In Brief

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The gap between the amount of U.S. federal taxes paid and the amount of tax owed is staggering—over $450 billion per year. The authors examine the reasons behind why this gap is so large. The data suggests that the IRS has received insufficient funding for its efforts to examine returns, conduct collections, and enforce noncompliance.

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The federal tax gap is the IRS’s estimate of the difference between taxes owed and taxes voluntarily paid on a timely basis. The most recent IRS estimate of the tax gap stands at $458 billion per year; the IRS further estimates that its enforcement and collection activities take in approximately $52 billion in taxes, leaving a net gap of $406 billion per year. The tax gap effectively shifts the tax burden from those who don’t comply to those who do. A recent IRS survey found 93% of respondents believe those who fail to meet their tax obligations should be held accountable (IRS Oversight Board, 2014 Taxpayer Attitude Survey, December 2014, http://bit.ly/2xiLGen).

Understanding the amount of the tax gap given above requires a closer look at both the gap itself and major IRS enforcement activities. The authors evaluated the composition of the tax gap and quantified the importance of third-party information reporting on individual compliance. The most recent year of the latest IRS estimate of the tax gap is 2010. Major IRS enforcement expenditures, people, and activities were reported from 2010 to 2016, the last year for which information is available. The information was taken from publicly available reports, primarily the annual IRS Data Books for 2010–2016. The review of IRS enforcement found several contributing elements that could reduce the tax gap; this article covers these elements, addresses the relationship between federal and state tax compliance, and concludes with recommendations for the government.

Federal Tax Gap Structure

The gross tax gap consists of individual income taxes ($319 billion), employment taxes ($91 billion), corporate income taxes ($44 billion), and estate and excise taxes ($4 billion). The gross tax gap can also be viewed in terms of behavior—filing and underreporting at $387 billion, filing and underpaying at $39 billion, and nonfiling at $32 billion, as depicted in Exhibit 1.

EXHIBIT 1

Average Annual Federal Tax Gap 2008–2010 (dollars in billions)

Tax Gap; Individual Income; Employment; Corporate Income; Estate & Excise; Total Underreporting; $264; $81; $41; $1; $387 Underpayment; 29; 6; 3; 1; 39 Nonfiler; 26; 4; –; 2; 32 Gross Tax Gap; 319; 91; 44; 4; 458 Enforcement; (28); (12); (9); (3); (52) Net Tax Gap; 291; 79; 35; 1; 406 Source: IRS, Federal Tax Compliance Research: Tax Gap Estimates for Tax Years 2008–2010

The largest share of the gross tax gap, estimated at $264 billion per year (or 58% of the total gross tax gap) is attributed to individuals filing returns with underreported taxes (understating income and overstating deductions and credits). Exhibit 2depicts the major impact that third-party information reporting has on the individual underreporting tax gap—a little more than half of the underreporting gap derives from areas with little or no third-party reporting.

EXHIBIT 2

Individual Income Tax Underreporting by Source (dollars in billions)

Income Subject To; Gross Tax Gap; Underreported Tax Gap Little or no information reporting; $136; 51.5% Some information reporting; 33; 12.5% Substantial information reporting; 15; 5.6% All others (primarily credits); 75; 28.4% Total individual underreporting tax gap; 264; 100% Source: IRS, Federal Tax Compliance Research: Tax Gap Estimates for Tax Years 2008–2010

IRS Enforcement Expenditures and Personnel

In recent years, IRS enforcement has experienced significant cutbacks in expenditures and personnel; specifically, there was a decrease in expenditures from $5.49 billion to $4.71 billion over the seven years. This reduction of $784 million represents a 14.3% drop, which correlates with a drop in the number of examination and enforcement positions—on average, more than 11,000 positions, or more than 25%, from 2010 to 2016. Furthermore, overall examinations decreased by more than 568,000 (32%) during the same period. Exhibit 3 magnifies this analysis by highlighting the reduction in coverage rates (i.e., examinations per 100 filed returns) by type of return over time; 8 of 10 return categories experienced decreases in their coverage rate. The decline in the coverage rate for individual returns of 36% (from 1.11 to .70 per 100 returns) is especially noteworthy, given that individual noncompliance is the largest share of the gross tax gap.

EXHIBIT 3

Examination Coverage Rate by Return Type

2010; 2011; 2012; 2013; 2014; 2015; 2016 Individuals; 1.11%; 1.11%; 1.03%; 0.96%; 0.86%; 0.84%; 0.70% Corporations< 10 Million; 0.94%; 1.02%; 1.12%; 0.95%; 0.95%; 0.92%; 0.80% Corporations ≥ 10 Million; 16.58%; 17.64%; 17.78%; 15.84%; 12.23%; 11.15%; 9.53% S Corporations; 0.37%; 0.42%; 0.48%; 0.42%; 0.36%; 0.40%; 0.34% Partnerships; 0.36%; 0.40%; 0.47%; 0.42%; 0.43%; 0.51%; 0.38% Fiduciaries; 0.17%; 0.10%; 0.17%; 0.25%; 0.12%; 0.16%; 0.10% Employment; 0.21%; 0.22%; 0.23%; 0.20%; 0.19%; 0.18%; 0.18% Excise; 2.33%; 2.40%; 3.26%; 1.61%; 1.50%; 1.34%; 1.35% Estate; 10.12%; 18.23%; 29.90%; 11.58%; 8.46%; 7.78%; 8.82% Gifts; 0.74%; 1.16%; 1.42%; 1.07%; 0.83%; 0.95%; 0.77% Source: IRS, Data Book Table 9(a), 2010-2016

There has also been a significant decrease in collection actions since 2010. The number of levies from 2010 to 2016 decreased 75% (from 3.6 million to 870,000), while the number of liens decreased 57% (from 1.096 million to 471,000). The strongest enforcement actions against noncompliance also decreased significantly; the number of seizures decreased from 605 to 436 (27%), and the number of criminal investigations declined from 4,706 to 3,395 (27%). It is worth noting that the IRS generally undertakes these two types of enforcement actions in only the most extreme cases.

Exhibit 4 conveys the impact of the declines in IRS enforcement activities on enforcement revenue collections. In total, there was a decrease of more than $3 billion in combined enforcement tax collections from 2010 to 2016. The decrease in tax collections from examinations is most significant, dropping more than 40% ($16.9 billion for 2010 to $9.93 billion for 2016) during the period.

EXHIBIT 4

Enforcement Revenue Collections (dollars in billions)

2010; 2011; 2012; 2013; 2014; 2015; 2016 Examinations; $16.9; 12.4; 10.2; 9.83; 12.51; 7.32; 9.93 Appeals; 6.7; 6.5; 4.2; 6.83; 6.47; 6.0; 2.1 Document matching; 4.9; 5.2; 5.27; 5.29; 4.97; 5.14; 5.01 Collections; 29.1; 31.1; 30.44; 31.40; 33.20; 35.74; 37.26 Total; 57.6; 55.2; 50.2; 53.35; 57.15; 54.20; 54.29 Source: IRS, FY 2016 Enforcement and Service Results

Federal Compliance and Impact on New York State

The above information relates only to federal tax compliance; however, there is likely a close connection between federal tax compliance and state tax compliance. Perhaps the best available information on compliance at the state level relates to the state of New York. A 2010 study in the Journal of State Taxation completed an analysis of state taxes based on IRS information for New York individual taxpayers with business income, without wage income, and with itemized deductions on their federal returns. The study estimated the New York state tax gap for this selection of taxpayers to be $3.6 billion for 2007 (Yongzhi Niu and Roger Cohen, “Personal Income Tax Gap for Business Earners in New York State: From the Real Estate Tax Perspective,” http://bit.ly/2eTqH7l).

Funding Is Crucial

The staggering size of the tax gap has some questioning the cuts in the IRS enforcement budgets and personnel levels. Seven former IRS Commissioners issued a Nov. 9, 2015, joint letter to Congress stating, “We fail to understand how it makes any logical sense to continue to reduce, rather than increase the IRS budget.” In November 2016, the Government Accounting Office issued Financial Audit—IRS’s Fiscal Years 2015 and 2016 Financial Statements (GAO-17-140); the Management’s Discussion and Analysis section notes, “Historical collection results suggest that reductions to the IRS budget have resulted in the government forgoing more than $5 billion a year in enforcement revenue to achieve budget savings of a few hundred million dollars” (GAO, 26). Finally, in his Jan. 19, 2017, Senate confirmation hearing, Treasury Secretary Steven Mnuchin stated, “I am very concerned about the staffing of the IRS. It is an important part of fixing the tax gap.”

In the authors’ view, Congress and the President should carefully consider the appropriate level of funding so that the IRS can successfully fulfill its mission statement of providing America’s taxpayers top-quality service by helping them understand and meet their tax responsibilities and enforcing the tax laws with integrity and fairness to all.

H. Wayne Cecil, PhD, CPA is a professor of accounting at Florida Gulf Coast University, Fort Myers, Fla.
Teresa A. King, PhD, CPA is a professor of accounting at Georgia College & State University, Milledgeville, Ga.