Closing the Tax Gap after Tax Reform
Administering and enforcing the tax code is no small task. In 2017, the IRS processed 245 million tax returns, collected $3.4 trillion in taxes, and issued refunds to over 120 million households.
So, how will the Tax Cuts and Jobs Act impact the IRS’s tax administrative duties, and, more specifically, how will the IRS adapt its mechanisms for closing the tax gap under the new laws?
Before we can answer that question, we have to explore the two basic motivations for paying your taxes—intrinsic motivation and extrinsic motivation. With intrinsic motivation, individuals pay their taxes because they admire civic virtue. With extrinsic motivation, individuals pay their taxes because they fear punishment.
The IRS has dedicated a significant amount of resources to better understanding taxpayer behavior and preferences. The Comprehensive Taxpayer Attitude Survey (CTAS) is one measure used to evaluate taxpayer attitudes and inform IRS efforts to improve taxpayer services.
The CTAS results for 2017 showed that the majority of taxpayers find cheating on their income taxes to be unacceptable and nearly all taxpayers responded that they believe it's their civic duty to pay their fair share of taxes. See charts below from the 2017 IRS Data Book.
Despite these civic-minded virtues and government-friendly results, the IRS has estimated that the tax gap is around $450 billion each year. The tax gap is the difference between taxes paid and taxes owed.
Noncompliance is usually attributed to non-filing, underreporting, and underpayment. Taken as a whole, these components of noncompliance represent roughly 15% of the total tax liabilities each year.
The IRS uses several mechanisms to combat the tax gap, but the one most taxpayers fear is an IRS audit. Some are surprised to learn that the IRS only audits 1% of all returns filed each year.
Further, according to IRS data, the number of individual and partnership audits has declined in recent years. In 2016, the IRS audited 0.6 percent of individual income tax returns and 1.0 percent of corporate income tax returns.
Selection is determined based on a discriminate index formula (DIF). The formula helps agents identify income that is often misreported. For example, an individual income tax return with a Schedule C attached is more likely to be flagged than a return that only includes W-2 earnings.
For most individuals, earned income is reported to the IRS on Form W-2 by their employer. Unearned income, such as dividend or interest income, is reported to the IRS by banks and other financial institutions on Form 1099. This means there is very little opportunity for manipulation.
According to the IRS, only 1% of income is underreported when there is adequate withholding and information reporting by third parties. In contrast, over 60% of income is misreported when there is little to no information reporting.
Some practitioners argue that the passage of the Tax Cuts and Jobs Act has resulted in even fewer opportunities for manipulation because the new law doubles the standard deduction and caps the state and local tax deduction. This means fewer taxpayers will itemize their deductions and more taxpayers will rely on the standard deduction—a flat amount tied to the taxpayer’s filing status.
The Tax Policy Center predicts the number of households itemizing their deductions will go from 46 million to 21 million under the new law.
Other practitioners argue that the incentive to create pass-through businesses, such as partnerships and sole proprietorships, in order to benefit from the new section 199A business deduction, will only contribute further to the tax gap. They note that the business income generated by these pass-through entities generally escapes withholding and information reporting—the category of income most often misreported.
The IRS will likely consider both arguments in developing mechanisms to close the tax gap under the new legislation. One approach may be devoting more resources to pass-through entity returns and fewer resources to returns that are subject to standard withholding and information reporting. Another approach may be reducing the number of corporate income tax audits and increasing the number of individual and partnership audits, thereby reversing the trend from recent years.
Whatever the IRS decides to do in the short-term, taxpayer data collected over the next few years will likely focus on the decrease in itemized filers relative to the increase in pass-through entities. These details can be used to refine the IRS’s DIF formula over the long-term, resulting in more strategic audits of income tax returns under the new law.
Tara Fisher has been practicing international tax for over 15 years. Her professional background includes working for the U.S. Congress Joint Committee on Taxation, the national tax practice of PricewaterhouseCoopers, the University of Pittsburgh, and American University in Washington D.C.