IRS Releases New Tax Gap Estimates

January 10, 2012

On Jan. 6, the Internal Revenue Service (IRS) released a new set of tax gap estimates for tax year 2006. These new estimates represent the first full update of the original report in five years, and it shows the nation’s compliance rate is essentially unchanged from the last review covering tax year 2001.

The gross tax gap is defined as the amount of true tax liability faced by taxpayers that is not paid on time. For 2006, the gross tax gap was estimated to be $450 billion and the voluntary compliance rate for 2006 remained unchanged at 83.1 percent, which is within the range of error of the previous estimates of 83.7 percent for 2001.

The net tax gap is defined as the amount of true tax liability that is not paid on time and is not collected subsequently, either voluntarily or as the result of enforcement activities. Thus, the net tax gap represents the amount of tax liability that is never paid. The net tax gap for 2006 is estimated to be $385 billion, which is $95 billion higher than the $290 billion net tax gap previously estimated for 2001. The IRS recovered approximately $65 billion in revenue in 2006 through audits, late payments and other measures.

The tax gap is divided into three components: non-filing, underreporting and underpayment. As was in the case in 2001, the underreporting of income remained the biggest contributing factor to the tax gap in 2006. Under-reporting across taxpayer categories accounted for an estimated $376 billion of the gross tax gap in 2006, up from $285 in 2001. Tax non-filing accounted for $28 billion in 2006, up from $27 billion in 2001. Underpayment of tax increased to $46 billion, up from $33 billion in the previous study.

The new study found that compliance is highest where there is third-party information reporting and/or withholding. For example, most wages and salaries are reported by employers to the IRS on W-2 forms and are subject to withholding. As a result, a net of only one percent of wage and salary income was misreported. Conversely,  amounts subject to little or no information reporting had a 56 percent net misreporting rate in 2006.

Since IRS Commissioner Doug Shulman began his five-year term in March 2008, virtually all major initiatives launched by the IRS since 2008 have been designed to focus on the tax gap through more effective enforcement or improved service to taxpayers.

On Capitol Hill, the top tax-writers in both chambers said the new IRS data underscored the need for overhauling the tax code and making it simpler.

Such simplification, according to a spokeswoman for Rep. Dave Camp (R-Mich.), who chairs the House Ways and Means Committee, “…not only will compliance increase because average Americans will make fewer mistakes on their tax returns, but it will create greater certainty, which is key to job creation.”

In a release, Sen. Max Baucus (D-Mont.), chairman of the Finance Committee, pointed out that the $450 billion in the 2006 tax gap would have funded the Veterans’ Affairs Department four times over in 2011. For further comparison’s sake, around $500 billion in defense cuts are due in 2013, as a result of last year’s deal to raise the debt ceiling.

IRS provided links to supporting resources available on its website, including: a fact sheet about the 2006 tax gap estimates, a description of estimation methods used, a tax gap map, and an overview of the 2006 tax gap.

Please click here for NSBA’s proposal on tax reform.