At first glance, the recent testimony of Treasury Secretary Henry Paulson, Jr. before the Senate Finance Committee on ways to reduce the tax gap was fairly typical, in that he urged Congress to approve the Presidential-submitted budget with increased IRS funding, and to pass 16 legislative proposals aimed at narrowing the tax gap.

To no one’s surprise, he indicates that the vast majority of the tax gap is attributable to underreporting of income, and that most of that is attributable to individuals with business income and corresponding self-employment tax liabilities.

What was surprising was Paulsen’s statement that, “It's unclear whether this underreporting is the result of deliberate deception, or a simple misunderstanding of what needs to be reported and how to do it.” To me, that’s scary! If the Treasury can’t determine the basic underlying explanation after so much study, I would expect it would be really hard for it to substantially reduce the tax gap.

Another interesting conclusion by Paulsen is, “[A] big part of the tax gap we simply won't be able to reach without adding draconian and painful requirements on all taxpayers. And I don't believe any of us really want to do that.” He specifically rejects requiring individuals to file 1099s reporting their transactions with service providers, such as a doctor, auto mechanic, and dry cleaner; eliminating cash transactions in favor of electronic transactions, with card issuers and banks providing statements to the IRS so the payments can be matched with a business's reported income; or doubling or tripling the number of IRS agents and audits. He also said he doesn’t believe that a reduction in the tax gap should be viewed as a revenue raiser.

Unfortunately, his testimony seemed to be a “call for business as usual” -- that of approving an increased IRS budget and a bit of legislative tweaking. It didn’t instill much confidence that the Treasury will be able to get a handle on reducing the tax gap. But on the plus side, there was Paulsen’s promise that he doesn’t support “adding draconian and painful requirements on all taxpayers.”

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