The Federal Tax Gap

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Mr. Chairman and members of the committee, thank you forinviting me to testify today regarding the "tax gap," which is thedifference between the amount of taxes owed and the amount of taxesactually paid.

The net tax gap, after enforcement, is $290 billion, or 14percent of what is owed, according to the Internal RevenueService.1 Put another way,compliance with the federal tax system stands at 86 percent. Ithink to most people, that compliance rate would sound quite high.After all, we rarely get 100 percent compliance with any law.Consider automobile seatbelt laws. The national compliance ratewith seatbelt laws was 81 percent in 2006, and that is despitelarge education campaigns on that issue.2

International evidence also suggests that the federal taxcompliance rate is high. Friedrich Schneider, a professor ofeconomics at Johannes Kepler University in Austria, completed adetailed study last year on the size of underground, or shadow,economies in 145 countries.3He is perhaps the world's top expert on underground economies andtax evasion. Schneider defines the shadow economy to include legalactivities that are not reported to governments in order to avoidtaxes and regulations. Reviewing the literature, he finds that "inalmost all studies, it has been found that the tax and socialsecurity contributions are one of the main causes for the existenceof the shadow economy."4

Schneider finds that the shadow economies of developingcountries are much larger than those of the advanced nations of theOrganization for Economic Cooperation and Development. Looking at21 OECD nations in 2002, he found that the average size of shadoweconomies was 16 percent of gross domestic product. The UnitedStates had the smallest shadow economy at just 8 percent of GDP,according to Schneider's analysis.

In a study for the International Monetary Fund in 2000,Schneider similarly found that the United States had a smallershadow economy than nearly all other countries.5 In sum, Americans seem to be highlylaw-abiding when it comes to government taxes and regulations.

Another factor to consider is that the size of the federal taxgap does not seem to have increased over the years. The GovernmentAccountability Office noted recently that "the rate at whichtaxpayers voluntarily comply with our tax laws has changed littleover the past three decades."6 Thus, to the extent that the tax gap is a problem,it is not getting any bigger.

For these reasons, the intense focus in Congress on the tax gapin recent months is perplexing. Americans should pay the amount oftaxes that they owe, but the tax gap is far down on a long list ofproblems with the federal tax system. Congress should focus on thefollowing items as more pressing problems needingattention:7

  • America's high-rate and uncompetitive corporate income tax,which is a growing concern in our increasingly globalizedeconomy.
  • The excessive taxation of savings and investment under theincome tax, which reduces the growth rate of the U.S. economy.
  • High marginal tax rates on individuals and businesses, whichare a hurdle to productive activities and encourage unproductiveavoidance activities.
  • The enormous complexity of the tax code. The number of pages offederal tax law and regulations increased from 40,500 in 1995 to66,498 by 2006.8
  • Increasing horizontal inequity in the tax code. The plethora ofdeductions and credits added in recent years creates unfairness byimposing different tax burdens on people with similar incomes.
  • The alternative minimum tax, which threatens to hit 30 milliontaxpayers by the end of the decade if not reformed orrepealed.

Americans have a responsibility to pay all the taxes that theyowe. But Congress has a responsibility to make sure that laws areas simple as possible and easy to comply with. With the tax code,Congress is utterly failing in its responsibility. James Madisonnoted that "it will be of little avail to the people that the lawsare made by men of their own choice, if the laws be so voluminousthat they cannot be read, or so incoherent that they cannot beunderstood ... or undergo such incessant changes that no man whoknows what the law is today can guess what it will betomorrow."9

Let's make the tax code coherent first before we consider anyadditional regulatory actions to close the tax gap. Focusing on thetax gap first puts the cart before the horse. Let's reform the codeto increase economic efficiency and fairness, and an importantbyproduct will be to increase tax code compliance.

Observations on the Tax Gap Estimates

Most of the tax gap regards individual taxes, not corporatetaxes. IRS data shows that the corporate tax gap is only 9 percentof the overall gap.10 Yetconcerns are often expressed about supposed rampant corporate taxabuse. In recent remarks about the tax gap, Senator Kent Conrad(D-ND) talked about the "hemorrhaging" of federal tax revenues fromcheating by large multinationals with offices in the CaymanIslands.11

However, the problem on the corporate side is legal taxavoidance by multinationals due to our high corporate tax rate, notillegal tax evasion. Interestingly, the Joint Committee on Taxationreport on Enron found hundreds of Enron subsidiaries in theCaymans, but the JCT had a hard time showing that the firm's taxmachinations were actually illegal.12 The corporate tax code encourages the creationof very complex corporate tax structures that are usually legal,but they do make tax compliance much more difficult.

Note that corporate tax revenues have soared in recent years.Corporate tax revenues are expected to be $342 billion in fiscal2007, which is up a remarkable 65 percent over the peak at the endof the last boom in fiscal 2000 of $207 billion.13 Corporate tax revenues are clearly not"hemorrhaging."

The tax gap related to the estate tax is also worth looking at.At $8 billion, the tax gap for the estate tax is a huge 29 percentof the $28 billion in estate tax revenues in 2001. This large gapindicates the large inefficiency of the estate tax, which probablydrives relatively more tax avoidance and evasion than any otherfederal tax. This is one reason why many tax experts support repealof this tax.

The federal FICA payroll tax has a very low tax gap of just $14billion. Experts note that the FICA tax has a low tax gap becauseof employer withholding. But another factor that promotes highcompliance is that the payroll tax is the simplest federal tax. Ithas a low, flat rate and no deductions. It is a model to considerfor reforms of the federal income tax. Indeed, the Hall-Rabushkaflat tax for individuals would consist simply of a flat-ratepayroll tax, and thus would likely have a high compliance rate.

Major tax reforms would reduce the tax gap by reducing taxpayerconfusion and aggressive tax planning. Many taxpayers pay the wrongtax amount because they are confused about what income is taxableand what tax breaks are allowed. And since complex tax rules aresubject to multiple interpretations, they spur taxpayers to takerisks on tax strategies in the hope that they are not caught by theIRS. The Joint Committee on Taxation noted that "taxpayers mayconsciously choose to 'play the audit lottery' by taking aquestionable position on their tax returns, in the belief thatcomplexity will shield them from discovery."14 In its report on Enron, the JCT concludedthat the company "excelled at making complexity anally."15

The IRS estimate of the tax gap includes $32 billion related toclaiming the wrong amounts of credits and deductions. The number ofsuch "tax expenditures" has soared in recent years. Indeed, the GAOfound that the number of tax expenditures has more than doubledsince 1975.16 Table 1 showsthe number of tax expenditures relating to energy and educationhave more than doubled since 1995. The explosion of tax credits anddeductions has added complexity and increased the system'sunfairness by promoting horizontal inequities.

chart

The largest source of the tax gap is the small business andself-employed sector of the economy. It is this sector that wouldbear the burden of many proposed actions to reduce the tax gap, asit would have to pay higher taxes and deal with greater paperwork.If Congress and the IRS increased reporting requirements and taxregulations to try and reduce the tax gap, most of the addedcompliance burden would fall on law-abiding businesses that arealready paying their full load of taxes.

Note that individuals and businesses already spend more than 6billion hours.or more than 3 million person-years.complying withfederal taxes. Many members of Congress, usually around April 15,decry that large burden. Yet trying to reduce the tax gap byimposing added paperwork on businesses would increase the timespent on unproductive compliance activities.

Note that small businesses already have a higher ratio of taxcompliance burdens to taxes collected than do large businesses. Forsmall businesses, tax compliance costs can be larger than actualtaxes paid.17 The IRSTaxpayer Advocate has found that the heavy compliance burden onsmall businesses is one of the most serious problems with the taxsystem.18 Thus, targetingsmall businesses with more regulations to try and close the tax gapseems especially unfair.

Senator Kent Conrad (D-ND) recently stated that "closing the taxgap is not about raising taxes on anyone."19 But in fact, it is. Certainly, some individualsand businesses are currently not paying all they owe. But takingactions to increase taxes paid would create all the usual"deadweight losses," or inefficiency costs, that any tax increasewould create. If a small business is required to pay more tax, itwill have less cash flow available for capital investment andhiring workers. There is no free money sitting around for thefederal government to simply grab without negative side-effects onthe economy.

Conclusion

In conclusion, the great attention being placed on the tax gapseems out of place given that the problem is not excessive comparedto other countries, nor is it getting worse over time. Federalrevenues are up above historical norms at 18.5 percent of GDP infiscal 2007. Indeed, data for the first four months of fiscal 2007show a 10 percent increase over fiscal 2006.20

The fiscal problem in Washington is not a lack of revenue. Thusburdening small businesses and the economy with more taxregulations to try and close the tax gap is the wrong way to go. Inhis classic work, The Wealth of Nations, Adam Smithrecognized that the total cost of taxation is "a great deal more"than just the amount of revenue collected. For one thing, he arguedthat "by subjecting the people to the frequent visits and theodious examination of the tax-gatherers, it may expose them to muchunnecessary trouble, vexation, and oppression."

Rather than increase odious tax-gathering activities, we shouldinstead reform the tax code to reduce marginal rates and eliminatespecial preferences. That would be beneficial for families and theeconomy, and it would have the side effect of reducing the taxgap.

Thank you for holding these important hearings. I look forwardto working with the committee on tax issues, particularly tax codesimplification and reform.


1 The IRS estimates arediscussed in Government Accountability Office, "Tax Compliance,"GAO-07-391T, January 23, 2007. See also U.S. Department ofTreasury, "A Comprehensive Strategy for Reducing the Tax Gap,"September 26, 2006.

2 National Highway TrafficSafety Administration, "Seat Belt Use in 2006: Overall Results,"November 2006,www-nrd.nhtsa.dot.gov/pdf/nrd-30/NCSA/RNotes/2006/810677.pdf.

3 "Shadow Economies of 145Countries all over the World: What do we really know?" May 2006,www.econ.jku.at/Schneider/ShadEconomyWorld145_2006.pdf.

4 "Shadow Economies of 145Countries all over the World: What do we really know?" May 2006, p.5, www.econ.jku.at/Schneider/ShadEconomyWorld145_2006.pdf.

5 Friedrich Schneider andDominik Enste, "Shadow Economies Around the World: Size, Causes,and Consequences," International Monetary Fund, Working Paper00/26, February 2000.

6 GovernmentAccountability Office, "Tax Compliance," GAO-06-1000T, July 26,2006, p. 1.

7 For a discussion ofproblems with the tax code, see Chris Edwards, "Options for TaxReform," Cato Institute Policy Analysis no. 536, February 24, 2005,www.cato.org/pub_display.php?pub_id=3681.

8 Based on the page countof the CCH Standard Federal Tax Reporter. See Chris Edwards,"Income Tax Rife with Complexity and Inefficiency," Cato InstituteTax & Budget Bulletin no. 33, April 2006,www.cato.org/pubs/tbb/tbb-0604-33.pdf.

9 James Madison, TheFederalist Papers, No. 62.

10 For all tax gapfigures, see Government Accountability Office, "Tax Compliance,"GAO-07-391T, January 23, 2007. See also U.S. Department ofTreasury, "A Comprehensive Strategy for Reducing the Tax Gap,"September 26, 2006.

11 Senator Kent Conrad(D-ND), Remarks at a Senate Budget Committee "Hearing on PresidentBush's FY2008 Budget Proposals on Tax Compliance," February 14,2007.

12 In testifying on theEnron activities, then JCT chief of staff, Lindy Paull, said, "Idon't know if you could call it illegal." See Peter Behr, "EnronSkirted Taxes Via Executive Pay Plan," Washington Post, February14, 2003, p. E1.

13 Budget of the U.S.Government, FY2008, Historical Tables, p. 30.

14 Joint Committee onTaxation, "Study of the Overall State of the Federal Tax System,"JCS-3-01, April 2001, volume 1, p. 102.

15 Joint Committee onTaxation, "Report of Investigation of Enron Corporation and RelatedEntities Regarding Federal Tax and Compensation Issues, and PolicyRecommendations," volume 1: Report, JCS-3-03, February 2003, p.16.

16 GovernmentAccountability Office, "Tax Compliance," GAO-06-1000T, July 26,2006. p. 7.

17 Art Hall, "ComplianceCosts of Alternative Tax Systems II," Tax Foundation, March1996.

18 Internal RevenueService, National Taxpayer Advocate, Annual Report to Congress, FY1999.

19 Senator Kent Conrad(D-ND), Remarks at Senate Budget Committee "Hearing on PresidentBush's FY2008 Budget Proposals on Tax Compliance," February 14,2007.

20 Congressional BudgetOffice, "Monthly Budget Review," February 6, 2007.

Chris Edwards

Budget Committee
United States House of Representatives