The net tax gap, after enforcement, is $290 billion, or 14 percent of what is owed, according to the Internal Revenue Service.1 Put another way, compliance with the federal tax system stands at 86 percent. I think 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 rate with seatbelt laws was 81 percent in 2006, and that is despite large education campaigns on that issue.2
International evidence also suggests that the federal tax compliance rate is high. Friedrich Schneider, a professor of economics at Johannes Kepler University in Austria, completed a detailed study last year on the size of underground, or shadow, economies in 145 countries.3 He is perhaps the world’s top expert on underground economies and tax evasion. Schneider defines the shadow economy to include legal activities that are not reported to governments in order to avoid taxes and regulations. Reviewing the literature, he finds that “in almost all studies, it has been found that the tax and social security contributions are one of the main causes for the existence of the shadow economy.“4
Schneider finds that the shadow economies of developing countries are much larger than those of the advanced nations of the Organization for Economic Cooperation and Development. Looking at 21 OECD nations in 2002, he found that the average size of shadow economies was 16 percent of gross domestic product. The United States 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 smaller shadow economy than nearly all other countries.5 In sum, Americans seem to be highly law‐abiding when it comes to government taxes and regulations.
Another factor to consider is that the size of the federal tax gap does not seem to have increased over the years. The Government Accountability Office noted recently that “the rate at which taxpayers voluntarily comply with our tax laws has changed little over 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 gap in recent months is perplexing. Americans should pay the amount of taxes that they owe, but the tax gap is far down on a long list of problems with the federal tax system. Congress should focus on the following items as more pressing problems needing attention:7
- America’s high‐rate and uncompetitive corporate income tax, which is a growing concern in our increasingly globalized economy.
- The excessive taxation of savings and investment under the income tax, which reduces the growth rate of the U.S. economy.
- High marginal tax rates on individuals and businesses, which are a hurdle to productive activities and encourage unproductive avoidance activities.
- The enormous complexity of the tax code. The number of pages of federal tax law and regulations increased from 40,500 in 1995 to 66,498 by 2006.8
- Increasing horizontal inequity in the tax code. The plethora of deductions and credits added in recent years creates unfairness by imposing different tax burdens on people with similar incomes.
- The alternative minimum tax, which threatens to hit 30 million taxpayers by the end of the decade if not reformed or repealed.
Americans have a responsibility to pay all the taxes that they owe. But Congress has a responsibility to make sure that laws are as simple as possible and easy to comply with. With the tax code, Congress is utterly failing in its responsibility. James Madison noted that “it will be of little avail to the people that the laws are made by men of their own choice, if the laws be so voluminous that they cannot be read, or so incoherent that they cannot be understood … or undergo such incessant changes that no man who knows what the law is today can guess what it will be tomorrow.“9
Let’s make the tax code coherent first before we consider any additional regulatory actions to close the tax gap. Focusing on the tax gap first puts the cart before the horse. Let’s reform the code to increase economic efficiency and fairness, and an important byproduct will be to increase tax code compliance.