Federal Tax Gap: Size, Contributing Factors, and the Debate over Reducing It

Federal Tax Gap: Size, Contributing Factors, and the Debate over Reducing It

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Updated October 30, 2023
Federal Tax Gap: Size, Contributing Factors, and the Debate
over Reducing It
Nature of the Federal Tax Gap
corporate income and employment taxes), the IRS relies on
The federal tax gap is a measure of overall taxpayer
a variety of data sources and empirical methods.
noncompliance in a specified period. The Internal Revenue
Service (IRS) provides two estimates of the federal tax gap:
There are some deficiencies with the IRS’s estimation
a gross measure and a net measure. The gross tax gap is the
methods that have raised some questions about the accuracy
difference between the total amount of federal individual
of its tax gap estimates. In a March 2023 report, the
and corporate income, employment, and estate and gift
Treasury Inspector General for Tax Administration found
taxes owed in a year and the total amount of those taxes
that the IRS does not include estimates of all sources of
paid voluntarily on time. The net tax gap is the difference
taxpayer noncompliance in its tax gap estimates. For
between all taxes owed and taxes paid after accounting for
instance, in estimating income underreporting, the IRS
late taxpayer payments and taxes collected through IRS
excludes excise taxes; estate and trust taxes; unrelated
enforcement actions. This estimate does not consider the
business income taxes; some employment taxes; subchapter
deterrent effects of IRS enforcement on taxpayer
S corporate income; and individual income taxes for U.S.
noncompliance.
taxpayers with foreign addresses. It is unclear how much
larger the income underreporting estimate would be if those
The federal tax gap has three main components: failure to
sources were included.
file, income underreporting, and tax underpayment.
Size of the Tax Gap
There are several reasons why the federal tax gap may be a
The most recent tax gap estimate by the IRS covers tax
concern for policymakers. The gap represents uncollected
years 2020 and 2021. According to the report, the average
revenue that the federal government could use for many
gross gap in that period was a projected $688 billion, which
purposes, including reducing the budget deficit. The gap
yielded a taxpayer net compliance rate of 86.2% for all
imposes costs on compliant taxpayers that are not borne
federal taxes owed. Late payments and IRS enforcement
equally by noncompliant taxpayers (e.g., higher taxes in the
actions resulted in a projected average net gap of $582
future, cutbacks in beneficial government programs, and
billion.
larger interest payments on federal debt to finance budget
deficits). Sustained growth in the tax gap may undermine
As Table 1 shows, between 2001 and 2021, the net federal
public confidence in the fairness and integrity of the federal
tax gap (2021 dollars) reached its lowest level in 2001
tax system, encouraging more noncompliance.
($444 billion) and its highest level in 2021 ($582 billion),
with some ups and downs in between. The net taxpayer
Estimating the Federal Tax Gap
noncompliance rate was the same in 2001 and 2021, with
The IRS has been estimating the size and composition of
the highest rate in 2008-2010 and the lowest rate in 2014-
the tax gap since 1979. Until 1989, the estimates for tax
2016.
compliance were based on data obtained through the
Taxpayer Compliance Measurement Program (TCMP). The
Table 1. Net Federal Tax Gap Estimates from 2001 to
data came from comprehensive in-person audits by IRS
2021
examination officers of random samples of individual,
corporate, and employment tax returns. Many audited
Billions of
Billions of
Net Taxpayer
taxpayers found them burdensome, as they were required to
Current
2021
Noncompliance
provide supporting documents for every tax return line
Year(s)
Dollars
Dollars
Ratea (%)
item. The IRS suspended use of the TCMP in 1988.
2001
$290
$444
13.7%
In 2000, the IRS adopted a different method of collecting
2006
$385
$516
14.5%
individual tax compliance data known as the National
Research Program (NRP), which is still in use today. To
2008-
$406
$508
16.3%
estimate compliance, the NRP uses a random stratified
2010
sample of about 13,000 taxpayers deemed representative of
2011-
the entire filing population to select tax returns for audit.
$380
$450
14.2%
2013
Random sampling provides information on both compliant
taxpayers and noncompliant taxpayers who otherwise might
2014-
$428
$486
13.0%
be difficult to identify using the IRS’s income detection
2016
tools. To estimate other components of the tax gap (e.g.,
2017-
$481
$514
13.2%
2019
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link to page 2 Federal Tax Gap: Size, Contributing Factors, and the Debate over Reducing It
2020-
involved in examinations and collections (58%) and
$582
$582
13.8%
2021
prefiling assistance (28%).
Source: Internal Revenue Service, Tax Gap Estimates; and Bureau of
Income Visibility
Labor Statistics, Annual Average Consumer Price Indexes.
Another force is the IRS’s ability to track down taxable
income. Income is easiest to track when it is subject to
a. The percentage of federal taxes owed in a year that were not
information reporting by third parties. Compliance is even
paid on time, after IRS enforcement actions and late taxpayer
greater when income is also subject to employer
payments.
withholding, as is the case for wages and salaries.
Sources of the Federal Tax Gap
According to IRS estimates, underreported tax liability in
2021 was $167 billion for income subject to little or no
The federal tax gap has three main sources: (1)
information reporting (e.g., farm income, sole proprietor
understatement of tax liability through unreported income
income, rents, and royalties), but only $9 billion for income
or overstated deductions, credits, and other income
subject to substantial reporting and withholding.
adjustments; (2) failure to pay taxes owed on time; and (3)
failure to file a return on time.
Tax Code Complexity
The federal tax gap is also thought to be influenced by the
Table 2. Components of the Gross Federal Tax Gap
federal tax code’s complexity. Frequent changes in tax
(billions of current dollars)
provisions complicate tax filing for many individuals,
Components
2011-2013
2020-2021
leading to unintended errors that add to the tax gap. Tax
code complexity also creates opportunities for taxpayers
Nonfiling
$37 (8%)
$65 (10%)
who can afford to hire tax professionals to reduce their tax
liability through questionable interpretations of the code.
Underreported
$349 (80%)
$511 (79%)
Income
Inflation Reduction Act
The 117th Congress passed legislation intended, in part, to
Underpayment of
$52 (12%)
$69 (11%)
reduce the federal tax gap. Under the law, commonly
tax
known as the Inflation Reduction Act (IRA; P.L. 117-169),
Gross Tax Gap
$438
$644
the IRS was to receive nearly $79 billion in mandatory
funding through the end of FY2031, in addition to its
Source: Internal Revenue Service; Research, Applied Analytics, and
annual appropriations. (That amount was later reduced by
Statistics; Tax Gap Projections for Tax Years 2020 & 2021, Publication
$21 billion between FY2023 and FY2025 by the Fiscal
5869; October 2023.
Responsibility Act of 2023 [P.L. 118-5].) The IRA
As Table 2 shows, underreported income is by far the
specified that $3 billion was to improve taxpayer services,
largest source of the federal tax gap, accounting for 80% of
$46 billion to expand enforcement actions, $25 billion to
the gross tax gap in 2011-2013 and 2020-2021. The three
maintain and upgrade the IRS’s information systems, and
components’ shares shifted little between the two periods.
$5 billion to accelerate the IRS’s efforts to modernize its
information technology infrastructure.
The main source of the gross tax gap is individual income
underreporting. In 2021, it accounted for 73% of total
As enacted, the IRA has the potential to boost revenue
underreported income and 58% of the gross tax gap.
collection. The Congressional Budget Office has estimated
Unreported individual business and nonbusiness income
that the IRA funding would increase revenue by $180
made up 74% of total individual underreported income and
billion between FY2022 and FY2031.
over 42% of the gross tax gap. Much of individual business
income is subject to little or no withholding and
Critics say that too much of the IRA funding for the IRS is
information reporting, making it more difficult for the IRS
targeted at enforcement and not enough at taxpayer services
to detect than wage, interest, and dividend income.
and information systems modernization. This emphasis on
According to IRS estimates, in 2014 to 2016, the net
enforcement raises at least two perennial issues. One is the
misreporting percentage for wages and salaries was 1%, but
return on investment (ROI) from new enforcement actions
it was 15% for partnership and S corporation income and
tied to IRA. Such actions vary in their cost-effectiveness.
55% for sole proprietor income.
Some argue that the IRS should invest its IRA enforcement
Contributing Factors
funds in actions with the highest ROI.
The other issue is the impact of increased investment in tax
IRS Resources
enforcement on taxpayer rights. Some are concerned that
The sizes of the IRS budget and staff, especially for
substantial increases in enforcement may lead the IRS to
enforcement activities and taxpayer services, affect the tax
devote less attention to the protection of taxpayer rights. As
gap through their impact on taxpayer compliance.
the National Taxpayer Advocate recently noted, the IRS’s
Substantial decreases in those resources since FY2010 have
added investments in enforcement should avoid increasing
resulted in sharp declines in audit rates for high-income
taxpayer filing burdens, prioritize the protection of taxpayer
individuals, partnerships, and large corporations.
rights, and heed the concerns of compliant taxpayers.
Between FY2010 and FY2022, the IRS budget (measured
as total obligations in 2022 dollars) declined 18%. The
Gary Guenther, Analyst in Public Finance
IRS’s full-time equivalent workforce declined 17% in the
IF11887
same period, with higher rates of decline among employees
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Federal Tax Gap: Size, Contributing Factors, and the Debate over Reducing It

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