Shrinking the Tax Gap: A Comprehensive Approach

Over the course of the past year, we have written independently about the substantial revenue potential of a significant investment in tax compliance. In several articles, we have estimated that overhauling the IRS — by increasing effectively allocated examination resources, filling the holes in information reporting of income that cannot now be cross-checked against third-party reports, and investing in technology so the IRS is better able to leverage the information it collects — can raise well over $1 trillion.¹

The Congressional Budget Office, too, recently acknowledged that additional compliance efforts will be high-return investments on behalf of the government.² Its projections are based on conservative estimates of traditional enforcement approaches and therefore show smaller (although still significant) revenue gains than our proposals, which describe more far-reaching improvements to how the IRS does business.³

In this short article, we come together to provide some detail about the steps a new administration should take to attack the tax gap. Many useful actions can be taken through near-term executive actions. More fundamental changes are likely to require legislation. These reforms will not only generate major amounts of long-term revenue from taxes already on the books but, equally important, they will create a system that is fairer to the majority of compliant taxpayers and provide a far sounder foundation for our federal tax system, which accounts for close to a fifth of the entire U.S. GDP.

Combining the insights of our past work, we reach the conclusion that investing less than $100 billion in the IRS over a decade will generate $1.2 trillion to $1.4 trillion in additional tax revenue, primarily from high-income individuals, who are disproportionately responsible for underpayment of owed tax liabilities.

I. Introduction

The federal government will lose more than $600 billion this year because of taxes that were legally owed but unpaid. Over the course of the next decade, barring changes in tax administration efforts, we can expect to lose an estimated $7.5 trillion, or around 3 percent of GDP, annually that our existing law should allow us to collect.⁴

The bulk of the tax gap is attributable to individuals underreporting their income on tax returns.⁵ The failure of a minority of taxpayers to pay what they owe imposes significant burdens on those who are fully compliant: Unpaid taxes total more than all the individual income taxes paid by the lowest 90 percent of earners.⁶

The proportion of underpaid taxes is not evenly distributed among taxpayers. Most taxpayers are fully compliant with tax obligations, because their payments are automatically withheld or are clearly reported. Consequently, taxpayers with more complex sources of income, most of whom are in high-income brackets, are responsible for the vast majority of unpaid taxes. Indeed, the top 1 percent of earners are responsible for at least 30 percent of the tax gap.⁷ This estimate may well be understated, because the audit studies relied on for official estimates likely miss some of the opaque income that high-earners accrue, for example through passthrough businesses (which don’t pay tax directly, but whose income is reported on the tax returns of their owners).

The result is a two-tiered tax administration system in which many of those most able to pay their tax liabilities are in fact paying less than they owe. Perversely, the five counties with the highest audit rates are low-income, disproportionately African American, communities;⁸ whereas a few hundred of the wealthiest tax evaders who failed to even file returns were not pursued by the IRS, adding $10 billion to the tax gap over three years.⁹

A strong attack on noncompliance will require a reform of the tax administration process that includes three key elements that together can greatly improve its effectiveness and efficiency: (1) a greater and more effectively allocated enforcement effort; (2) increased information reporting; and (3) a substantial investment in technology.

A. Enforcement Effort

Over the last 25 years IRS funding has been steadily cut, reducing enforcement resources by 28 percent, even as returns increased by 31 percent.¹⁰ Faced with fewer resources, the IRS has pulled back from enforcement efforts across the board, with the most precipitous drop for high earners (Table 1). Audit rates for the top 1 percent have fallen so significantly that those earners are as likely to face IRS scrutiny as are individuals claiming the earned income tax credit.¹¹

One explanation for this approach is that Congress has pressured the IRS to focus on refundable tax credit errors.¹² But the decline in audits of higher-income taxpayers also stems from the fact that it is more efficient to focus on lower- and middle-income cases. This is, at least in part, because higher-income taxpayers hire sophisticated lawyers and accountants capable of expending years and significant resources on fighting IRS claims that additional taxes are owed; and on the other side, the IRS has limited resources and lacks the workforce needed to detect more complex forms of underreporting.¹³

Table 1. Decline in Audit Rates by Filer Category

Filer Category	Percent Audited		Percent Decline
	2011	2018
All filers	0.93%	0.51%	-45.8%
Individuals	1.1%	0.6%	-46.5%
EITC recipients	2.1%	1.4%	-34.2%
With annual income exceeding $1 million	12.5%	3.2%	-74.1%
$1 million-$5 million	11.8%	2.2%	-81.3%
$5 million-$10 million	20.8%	4.2%	-79.7%
$10 million+	29.9%	6.7%	-77.8%
Corporations	1.5%	0.9%	-41.6%
With assets exceeding $20 billion	95.6%	49.3%	-48.4%
Employers	0.22%	0.14%	-36.8%
Estates	18.2%	8.6%	-52.8%
With assets exceeding $5 million	30.4%	18.7%	-38.4%
Source: IRS, IRS Statistics of Income Data Book, Tables 9a and 9b. Audit rates by annual income are imputed from Table 9b; all other data are from Table 9a.

B. Insufficient Information Reporting

When the IRS has information from third parties that can be used to cross-check taxpayers’ filings, income is accurately reported and taxes are paid. Noncompliance rates are less than 5 percent when substantial third-party information reports exist. In contrast, only 45 percent of income that is not reported on by third parties is eventually taxed.¹⁴

High earners are the primary beneficiaries of the tax gap because more of their income accrues in these opaque categories — like capital gains, partnership income, proprietorship income, and rental income —which together make up 60 percent of unpaid individual income taxes.¹⁵

C. Inadequate Technology

At current low levels of technological investment, it is hard for the IRS to transition to the use of more state-of-the-art data analytics tools (like machine learning) to leverage the information it already collects from taxpayers. Often the IRS fails to match cross-party reports to individual tax returns, negating their value.¹⁶ Further, taxpayers’ interactions with the IRS are more time-consuming and inefficient than necessary for both the taxpayers and the IRS.¹⁷

The IRS has successfully implemented new technology for specific applications, like a program to forestall improper refunds. Given the mandate and funding to do so, the IRS will be able to invest in technological improvements that will improve taxpayer compliance and service.

II. Shrinking the Tax Gap Should Be a Top Priority

In our earlier work, we have independently analyzed the potential of tax compliance initiatives.¹⁸ Our estimate is that a vigorous program to collect unpaid taxes can produce a net gain of up to $1.4 trillion over 10 years, with the gains continuing well beyond the standard 10-year budget window.¹⁹

Table 2. Revenue and Cost Estimate to Shrink the Tax Gap, 2020-2029 (dollars in billions)

	2019	2020	2021	2022	2023	2024	2025	2026	2027	2028	2029	Total
IRS base budget	$12.3	$12.6	$12.9	$13.1	$13.4	$13.7	$13.9	$14.2	$14.5	$14.8	$15.1	$138.3
Technology cost increment		$0.1	$0.4	$0.5	$0.7	$0.9	$1.3	$1.7	$2	$2.2	$2.3	$12
Staffing cost increment		$0.6	$1.4	$2.3	$3.3	$4.4	$5.6	$7.2	$8.2	$9.4	$9.4	$51.8
Total cost increment		$0.7	$1.8	$2.8	$4	$5.4	$6.9	$8.9	$10.1	$11.5	$11.7	$63.8
Revenue gain		$32	$65	$89	$111	$131	$149	$171	$199	$219	$243	$1,408
Ratio revenue gain to cost increment												22
Unmitigated tax gap		$602	$631	$661	$693	$731	$763	$815	$866	$897	$935	$7,593
Revenue gain as percentage of unmitigated tax gap		5%	10%	14%	16%	18%	20%	21%	23%	24%	26%	19%
Source: Authors’ calculations.

Shrinking the tax gap will have the added virtue of increasing efficiency by redirecting toward legal and more valuable activities the socially wasteful efforts now expended on evading tax liabilities.

Our proposed program consists of three parts: (1) increased examination activity that is more focused on high earners with income from lower-visibility sources (who are most likely to be noncompliant); (2) more effective enforcement of tax laws through increased third-party reporting of income that is not currently reported to the IRS; and (3) investment in technology that enables the IRS to make full use of the information it collects and to improve service to taxpayers.

A. Ramping Up Enforcement

Our work has previously called for raising annual audit rates to at least 20 percent for individuals earning more than $1 million annually, who tend to have less-visible sources of income.²⁰ The IRS can immediately begin refocusing attention on higher-income returns with low compliance, even absent legislation. But a substantial uptick in examinations of high-income returns will require hiring and training more agents who are capable of complex examinations, because simply shifting employees who now conduct correspondence audits of low earners is unlikely to be effective.²¹ More special agents will also be needed to investigate criminal tax evasion cases, which have fallen by nearly 40 percent over the last decade, less than 700 cases referred for prosecution in 2019.²² And beyond an initial staffing increase, staff with various skill levels will have to be rebuilt over time to handle the increased caseload resulting from more examination of noncompliant returns.

B. Increasing Third-Party Reporting

Despite the low level of current enforcement, the tax system continues to function because most taxpayers do not need to be audited. Their income is either withheld or clearly reported by third parties, and the compliance rate on this income is 95 to 99 percent.²³

But when the IRS has no information from third parties to help verify taxpayers’ filings — for example, for most business income — less than half of owed liabilities are reported.²⁴ Adding third-party reporting for these types of income will be essential. In fact, the Government Accountability Office and the Treasury Inspector General for Tax Administration have both identified third-party reporting as one of the most effective ways to increase compliance.²⁵

The addition of third-party reporting will improve compliance because taxpayers and return preparers will know that the IRS has the capacity to cross-check information that is reported on tax filings. High earners who accrue income from opaque sources without third-party reports are today undeterred from underpayment because the risk of audit is low and the consequences are weak, even if there is an audit. Taxpayers and preparers who wish to skirt the laws can reasonably play the audit lottery.

C. Improving IRS Technology

More reporting alone will not be sufficient, however, because the IRS cannot make use of all the information it already collects. Moreover, the traditional audit process is expensive because much of it is focused on IRS agents collecting and analyzing data manually. For example, the IRS receives Schedules K-1, which report income from partnerships and passthrough entities, many of which are owned by high-income taxpayers. But these information reports are not used for automated matching because of limitations in IRS technology.²⁶ And even in more routine cases, the IRS closes only a fraction of the mismatches it can identify.²⁷

Upgrading IRS technology will therefore be an essential component of improving the efficiency and effectiveness of the compliance process. Technology available to the IRS, and in limited use already,²⁸ will allow the agency to use all available data, including new information reports, to precisely identify deficiencies in returns and greatly improve productivity of the follow-up audit process. Even with the rudimentary technology the IRS uses today, the productivity of audits in which the return is analyzed by computer before the case is started is many times greater than in traditional audits.

Further, upgraded technology will enable the IRS to enhance the experience of all taxpayers. It will improve taxpayers’ ability to communicate with the IRS when questions arise, reduce the number of unnecessary audits of compliant returns, and reduce the time it takes to complete an audit if one is required.²⁹

III. How to Proceed?

Progress on compliance efforts can be accomplished through executive actions, although a more substantial overhaul of the IRS will likely require legislative approval and authorization.

A. Executive Actions

The president can issue an executive order directing the Treasury secretary and the IRS commissioner to address the tax gap by improving enforcement efforts.

Treasury, in consultation with the IRS, can then take several steps immediately:

• first, in early meetings between the incoming Treasury secretary and the IRS commissioner, the secretary can gauge existing leadership’s willingness to oversee a strong attack on the tax gap and ask them to identify their top-priority staffing and funding needs;

• Treasury can also direct the reallocation of enforcement resources toward high-income taxpayers and corporations with substantial book income but low tax liabilities;

• Treasury can promulgate regulations to disallow opinions from highly paid tax advisers to constitute reasonable cause defenses against IRS action;

• an IRS notice can add gift and estate tax avoidance strategies to the set of transactions that must be reported on by tax advisers;³⁰

• the IRS can commit to pursuing extensions of the statute of limitations when cases are brought against high-income noncompliers;³¹

• the IRS and Treasury can work together to develop a rule requiring that all gig economy workers receive information reports;³²

• the IRS can announce plans to seek the highest penalties and sanctions for high-income noncompliers and for tax experts who advise and facilitate their malfeasance;

• the IRS and the Justice Department can pledge to prioritize the prosecution of criminal tax fraud and economic substance cases against those engaging in tax-motivated transactions; and

• the IRS, with cooperation from the Justice Department, can be directed to reallocate the focus of its criminal investigators primarily to tax evasion of legal income by high-income filers and nonfilers.

B. Legislative Actions

Early on in a new administration, a supplementary appropriation can increase enforcement resources allocated to examinations of noncompliant high-income taxpayers and the businesses they own.

Ideally, more foundational changes to the IRS will be the subject of a legislative effort focused on compliance. Legislation can accomplish four objectives simultaneously:

1. it can provide a gutted IRS the resources it needs — over a multiyear horizon — to revitalize enforcement efforts;

2. it can provide a framework for accountability to ensure that resources are effectively deployed;

3. it can direct focus on badly needed technological reforms; and

4. it can provide for additional third-party reporting that the IRS can rely on to ensure that taxpayers are accurately reporting their income and fulfilling their tax obligations.

1. Legislative mandate to shrink the tax gap.

Legislation can lay out a mandate for the IRS to shrink the tax gap by 20 percent, with a focus on taxpayers with the largest deficiencies.

Setting a legislative mandate and direction for the IRS will be a critical step in a long-term effort to create a more effective compliance process. Real reform requires investments and changes in the way the IRS does business, and those will take some years to be fully effective. The IRS legal framework, internal process, and culture are set up to implement the tax code. Clear direction in the tax code is thus likely to be followed.

Two examples illustrate how powerful a legislative mandate can be.

In the Internal Revenue Service Restructuring and Reform Act of 1998 (RRA ‘98), the IRS was given clear direction to implement specified taxpayer rights and to convert from paper to 80 percent electronic filing. Over the next decade those goals were largely achieved, although few thought they were possible when RRA ‘98 was enacted.

The IRS in 2010 was also given responsibility for implementing a major part of the Affordable Care Act: its 47 tax and insurance subsidy provisions (the GAO reported that 18 of those provisions each affected at least $1 billion of federal revenue or spending and had to be implemented in the first three years after passage of the ACA).³³ The IRS successfully implemented this program in three years and continues to do so, despite intense opposition from the Trump administration and Republicans in Congress.

Once a clear mandate and direction for reducing the tax gap is set into law, the IRS will propose specific programs and resources to accomplish that. With support from the administration, those programs will be funded and executed and will succeed over time.

Following the pattern set in RRA ‘98, we suggest formulating the mandate in a form such as the following:

A formulation in this manner will ensure that the IRS focuses on noncompliant upper-income taxpayers with low-visibility business income, including those who gain income from passthroughs, because those taxpayers are largely responsible for the sizable tax gap.

2. Additional authorities needed.

Most of our recommended program can be carried out within current IRS authorities, but some additional authorities will be required. More research will be needed to identify all changes in authority needed, but the following will be three essential legislative reforms:

1. The IRS will need authority to require a new Form 1099 report from financial institutions reporting summary deposits and withdrawals from accounts held by individual taxpayers and passthrough business entities that meet designated reporting criteria. Those taxpayers would receive the new Form 1099 and be required to reconcile it with their tax return. This new Form 1099 report would be required for only a small fraction of individual taxpayers. One possibility would be to limit additional information reporting to individuals who have the highest 25 percent (or even more narrowly, 1 percent) of adjusted gross income and have income from low-visibility sources, including business entities they own.³⁴

2. The IRS will need to expand its authority to audit partnerships at the entity level beyond what is provided for in the Bipartisan Budget Act of 2015. Current authority allows the IRS to audit and assess deficiencies at the entity level, which is essential for any effective audit program of significant-sized partnerships. However, that authority is limited to only specified partnerships with many partners. That authority needs to be extended to all partnerships.

3. To increase deterrence effects, proposed legislation should also include stiffer penalties for high-end evaders and the tax return preparers who abet them. Means-based adjustments to tax penalties can ensure that they are meaningful and deter misreporting. Similarly, sanctions for preparers — for example, when indefensible opinions facilitate abusive tax transactions — will discourage bad practices.³⁵ Further, legislation should require the IRS to regulate paid return preparers who profit while exposing their customers to significant errors, particularly in the EITC area.

3. Keeping score.

It is important to note that our revenue estimate — of approximately $1.4 trillion in gains over a 10-year horizon — does not replicate the score that official scorekeepers will assign this legislation. That is in part because, as in all scorekeeping, there is a degree of uncertainty that will invariably lead to different conclusions.

But it is also because, in this arena, existing rules actually prohibit official scores from including any revenue gains associated with compliance investments like those we propose.³⁶ Perversely, this means that investments in the IRS will show up as costing the government money, even though by conservative estimates $1 spent on IRS enforcement returns $12 in additional tax revenue collected.³⁷

Scores that appropriately account for the substantial revenue at play will be imperative to legislative success. Scoring guidelines could be revised by agreement of the Office of Management and Budget, the House and Senate budget committees, and the CBO. Other possibilities exist as well. For example, the chair of the budget committee could direct scorekeeping to tally the likely revenue effects of this legislation. It is worth noting that there has already been progress on scoring: Unofficial scores of revenue gains are commonplace, and the CBO now incorporates revenue effects in its update of baseline budget projections.³⁸

IV. Conclusion

Overall, we believe a top priority of tax reform efforts should be improving tax administration. Executive action can be undertaken immediately and should be coupled with a comprehensive legislative proposal that mandates that the IRS address the tax gap by greater audit scrutiny on the most noncompliant taxpayers, an increase in information reporting, and sustained investment to upgrade technology. The result will be well more than $1 trillion in additional tax revenue over the course of a decade; and, even more importantly, a more efficient and equitable tax system.