Tax Gap: Measuring the IRS’s Bottom Line
Cindy Blanthorne and Kristen Selvey Yance
APRIL 2006 - The
IRS recently reported that the gross tax gap is estimated
to be approximately $345 billion (see “IRS Updates Tax
Gap Estimates,” IR-2006-028, from www.irs.gov/newsroom/).
primary purpose of the tax system is to raise revenue for
the U.S. Government. According to the U.S. Budget, tax receipts
represent 58.8% of federal revenue; the federal deficit
is projected to be $364 billion and $521 billion for the
years 2005 and 2004, respectively. Therefore, the $345 billion
tax gap has a considerable effect on the federal budget
(see “Analytical Perspectives: Budget of the United
States Government, Fiscal Year 2005,” from www.whitehouse.gov).
measuring the magnitude of the tax gap is important, from
an economic standpoint identifying the source of the tax
gap is a necessary precursor to developing a structured
plan to reduce the gap. To guide enforcement efforts, policymakers
must identify who is cheating as well as how they are cheating.
Identification of tax-gap sources also matters from a psychological
standpoint, because tax evasion has been linked to the perceived
fairness of taxpayer burden. That is, taxpayers are more
likely to cheat if they perceive others in similar situations
(occupation, education, income) are cheating:
United States has long been proud of the “taxpayer
morale” of its citizens—the willingness to
pay voluntarily the income taxes necessary to finance
government activities. Taxpayer morale ultimately depends,
however, on the belief that taxes are fair. If the basis
for this belief comes under suspicion, voluntary compliance
with the tax laws is jeopardized. ... Taxpayers resent
paying substantially more than their neighbors who have
equal or higher incomes. (“Tax Reform for Fairness,
Simplicity, and Economic Growth,” U.S. Department
of the Treasury, 1984; www.treas.gov/offices/tax-policy/library/tax-reform).
Tax Gap Defined
gross tax gap is the difference between the amount of tax
that should have been paid, on a timely basis, and the amount
actually received by the government for a specific tax year.
In essence, it is the “bottom line” of the U.S.
system of taxation. The amount received is relatively easy
to quantify, but how much should have been paid if taxpayers
were completely compliant requires estimation. The tax gap
has three components: nonfiling, underreporting, and underpayment
(“Understanding the Tax Gap,” FS-2005-14, www.irs.gov/newsroom/).
the nonfiling component is made up of taxpayers who do not
file a tax return even though they are required to do so.
It follows that taxpayers who do not file do not pay their
tax liability. Second, the underreporting component is made
up of taxpayers who file their tax returns but understate
their tax liability. Underreporting can result from understated
income or overstated deductions, exemptions, and credits.
Third, the underpayment component is made up of taxpayers
who file their tax return but do not make the required payment.
detailed research on tax evasion has not been conducted
in 17 years. All estimates of the tax gap reported in the
last decade and a half have been based on data from the
1988 tax year. The 1988 data were gathered through an extensive
audit process called the Taxpayer Compliance Measurement
Program (TCMP). Data collection was halted in 1988 because
of budget cuts and the belief that the program was too intrusive.
TCMP audits required randomly selected taxpayers to provide
documentation for every item on their tax return. Information
collected during the TCMP audit period was analyzed and
then used to score subsequently filed returns. A high score
indicated a higher probability of noncompliance and, therefore,
IRS scrutiny (see Darlene Pulliam Smith, “The IRS
Market Segmentation Specialization Program,” The
CPA Journal, February 2001).
system of measuring tax compliance, the National Research
Program (NRP), has been launched. The number of tax returns
audited under the NRP does not differ substantially from
the past program. However, the manner of selection and the
actual review have been refined. The NRP randomly selects
tax returns for review, with an oversampling of high-income
tax returns. The sample-selection procedure facilitates
analysis of important subcategories of taxpayers. For example,
6% of all individual income tax returns reported a profit
or loss from business activities (i.e., Schedule C). Of
the tax returns selected for review by the NRP, however,
approximately 46% included a Schedule C (FS-2005-14).
audit process of the NRP is less intrusive for taxpayers
than TCMP audits were. The IRS shifted most of the burden
onto itself through the use of information already available
to the IRS. For instance, the TCMP required all audited
taxpayers to provide line-by-line documentation of the amounts
reported on their tax returns. Instead, only a small fraction
of the tax returns selected for review through the NRP require
line-by-line auditing. Furthermore, the IRS attempts to
verify as many line items as possible before requiring the
taxpayer to substantiate the amounts reported (“IRS
Sets New Audit Priorities,” FS-2002-12, www.irs.gov/newsroom/).
tax gap for the first NRP sample year—comprising approximately
46,000 individual income tax returns from 2001—was
recently reported by the IRS. As shown in the Exhibit, the
gross tax gap is estimated at $345 billion. The NRP estimate
is higher than the related estimate based on the 1988 TCMP
data, which was $311 billion. The NRP reported a noncompliance
rate of 16.3% of the true tax liability.
discussed above, the gross tax gap is broken down into three
components: nonfiling, underreporting, and underpayment.
shows that the majority of the tax gap is the result of
the underreporting component. It is estimated that at least
80% of the gross tax gap, $285 billion, stems from taxpayers
who underreport taxable income rather than taxpayers who
do not file tax returns or who underpay their tax liability
when they do file.
income tax is by far the largest contributor, in terms of
the type of tax, to the gross tax gap and the underreporting
component of the tax gap. NRP estimates that $197 billion
of underreporting is the result of noncompliance by individual
taxpayers. Furthermore, tax evaders are much more likely
to understate income than they are to overstate deductions,
credits, and exemptions. Understatement stems from income
invisibility and the lack of a paper trail. Income that
is not reported by taxpayers is difficult for the IRS to
discover. But deductions, exemptions, and credits must be
substantiated by the taxpayer. Income from business activities
makes up the majority of underreported income. In comparison
to business income, income from other sources, such as wages
or investment income, is more likely to be directly reported
to the IRS by third parties, such as employers. Furthermore,
income taxes owed on wage income are withheld by employers
and remitted directly to the IRS, making the opportunity
for underreporting minimal.
the extreme, underreporting business income entails neglecting
to report the existence of a business activity. It is difficult
for the IRS to identify income from businesses that they
do not know exist. In addition, this type of underreporting
has the potential to lead to a second layer of evasion called
the shadow economy. Cash payments for wages or supplies
are less likely to be reported as income by recipients.
Increased tax and Social Security obligations create incentives
to work in the underground economy, where earnings go unreported.
(For more detail, see F. Schneider and D.H. Enste, The
Shadow Economy: An International Survey, Cambridge
University Press, 2002.)
Effects of the Tax Gap
the primary source of revenue for the U.S. government, a
tax system with a significant gap between what it collects
and what it is owed negatively affects the government’s
finances. With rising healthcare costs and the baby boom
generation entering retirement, federal spending on Medicare,
Medicaid, and Social Security programs is projected to grow
dramatically in the coming years. Budget simulations completed
by the Government Accountability Office (GAO) predict an
unsustainable fiscal path that is likely to “erode
… our economy, our standard of living, and ultimately
our national security” (statement of David M. Walker,
Comptroller General of the United States, “Tax Gap,”
Testimony Before the Committee on the Budget, U.S. Senate,
GAO-06-453T, available from www.
magnitude of the tax gap has serious financial ramifications
for the U.S. federal budget and imposes a significant and
unnecessary financial burden on individual citizens who
honestly comply with the tax law. Yet it is unrealistic
to expect the tax gap to ever be zero. An effective system
must measure the tax gap and identify its sources in order
to direct monitoring and enforcement efforts. The NRP is
the IRS’s attempt to accomplish these goals with minimal
intrusion to taxpayers.
Blanthorne, CPA, PhD, is an assistant professor at
the University of North Carolina at Charlotte.
Kristen Selvey Yancey is a tax associate at RSM McGladrey,