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Wednesday, February 17, 2010

Tax Gap, Tax Enforcement, and Tax Compliance Proposals in the 111th Congress

James M. Bickley
Specialist in Public Finance

Recent and projected large federal budget deficits have generated congressional interest in the feasibility of raising revenue by reducing the tax gap. The Internal Revenue Service (IRS) defines the gross tax gap as the difference between the aggregate tax liability imposed by law for a given tax year and the amount of tax that taxpayers pay voluntarily and timely for that year. And it defines the net tax gap as the amount of the gross tax gap that remains unpaid after all enforced and other late payments are made for the tax year. For tax (calendar) year 2001 (the most recent year available), the IRS estimated a gross tax gap of $345 billion, equal to a noncompliance rate of 16.3%. For the same tax year, IRS enforcement activities, coupled with other late payments, recovered about $55 billion of the gross tax gap, resulting in an estimated net tax gap of $290 billion. 

The estimated gross tax gap of $345 billion consisted of underreporting of tax liability ($285 billion), nonfiling of tax returns ($27 billion), and underpayment of taxes ($33 billion). (Taxes on illegal activities are excluded from these estimates.) Most of the underreporting of tax liability concerned underreporting of individual income liability ($197 billion). The percentage of individual income that was underreported varied significantly depending on the degree of information reporting and whether or not withholding was required. 

The IRS replaced the Taxpayer Compliance Measurement Program—a systematic approach for estimating the tax gap—with the National Research Program (NRP). One of the guiding principles for the NRP was to minimize the compliance burden on those taxpayers selected for audit in the NRP sample. The new methodology of the NRP was applied to the underreporting gap for the individual income tax for tax year 2001. 

Estimates of the gross tax gap have been heavily publicized; perhaps as a result, some public officials have emphasized better enforcement of tax laws in order to raise revenue. Three factors affect the dollar amount that can be collected by increased enforcement. First, much of the gross tax gap for individual income tax filers is due to types of unreported income that are difficult to detect. Second, some of the detected tax liability cannot be easily collected, particularly from those taxpayers who are currently unable to pay. Third, many detected tax liabilities are so small relative to enforcement costs that it is not cost-effective to pursue collection. 

From FY2001 to FY2007, greater tax enforcement efforts by the IRS increased enforcement revenue from $33.8 billion to $59.2 billion. For FY2008, the IRS reported a decline in enforcement efforts and a reduction in enforcement revenues to $56.4 billion. IRS funding for enforcement rose for FY2009, but enforcement revenues declined to $48.9 billion. The IRS attributed this decline in revenues to the recession and the closing of a significant number of highgrossing tax shelter cases. The Office of Tax Policy developed a strategy it terms "comprehensive, integrated and multi-year" to reduce the tax gap. In the 111th Congress, enforcement areas include tax shelters, the earned income tax credit, tax exempt organizations, and tax havens. After a review of return preparers, the IRS has formulated eight new regulations applicable to tax return preparers, which it will begin implementing in 2010. 

As of February 2, 2010, nine bills have been introduced in the 111th Congress relevant to the tax gap: H.R. 572, S. 265, H.R. 735, H.R. 796, S. 569, H.R. 1265, S. 506, H.R. 2268, and S. 1934. 

This report will be updated as issues develop or new legislation is introduced. 

Date of Report: February 2, 2010
Number of Pages: 19
Order Number: R40219
Price: $29.95

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