Democrats’ Tax Gap Manipulation

The IRS recently issued a new projection of the tax gap.¹ While the projection’s release received much attention and some hand-wringing from Democrats,² it actually adds little to the previous estimate. Essentially, the new projection adjusts that estimate for recent receipts, not changes in compliance.

The tax gap figure is used to gauge taxpayer compliance and projects the difference between taxes believed to be owed and taxes actually paid. Per the IRS’s projection, the 2021 tax gap is $688 billion, an increase of over $192 billion compared with the 2014-2016 estimate.³

In releasing this information, the IRS pledged an “urgent” crackdown by boosting IRS enforcement, especially on high-income individuals, partnerships, and corporations.⁴ But the premise for this new crackdown is built on a flawed foundation, albeit a convenient narrative to support the IRS’s bloated budget and new auditing regime.

It is crucial here to understand what the IRS’s $688 billion projection is and is not. It is simply a projection of what the 2021 tax gap would be, assuming that the tax law and compliance rates from the 2014-2016 estimate are held constant and applied to the 2021 economy.

In other words, it is a projection of an estimate, which is Washington-speak for a guess (projection) of a guess (estimate). Like any double guess, it is wise to approach such a claim with healthy skepticism.

The IRS claims the tax gap is dramatically rising. This is misleading at best.

When viewed in proportion to the economy’s size over the last 20 years, the tax gap is actually flat and historically average. The Cato Institute examined the tax gap as a percentage of GDP and found that for 2021, the tax-gap-to-GDP ratio was 2.9 percent, squarely in line with the last 20 years of estimates.⁵

Further, an equally valid way of expressing the tax gap is in the share of taxes the IRS believes are voluntarily paid — the so-called voluntary compliance rate. The new projection pegs this rate at 84.9 percent, while the 2014-2016 estimate had it as 85 percent. In stark contrast to overblown characterizations of tax cheating run amok, the tax compliance rate is in fact high and stable.

There are other problems with the IRS simply recycling an old estimate.

First, in 2021 the economy experienced its most rapid expansion in three decades, inflation saw its sharpest increase in 40 years, and the federal government was in the midst of disbursing $4.6 trillion in pandemic-related aid.⁶ These factors inflate the tax gap, as people and businesses spend and earn more, without increasing the amount of tax evasion.

Second, the recycled estimate was based on compliance behavior with old tax laws, which profoundly changed in 2017 with Republican-led tax reform. With improvements like increasing the standard deduction, decreasing the alternative minimum tax’s impact, and lowering marginal rates, Republican tax reform made paying and filing taxes easier for Americans, which simplified compliance. Shortcuts like presuming identical compliance — despite major changes in tax law — lead to errors.

When issuing its new tax gap guess, the IRS reflexively identified “high-income and high-wealth individuals, partnerships and corporations” as areas of concern, but cited no evidence. Historically, these groups have high levels of compliance, according to IRS data.⁷ These data also show the most sizable parts of the tax gap are principally attributable to taxpayers of modest means — particularly, small businesses trying to navigate an overly complex tax code.⁸ That is why I have repeatedly called on the IRS to use its special funding to help taxpayers comply on the front end, rather than targeting them for mistakes.⁹

With its new tax gap projection, the IRS conveniently created a justification for its supersize supplemental enforcement budget. Yet the IRS’s bold proclamations are stale and misleading. Measuring the tax gap requires a better approach using relevant, reliable data and sound methodology. If such a true tax gap estimate were published, I would expect to see evidence of the Tax Cuts and Jobs Act’s positive impact on the tax gap.