxpayers do not pay the correct amount of taxes they owe. The gap is not large in relative terms-the IRS estimates about an 84 percent compliance rate. According to the IRS, of those who underpay, 82 percent underreport their tax liability, 8 percent fail to file returns, and 10 percent underpay known tax debts.
Most of the compliance problem comes from honest taxpayers who try to comply with the tax code but are tripped up by its increasing complexity and unwieldiness. The remainder is due to tax evasion by those who knowingly break the law.
Tax compliance is high when payments or wages are reported by a third party, such as a W-2 from an employer or a 1099 from a bank for interest earned. Compliance is the highest (nearly 99 percent) when there is also tax withholding, such as with the withholding of income and Social Security taxes from paychecks.
Compliance is lowest when there is no third party reporting, such as payments to a lawn service or hairdresser. The costs of complying with the complex tax code are already extremely high for these types of small businesses and entrepreneurs, and so further efforts to tighten the tax noose could make this burden crushing. Instead, lawmakers seeking to improve compliance should simplify the tax code so these types of businesses do not have to employ hordes of expensive lawyers and accountants just to pay their taxes.
All taxpayers, not just small businesses, face rising compliance costs. Americans spent billions of hours and an estimated $279 billion filling out their federal income taxes last year alone. This cost is nearly as much as the tax gap itself. Still, lawmakers maintain a misplaced focus on "free" revenues from closing the tax gap. Taxpayers should be aware of what this would entail.
Increase Reporting to the IRS
As the IRS's Nina Olson, the National Taxpayer Advocate, has stated, "No one wants to be obligated to file a document with the IRS every time he or she takes a cab ride, has someone mow their lawn, or calls a plumber to fix a broken faucet." Yet many tax gap proposals would boost the reporting that businesses and individuals have to do to unprecedented levels.
It is already costly and burdensome to report financial information to the IRS. In order to collect more taxes, the IRS would have to ferret out more information about income and deductions than it is already privy to. This would require foisting new layers of reporting and complexity on Americans taxpayers, an especially invasive policy given the explosion of online entrepreneurship. New reporting measures would have to:
Increase Payments Subject to Withholding
Because compliance is highest for taxes automatically withheld
by a third party, increasing payments subject to withholding would
be the logical extension of increased reporting. This would turn
ordinary citizens into IRS agents. All over America, each time a
payment is made for services, individuals would have to figure out
the correct level of taxes to withhold and send on to Washington.
This would require new regulations, procedures, and forms, and the
time-consuming and tedious task of complying would be fraught with
error and abuse-a compliance nightmare in its own right.
For example, a regular taxpayer could have to:
These types of policies have been tried before, though not to such extremes. In the mid-1990s, the IRS sought to crack down on landlords in the Section 8 voucher rental housing program. These landlords had to report their taxpayer identification information to the housing authority. If their information was deemed inaccurate by the IRS-a frequent occurrence-the housing authority had to withhold a portion of the rental payment - irrespective of the landlord's costs-and forward it to the IRS. This led to an immense waste of housing authorities' resources and yielded little in results. Some landlords threatened to evict their low-income tenants because they didn't want to deal with the IRS. If government-regulated housing authorities had to struggle to comply with the IRS in its crackdowns, ordinary Americans would have little chance.
Increase the Power of the IRS
The IRS has the charge to collect and enforce the federal tax code, and extending its power seems an obvious step toward increasing compliance. But giving the IRS more power could infringe on personal liberties that Americans cherish and stifle economic growth. In the tax gap debate, the IRS often couches measures to close the tax gap in euphemistic generalizations that no one could object to such as "improve research," "improve compliance activities," "invest in IT," and "improve tax payer service." However, none of these phrases captures the reality of a more powerful IRS.
Investigations into abuses by the IRS a decade ago revealed an overzealous agency with staff, from agents to executives, free to gratuitously impose highly punitive measures on taxpayers. IRS agents anonymously testified that they had repeatedly seen senior IRS staff and executives "violate or ignore Internal Revenues Manual procedures and Treasury regulations simply because they wanted to punish a taxpayer."
Closing the tax gap could cause a resurgence in these kinds of abuses. Proposals currently being discussed would:
Simplify to Increase Compliance and Revenues
As Treasury Secretary Henry Paulson noted, "When I look at what needs to be done, I concluded that there is not a pot of gold to pay for AMT, to balance the budget, whatever, unless we sign on for specific reporting provisions, increased reporting that I would recommend against." In other words, most measures are too invasive and costly to consider. Paulson's trepidation should be weighed heavily by lawmakers. A better approach would be to simplify the tax code by reducing rates and broadening the tax base by getting rid of the myriad of deductions and loopholes that now plague the system.
At 17,000 pages, the tax code is incredibly complex, leading to many compliance problems, and every year Congress inserts more complicating loopholes and special interest provisions into it. Efforts to close the tax gap through enforcement would only add to this complexity. As international experience has shown, higher tax complexity and higher burdens result in more taxpayer mistakes and evasions.
Legislators who view the tax gap as a pot of gold to pay for their spending agendas have misplaced faith in the IRS. Taxpayers should know what increased IRS enforcement would mean to them, from burdensome reporting to a loss of personal privacy. Efforts to raise compliance would have a negative impact on economic growth, individual freedom, and the burden of tax compliance. The best mechanism to reduce the tax gap is to reform the current overcomplicated tax system.
Acosta Fraser is Director of, and Will Packer is a Research
Associate in, the Thomas A. Roe Institute for Economic Policy
testimony before the Subcommittee on Financial Services and General
Government, Committee on Appropriations, U.S. House of
Representatives, March 5, 2007, at www.irs.gov/pub/irs-utl/
 Office of Management and Budget, "Analytical Perspectives, Budget of the U.S. Government, Fiscal Year 2008," February 2007, p. 192.
 Nina Olson,
testimony before the Committee on the Budget, U.S. Senate, February
15, 2006, at http://budget.senate.gov/democratic/
 Internal Revenue Service, "Small Business/Self-Employed Subgroup Reports," November 16, 2006, at www.irs.gov/pub/irs-utl/2006_irpac_public_meeting.pdf.
of the Treasury, "A Comprehensive Strategy for Reducing the Tax
Gap," September 26, 2006, at www.ustreas.gov/press/releases/
Everson, testimony before the Committee on the Budget, U.S. Senate,
February 14, 2007, at http://budget.senate.gov/republican/