The Tax Gap and What it Means for Taxpaying Entities

Shannon Henschel

Associate Editor

Loyola University Chicago School of Law, JD 2024

Every three years, the Internal Revenue Service (IRS) releases the estimated gross tax gap calculated for the three years prior. Recently, the estimated tax gap for the years 2014 to 2016 was revealed to be $496 billion. This startlingly high number represents a continuing trend of noncompliance by American taxpayers that feeds into the federal budget deficit.

The meaning of the tax gap

The tax gap is simply the difference between total taxes owed and total taxes paid on time. The tax gap has increased over the last several years. For the 2011 to 2013 time period, the tax gap was estimated to be $441 billion, which is substantially similar to previous years and suggests that there has been no significant change in the amount of the tax gap or business’s rate of compliance with paying their taxes.

The release of the $496 billion tax gap estimate for 2014 to 2016 is staggering when combined with the IRS’s projection for the 2017 to 2019 estimated tax gap – which comes out to $540 billion.

Causes of the tax gap

The tax gap is a result of individuals and corporations either underpaying, not reporting, or never filing their taxes. While the IRS may eventually receive some late payments either voluntarily or by enforcement, they will still forgo the majority of missing taxes. The 2014 to 2016 estimated tax gap of $496 billion only decreased to $428 billion after the IRS received late payments.

By far, the largest contributor to the tax gap is underreported income. For the 2014 to 2016 tax gap, $398 billion, or 80 percent, of the gross tax gap was attributable to underreported income. It is estimated that this comes from self-employed individuals underreporting their earnings from pass-through entities such as sole proprietorships, partnerships, and S corporations.

Additionally, it is likely that it is the wealthiest of Americans who are largely contributing to the tax gap. Earnings from stocks and other obscure sources are often hard to value, due to earnings not being realized until stocks or other assets are sold. Additionally, the wealthiest of Americans have access to lawyers to help them conceal their taxable income.

However, the IRS does not know the exact details of each case of taxpaying entity’s underpayment, under reporting, or failure to file their taxes. While the recently increased tax gap is partially caused by taxpayers’ decision to not comply with state, local, and federal tax laws and regulations in a timely manner, a multitude of other factors could also contribute. Factors such as a growth in economic activity, exploitation of gray areas in developing tax rules, or honest mistakes could all be additional contributing factors. Tax codes for businesses become more and more complex each year, so exploitation of gray areas and honest mistakes could also be play a part. Therefore, the tax gap cannot be solely blamed on tax evasion.

Implications and resolutions to the tax gap

President Biden passed the Inflation Reduction Act this past August, which aims to curb the United States’ growing inflation in part by reducing the deficit. To further this cause, $80 billion was allocated to the IRS to use over the next ten years to help close the tax gap and divert more funds back toward the deficit.

The IRS has been incredibly understaffed and equipped with outdated technology and resources which has presumably led to the tax gaps each year. The inefficiency of the IRS may also feed into public dissatisfaction with the IRS and deter them from reaching out to the agency for help while paying taxes. In fact, last year the IRS received 230 million calls and only had 15,000 IRS employees to answer those calls, which meant each employee had to answer 16,000 calls. This led to only eleven percent of people being able to get in touch with a human at the IRS last year.

The IRS plans to use the $80 million to hire more employees, replace the outdated technology within the agency, and audit the wealthy corporations who are contributing to the tax gap with tax-avoidance schemes and not complying with the IRS. By making the agency more efficient, regular Americans who are simply just trying to pay their taxes will have an easier time, and wealthy corporations will have a harder time evading their taxes. Both solutions will lead to a smaller tax gap.

While the majority of Americans hold contempt toward the IRS, the agency exists to serve the public and its goal to resolve the tax gap is rooted in its desire to promote fairness. The existence of the tax gap shows that taxes do not affect every American the same, and hopefully a decreased tax gap will lessen that disparity.