The new Tax Gap Map: not much has changed

On Thursday, the IRS released new federal tax gap estimates, including a new Tax Gap Map (on page 3 here). It’s been a while; the previous estimates were calculated in December 2011, for tax year 2006. The principal new addition to the Tax Gap Map is that the estimate of the net tax gap (the gross tax gap reduced by enforced and late payments) is now broken down by type of tax. Also, the new release is different in that it doesn’t focus on a single tax year but rather averages for tax years 2008-2010.

The new estimates show an estimated gross tax gap of $458 billion—compared to $450 billion for 2006—and an overall “voluntary compliance rate” of 81.7% of tax liability, compared to 83.1% for 2006. At first glance, these figures suggest that voluntary compliance is declining and that the tax gap is growing. However, the IRS explains on page 2 of its report that these differences “are driven by improvements in the accuracy and comprehensiveness of the estimates through updates in methods and the inclusion of new tax gap components.” In particular, the IRS explained that “[h]ad the improvements not been made, the TY 2008–2010 tax gap estimates would have been slightly lower than the previous TY 2006 estimates.” (Emphasis added.) And although only about half of the decline from the estimated 83.1% rate to the new estimate of 81.7% is due to changes in methodology, the IRS explains the many factors that may change over time, the remaining 0.7% percentage point difference can’t be relied upon to indicate a real decline in voluntary compliance. Jim Alm & Jay Soled have argued that the tax gap may decline over time, for a variety of reasons, including the increasing use of electronic-payment mechanisms, which result in much more visible transactions than cash does, although they acknowledge that there are countervailing trends, as well, including the underfunding gap the IRS has been struggling with.

The single biggest contributor to the federal tax gap, in terms of dollars, according to the IRS’s estimates, remains underreporting by individuals of business income, at $125 billion (very similar to the $122 billion figure for 2006). Think cash transactions. It remains clear that third-party information reporting makes a huge difference. Page 5 of the IRS release shows that in a nice bar graph. While the IRS estimated that wages and salaries, which are subject to both information reporting and withholding, experienced the lowest net misreporting rate, at 1%, income subject to substantial information reporting experiences a fairly low 7% misreporting rate. By contrast, income subject to little or no information reporting has a 63% misreporting rate. That last category includes such things as non-farm sole proprietor income, farm income, and rents and royalties. The comparable figure for 2006 was lower, at 56%. However, the definition has changed: the IRS notes that that category no longer includes adjustments to income.

The IRS’s definition also changed for the category of “Income subject to some information reporting.” In the graph for tax year 2006, that category included deductions and exemptions, and showed an estimated net misreporting percentage of 11%. The new graph, for tax years 2008-2010, does not include deductions and exemptions, and the new estimate is 19%. Misreporting a deduction or exemption requires an affirmative entry on the tax return, while omitting income does not. Deductions and exemptions are therefore also visible to the IRS on the tax return, while omitted income is not. Accordingly, it is not surprising that removing deductions and exemptions to focus just on income would increase the net misreporting percentage in this category.

So, overall, not much has changed on the compliance front, at least according to IRS estimates. Of course, these figures are only as current as the 2010 tax year, and represent an average of three years, 2008-2010. It is too soon to tell whether IRS budget cuts, which began in 2011, have negatively affected compliance.

3 thoughts on “The new Tax Gap Map: not much has changed

  1. I’m so curious about the new net tax gap estimates by type of tax and what this tells us about the gross vs. net for each different type of tax. For example, just eyeballing: The gross number goes from $4 billion for estate and excise taxes down all the way to “just” a $1 billion net tax gap. But for the employment taxes the percentage decline between gross and net isn’t quite so dramatic — $91 billion to $79 billion. Interesting stuff.

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  2. Excellent point! The decline from gross tax gap to net tax gap is by far the most dramatic for estate tax: none of the others come close to the 75% decline (from $4 billion gross to $1 billion net). Excise taxes are next at decline from about $0.4 billion to $0.2 billion, or 50%. (We don’t know the exact figures due to rounding.) The others range from a low of about 8.8% (the individual income tax) to a high of 20.5% (the corporate income tax). Employment taxes experience a 13.2% reduction ($91 billion gross; $79 billion net). Unfortunately, we can’t tell from these figures if the reductions are mostly due to enforced collections or mostly due to late voluntary payments (or how the composition of the payments differ across tax categories) because those two types of late payments are not reported separately. I don’t see anything in the report explaining what’s going in the different categories. If I find out more on this, I’ll follow up.

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