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Congress examines the tax gap and taxpayer noncompliance

The House Ways and Means Committee held a hearing Thursday to examine taxpayer noncompliance and how it is contributing to the estimated tax gap of approximately $400 billion to $460 billion between taxes owed and actually paid.

“The most recent Internal Revenue Service estimate of the annual gross tax gap is about $460 billion and, after enforcement activities and late payments, the net amount is $400 billion a year,” said House Ways and Means Committee chairman Richard Neal, D-Mass., in his opening statement. “Despite this astounding number, the true tax gap is greater than what the IRS estimates. This is because the IRS estimate does not include taxes owed on income from illegal activities or taxes avoided on certain international activities. The tax gap simply represents estimates of different types of noncompliance with our individual, corporate, and other tax laws.”

He pointed out that there is noncompliance in the form of underreporting, which includes taxpayers who understate their income or overstate their deductions, exemptions, or credits. That accounts for nearly $390 billion of the gross tax gap. Noncompliance by taxpayers who file their tax returns but fail to meet the deadline to pay what they owe accounts for about $40 billion of the gross tax gap.Then noncompliance by taxpayers who are required to file a tax return, but don’t accounts for about $32 billion of the gross tax gap.

House Ways and Means Committee chairman Richard Neal, D-Mass.
Richard Neal Photographer: Anna Moneymaker/Bloomberg

Neal pointed out that the amount of the tax gap that the IRS can collect depends on its funding and resources. “Insufficient IRS funding creates incentives for some taxpayers to take aggressive tax positions,” he said. “Well-advised taxpayers, including multinational companies and high-income taxpayers, have the incentives and the resources to do just that.”

While high-income taxpayers have the most opportunity to engage in tax avoidance planning, the IRS isn’t focusing its audits on them. “Instead, in 2017, the IRS targeted low-income, Earned Income Tax Credit taxpayers,” said Neal. “Many question why the IRS is using its limited resources in this manner rather than deploying them on high-income taxpayers and corporations where the return is greater per hour of a revenue agent’s time. Taxpayers are more compliant when they may be audited. But the overall audit rate has plummeted below one-half of one percent. IRS examination personnel have decreased by nearly 5,000 employees — or 38 percent — over seven years, and IRS revenue officers have decreased by over 1,600 employees — or 42 percent — during the same period. With fewer officers, Treasury fails to collect billions of dollars each year.”

The top Republican on the tax-writing committee, Rep. Kevin Brady, R-Texas, took issue with the accusation about budget cuts. "I know many of the other side of the dais today will cry foul and claim that Republicans have 'gutted' the IRS over the years,” he said. "The truth is that the IRS budget has been stable over the last several years and any cuts by Congress were made only when compared to an all-time budget high. Republicans are committed to ensuring that our nation’s tax administrator does the job it’s built to do: administer our tax code. Because especially as it concerns closing the tax gap, the solution must be myriad. There is no one single approach that will fully and cost-effectively address the tax gap. The IRS cannot audit its way out of the tax gap. Solving the tax gap requires multiple solutions across different types of taxes.”

Brady believes the IRS should be paying more attention to the tax compliance of “gig economy” workers and pointed to recent reports from the Treasury Inspector General for Tax Administration. "We know that in order to address this gap, we must address our changing economy,” he said. "'Gig' economy workers — such as folks who drive for Uber or use their home as an Airbnb — contribute greatly to our economy. We support innovation in our workforce and want to ensure these companies can succeed. But as TIGTA, who we will hear from today, recently discovered, there is greater risk of folks who participate in the gig economy of noncompliance. TIGTA recommended to the IRS that the agency develops a strategic plan to address tax administration in the gig economy — and the IRS agreed on its importance. And as TIGTA has found, the IRS can be using its current resources more effectively. There are opportunities that exist to help the IRS complete smarter audits; and GAO has recommended ways in which the IRS could allocate enforcement resources to maximize its audit results.”

J. Russell George, inspector general at TIGTA, presented a report on the tax gap and taxpayer noncompliance and pointed to some of TIGTA’s earlier reports on taxing the gig economy. “In a report evaluating the gig economy’s impact on self-employment tax compliance, TIGTA reported that cases with billions of dollars in potential tax discrepancies involving taxpayers who earn income in the gig economy are not being worked by the IRS,” he said. “Many cases were not selected to be worked by the IRS due to the large volume of discrepancies that were identified and resource constraints. In addition, a lack of an overall gig economy compliance strategy led IRS employees to remove thousands of cases from inventory without justification or with justifications that were inaccurate.”

James R. McTigue, Jr., director of strategic issues at the Government Accountability Office, also presented a report by the GAO on how multiple strategies are needed to address taxpayer noncompliance. “GAO’s work has demonstrated that no single approach will fully and cost effectively address noncompliance since the problem has multiple causes and spans different types of taxes and taxpayers,” said the report. “In light of these challenges, GAO has made numerous recommendations to IRS — some of which have not yet been implemented — such as developing and documenting a strategy that outlines how IRS will use data to update compliance approaches to help address the tax gap. Reducing the tax gap will also require targeted legislative actions. For example, expanding third-party information reporting could increase voluntary compliance and providing IRS with the authority to regulate paid tax return preparers could improve the accuracy of the tax returns they prepare.”

Representatives from the IRS also testified at the hearing. Dr. Benjamin Herndon, chief research and analytics officer at the IRS, discussed how the IRS comes up with its estimates of the tax gap, and why there hasn’t been one since 2016, covering tax years 2008 through 2010. He said the IRS plans to release an updated estimate later this year.

“In terms of what makes up the tax gap, the underreporting of business income by individual taxpayers — income of sole proprietors, farmers and those earning rental, royalty, partnership, and S Corporation income — is the largest contributor, accounting for $125 billion of the total $458 billion in the 2008-2010 period,” said Herndon. “The IRS believes that the lack of reliable and comprehensive reporting and withholding for business income received by individuals is the main reason for these findings. These statistics provide further confirmation that “visibility” of income sources and financial transactions is a significant contributor to increasing the compliance rates, and enhanced information reporting is one of the few means of sizably increasing the compliance rate. Business income reported on Form 1040s is a much lower-visibility income source because it is not often subject to the same information reporting and withholding requirements that exist for salary and wage income.”

Kenneth Wood, former deputy associate chief counsel at the IRS, also spoke at the hearing. He retired last August, but discussed how large multinational corporations can avoid paying taxes by using strategies such as transfer pricing. “The facts of each transaction are, typically, very complex, the economic analysis is difficult and not susceptible of precision, and the legal guidelines are somewhat blunt,” he said. “In short, the task of auditing the pricing of trillions of dollars of transactions, within the statute of limitations, is an extraordinarily heavy lift. And as budgets shrink and senior personnel with substantial transfer pricing experience retire and cannot be replaced, transfer pricing audits become more and more challenging, and tax revenues fall. An economic analysis from 2010 estimated that inappropriate transfer pricing was draining more than $28 billion annually from the Treasury. On the other side of the equation are large, well-advised multinational corporations that control the facts but resist responding to legitimate IRS inquiries in a timely manner in the hope that they can run out the clock before the IRS has fully developed its case. Given the tax dollars at risk, these taxpayers spend tens of millions of dollars annually on tax litigation. If you are curious, I suggest you review the financial statements of taxpayers that have recently litigated, or are litigating, a large transfer pricing case. These expenditures support not just a substantive defense of their tax position but also efforts to undermine the IRS’s ability to develop its case. It is hardball litigation by counsel zealously representing their clients, and they have far larger budgets than the IRS. Taxpayers are understandably willing to spend millions to save billions. While the IRS has excellent, very hard working litigators, the organization has far fewer resources than taxpayers to devote to these cases.”

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