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Crapo on Tax Gap
Senator Mike Crapo, Ranking Member of the Finance Committee, is out with a piece in Tax Notes that highlights the various flaws in recent tax gap estimates. It’s a useful reminder that while these figures are great at generating headlines, they’re a lousy framework on which to base tax policy.
As longtime readers know, we’ve been skeptical of these figures for years. While S-Corp strongly supports policing illegal tax evasion, our message to policymakers has been that it’s wrong and counterproductive to characterize the entire gap as willful evasion.
Senator Crapo shares that skepticism. On the newly-released tax gap figures, he writes:
It is crucial here to understand what the IRS’s $688 billion projection is and is not. It is simply a projection of what the 2021 tax gap would be, assuming that the tax law and compliance rates from the 2014-2016 estimate are held constant and applied to the 2021 economy.
In other words, it is a projection of an estimate, which is Washington-speak for a guess (projection) of a guess (estimate). Like any double guess, it is wise to approach such a claim with healthy skepticism.
Setting aside the fact that these estimates are based on shaky assumptions, when taken at face value the IRS data does show a $138 billion increase in the tax gap over the past few years. Does that necessarily mean the tax gap has risen dramatically? Not so, explains Senator Crapo:
When viewed in proportion to the economy’s size over the last 20 years, the tax gap is actually flat and historically average. The Cato Institute examined the tax gap as a percentage of GDP and found that for 2021, the tax-gap-to-GDP ratio was 2.9 percent, squarely in line with the last 20 years of estimates.
Further, an equally valid way of expressing the tax gap is in the share of taxes the IRS believes are voluntarily paid — the so-called voluntary compliance rate. The new projection pegs this rate at 84.9 percent, while the 2014-2016 estimate had it as 85 percent. In stark contrast to overblown characterizations of tax cheating run amok, the tax compliance rate is in fact high and stable.
We made these exact points last year while highlighting that the U.S.’s voluntary compliance rate is among the best in the world. What should be cause for celebration and something to build on instead has been distorted into a talking point used to increase the budget of the IRS.
What are the problems with the tax gap’s methodology? Senator Crapo identifies several:
First, in 2021 the economy experienced its most rapid expansion in three decades, inflation saw its sharpest increase in 40 years, and the federal government was in the midst of disbursing $4.6 trillion in pandemic-related aid. These factors inflate the tax gap, as people and businesses spend and earn more, without increasing the amount of tax evasion.
Second, the recycled estimate was based on compliance behavior with old tax laws, which profoundly changed in 2017 with Republican-led tax reform. With improvements like increasing the standard deduction, decreasing the alternative minimum tax’s impact, and lowering marginal rates, Republican tax reform made paying and filing taxes easier for Americans, which simplified compliance. Shortcuts like presuming identical compliance — despite major changes in tax law — lead to errors.
When issuing its new tax gap guess, the IRS reflexively identified “high-income and high-wealth individuals, partnerships and corporations” as areas of concern, but cited no evidence. Historically, these groups have high levels of compliance, according to IRS data. These data also show the most sizable parts of the tax gap are principally attributable to taxpayers of modest means — particularly, small businesses trying to navigate an overly complex tax code.
Bad data drives bad policy, and we’re seeing that play out in real time. The $80 billion IRS funding boost included in last year’s Inflation Reduction Act was sold as necessary in plugging the growing tax gap and bringing in revenue that would otherwise go uncollected. In reality, a large percentage of the tax gap is from low- and middle-income taxpayers and those who are simply unable to pay what they owe. No amount of additional enforcement and sensational press releases will solve that problem. As Senator Crapo concludes:
With its new tax gap projection, the IRS conveniently created a justification for its supersize supplemental enforcement budget. Yet the IRS’s bold proclamations are stale and misleading. Measuring the tax gap requires a better approach using relevant, reliable data and sound methodology.
We could not have said it better.
No One is Ready for the CTA
Just in time for Thanksgiving, Sunday’s Wall Street Journal’s editorial page highlighted our Main Street letter calling for a one-year delay of the Corporate Transparency Act’s reporting requirements. Appropriately titled The Coming Deluge for Small Business, the article reads:
The CTA assigns the Treasury Department’s Financial Crimes Enforcement Network (FinCEN) with identifying shell companies used for illegal transactions and creating a registry of businesses with less than $5 million in annual sales and fewer than 20 employees.
That describes most small businesses in the country. In a Nov. 16 letter to Congressional leaders, 69 groups representing millions of small business owners say neither they nor FinCEN are ready for the law to go live in January 2024.
…The small business owners have asked that the statute be delayed for a year so they and their regulator can get their acts together. As it currently stands, the government isn’t ready to handle what they are requesting, and small business owners don’t know what they are supposed to provide. Short of cancelling the whole thing, a time-out is the least the feds can do to avoid a national bureaucratic meltdown.
As a reminder, federal regulators have yet to finalize two-thirds of the regs needed to implement the new statute – including the “Access Rule,” which specifies who can access the database and any updates to the “Customer Due Diligence Rule” which applies to financial institutions – yet they are plowing forward with plans to begin collecting data en masse starting January 1, 2024.
And while FinCEN regulators claim they are “working hard” to engage with affected small businesses, those efforts are showing little results. A recent NFIB survey found 90 percent of respondents are unaware the new reporting requirements even exist. Given the CTA’s steep civil and criminal penalties, that’s a big problem.
Meanwhile, the authors of this mess sit back and do nothing. Despite bipartisan, bicameral support for a pause, Congress has yet to take action. We expect that will change next year when millions of small business owners realize they face jail time for failing to notify the Feds that their driver’s license has expired, but by then it will be too late. The database will be up and running and its proponents will be on to step two – making the database public.
That means the best chance of stopping this reporting regime may be a lawsuit taking place in an Alabama federal court. The suit was filed by the National Small Business Association a year ago and alleges that the CTA violates fundamental constitutional principles, including protections against unreasonable search and seizure. Oral arguments in the case were held yesterday in what should be the final step before the judge issues a ruling. Again, the goal is to get a favorable ruling before the reporting begins next year. Now that would be something to be thankful for.
Congress Can Still Prevent a Regulatory Trainwreck
With just a month to go before the Corporate Transparency Act’s reporting requirements take effect, it’s abundantly clear – not to mention extremely worrying – that federal regulators simply do not have their act together when it comes to implementing the new law.
Recognizing this, the Main Street business community today called on lawmakers to delay the Corporate Transparency Act’s reporting requirements by one year, which would give the Treasury Department’s Financial Crimes Enforcement Network (FinCEN) enough time to finish its work on the regulatory and education fronts.
The letter, which was signed by 70 trade associations including the National Federation of Independent Business, the Real Estate Roundtable, and the Associated General Contractors, points out two key items of unfinished business:
Of the three primary rules necessary to implement the new law, only one has been completed, the second is still at the “proposed” stage and needs to be finalized, while the third has yet to be released even as a proposed rule. FinCEN’s leadership has assured Congress they are ready to go starting next year but that is clearly not the case.
Meanwhile, FinCEN is woefully behind when it comes to educating stakeholders of their new obligations. A National Federation of Independent Business survey found that 90 percent of respondents were entirely unfamiliar with the reporting requirements. The CTA includes civil and criminal penalties of up to $10,000 and two years of jail time for failing to comply, so this lack of awareness is alarming and needs to be addressed before the law is implemented.
Starting next year nearly every small business in America will be required to report – and continuously update – a litany of personal information regarding their beneficial owners. The scope of the mandatory reporting is well beyond anything we’ve seen outside of the Tax Code, yet FinCEN doesn’t have all the rules in place to govern how this sensitive information will be used.
To add insult to injury, the AICPA recently pointed out that FinCEN has significantly underestimated the cost burdens associated with the new reporting regime, it has relied on vague and arbitrary standards in laying out the criminal and civil penalties under the statute, and it has implemented filing deadlines for newly-formed entities which, in some cases, are impossible to meet.
We’ve seen Treasury delay a major reporting regime before. Just last year, the IRS was unprepared to implement the lower 1099-K reporting thresholds and announced a one-year pause. FinCEN faces a nearly identical scenario with the CTA yet appears determined to plow forward regardless.
S-Corp’s preferred approach to the CTA is to repeal it altogether and we continue to support the NSBA’s constitutional challenge which would put this harmful law to rest. But with an effective date fast approaching, Congress and federal regulators need to accept that the CTA is just not ready for prime time.
Reality-Based Taxation
Actual tax policy remains on hold in Congress (listen to our recent “Talking Taxes in a Truck” for that discussion) but there’s been some activity in recent weeks that’s worth highlighting nonetheless. Specifically:
- Yesterday’s Finance hearing entitled, “Examining How the Tax Code Affects High-Income Individuals and Tax Planning Strategies”
- Wednesday’s Senate Budget hearing entitled, “Fairness and Fiscal Responsibility: Cracking Down on Wealthy Tax Cheats”
- A new Auten/Splinter paper examining income inequality and income shares
Here’s a quick summary of each and how it is all related to pass-through taxation. Kind of like six degrees of separation minus Kevin Bacon.
Senate Finance
Yesterday’s Senate Finance hearing was an obvious effort to rationalize why unrealized gains should be part of the tax base. As the Chairman argued:
Today, we’ll examine one strategy – among others – called “Buy Borrow Die.” Just three little words on the chart behind me, that have a huge impact. Here’s how it works: A corporate raider buys a business, and then borrows against its growing, untaxed value to fund their extravagant lifestyle. Everything from superyachts, to luxurious vacations, expensive art deals, you name it. It goes up and up in value all while not paying a dime in tax. And when they die, their assets are passed to their kids – often entirely tax-free – and the cycle continues.
Is any tax avoidance plan where the taxpayer has to die really that great? We prefer to stick around to enjoy our excessive after-tax income. Also, why does the Chairman sound like Robin Leach?
More to the point, how exactly does “Buy, Borrow and Die” work? First, a taxpayer (corporate raider) needs lots of appreciated stock. Second, the stock can’t be spinning off income, as the taxpayer would just use that to fund their (extravagant) lives. Think growth rather than value. Finally, the taxpayer borrows against the appreciated value of the stock.
Couple questions. Doesn’t the shareholder have to pay interest on the loan, and aren’t those interest payments taxable? While yesterday’s witnesses argued the stock’s appreciation always exceeds the interest so the benefit is permanent, the simple reality is that stock prices fall too, even for rich people. When they do, won’t the loan’s covenants demand repayment? When exactly does the loan get repaid, and how does the taxpayer pay it? Finally, doesn’t this trade lower capital gains taxes for higher taxes on interest? Is that a good deal?
Perhaps there are other, non-tax reasons the owner of a high-flying corporation might avoid selling their stock, such as SEC reports or the impact the sale might have on the stock’s price or the owner’s control of the company? Things like that.
And where is the corporate tax in all this? When Warren Buffett claimed he paid less taxes than his secretary, he left out the fact that his company paid billions in corporate tax. Yesterday’s witnesses with the exception of Doug Holtz-Eakin) did the same. Also, what about charitable donations of appreciated stock? Such donations are probably the dominant method wealthy taxpayers use to reduce their income taxes.
These issues didn’t come up because they don’t further the cause of taxing unrealized gains. Chairman Wyden has for years advocated for a mark-to-market approach (here). To get it enacted, however, he needs to 1) build political support for the idea and 2) overcome constitutional concerns regarding the definition of income under the 16th amendment.
This week’s hearing attempts to address challenge one, while the Moore v. United States decision by the 9th Circuit – and now before the Supreme Court — presumably is designed to address challenge two.
Senate Budget
While the Finance Committee focused on legal tax avoidance to promote mark-to-market taxes, the Senate Budget Committee targeted illegal tax evasion to promote more IRS funding. According to Chairman Whitehouse:
Most Americans follow the law and pay their taxes on time and in full. Many of the very wealthiest Americans, however, play by their own rules. Empowered by a tax code that is rigged in their favor, they rob the public weal of revenue and leave everyone else to foot the bill. Today, we will hear how the super-wealthy account for a large and disproportionate share of tax evasion, and cost the American people perhaps hundreds of billions every year….
Dr. Natasha Sarin, one of our witnesses today, estimates that the top 1 percent account for 30 percent of unpaid taxes. You heard that right: one percent of the population; thirty percent of the cheating.
Robbing the weal? That sounds bad, but don’t the top 1 percent pay more than 40 percent of all income taxes? Does that mean their compliance rate is better than average? Hard to say, as the truth in all this continues to be buried in a fog of iffy estimates and IRS budget battles.
What we do know is after decades of over-the-top rhetoric and unfulfilled promises, the tax gap remains just about where it has always been. This from CATO’s Chris Edwards’ testimony:
Auten/Splinter
An S-Corp mantra is you can’t make good tax policy without good data. Underlying this week’s hearings was the premise that the rich are getting richer and we need to use tax code to rein them in.
Missing was any examination of the premise, an omission which is particularly glaring given that its chief skeptics, economists Gerry Auten and David Splinter, just released an updated version of their Piketty/Saez/Zucman take-down. It is comprehensive and devastating. Here’s the abstract:
Concerns about income inequality emphasize the importance of accurate income measures. Estimates of top income shares based only on individual tax returns are biased by tax-base changes, social changes, and missing income sources. This paper addresses these shortcomings and presents new estimates of the distribution of national income since 1960. Our analysis of pre-tax income shows that top income shares are lower and have increased less since 1980 than other studies using tax data. In addition, increasing government transfers and tax progressivity have resulted in rising real incomes for all income groups and little change in after-tax top income shares.
For those uninterested in reading all 47 pages, this chart should suffice. Adjusting for changes in tax policy and other variables, the whole “the rich grabbed all the economic gains in recent decades” narrative simply falls apart.
The pass-through community is neck deep in this debate. Not only are we the target for higher taxes, but the growth of the pass-through sector post 86-TRA is a primary driver of P/S/Z’s errors in the first place. As Auten and Splinter write:
Our analysis addresses this issue by accounting for corporate retained earnings (i.e., profits after corporate tax not distributed as dividends), as well as base-broadening reforms that reduced taxshelter losses. Without these adjustments, top income shares are understated in the 1960s and 1970s, when high individual income tax rates created strong incentives to shelter income inside corporations.
So policies that improved tax transparency and enforcement back in the 1980s are being twisted to justify higher taxes on pass-throughs now. Their proposed solution, on the other hand, would simply return us to the pre-86 days of using corporations as tax shelters. Without all that income showing up on individual tax returns, its advocates could claim they made the world more equal, all while giving their corporate buddies the means to avoid the higher rates. Everybody wins, except for Main Street and the American economy.
Talking Taxes in a Truck Episode 31: Tax Grab Bag with Ryan Ellis – IRS Funding, SALTy Rumors, Year-End Tax Bill, and Mo(o)re
Congress is in overdrive tackling its legislative to-do list and things are starting to pile up on the tax policy front. To help us keep track of it all we’re joined by repeat podcast guest Ryan Ellis, Enrolled Agent and President of the Center for a Free Economy. Ryan kicks things off with a look at the latest developments on Capitol Hill, including the election of House Speaker Mike Johnson, rumors of a SALT cap deal, and ongoing negotiations over a year-end tax package. Ryan then draws on his experience as an IRS Enrolled Agent to talk IRS funding and the tax gap, and shares his thoughts on how the Supreme Court could shape the tax code through Moore v. U.S.
This episode of the Talking Taxes in a Truck podcast was recorded on November 3, 2023, and runs 50 minutes long.