By Alex Brill

The Senate Finance Committee held an important subcommittee hearing this week, “Closing the Tax Gap: Lost Revenue from Noncompliance and the Role of Offshore Tax Evasion.” The “tax gap,” which is the difference between the amount of tax rightfully owed by US taxpayers and the amount of tax actually paid, is not small. The IRS estimated the gross tax gap in 2019 to be roughly $600 billion, or 17 percent of total federal revenues. The annual net tax gap, which accounts for the fact that some of that revenue will be collected eventually, likely tops half a trillion dollars.

Although the tax gap realistically cannot be eliminated, reforms to tax law, changes to the IRS enforcement budget, and increases in tax reporting requirements could meaningfully reduce the gap and improve the fairness of the tax system.

Notably, at a time when partisanship is rampant, common
ground between Democrats and Republicans on the tax gap seems within reach. In
his opening statement at yesterday’s hearing, Senator John Thune (R-SD) said, “The
tax gap is real. Republicans on this Committee support closing it.”

President Biden has proposed a very large increase in the
IRS budget: $80 billion over the next decade. Republican members of the Finance
Committee and multiple witnesses rightly pointed out that the IRS cannot wisely
and efficiently allocate such largess in short order. Nevertheless, President
Biden’s proposal is a move in the right direction. The IRS should be given
significant additional resources over time to hire skilled workers and upgrade
antiquated computer systems.

In addition to more bodies and faster computers, there needs to be an increase in the amount of information reported to the IRS. As former IRS commissioner Charles Rossotti explained in his testimony, “Tax compliance is heavily driven by whether a taxpayer’s income is reported by third parties in a manner that the information can be efficiently used by the IRS.”

Rossotti rightly advocates for new reporting requirements on financial institutions that provide banking services to businesses owned by higher-income households. Third parties providing these data to the IRS will increase voluntary compliance, thereby shrinking the tax gap without everyone constantly being audited. Although such reforms will take time to yield results, Rossotti estimates that his three-pronged approach — focused and streamlined auditing, technology upgrades, and more information sharing — could shrink the tax gap by one quarter by the end of the decade.

Conservatives contemplating these proposals should keep
three things in mind.

First, there is nothing good or just about a tax system in
which most taxpayers pay what they owe, but some taxpayers are able to
underpay. This undermines trust in our tax system and requires those who are
compliant to bear an unfair share of the total tax collection.

Second, closing the tax gap is superior to increasing taxes
on high-income households who are already compliant. Increasing marginal tax
rates on ordinary income or capital gains of high-income households or hiking
the corporate income tax rate will have three certain effects: 1) exacerbate
the disparity in taxes paid by those who are compliant and those who cheat, 2) encourage
more taxpayers to pursue tax avoidance strategies, and 3) discourage investment
in capital and innovation. Closing the tax gap may not be costless, but, if
well executed, it is preferable to rate hikes.

Finally, tackling the tax gap is critical to the principle of
tax policy known as horizontal equity — that is, that similarly situated
taxpayers should pay similar amounts of tax. For example, two neighbors with
similar incomes should not pay vastly different taxes just because one earns
wages that are reported to the IRS and the other runs a business that keeps some
of its revenue “off the books.”

Partisan obstacles must still be addressed. Some Democrats have floated foolish ideas such as using new revenues from tax gap mitigation to offset the cost of SALT cap repeal, and Senator Grassley (R-IA) has expressed concern about IRS intrusion on small businesses if their budget is boosted by $80 billion. Nevertheless, the time is ripe for bipartisan cooperation on a sensible effort to help the IRS better collect the taxes that are owed.

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