More is Less: Tax Gap Study Shows Increased IRS Efforts Yielded Lower-than-Expected Returns

The IRS will need help to reduce the $450 billion annual loss to the US Treasury.

On Jan. 6, the IRS released its latest measurement of the tax gap, a staggering $450 billion a year, 30% more than the previous tax gap study five years earlier. The tax gap is the amount of taxes that are owed but not paid to the US Treasury by individuals, businesses, employers, estates and other taxpayers.  The IRS last measured the tax gap in 2005, using data from 2001 tax returns. The most recent update is a measurement of 2006 return data that was compiled from IRS data and the examination of 14,000 random tax returns.

To put the numbers in perspective, the national budget deficit was $248 billion in 2006. With a tax gap of $450 billion for the same year, the national loss in uncollected taxes might seem unacceptable to many Americans.

In fact, that’s exactly how the IRS views it. The tax gap is made up of three components, each representing a breach with tax laws that the IRS expects taxpayers to follow.

• Non-filing:  $28 billion a year lost to taxpayers who don’t file required tax returns
• Underreporting:  $376 billion a year lost to taxpayers who don’t report income or overstate deductions and credits on tax returns
• Underpayment:  $46 billion a year lost to taxpayers who don’t pay what they owe

The new tax gap study also revealed that the overall compliance rate slipped slightly from 83.7% to 83.1%. However, the IRS noted that, when accounting for the study’s margin of error, the compliance rate is relatively unchanged from the 2001 data.

Either way, the IRS has much to do to reach its target goal of an 86% voluntary compliance rate for tax year 2009 and Congress’ goal of 90% voluntary compliance by 2017, both of which will be measured in the next decade. Legislators and the IRS may have to face the facts:  To achieve voluntary compliance and close the tax gap, the IRS can’t do it alone. Traditionally, the IRS has used compliances initiatives such as notices, audits and voluntary disclosure programs. However, to meet its compliance goals, the IRS will need help from Congress.

Tax gap study reveals challenges the IRS faces.

The IRS has some effective tools to collect taxes that it knows taxpayers owe. These tools include audits, liens, levies, matching programs and discrepancy notices. In 2001, the IRS used enforcement methods like these to increase the voluntary compliance rate from 83.7%to a net compliance rate of 86.3%, after enforcement collections. In doing so, the IRS collected an additional $55 billion. In 2006, the voluntary compliance rate was measured at 83.1%. The IRS used enforcement to raise the net compliance rate to 85.5%, collecting an additional $65 billion. Even though the IRS collected $10 billion more in 2006 than in 2001, the compliance rate slipped by almost a full percent.

A 1% change in the voluntary compliance rate represents almost $27 billion a year to the US Treasury. If the IRS met Congress’ goal of 90% voluntary compliance, that would mean an additional $184 billion. From 2001 to 2006, the IRS increased its enforcement efforts to a far greater extent than the outcomes it realized. In that time, the IRS budget increased 21%, from $8.7 billion to $10.6 billion, and the compliance enforcement budget increased 36%, from $3.4 billion to $4.65 billion.

IRS compliance activity increases are shown below: