Tax Gap

Given congressional interest in both revenue-reducing measures such as the Alternative Minimum Tax and concerns about the federal budget deficit, policymakers are focusing their attention on possible revenue-raising measures that would, in effect, help pay for tax cuts elsewhere. One area of interest among many is closing the so-called “tax gap.”

The “tax gap” is a concept defined by the Internal Revenue Service for determining taxpayers’ compliance with their federal tax obligations. The gross “tax gap” is the difference between the amount of tax that should be paid, on a timely basis, and the amount actually received by the government for a specific tax year. Thus, the “tax gap” includes both deliberate and illegal tax evasion but also non-payment that occurs for more innocent reasons; taxpayer error or simple inability to pay.

IRS develops its “tax gap” estimates by measuring the rate of taxpayer compliance—the degree to which taxpayers fully and timely complied with their tax obligations. That rate is then used, along with myriad other assumptions, to estimate the dollar amount of taxes not timely or accurately paid. For tax year 2001, the IRS estimates nearly 17-percent of owed taxes were late or not paid at all, which translates into an estimated gross “tax gap” of $345 billion. The IRS recovered about $55 billion of this sum, leaving a net tax gap of $290 billion.

As defined by the IRS, the “tax gap” consists of three components: nonfiling (failure to file a return), underreporting (understating income or overstating deductions), and underpayment (failure to pay reported taxes owed). Of these, IRS argues underreporting is the largest, comprising 80 percent or $166 billion of the total gap. Of the $166 billion, IRS claims that small businesses are responsible for $109 billion.

Proposals to reduce the “tax gap” have included both changes in tax law as well as changes in IRS tax administration. Legislatively, the Joint Committee on Taxation has issued two reports outlining numerous legislative approaches for reducing the “tax gap.” The report contains proposals aimed at closing perceived “loopholes,” as well as measures that would address non-compliance—including simplification and clarification of tax laws, increased withholding, and increased information reporting. Several of the reports’ proposals were included as revenue-raising measures in the Tax Increase Prevention and Reconciliation Act of 2006 including the proposal that requires all federal, state and local government entities withhold and submit to the IRS three-percent of the value of all government contracts, much like employers withhold from the pay of their employees.

On Feb. 5, President George W. Bush released his $2.9 trillion budget proposal for fiscal year 2008 that includes provisions for narrowing the tax gap. The legislative proposals to improve tax compliance with minimum taxpayer burden include expanding information reporting requirements, improving compliance for businesses, strengthening tax administration and expanding penalties. Specific proposals in the area of increased reporting would require: reporting on payments to corporations; basis reporting on security sales; information reporting on merchant payment card reimbursements, a certified taxpayer identification number from non-employee service providers; and increase information return penalties.

Honest small business taxpayers are especially at risk of being subjected to needless and unwarranted regulatory burdens in an attempt to capture the few “bad apples” that do not fulfill their tax obligations. Small firms could be targeted and penalized by the IRS for small and unintentional transgressions.

NSBA is working to fight for the rights of these honest small-business taxpayers as lawmakers continue to address the tax gap. NSBA is beginning an initiative to raise awareness about the potential threat, to help give small businesses the tools they need to deal with this potential new environment, and to educate small businesses about common mistakes in tax preparation. Please visit www.preventirsabuse.org

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