Bartlett: The Tax Gap, Information Reporting, Withholding, Enforcement, and Politics

New York Times, The 'Tax Gap', by Bruce Bartlett:

In keeping with its apparent policy of releasing important economic reports late on Friday afternoons in the hope that no one will notice them, the Obama administration published new estimates of the so-called tax gap on Jan. 6. They deserve more attention. …

Noncompliance primarily takes the form of unreported income rather than taking unjustified deductions, exemptions and such. The bulk of unreported income is among unincorporated businesses, which can much more easily hide income from the IRS than workers who primarily earn wages from which their employers withhold taxes.

Information reporting and withholding are the IRS’s principal lines of defense against tax cheating. … Almost all wages and salaries are reported and taxes withheld. There is more noncompliance in areas like pensions and investment income, where there is reporting but generally no withholding. Noncompliance rises as reporting requirements weaken for things like alimony and capital gains and rises sharply where reporting requirements are nonexistent, such as for proprietors’ income, rents and royalties.

Effect of Information Reporting on Taxpayer Compliance

Tax year individual income tax underreporting gap and net misreporting percentage, by “visibility category.” (Dark bars represent underreporting gap, in billions of dollars on left scale; light bars show net misreporting percentage, defined as the net misreported amount of income as a percentage of the true amount, on right scale.)

Clearly, therefore, one solution to the tax gap is to increase reporting and withholding requirements. However, previous efforts by Congress to do so have been met with huge political resistance. People don’t like the intrusion into their privacy — and the diminution of their opportunities for tax evasion — and businesses don’t like the cost or the alienation of their customers.

Of course, another factor in tax compliance is enforcement. Someone who thinks the odds of being caught are close to zero is going to be strongly tempted to cheat no matter how low tax rates are.Unfortunately, Republicans have been treating the IRS like a political punching bag for years, cutting its personnel and restricting its ability to do its job. The number of IRS employees fell to 84,711 in 2010 from 116,673 in 1992 despite an increase in the population of the United States of 53 million over that period.

Federal revenues are at a historically low level and are a key cause of the federal budget deficit. Sooner or later, taxes will have to be increased. It would be better to minimize that increase by ensuring that taxpayers pay what they owe. It’s unfair to honest taxpayers and undermines tax morale when large numbers of people and businesses don’t pay their taxes.