With a Congress and an administration too fond of tax cuts and spending to solve the growing budget deficit, the tax gap has become a more convenient focus for deficit reduction. With the tax gap, the Congress can urge action by the Internal Revenue Service without having to figure out what to do itself.The IRS estimates that the tax gap is $345 billion, which, if collected, could make a significant dent in the projected annual deficit, which is now approaching $500 billion.
Yet, even while pushing some of the deficit reduction burden off to the IRS, Congress is also making it difficult for the IRS to reduce the tax gap most efficiently. Budget restraints on the IRS have resulted in the agency not being able to spend as much on enforcement as it would like, even though dollars spent on enforcement are more than offset by increased revenue.
The IRS's push for better information to address small business compliance has been hampered by congressional members concerned about placing further cost burdens on small business. Congress may, however, be more open toward trying to close the tax gap through tighter regulation of tax return preparers, whose lobby on Capitol Hill may not be as strong.
The tax gap
The most recent estimate of the tax gap is based on a study undertaken by the IRS of the 2001 tax year. In February 2006, the IRS estimated that the tax gap was growing and currently stood at around $345 billion. The IRS's current collection efforts reduce the tax gap to just below $300 billion. The Treasury Inspector General for Tax Administration has pointed to some flaws in the IRS study that might indicate that the actual tax gap is even higher than the IRS estimate.
The IRS study attributes the tax gap to three basic sources: underreporting ($283 billion), nonfiling ($30 billion) and underpayment ($32 billion). The underreporting comes primarily from individual income tax returns, with lesser amounts attributable to employment taxes, corporate income taxes, and estate and excise taxes.
The main components of the individual income tax underreporting are underreported business income ($83 billion to $99 billion); underreported non-business income ($42 billion to $57 billion); and overstated adjustments, deductions, exemptions and credits ($25 billion to $30 billion).
The percentage of noncompliance estimated from these numbers is around 15 percent to 16.6 percent of the true tax liability. This is an increase from the last study, done in 1998, when the noncompliance rate was estimated at 14.9 percent. Sen. Max Baucus, D-Mont., has challenged the IRS to get the compliance rate up to 90 percent, i.e. the noncompliance rate down to 10 percent.
The study alone will help the IRS better target its existing enforcement dollars to get the most return for the investment. The study also points to areas where the IRS might need additional tools and resources.
Not too surprisingly, compliance is highest where there is third-party reporting and/or withholding. The IRS estimates that only 1.5 percent of income reported on a W-2 form is misreported on a tax return.
The study identified several areas, however, where compliance is getting worse:
* Reporting of proprietor income and expenses, such as gross receipts, bad debts and vehicle expenses;
* Reporting of net income from flow-through entities, such as partnerships and S corporations; and,
* Reporting of various types of deductions.
The IRS has suggested a multi-pronged approach to attack the compliance problem. It is requesting more dollars from the Congress for enforcement. It is promoting private debt collection in recognition that its enforcement budget requests have often not been met. It is proposing new small business reporting requirements. Taxpayer Advocate Nina Olson has proposed back-up withholding on payments to independent contractors.
All of these suggestions seem focused on attacking the noncompliance problem where it is most severe. The congressional response to these proposals has been less than enthusiastic.
After years of short-changing the IRS on its budget requests and pushing taxpayer service at the expense of enforcement, Congress is starting to do better at getting the IRS some increased enforcement dollars. In part, the IRS is making internal allocations of resources back toward enforcement. But Congress has also come closer recently to giving the IRS the money that it is requesting to do its job. Then again, some speculate that IRS leadership has sufficient political acumen to request only what it feels it can get from Congress, rather than what it really needs.
The suggestions for new small business reporting requirements received a very unfriendly reception from the House Small Business Committee. Chair Don Manzullo, R-Ill., dismissed the proposals as a draconian burden on small business and suggested that education was the answer, not more reporting requirements. IRS Commissioner Mark Everson responded that underreporting of income is not an education problem.
After considerable delay, the IRS did get the go-ahead to proceed with private debt collectors. The IRS admits that the use of private debt collectors will return less money to the Treasury than if the IRS did the enforcement itself, but private debt collectors are only paid out of the money recovered, while additional enforcement dollars would need to be approved by Congress.
Although the IRS has designated the initial group of private collectors, some of the candidates not selected have gone to court to challenge the selection process. The private debt collector program is now on hold until some of these problems can be sorted out.
Focus on tax preparers
At the same time as the tax gap debate has been going on, the Government Accountability Office on April 4, 2006, released a study highlighting the errors on tax returns made by paid tax preparers. This study has created calls from some in Congress for greater federal oversight of professional tax preparers.
The IRS, through its tax shelter crackdown on both taxpayers and promoters of tax shelters, has already shown its interest in attacking tax shelters from the promoter point of view. The 2005 revisions to Circular 230 also tighten practitioner standards.
Taxpayer Advocate Olson has also suggested that an IRS e-file and expanded electronic payment program could increase compliance. The congressional response so far has been to draft legislation that would prohibit the IRS from getting into the electronic tax return filing business.
The IRS has negotiated a free filing program over the last several years with a number of private electronic filing services. While that program has been successful, Congress was critical of the IRS for a change made this year that put a top income limit on those eligible for the free filing program and that resulted in lower participation. The concern appears to have been that some private providers were providing free filing services to all comers in an effort to sell them other services. The IRS and some of the other private providers apparently wanted to try to direct the program more toward needier taxpayers and to provide better protection for taxpayers from solicitations for other services.
Congress does appear to be listening to the tax return preparation industry in its efforts to keep the IRS out of direct competition for electronic return filing business, but tax preparers may prove to be a more attractive target to go after in an attempt to close the tax gap than imposing increased reporting requirements on small business.
Tax preparers are well aware of problems in the industry. Who has not had clients tell them that a preparer down the street has suggested some tax treatment that, to the knowing eye, at best looks a little shady and at worst is clearly illegal? Just as auditors saw the federal government take a greater regulatory role with the Sarbanes-Oxley Act in response to Enron and WorldCom, the tax preparation industry could find itself an easy target for closing the tax gap if they are viewed as more of the problem that the solution.
The IRS still is generally of the view that paid preparer returns are more accurate than self-filed returns. The paid preparer is a third party looking over the taxpayer's information and with a separate exposure to potential penalties for an inaccurate return.
Still, the GAO report and some of the congressional responses show that a tax return preparation industry that cannot clean up its own bad apples may well find itself a target of convenience to close the tax gap, just as the tax gap is becoming a target of convenience to reduce the deficit.
George G. Jones, JD, LL.M, is managing editor, and Mark A. Luscombe, JD, LL.M, CPA, is principal analyst, at CCH, a WoltersKluwer company.
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