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London’s Underground (which is a subway to us Yanks) is known for its iconic warnings to “mind the gap.” That’s the spatial crevice between the train and the station platform. In D.C., a different gap is garnering attention: the tax gap. This is the delta between taxes owed to the government and actually paid.
On May 20, 2021, as part of the Administration’s pitch for an $80 billion increase in IRS funding, Treasury released a report that outlines the magnitude and categorical causes of the tax gap, and in broad strokes how it would deploy the $80 billion over a 10-year period to shrink the gap. According to Treasury, the tax gap totaled nearly $600 billion in 2019 and will rise to about $7 trillion over the course of the next decade if left unaddressed (roughly equal to 15% of taxes owed and almost 3% of GDP on an annualized basis, per the report). The report may interest readers not only for its justifications regarding the proposed budget increase but also as insight into how Treasury and the IRS define the tax gap problem and intend to deploy their enforcement resources to address it.
The report describes three categories of tax gap-generators. By far the largest contributor is the “underreporting tax gap,” which consists of taxpayers who underreport income or overclaim deductions and credits on tax returns. According to the report, this category accounts for roughly 80% of the tax gap. The other two categories are: the “nonfiling tax gap,” which consist of taxpayers who fail to file returns in a timely manner; and the “underpayment tax gap,” which consists of taxpayers who underpay taxes despite reporting obligations in a timely manner. These two components make up an estimated 9% and 11% respectively. Within the underreporting tax gap category, the report further states: “Research also finds that underreporting tends to rise with income when taxpayers are ranked by their total income, including the unreported amount. In part, tax evasion rises with higher incomes because higher-income taxpayers have sophisticated accountants and tax preparers who can stake out aggressive tax positions that can help shield true tax liability.”
The report advocates a first step towards closing the gap through “a sustained, multi-year commitment to rebuilding the IRS, including nearly $80 billion in additional resources over the next decade.” The report describes the areas into which these resources would be invested. Treasury proposes to devote much of the funding to hiring revenue agents capable of complex global high net-worth examinations and building the technological infrastructure to support a new information reporting regime. This includes the hiring and retention of at least 5,000 new enforcement personnel, growing the size of the IRS by as much as 15% each year, and revitalizing the IRS’s examination of large corporations, partnerships, and global high-wealth and high-income individuals. It also includes overhauling the IRS’ outdated technology.
The report highlights that the IRS still uses the Individual and Business File Systems which were designed around 1962 and are among the oldest IT systems in the federal government. The report also describes the IRS’ continued usage of “aged” software. Technology is central to IRS enforcement techniques that rely on data analytics, as well as many other IRS functions.
Resources would also be dedicated to regulating paid tax preparers and increasing penalties for those who commit or abet evasion. The report suggests a perception of widespread use of unregulated preparers who lack the training to provide accurate tax assistance, and that more rigorously regulating the return preparation practice may nip instances of tax evasion in the bud. The resources are also proposed to go towards increasing information reporting. The report states that when the IRS can verify taxpayer filings with third-party information reports, such as Forms W-2 submitted by employers to report wages, compliance rates exceed 95%.
In contrast, without third-party reporting, compliance rates fall below 50%. As part of this concern, Treasury is anticipating compliance issues and potential end-runs around information reporting regimes through the usage of cryptocurrencies. The report adds: “Cryptocurrency already poses a significant detection problem by facilitating illegal activity broadly including tax evasion.” Cryptocurrencies present novel challenges for the IRS, which the report suggests increased funding would in part assist in tackling.
The report further discusses the return on investing into these areas of enforcement. The report states: “Experts at the Treasury Office of Tax Analysis estimate that these initiatives would raise $700 billion in additional tax revenue over the next decade.” Elsewhere the report states: “The Office of Tax Analysis’ revenue estimate for the IRS funding proposal is projected based on these ROI estimates. Total additional revenue generated from the $80 billion increase in the IRS budget over 10 years is estimated to be around $320 billion during this horizon, which suggests roughly a 4-to-1 ROI.” The $320 million appears to be inflation-adjusted.
There is an open question about how the proposals would be revenue-scored, but if Treasury’s revenue estimates are in the ballpark and factored into the scoring, the revenue from the initiatives should dwarf the $80 million that Treasury seeks to aid in the collection of the revenues. Of course, other political obstacles aside from scoring should be expected. Throwing money at a problem doesn’t necessarily solve it. As important as the amount of funding, is how wisely the IRS spends it. Congress may press Treasury to provide more detail about their plan to justify the $80 billion price-tag. Even in the midst of around $5 trillion in Covid relief and $1 trillion-plus in proposed infrastructure spending, $80 billion is a hefty sum.
For taxpayers and their advisors, there are important take-aways from the report regardless of the legislative outcome of the particular spending proposal on the table at this moment. It reflects Treasury’s keen interest in increasing tax enforcement, particularly in regard to large corporations, partnerships, and global high-wealth and high-income individuals. It also reflects the perspective that for every dollar spent on tax enforcement against these groups of taxpayers, the IRS will be able to close the tax gap by multiples on such investment. While Treasury and IRS mind the tax gap, it behooves taxpayers to mind their tax exposures and take steps to prepare for a spike in tax enforcement.