What is the Tax Gap?

The tax gap is a term used by the Internal Revenue Service (IRS) and by many state and local tax agencies. It represents the difference between what is actually owed to tax-collecting agencies and what is really paid to them. It’s difficult to know exactly the exact tax gap is for institutions like the IRS. Audits in 1998 led to projected tax gap figures of about 250-300 billion US dollars (USD) per year.

Only 50,000 people or businesses were audited, so the figure is a projection from a relatively small sample. In large states like California, 2005 projections suggest a loss of about 6 billion dollars a year in state taxes. 2005 federal studies concluded that the tax gap cannot be estimated with complete accuracy, but suggest the tax gap has widened since 1998 while ability to collect owed taxes remained about the same.

Some portion of the tax gap is recovered each year by enforcing payment of taxes owed, and through auditing. About 55 billion USD a year is eventually paid. This means estimates of the gross tax gap are really about 350 billion USD a year. The net tax gap is somewhere between 250-300 billion USD.

There are three main causes for the tax gap: failure to file returns, underreporting income, and failing to pay for taxes owed. Of these, the largest share of the tax gap is due to underreporting. From IRS estimates, about 250 billion dollars is lost each year due to underreporting.

Underreporting includes not fully reporting all income. People or businesses may also take too many deductions or may claim tax credits to which they are not entitled. Individuals are most likely to underreport income, not pay their taxes in full, or fail to file completely. They account for the largest share of the tax gap on the federal level. In contrast, studies conducted by the California Franchise Tax Board suggested small businesses were most responsible for the state tax gap.

People who don’t pay taxes accurately may not do so intentionally. Though some people elude taxes through underreporting, many people simply make mistakes when filing their tax reports each year. These mistakes may or may not be caught by state tax boards or the IRS. For many, underreporting or purposefully not filing is no mere mistake but a deliberate attempt to evade taxes.

Given the loss to federal and state governments, President George W. Bush has called for greater spending to conduct more audits and to collect more taxes owed. The president has also noted that complexity in tax law is in part to blame for the tax gap, and advocates for greater spending to reduce this complexity in order to gain more tax compliance. It is unclear whether greater spending or more audits would change the behavior of those who knowingly underreport on their taxes or who do not file. However, it is abundantly clear that the tax gap represents a significant loss to both state and federal government each year.