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As our elected officials debate how best to address a national debt approaching $30 trillion while simultaneously increasing spending levels and addressing wealth inequality, it should not be surprising that tax policy is at the forefront of the discussion
In that context, there has been an especially intense focus on the tax gap. That “gap” is the amount of tax that taxpayers legally owe the U.S. government but is not actually collected.
The tax gap, however, is a macro measurement based on estimates surrounding millions of taxpayers. It does not translate consistently at the individual level. In fact, many people — at all levels of taxable income — embody what some have referred to as a “reverse tax gap.”
These people overpay their taxes, often repeatedly. Given this phenomenon, while reducing the tax gap seems a laudable goal, reducing the reverse tax gap should also be prioritized.
The IRS has long studied the tax gap as a way of measuring tax compliance. According to the IRS, recent estimates for 2011, 2012 and 2013 showed an average annual gross tax gap for all types of taxpayers, including individuals and businesses, of approximately $441 billion.
After late payments and audits, the net tax gap was about $381 billion. The IRS estimates that these numbers translate into a compliance rate of about 83.6% or, after enforcement efforts, 85.8%, leading the IRS to conclude, perhaps surprisingly, that “in general, the tax gap estimates dating back decades consistently show the United States enjoys a relatively high and stable voluntary tax compliance rate.”
Importantly, however, while the country’s tax gap is substantially smaller than it is in many other countries (it’s about twice as large in Italy), it may be increasing. IRS Commissioner Charles Rettig recently suggested that transactions involving cryptocurrency, offshore transactions and illegal income could eventually lead to a tax gap of more than $1 trillion if not adequately addressed.
There is logic in focusing on the tax gap, especially as overall tax receipts increase.
It seems clear that we should enforce our tax laws. And enforcement is the job of the executive branch, including the IRS. The mission of the IRS is to “provide America’s taxpayers top-quality service by helping them understand and meet their tax responsibilities and enforce the law with integrity and fairness to all.”
Rettig has noted that “our mission statement reflects our values: We put ‘service’ first, making it easier for Americans to understand and satisfy their tax obligations as the most important thing the IRS can do to affect the tax gap.”
Perhaps it’s that sense of service that leads to this interesting comparison. In the fiscal year 2020, the IRS closed 452,515 individual income tax examinations yielding about $5.5 billion in recommended additions to tax, an average of $12,230 per examination. Yet, 16,305 of its closed examinations — on individual returns spanning the full spectrum of income levels — resulted in recommended refunds of more than $813 million.
Now, 16,305 examinations resulting in recommended refunds may not seem like a large overall number. But keep in mind that we’re talking about a set of taxpayers and returns that were examined by the IRS. Presumably, the IRS utilizes its limited resources prudently and focuses its audits primarily on questionable returns most likely to lead to additional taxes.
Yet, even within that select (read: suspect) group, there were, in fact, thousands of returns in which the examined taxpayers overpaid their taxes to the tune of more than $800 million. Imagine how that extrapolates into the general population of returns.
So, what does all this mean?
The tax gap is real but so, too, is the reverse tax gap. So, while too many people underpay their taxes, there are also too many people who overpay their taxes, primarily because they just do not understand the tax laws, make mistakes and/or do not have access to sufficient professional assistance.
To be clear, the IRS does make efforts to help, and services like the Taxpayer Advocate Service need to be acknowledged. But they’re not enough.
Missed opportunities and mistakes
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The same can be said of the tax-compliance industry. There are many outstanding tax professionals who proactively work with clients to ensure that they are taking every available credit and deduction, while reporting only the income required to be reported.
But there also are many tax professionals who function in a more administrative role, taking information from clients and simply inputting it into the appropriate tax forms.
The list is long, but among the most common missed opportunities or mistakes for individuals are:
- Overpaying capital gain taxes because of improper tax-basis calculations or records;
- Not claiming available tax credits;
- Not taking advantage of deductions for charitable contributions and expenses;
- Failing to understand tax-advantaged accounts such as IRAs, 401(k) plans, health savings accounts, and flexible savings accounts;
- Not deducting state and local taxes, including sales taxes in states that don’t impose income taxes; and
- Paying too much in estimated and withholding taxes.
The required solutions to these problems are more complex than most are willing to admit.
We may need more enforcement staff for the IRS, but we also need further investments in taxpayer and tax-professional education and support.
And what about a new approach to audits? How about looking for deficiencies but also looking for overpayments as part of the regular audit process?
Better compliance technology, simpler tax rules, and subsidies for professional tax advice, including restoring the deductibility of fees for such advice, should also be part of the solution.
One way or another, focusing solely on the tax gap is not enough; we must also address the reverse tax gap.