Tax Planning

How to End the $400 Billion “Tax Gap”

The Government Accountability Office (GAO) recently trotted out its latest estimates of the “tax gap,” the supposed difference between taxes collected and taxes due.

That number is now a whopping $406 billion per year. If it’s correct, every American over the age of 18 – all 252 million of us – is underpaying their taxes by about $1,610 per year.

The GAO attributes the size of the tax gap to three causes:

  • Insufficient information submitted to the IRS by third parties;
  • The need for IRS resource trade-offs; and  
  • The complexity of the Tax Code.

It’s hard to take the first two factors seriously. Let’s deal with third-party reporting first.

The IRS has been receiving a cascade of information for more than a century. The blizzard of paperwork started as a trickle in during World War 1. In 1917, Congress enacted the War Revenue Act, which required employers to notify the Bureau of Internal Revenue (BIR) if they paid an employee $800 or more annually.

The law also gave the BIR sweeping powers to impose additional reporting obligations. So in 1924, the BIR demanded that publicly traded companies report dividends paid to their shareholders on Form 1099. By 1933, brokers had to submit detailed annual reports on every client with more than $25,000 in securities trading volume. And starting in 1943, Congress started requiring employers to withhold tax from employees and remit the funds they withheld to the Treasury.

Meanwhile, a steady stream of new variants of Form 1099 came into existence. Today, more than 20 versions of the form exist. Among many other classes of income, they cover:

  • Payment of interest and dividends
  • Proceeds from barter exchanges
  • Cancellation of debt
  • Merchant card and third-party network payments

Most recently, the IRS has demanded the trading records of account holders on US cryptocurrency exchanges.

The GAO is also concerned that the IRS needs to make “resource trade-offs.” That’s bureaucrat-speak to avoid revealing embarrassing facts about the IRS. In 2010, Congress discovered the IRS had selectively targeted non-profit groups for audit based on their political ideology. It responded by cutting funding for the agency several years in a row. But the cuts are now history, and the IRS’s budget is once again rising.

It’s illuminating to look at the choices the IRS made when Congress cut its budget. For instance, in 2010, President Obama signed the Foreign Account Tax Compliance Act (FATCA) into law. The law was a regulatory nightmare for Americans with overseas interests, especially the nine million US citizens living full-time in another country. Many of them found their bank accounts closed and their mortgages canceled. Many even lost their jobs because foreign financial institutions and employers were worried about compliance with the new law.

Drawing on its authority to enforce citizenship-based taxation, the IRS made enormous efforts to collect taxes and penalties from overseas Americans and US taxpayers with foreign investments. It applied a full-court press to overseas banks, forcing them to disclose the records of US clients’ accounts. Even then, the IRS was able to collect only about $10 billion. That’s chump change compared to the alleged size of the tax gap.

That leaves us with the third factor contributing to the enormous size of the tax gap: the complexity of the Internal Revenue Code (IRC). It’s more than 75,000 pages long, and you’re expected to comply with every word. Regulations issued to interpret the IRC occupy several thousand more pages. And the Internal Revenue Manual, which sets out IRS procedures, fills an entire bookshelf. Form 1040, the centerpiece of your personal tax return, now comes packed with six separate schedules. You can find around 80 of the most common tax forms at this link. Incidentally, the list omits at least a half-dozen forms pertaining to international investments or income.

The IRC, combined with congressional politics, also creates enormous uncertainty. The estate tax is a great example. A taxpayer who died in 2009 had a $3.5 million estate tax exemption. Then Congress temporarily ended the estate tax in 2010, and that year beneficiaries paid no estate tax.

Next, Congress set a $5 million exemption through the end of 2012, reverting to $1 million in 2013. And in 2012, Congress gave Americans a $5 million permanent estate tax exemption, indexed annually for inflation.

In 2017, Congress amended the Tax Code again to temporarily increase the estate tax exemption to $11 million, indexed for inflation. Unless it makes the exemption permanent, in 2026, the exemption will revert to $5 million, indexed for inflation between 2018 and 2025.

That’s just one example. I could go on about the duplicative reporting obligations for foreign investments and the shifting rules for retirement plans. Then there are the complex rules that apply to what the IRS calls “tax shelters,” passive income loss limitations, and so much more.

Instead of worrying about a tax gap that is largely the result of a Tax Code no one understands, why not simplify the rules? Establishing a flat tax on all income and a value-added tax could generate more than enough money to run the US government. More importantly, it would replace the current 75,000-page IRC with a few pages of easy-to-follow rules.

A simple tax system would also eliminate most of the tax gap. That’s what happened in Russia, which in 2001 introduced a flat individual tax rate of 13%. Tax revenues soared 25% in each of the first two years after the reform came into effect. The third year saw a 15% increase.

There’s no reason the US couldn’t take the same path. What’s Congress waiting for?

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