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Closing the $688 billion tax gap won’t help solve the US debt problem

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The IRS is promising its focus on increased tax compliance will help with the nation’s debt problem.

“Achieving our goals will result not only in a fairer tax system,” IRS commissioner Danny Werfel testified before Congress in October, “but also in benefits for taxpayers and the nation because detecting and stopping noncompliance in these areas would result in significant additional revenues and reduce the deficit.”

Not so fast, says one expert.

Even if the Internal Revenue Service achieves a 100% collectible rate, up from the current 86.3% net compliance rate, and closes the estimated $688 billion tax gap, that won’t be enough to meaningfully shrink the chasm between how much the US spends versus how much revenue it takes in.

“You’re running a $1.7 trillion dollar deficit,” Scott Hodge, president emeritus and senior policy adviser at the Tax Foundation, told Yahoo Finance. “Even perfect tax compliance — an impossible goal — would fall short of eliminating the deficit.”

The IRS estimated that the national tax gap was $688 billion in 2021, up 14.4% from $601 billion in 2020 and nearly double from $345 billion in 2001. It attributed the tax gap increase to a growing US economy.

For instance, 2021’s estimated tax gap accounted for 2.6% of overall gross domestic product, or GDP, which was $23 trillion in the same period. This ratio has largely stayed consistent since 2014 — oscillating between 2.3% and 2.6% — demonstrating that both elements grow correspondingly.

“While $688 billion sounds like a big number and is touted as a big increase from prior years, it is hardly different as a share of the economy than the tax gap figures from prior years,” Hodge wrote.

Tax collections were also relatively stable when compared to GDP. Between 2015 and 2021, the share of IRS revenue collection has ranged between 16.4% to 18.3% of GDP, while gross revenue continued to climb at an average rate of 3.2%. Revenue collected reached $4.1 trillion in 2021, but the highest GDP share ratio was 18.3% in 2016 when the IRS collected $3.3 trillion in revenue.

Yet the agency’s revenue has not kept pace with federal spending. Federal spending was $7.65 trillion in 2021, $6.5 trillion in 2022, and $6.13 trillion in 2023.

The federal government’s share of spending compared to GDP has clocked in between 20% to 30% between 2015 and 2021, government data shows. This is much higher than the tax collection-to-GDP ratio of 16.4% to 18.3% in that same period.

So even if the IRS collects 100% of estimated revenue and closes the tax gap by hundreds of billions of dollars, the government still can’t meet its growing deficit.

“While it would be unrealistic to expect revenues to match the level of spending during the pandemic years of 2020 and 2021, 100 percent tax compliance would have fallen well short of matching federal outlays even in pre-pandemic years,” Hodge wrote.

The federal government's share of spending compared to GDP has clocked in 20%-30% between 2015 and 2021. This is much higher than the tax collection-to-GDP ratio of 16.4% to 18.3% in that same period. (AP Photo/Alex Brandon)

The federal government’s share of spending compared to GDP has clocked in 20%-30% between 2015 and 2021. This is much higher than the tax collection-to-GDP ratio of 16.4% to 18.3% in that same period. (AP Photo/Alex Brandon) (ASSOCIATED PRESS)

‘We have to be realistic’ about the tax deficit

In 2021, the US net compliance rate was 86.3% — after accounting for late payments and IRS auditing efforts — compared with the agency’s estimated total liability. This ratio is higher than the voluntary tax compliance rate of 84.9% — the share of US taxpayers who voluntarily pay on time without any enforcement efforts, the IRS Tax Gap Projection research reported.

“Relative to the rest of the world, Americans are very compliant for what is essentially a voluntary tax system,” Hodge said. “We have to be realistic about how much this is going to go to solving the deficit problem.”

The three components contributing to the $688 billion shortfall in 2021 were non-filings of $77 billion, underreporting of $542 billion, and underpayment of $68 billion, the IRS website shows.

And there are three approaches to promote more compliance, according to Caroline Bruckner, tax professor at the American University Kogod School of Business and managing director of the Kogod Tax Policy Center.

“To some degree, the IRS engages in all three,” Bruckner wrote to Yahoo Finance. “However, my latest research suggests we don’t do nearly enough tax education. People don’t know what’s due when or how to file their taxes properly.”

The three components contributing to the $688 billion shortfall in 2021 were non-filings of $77 billion, underreporting of $542 billion, and underpayment of $68 billion, says the IRS.

The three components contributing to the $688 billion shortfall in 2021 were non-filings of $77 billion, underreporting of $542 billion, and underpayment of $68 billion, says the IRS. (Getty Images) (courtneyk via Getty Images)

The agency has also announced plans to step up enforcement efforts and reduce the tax gap by focusing on wealthy individuals with income above $1 million and more than $250,000 in recognized tax debt. It is working on auditing 1,600 taxpayers who owe hundreds of millions of dollars in unpaid taxes, according to an IRS announcement.

“In all of our compliance work, our goal is to increase our efforts on those posing the greatest risk to our nation’s tax system,” Werfel said last month, “whether that is the wealthy looking to dodge paying their fair share or promoters aggressively peddling abusive schemes.”

Still, Hodge warned that there is a “delicate balance” between attempting to increase compliance and overburdening responsible taxpayers as well as relying on its deficit reduction argument.

“We have to really be realistic that the IRS can only do so much,” Hodge said, “especially when the deficit is so large.”

Rebecca Chen is a reporter for Yahoo Finance and previously worked as an investment tax certified public accountant (CPA).

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