Each year, millions of Americans pay their taxes. We suffer through the nightmare of unfathomable IRS forms, spend tens of billions of dollars on tax experts so the IRS won’t audit us … and yet watch as other people slip through the cracks.
Those cracks are pretty large. The IRS has concluded that approximately 16.3 percent of taxes simply don’t get paid. This was the case in 2001, 2006, and 2008-2010.
In 2018, this meant that almost $643 billion in federal taxes simply went unpaid, based upon the $3.3 trillion pulled into federal coffers– what the IRS and Government Accountability Office (GAO) call the “compliance gap.” That’s 83 percent of the 2018 federal deficit, and almost $2,000 per American that is simply not being paid.
GAO’s recent testimony to Congress concluded that the three major causes of unpaid taxes are third-party reporting issues (such as employers making errors when reporting employee pay), reduced IRS budgets and staffing despite increased IRS responsibilities, and the complexity of the tax code.
So, the questions are: how do we improve compliance? And, frankly, how does this affect you?
Let’s get a few housekeeping details out of the way
First and most important: We will never hit 100 percent tax compliance. People cheat on their taxes, they don’t report income made in cash, businesses go under and don’t pay the fine for not filing quarterly taxes, etc.
A second qualifier: While the rich and well-connected certainly take advantage of the tax code (more on that later), the vast majority of special interest tax loopholes help the average American. This important fact was highlighted by the IRS Taxpayer Advocate’s 2010 annual report – a report which also noted that “tax simplification would go a long way” toward improving taxpayer trust in the system, and “reducing tax preferences…in exchange for lower rates” is “the most promising approach” to simplifying the code.
Third, the aforementioned 16.3 percent compliance gap comes after the IRS enforces the law. The “voluntary compliance rate” is actually slightly lower – the 16.3 percent number is the “net compliance rate.” I am using the latter because it’s the end-point rate of non-compliance.
Identifying the underlying cause(s) of compliance issues
In looking at the GAO’s testimony and its related summary, I concluded that reduced complexity would lead to positive changes in other areas of compliance concern. I asked GAO Director of Strategic Issues James McTigue if “reduced complexity [would] reduce the need for IRS resources and the error rate of third-party reports.” He said yes…and no.
Reduced complexity in the tax code would facilitate IRS’s efforts to ensure compliance with the tax code and help taxpayers voluntarily comply with our tax laws. For example, with fewer provisions in the code, IRS would be able to focus its taxpayer service and enforcement efforts more narrowly. Reduced complexity likely would not reduce the benefit of third-party reporting. Regardless of the provisions in the tax code that affect how income is treated, compliance will be highest when income is reported to IRS and taxpayers.
Committee for a Responsible Federal Budget Senior Vice President Marc Goldwein told PJ Media that IRS funding should be the first priority. “Non-compliance is being driven by pass-through businesses which are misreporting income, overtaking deductions, etc.,” he explained, and while “we don’t want to burden small businesses, we should do more to ensure there is more regular reporting and verification for larger small businesses.”
While Goldwein did endorse improved compliance “by virtue of the tax code being simpler” and thus providing “fewer opportunities for abuse and error,” he also put regulatory changes ahead of streamlining. “The first thing is to increase the IRS’s budget for oversight and compliance,” something which “the last two presidents have endorsed in their budgets.”
Goldwein also said that “changes in rules/authorities” would “improve existing oversight processes.”
Trump tax law
Tax lobbyist and Center for a Free Economy President Ryan Ellis said that the Tax Cuts and Jobs Act (TCJA) “showed us how to simplify taxes in a politically viable way.” Citing the Joint Committee on Taxation (JCT), Ellis said that TCJA reduced the number of individual tax filers who itemized deductions from 30 percent to 12 percent. He also said the tax law restricted deductions “in a means-tested way,” expanded the standard deduction to cover those affected by the means-testing, and “use extra money to lower rates and increase [the] child [tax] credit.”
McTigue said TCJA made the tax code both more and less complex. Citing a Tax Policy Center (TPC) report, he noted several ways in which the law reduced complexity. “TPC estimates that the number of people who itemize will fall … from 26.4 percent … to about 11 percent” in 2018.
“One area of increased complexity TPC cites relates to the new 20 percent deduction for income from pass-through businesses,” said McTigue.
Goldwein agreed with both McTigue and Ellis. “For the majority of people – TCJA made the tax code simpler. But, if you’re looking at the taxpayers and the tax units that are most problematic from a compliance perspective, TCJA made it worse,” he said. “At the lower levels, it means a lot of business income that we wouldn’t want deductible which is [deductible]. As we go up, the rules narrow what does and what doesn’t count … and that will create more non-compliance because the rules are complicated, wishy-washy, and easier to fudge.”
“I expect compliance will be worse in terms of dollars lost from compliance,” Goldwein concluded.
How does this affect me?
There are four major benefits to increasing compliance. Since we’ll never get to 100 percent compliance, let’s assume we can eliminate 50 percent of non-compliance through a streamlined tax code.
Benefit 1: This would eliminate almost $321.5 billion or 41 percent of the 2018 deficit. With deficits getting worse after two decades of irresponsible spending and the worst recession in 75 years, this delays fiscal disaster.
Benefit 2: U.S. citizens will have more money in a faster-growing economy because a flatter and less complex tax code incentivizes more working. Additionally, taxpayers won’t get dinged for others’ non-compliance and won’t have to pay for such a large IRS.
Benefit 3: Greater compliance changes how we talk about federal spending. Cutting just over $450 billion in a budget of $4 trillion will cause a lot less pain than cutting nearly $800 billion. Effective, bipartisan budget options are plentiful … and a smaller deficit makes those cuts politically easier to swallow. (Assuming politicians don’t decide to push off deficit reduction because deficits are smaller. That’s on the rest of us to elect the right folks!)
Benefit 4: Reducing tax complexity accomplishes two normally partisan priorities – reducing tax code class warfare and reducing the ability of the well-connected to get special government assistance.
Conservatives are often furious that even though the rich pay the highest taxes, they are still targeted by liberals to pay even more. Simplification would reduce the ability of politicians to use the tax code to target opponents and reward allies.
But liberals would also see one of their political priorities move forward – reducing the opportunity for the wealthy and well-connected to get special tax benefits. While these special interest tax loopholes are relatively small in dollar value, they are often very beneficial to the economic futures of their recipients.