The Tax Gap: Is this the Best Solution?

We’ve long been skeptical when it comes to IRS pronouncements of a “tax gap” – the difference between a taxpayer’s actual income tax liability and what they actually paid.

Last month, the IRS announced its latest tax gap estimate. The total for 2020 and 2021 came to $688 billion per year.

To close the gap, the IRS says it will use funding from the Biden administration’s massive Inflation Reduction Act to force tax compliance from a variety of targets, including high-net-worth individuals, partnerships, and corporations.

Now, we largely agree with Oliver Wendell Holmes’ famous adage that “taxes are the price we pay for civilization.” But we’re skeptical of any calculation of a tax gap in light of the inherent complexity of the Internal Revenue Code (IRC) foisted upon us by Congress.

As of 2018, it was more than 75,000 pages long, and you’re expected to comply with every word of it. Regulations issued to interpret the IRC occupy several thousand more pages. And the Internal Revenue Manual, which sets out official IRS procedures, fills an entire bookshelf.

Form 1040, the centerpiece of your personal tax return, now comes packed with six separate schedules. You can find around 80 of the most common tax forms at this link. The list omits at least a half-dozen forms we deal with regularly which pertain to international investments or income.

Another factor which contributes to the tax gap is taxpayer uncertainty. Which rules apply, and when?

The estate tax is a great example. A taxpayer who died in 2009 had a $3.5 million estate tax exemption. Then, after a protracted political battle, Congress temporarily ended the estate tax in 2010, and that year beneficiaries paid no estate tax.

Next, Congress set a $5 million exemption through the end of 2012, reverting to $1 million in 2013. But in 2012, Congress gave Americans a $5 million “permanent” estate tax exemption, indexed annually for inflation.

Except it wasn’t really permanent.

In 2017, Congress amended the IRC again to temporarily increase the estate tax exemption to $11.18 million, again indexed for inflation.

Unless it makes the exemption permanent, in 2026, the exemption will revert to $5 million, indexed for inflation between 2018 and 2026.

That’s just one example. We could go on about the duplicative reporting obligations for foreign investments and the shifting rules for retirement plans.

Then there are the complex rules that apply to what the IRS calls “tax shelters,” passive income loss limitations, and so much more.

Digging into the nuts-and-bolts of how the IRS calculates the tax gap makes for some mind-numbing reading. If you suffer from insomnia, we highly recommend it.

The current tax gap consists of three primary components, according to the IRS:

1. Underreporting, which reflects tax understated on timely filed returns. That alone accounts for $542 billion of the tax gap, up from $445 billion in tax years 2017-2019.
2. Failing to pay or file tax returns ($77 billion).
3. Underpayment ($68 billion).

But even assuming these numbers are remotely accurate, it’s important to understand that the vast majority of the tax gap doesn’t represent willful tax evasion.

Indeed, Nina Olson, the IRS’s former taxpayer advocate, told Congress in 2006 that in 94% of audits, IRS examiners found no willful tax evasion. Instead, they merely discovered inadvertent errors by taxpayers and their advisers who simply don’t understand the monstrously complex rules.

It’s also important to look behind the headlines. The IRS press release announcing the latest tax gap numbers claims that:

Between tax years 2014-2016 and tax year 2021, the estimated tax liability increased by about 38%.

While $688 billion is a big number, it represents around 2.9% of 2021’s domestic GDP. And in those terms, the current tax gap estimates are only about 0.2% higher (2.7% versus 2.9%) than in the 2014-2016 period. That’s a 7% increase averaged across GDP – a much less dramatic increase than 38%.

Conceptually, the enormous tax compliance industry that has sprung up to help taxpayers comply with the IRC reminds us of the trade in indulgences once carried out by the Catholic Church.

In exchange for a monetary payment, the church would absolve you of your past sins. Assuming you committed no additional sins, at death, you would be released from purgatory and ascend to heaven.

Naturally, if you committed future sins, you could make an additional payment.

How different is that system from the tax compliance industry, where we pay our tax advisors, the equivalent of priests, to interpret an arcane body of law to avoid financial penalties that could rain down on us or our successors?

To the extent there’s a tax gap at all, we would propose a simple solution: a radical simplification of the IRC.

Establishing a flat tax on all income, possibly combined with a value-added tax, would generate more than enough money to run the US government.

And it would eliminate most of the tax gap.

The reason a flat tax works is that it’s incredibly simple. There’s also an inherent fairness to it, because everyone pays the same percentage of their income in tax.

That ends the class warfare aspect of taxation along with the incentives to politicize the tax system. As well as the payment of what amount to indulgences to tax advisors to help us parse tax laws and regulations.

All those resources could instead be marshalled to help grow our economy.

For proof that this concept works, we need look no further than three countries that were once part of the Soviet Union which have shifted to a flat tax: Estonia, Lithuania, and Latvia. Since they made the shift in 2004, all three countries – especially Lithuania – have enjoyed some of the highest economic growth rates in the world.

We’re not saying the results would be identical in the United States. But we suspect that if our country started to move toward tax simplifications, the implications would be very positive.

All it would take to begin is for Congress to act. But we’re not holding our breath for that to happen.