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.