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Tax Gap Claims Come Up Short, Again
We’ve been skeptical of grandiose promises to close the so-called tax gap for years (here, here, here). Part of that skepticism stems from the blatant self-interest of those making the estimates – we could raise billions, trillions, quadrillions if only you gave us more money! (Perhaps the CRS or JCT could be in charge of making these estimates in the future?)
Last week’s piece from The Hill is a perfect example. Under the breathless headline, “Lucrative IRS program targeting wealthy tax cheats is withering from a lack of funds,” the article reveals many things, none of which are consistent with the headline.
First, far from lucrative, the program’s returns stink. Here’s The Hill:
The Finance Committee report found that since 2007, the whistleblower program has brought in almost $6.5 billion while paying out just over $1 billion in rewards.
Despite those soaring returns, the number of investigations opened by the IRS as a result of the program has fallen from 43 in 2014 to just six in 2020, according to the report.
Revenues from the program have also been falling, down to $245 million collected from noncompliant taxpayers in 2021 from $1.4 billion in 2018.
Six-and-a-half billion in 15 years? Oooh. Cuing Dr. Evil. Seriously, that’s less than $500 million a year, or enough to fund the federal government for about an hour.
Second, notice the cherry-picked statistics? We are told collections in 2021 were only one-sixth of those in 2018. But 2018 was a banner year for the program and an obvious outlier. When you compare 2021 collections to the program’s average (again, around $500 million annually), the reduction is much more in line with normal variations. Moreover, the budget cuts to the IRS began a decade ago – shouldn’t the reduced funding have depressed 2018 collections, too?
Third, where’s the meat? This program encourages Americans to snitch on their neighbors, colleagues, and employers with really substantial rewards and all they can gin up is a few billion over 15 years? What happened to all those billionaire tax cheats the IRS has promised?
As we’ve noted in the past, the reality of the tax gap is much more complicated than the Marvel Comic version being peddled by the IRS and its supporters. First, much of the gap is from taxpayers who are broke and unable to pay anything, let alone a large tax debt. Second, much of the debt is owed by lower-income Americans and would require lots of enforcement to collect relatively small amounts.
And third, a not insubstantial amount is the result of disputes between the IRS and taxpayers. In those cases, they count the amounts in dispute as part of the tax gap, even when the taxpayer prevails. Let that sink in for a second: in cases where the IRS is wrong, they still add that amount to the tax gap estimates.
All of which is why former Finance Committee staffer Dean Zerbe’s comment should have been the story’s headline:
I don’t think people realize how much the IRS kind of shoots blanks, meaning that they audit folks and it just kind of comes up to zero or next to a zero. The whistleblower program is much better at really targeting the bad actors,” he said.
The program itself is designed to go after the big-dollar folks. The way that the law is structured, it kicks in for major corporations, for wealthy individuals and very wealthy individuals,” he added.
How are those comments consistent with the rest of The Hill’s story, or the recent tax gap narrative? If most IRS audits turn up little or nothing, how will more audits produce the windfall promised by the Inflation Reduction Act?
And if the whistleblower program is so much better at targeting the cheats than random audits, why does it produce relatively miniscule amounts of revenue? Either it’s not that great of a program, or the tax cheats aren’t really that rich or prevalent.
None of this makes any sense and it all points to the ultimate futility of all that new IRS funding. The US tax code relies on Americans paying their taxes in good faith and, with some exceptions, it works very well. Our compliance rate is among the highest in the world, after all.
But good faith works in both directions. It requires a tax code that’s fair and understandable, and an enforcement agency that helps taxpayers comply with the rules – rather than targeting them as tax cheats.
With that in mind, we’ll go out on a limb here and predict that more whistleblowers and thousands of new, poorly trained auditors are not going to result in the predicted revenue windfall. It will, however, severely undermine the good faith necessary to make it all work.
Disable the ENABLERS Act
Worried about your privacy? You should be. Congress is back and is quietly moving legislation that threatens the privacy and security of millions of business owners, charities, foundations, and investors.
The bill is called the Establishing New Authorities for Business Laundering and Enabling Risks to Security (ENABLERS) Act, and it has already passed the House as a rider on the annual National Defense Authorization Act (NDAA).
In simple terms, the Act would dramatically expand the Corporate Transparency Act’s (CTA) reporting requirements imposed on business owners and their employees. Here’s how Bloomberg describes the policies:
This is where tax professionals come in. The version of the bill that passed the House earlier this year would require “professional service providers who serve as key gatekeepers to the U.S. financial system adopt anti-money laundering procedures that can help detect and prevent the laundering of corrupt and other criminal funds into the United States.”
So, who exactly is a gatekeeper? “Ghostbusters” jokes aside, it’s you and me. Under the current version of the bill, any person—government workers excepted—who provides corporate or legal entity formation services, trust services, third-party payment services, or legal or accounting services involving certain financial activities would qualify.
If that sounds broad and potentially complicated, it is.
The bill would give Treasury up to one year to figure out the specifics, including who exactly would be considered a gatekeeper—and what their responsibilities would entail. Some examples in the bill include identifying and verifying account holders, collecting and reporting information, creating anti-money laundering programs, alerting authorities to suspicious transactions (think SARs, or suspicious activity reports), and establishing due diligence policies and controls.
As broad as Bloomberg makes it appear, the Act’s text is even broader. The bill doesn’t just target professionals, but instead appears to touch every business or non-profit in America other than those who are already “appropriately regulated” – whatever that means. Here’s who is covered according to the bill text:
(A) any person involved in—
(i) the formation or registration of a corporation, limited liability company, trust, foundation, limited liability partnership, partnership, or other similar entity;
(ii) the acquisition or disposition of an interest in a corporation, limited liability company, trust, foundation, limited liability partnership, partnership, or other similar entity;
(iii) providing a registered office, address or accommodation, correspondence or administrative address for a corporation, limited liability company, trust, foundation, limited liability partnership, partnership, or other similar entity;
(iv) acting as, or arranging for another person to act as, a nominee shareholder for another person;
(v) the managing, advising, or consulting with respect to money or other assets;
(vi) the processing of payments;
(vii) the provision of cash vault services;
(viii) the wiring of money;
(ix) the exchange of foreign currency, digital currency, or digital assets; or
(x) the sourcing, pooling, organization, or management of capital in association with the formation, operation, or management of, or investment in, a corporation, limited liability company, trust, foundation, limited liability partnership, partnership, or other similar entity;
The pool of covered individuals continues through subsection (D), but you get the idea. Covered individuals would be required to collect and report beneficial ownership information, report any suspicious transactions, and establish anti-money laundering policies.
In terms of enforcement, covered individuals would be subject to Treasury audits initially, but the Act requires Treasury to make recommendations for additional enforcement activities after a year. By way of example, the related Corporate Transparency Act imposes fines up to $10,000 and jail time up to two years for failing to make the appropriate reports.
The stated purpose of this effort is to help Treasury and law enforcement identify illegal activities taking place within businesses and investments but, as with the CTA, it’s highly unlikely that criminals engaged in such conduct will self-report their crimes.
Instead, the burden will fall on the millions of law-abiding business owners and investors who will be forced to comply with these new reporting requirements.
The irony is that this legislation is being rushed through Congress before the CTA has even taken effect. Final rules for implementing the CTA are due out this month, and once they are finalized, an estimated five to six million businesses will be required to annually report the personal information of their owners to Treasury. The ENABLERS Act would expand those reporting requirements to non-profits and larger businesses, while also increasing the total amount of information Treasury collects.
Proponents of this data grab claim the information will remain secure, private, and used solely for law-enforcement purposes, but the recent record suggests otherwise:
- Thousands of suspicious activity reports (SARs) were purposefully leaked out of FinCEN in 2020 in an obvious attempt to embarrass FinCEN and the reporting banks. The leaker was identified and punished, but by then the information was already public.
- Hundreds of tax returns of the wealthiest Americans were leaked to ProPublica, again for political purposes. This time, no leaker has been identified or punished.
- Just last month, an Ivy League professor testified before the Senate Banking Committee that the FinCEN database should be made public to enable political operatives to more easily target the owners of real estate and other businesses.
In other words, while the ENABLERS Act and CTA regulations will be marginally beneficial to law enforcement agencies, at best, the databases they produce can and will be used politically to name and shame the millions of covered business owners, non-profits, the professionals they work with and their employees.
As noted, the ENABLERS Act has passed the House as part of the National Defense Authorization Act and is awaiting consideration in the Senate. It’s a sneaky way to impose new regulations on businesses, and we expect the business community to strongly oppose this this data grab, much as it opposed the CTA. The question is, will anybody listen when we do?
Shrinking Main Street
ADP is out with its revised, independent jobs forecast this week and it shows continued challenges for Main Street. As with past reports (before they revamped the product to produce a truly independent alternative to the monthly BLS reports), the latest data shows a continued divergence in the economy, with larger businesses adding jobs while smaller firms shed them.
According to ADP, private employers created 132,000 net jobs in August. But while large firms (those with more than 500 employees) added 54,000 jobs, small businesses with less than 20 employees contracted by roughly the same amount, losing 47,000 jobs. As the chart below shows, this is part of an ongoing trend:
Add the numbers up and you find that, since the start of 2022, small businesses have lost a whopping 385,000 jobs while employment at larger firms increased by 481,000.
Why is the small business sector contracting? Inflation is definitely a culprit. As CNBC recently reported, small businesses are facing an unprecedented rent crisis:
Inflation has been the No. 1 concern of small businesses for some time, as high prices in raw materials, labor, energy and transportation cut into margins. Higher rents, and landlords feeling more aggressive the farther away the nation moves from the peak of Covid, have compounded the hit from inflation being felt on Main Street.
How much has rent spiked? Forty-five percent of small businesses surveyed said they’re paying at least 50 percent more in rent than they did prior to Covid, while 12 percent said rent payments have tripled. At the same time, 77 percent of respondents reported revenue that’s still below pre-Covid levels, a dynamic that could worsen as the Federal Reserve takes steps to shut down inflation.
But if aggregate employment numbers are on the rise, why does it matter that Main Street is shrinking? As we’ve written before, small businesses have historically been the drivers of job creation and economic expansion, accounting for nearly two-thirds of new jobs historically. Which makes sense – compared to larger, established companies, smaller, younger firms are more likely to hire and expand. Data from the Census Bureau bears this out:
The bottom line is that this migration of workers from small businesses to large, publicly-traded firms is bad news for most of the country. As our employment heatmap from EY shows, most of the country relies on non-public firms for their job base:
At the end of the day, only so much economic consolidation can occur before growth and hiring levels inevitably flatline. We need smaller businesses and startups for net job creation – unfortunately, the post-pandemic economic environment isn’t helping. Nor is the adoption of policies that raise their costs and increase the burden of government. Something to keep in mind the next time the White House touts an otherwise positive job report.
Inflation Reduction Act Targets All Taxpayers
The Inflation Reduction Act (IRA) has kicked off a rigorous debate over the $80 billion in new funding for the IRS. Republicans argue the funds will be used to audit the middle-class while the Biden Administration assures us that nobody under $400,000 will see increased audit “rates.”
So where does the truth lie? In short, the IRA will substantially increase the number of IRS audits over the next decade, including higher numbers of audits for middle-income taxpayers and Main Street businesses. Here’s the breakdown.
The IRA allocates some $80 billion over the next decade in additional funding to the tax-collecting agency, with more than half of that going towards what the bill describes as “improving taxpayer compliance.” The Congressional Research Service has a handy chart that shows how the money is divvied up:
Those new “enforcement” dollars are supposed to reduce the so-called tax gap, or the annual difference between what Americans should pay versus what the IRS brings in. The premise is that there’s a treasure trove of uncollected money out there, but the IRS lacks the resources to chase it all down.
This notion is pure fiction, as we’ve discussed in the past. Let’s say the annual tax gap is around $600 billion annually (the estimate keeps changing, it’s based on old data, and the whole thing is highly questionable, so we’ll stick with a round number) while congressional scorekeepers estimate the $45.7 billion in new IRA enforcement funding will raise an additional $204 billion in gross revenue.
That’s just 3 percent of the tax gap over the next decade. By that math, Congress would need to give the IRS an additional $1.5 trillion and hire hundreds of thousands of additional employees to close the entire gap. That’s obviously ridiculous, so perhaps the tax gap is not the treasure trove tax collectors think it is?
Worse, the new funding will result in a massive increase in IRS enforcement activity. As many Republicans have pointed out, a document released by Treasury last year projects the new funds would enable the IRS to hire an additional 87,000 employees by 2031.
The IRS currently employs about 80,000 workers, so the IRA would effectively double its workforce, yes? That’s what the CBO thinks:
Spending would increase in each year between 2021 and 2031, though the highest growth would occur in the first few years. By 2031, CBO projects, the proposal would make the IRS’s budget more than 90 percent larger than it is in CBO’s July 2021 baseline projections and would more than double the IRS’s staffing. Of the $80 billion, CBO estimates, about $60 billion would be for enforcement and related operations support. [Emphasis added]
But Treasury is pushing back, arguing that some of these new employees would replace retiring workers. They claim the actual increase in workers will be just 25 or 30 percent. That estimate, however, is inconsistent with Treasury’s own estimates back when they first proposed the $80 billion funding hike:
Because the expansion in the IRS’s budget is phased in over a 10-year horizon, each year the IRS’s workforce should grow by no more than a manageable 15%. By the end of the decade, however, the IRS’s budget would be roughly 40% above 2011 levels in real terms as a result of this proposal.
In 2011, the IRS had nearly 100,000 workers, so a forty-percent increase would translate to 140,000 workers. Not the doubling estimated by the CBO, but way more than Treasury is telling people now. Treasury needs to get its story straight.
Obfuscation aside, what is clear is that thousands of new IRS employees will be engaged in enforcement activities that result in higher numbers of audits – that’s where the additional $204 billion comes from, after all. Here’s the New York Times inadvertently highlighting our concerns:
The I.R.S. is beefing up its staff to keep pace with the growth in taxpayers and to replace departing employees. The Biden administration expects that about 50,000 I.R.S. employees will retire within the next decade and that the agency will hire 87,000 new employees, bringing the overall size of the agency to around 120,000. The number of enforcement agents is expected to double to about 13,000 from 6,500 over the next decade.
So you’re significantly increasing the overall size of the agency over a short time period and doubling the number of enforcement agents, even as you replace many of the existing auditors with younger, less experienced auditors? No, nothing to worry about here. Bottom line is it’s simply incorrect to argue there will not be a substantial increase both in the number of auditors or audits under the new law.
What about the argument that only taxpayers and businesses over certain income thresholds will see increased activity? We’re seeing lots of obfuscation there too, and it stems from a letter Treasury Secretary Janet Yellen recently wrote to senators:
These resources are absolutely not about increasing audit scrutiny on small businesses or middle-income Americans. As we’ve been planning, our investment of these enforcement resources is designed around the Department of the Treasury’s directive that audit rates will not rise relative to recent years for households making under $400,000.
And here’s the directive letter to IRS Commission Chuck Rettig:
Specifically, I direct that any additional resources—including any new personnel or auditors that are hired—shall not be used to increase the share of small business or households below the $400,000 threshold that are audited relative to historical levels. This means that, contrary to the misinformation from opponents of this legislation, small business or households earning $400,000 per year or less will not see an increase in the chances that they are audited.
First, this directive is pure political theater. Just as no Congress can tie the hands of a future Congress, no Treasury Secretary can tell the IRS what to do once she’s left office. Yellen likely won’t be in a position to enforce these demands in a year or two, let alone in 2031.
But what about while she’s in office? Notice her use of weaselly phrases like “audit scrutiny” and “audit rates” and audit “share” and increased “chances” and “existing resources” and “historic levels.” What exactly do those words mean? They mean the number of audits on households making less than $400,000 is going to increase, that’s what they mean. Here’s the CBO’s summary:
The proposed increase in spending on the IRS’s enforcement activities would result in higher audit rates than those underlying CBO’s baseline budget projections. Between 2010 and 2018, the audit rate for higher-income taxpayers fell, while the audit rate for lower-income taxpayers remained fairly stable. In CBO’s baseline projections, the overall audit rate declines, resulting in lower audit rates for both higher-income and lower-income taxpayers. The proposal, by contrast, would return audit rates to the levels of about 10 years ago; the rate would rise for all taxpayers, but higher-income taxpayers would face the largest increase. [Emphasis added]
This assessment is consistent with a subsequent preliminary score of the Crapo amendment 5404, which revealed that 10 percent of the projected new revenues come from taxpayers making less than $400,000. How could that be without increased enforcement?
Biden economic advisor Jared Bernstein apparently didn’t digest the nuance of all this, assuring CNBC viewers that the new IRS funding does not “touch one taxpayer under $400,000.” That’s not correct. This after claiming earlier this month that most of the IRA’s savings were “front-loaded” and therefore would help reduce inflation. That’s not correct, either.
Last year we had Ryan Ellis on the Talking Taxes in a Truck podcast to talk about this issue. He outlined the pain and heartburn that Main Street business owners experience when going through an audit, describing the day the IRS audit letter comes as “that Pepto Bismol moment.” Even audits where no new tax is owed are costly and stressful. With the Inflation Reduction Act, futures on Pepto Bismol are going up, and they are going up for everybody.
Ditch the IRA
The Main Street business community today sent a letter to lawmakers with a simple message: many of the proposed tax policies in the Inflation Reduction Act would harm individually and family-owned businesses and should be rejected.
The letter was signed by more than 70 trade associations representing millions of Main Street businesses from every corner of the country and every sector of the economy, including NFIB, the National Restaurant Association, the Associated Builders and Contractors, the National Association of Homebuilders, and others. It makes clear that the Inflation Reduction Act, which the House is expected to take up this week, falls well short of its intended purpose:
Inflation is at 40-year highs, we have had two consecutive quarters of negative economic growth, and we are witnessing a shrinking small business sector, yet the Inflation Reduction Act does nothing to address these immediate issues even as it increases the burden of the tax code shouldered by America’s small and family-owned businesses.
The Biden Administration claims the savings in the IRA are “front-loaded” and will reduce the deficit in the short-term, helping to ease inflationary pressures. That is simply not the case. Recent analysis by the Congressional Budget Office, Penn-Wharton, and others shows the Inflation Reduction Act would increase prices in the short term and do little to bring them down in the long run.
At the same time, the bill would give the IRS an additional $80 billion in funding, more than half of which would pay for thousands of additional IRS agents to conduct millions of additional audits. We support addressing the tax gap and oppose illegal tax evasion, but as former National Taxpayer Advocate Nina Olson observed recently, it is wrong and counterproductive to characterize the entire tax gap as willful tax evasion. From experience, we know many, if not most, of these additional audits will be conducted on the owners of family businesses who have fully complied with the tax code.
The letter also addresses the last-minute adoption of the Warner amendment, and how it chose to protect private equity investors at the expense of the small business sector.
Finally, the Warner Amendment adopted at the last minute presented the Senate with a clear choice between Wall Street and Main Street, and the Senate chose Wall Street. The amendment extends for two years the Section 461(l) cap on losses a business owner is permitted to claim. This $52 billion tax hike on pass-through businesses was adopted with almost no consideration, and the revenues it raises were used to offset the cost of exempting private equity investors from the fifteen-percent corporate minimum tax. The cap on active pass-through loss deductions is bad policy at any time, but it is particularly harmful when the economy is weak and an increasing number of businesses are suffering losses. The timing of this amendment’s adoption could not have been worse.
The Inflation Reduction Act fails to combat inflation while simultaneously raising the tax burden on small and family-owned businesses. The IRA is the last thing our country’s struggling Main Streets need right now; it’s time for lawmakers to abandon these policies and focus instead on the priorities of Main Street employers.