Saturday, March 6, 2010

The Federal Income Tax Gap: $400 Billion and Rising

U.S. taxpayers and foreign persons subject to U.S. taxation owe, but do not remit (or the IRS fails to collect), some $400 billion in annual taxes owed to the federal government. This number is based on an IRS estimate for tax year 2001, an estimate of the international tax gap, and an update due to population and income growth.

In the context of current trillion dollar deficits, $400 billion may seem a modest figure. If the tax gap had been plugged during the last 20 years, the U.S. budget would have routinely been in surplus. There would be little to no public debt (assuming the Congress did not spend the additional revenues). Even now, with $10 trillion in projected deficits over the next decade, eliminating most or all of the tax gap would slash that number by $3-4 trillion, no small amount.

Why does the tax gap remain so large in spite of beefed-up enforcement efforts at the IRS. The answer is twofold. First, the complexity of the tax code enables tax lawyers and planners to devise tax avoidance schemes, which are perfectly legal until the law catches up with these measures and disallows them.

Second, is high rates of taxation, which encourage cheating. For three years in the early 1980s, I served on the American Bar Association Commission on Taxpayer Compliance. Its report analyzed every conceivable reason for tax avoidance and evasion that contributed to the tax gap. The commission concluded that the most serious cause of the tax gap was high marginal rates of taxation.

Given this finding, the tax gap is likely to grow, not diminish. The expiration of the Bush tax cuts on December 31, 2010, means a rise in marginal tax rates from 33 and 35 percent to 36 and 39.6 percent respectively. This rise will increase the incentive to avoid or evade taxes. So too will increases in capital income tax rates (dividends, interest, and capital gains).

Failure to take this propensity into account means that some portion of the estimated additional revenue from higher rates of tax in 2011 and beyond will disappear into the black hole of the tax gap. Watch and see.

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