Tax Reform Is the Right Way to Lower the So-Called Tax Gap

Many politicians in Washington think they could get a lot more money to redistribute if Americans could be compelled into being fully compliant with the internal revenue code. Yet the world’s leading expert on the underground economy estimates that the United States has less evasion than any other nation [.pdf]. Moreover, the Wall Street Journal notes that the vast majority of noncompliance is the result of tax code complexity, which is why the only pro-growth way to generate more revenue is lower tax rates and simplification:

The “tax gap” is the difference between what the Internal Revenue Service thinks taxpayers should be paying and what it collects. The IRS currently estimates this at about $290 billion a year. Ask any Congressional chairman how he intends to close the deficit, expand the Medicare drug benefit, reform the Alternative Minimum Tax or subsidize college education, and the answer is invariably “close the tax gap.” Last year the Senate held some half-dozen hearings in search of this pot of gold. …We suppose politicians are allowed to dream. But it’s worth recalling that Washington has searched for this revenue Atlantis for decades without success. …Nina Olson, the IRS’s taxpayer advocate, told Congress last year that IRS auditors have found that an estimated 94% of noncompliance is the result of honest mistakes by tax filers who simply don’t understand the 17,000-page beast of a tax code. One obvious answer would be to simplify the code (more on that later). But this requires political will, so Congress naturally prefers the easier route of ratcheting up taxpayer regulation and enforcement. …Our personal favorite would require that Americans withhold taxes from any cash payments they make to such individual contractors as babysitters, gardeners or plumbers. They’ll love that one in the suburbs. Implicit in all these new plans is a much bigger IRS staff to monitor and chase tax miscreants. Here’s another bad idea: Many doctors and lawyers who are incorporated under subchapter S will often pay themselves lower wages but higher dividends, in order to reduce self-employment taxes. The law is vague on the limits of this practice, and it is undoubtedly abused. But the Joint Tax Committee’s preferred solution is to make all professional income – even dividend payments – subject to self-employment taxes; this is nothing more than a backdoor tax hike. …There is a better way. The more complicated a tax system, the more likely taxpayers won’t understand, or will try to dodge, the rules. Simple tax regimes, such as a single flat rate, encourage compliance and efficiency, not to mention economic growth. This has been the experience of many Eastern European countries after they imposed a flat tax, and the U.S. had similar jumps in reported tax income from “the rich” following the 1986 tax reform that cut rates and closed loopholes.