IRS’s New Estimates on Tax Gap Track Closely With NTUF’s

Last year, IRS Commissioner Chuck Rettig created a stir in the tax world when he announced that his “personal opinion” was that it was “not outlandish to believe that the actual tax gap could approach and possibly even exceed $1 trillion per year.” News outlets and legislators hoping for “free” revenue latched on to this number, and soon the figure of a $1 trillion tax gap was being taken as fact.

NTUF quickly pushed back on the narrative, noting that the IRS itself had no such institutional estimate — the IRS’s most recent estimate of the size of the tax gap at the time (for tax years 2011-2013, released in 2019) placed the gap at a far smaller $381 billion per year after factoring in late payments and enforcement efforts. 

NTUF also looked at some areas of the tax gap that may have grown or for which the IRS could be underestimating the tax gap. Even using the most pessimistic assumptions, NTUF placed the high-end estimate of the size of the tax gap at about $100 billion larger than the IRS’s official estimate. In other words, NTUF estimated that the tax gap may be larger than $381 billion, but it was nowhere near $1 trillion.

Nevertheless, the Commissioner’s comments drew a series of proposals to expand the size of Rettig’s agency. Eventually, the Inflation Reduction Act was passed, which included a staggering $80 billion increase to the IRS’s budget over the next decade. The Congressional Budget Office originally estimated that this would result in about $124 billion in net revenues over the next decade, though it later lowered this estimate to about $101 billion. 

But even as policymaking was driven by an off-the-cuff statement made by Commissioner Rettig in a hearing, the underlying numbers have not changed significantly. The IRS just released an updated estimate of the size of the tax gap, and it tracks far more closely with NTUF’s analysis of the issue than Commissioner Rettig’s.

The IRS’s updated estimate, for tax years 2014-2016, places the size of the net annual tax gap at $428 billion — larger than the previous estimate, but only by $47 billion. The report also includes a projected estimate for the 2017-2019 tax years of $470 billion after factoring in late payments and enforcement efforts.

These numbers are, of course, far closer to NTUF’s estimates than the Commissioner’s. What’s more, they provide a picture of a tax gap that is actually shrinking relative to economic growth. While true tax liability according to IRS estimates grew by 23 percent, the net tax gap grew by only 12 percent. This suggests that far from being a growing problem, tax compliance is actually improving — and even before handing the IRS an $80 billion budget increase.

Comparing the growth of the tax gap to the growth of gross domestic product (GDP) suggests that the increase described above is attributable to economic growth, not additional tax fraud. The size of the net tax gap relative to GDP is nearly exactly the same between 2011-2013 and 2014-2016, at 2.328 percent and 2.324 percent, respectively. Based on projections for 2017-2019, the size of the tax gap as a percentage of GDP is actually set to decline to 2.259 percent.

Outlandish estimates of the tax gap drive legislators to consider drastic and harmful measures, such as overly strict reporting requirements requiring online payment platforms to generate 1099-K tax forms for anyone with transactions exceeding a $600 threshold, or proposals to hand the IRS information on any bank accounts with over $600 in annual activity. These changes may generate a small amount of additional tax revenue on the margins, but significantly  burden taxpayers, violate their privacy, and put sensitive personal and financial information at risk.

Furthermore, legislators must understand what drives the tax gap. While news reporting tends to conjure up images of wealthy individuals intentionally hiding their fortunes in offshore accounts, the truth is far more mundane. The IRS report shows that the largest two drivers of the tax gap are “pass-through” businesses and the self-employment tax — the former category being made up primarily of nonemployer small businesses, and the latter including people such as freelancers and gig workers. There could be many causes behind these two trends, and it is dangerous to make policy off the cuff without digging deeper.

One consideration is that many so-called “tax cheats” do not have the element of intentionality that the term suggests (at least as politicians use it). Millions of Americans make inadvertent errors on their tax returns due to the monstrous complexity of the tax code — a large number of whom mistakenly claim refundable credits, for example, or even just interpret the tax code in a way that is logical but the IRS nevertheless disagrees with. Coming down with a hammer intended for tax frauds will inevitably squash many average taxpayers simply confused by our overly burdensome tax code. 

Legislators must consider these competing factors when they seek to tackle IRS enforcement issues in the future. A Congress concerned only with maximizing tax revenues will leave taxpayer rights by the wayside and fail to take into account the circumstances leading to underpayment. And given that the IRS continues to estimate a lower tax gap than is commonly reported, the juice may well not be worth the squeeze.