OVERVIEW OF THE TAX GAP 8 June 2016

OVERVIEW OF THE TAX GAP | 8 JUNE What the Tax Gap Is  The Gross Tax Gap is the amount of true tax liability for a given tax year that is not paid on time. Gross Tax Gap = Total True Tax Liability — Tax Paid on Time Net Tax Gap = Gross Tax Gap — Late payments of tax for TY  The Net Tax Gap is the portion of the gross tax gap that will never be paid or recovered.

OVERVIEW OF THE TAX GAP | 8 JUNE What the Tax Gap Is Not  Not the sum of all noncompliance (it’s the net of underpayments and overpayments)  Not the “underground economy” (some of the tax gap arises from other things, e.g., overstated deductions)  Doesn’t include the illegal sector (we want to eliminate illegal activity, not collect tax on it)  Not the same as Accounts Receivable (AR is cumulative, includes interest & penalties, and is limited to amounts that have been assessed)  Not generally observable

OVERVIEW OF THE TAX GAP | 8 JUNE Percentage Measures  Voluntary Compliance Rate  Net Compliance Rate VCR = Tax Liability Paid on Time Total True Tax Liability NCR = Tax Liability Eventually Paid Total True Tax Liability 82% VCR Paid on time 18% Gross Tax Gap 84% NCR Eventually paid 16% Net Tax Gap

OVERVIEW OF THE TAX GAP | 8 JUNE Major Components  Nonfiling Gap: the amount of tax liability not paid on time by those who do not file on time.  Underreporting Gap: the net amount of tax liability not reported on timely returns.  Underpayment Gap: the amount of tax reported on timely returns that is not paid on time. Unobserved Observed

Major Alternative Estimation Approaches  “Top-Down” Macro Methods  Compare national accounts with timely tax collections  Disadvantages of national accounts: Not likely to include much hidden income Not a tax concept (deductions, credits, marginal tax rates) No insight on relative compliance across income types, etc.  “Bottom-Up” Micro Methods  Base on observations at the taxpayer level  Challenges: representativeness and thoroughness of data OVERVIEW OF THE TAX GAP | 8 JUNE

Individual Income Tax Nonfiling Gap Methodology  Late Filers  Adjust amounts on returns to reflect 3 rd -party information.  Recalculate balance due.  Not-Filers  Identify income from 3 rd -party information documents.  Impute self-employment income based on similarity with filers.  Combine individuals (incl. dependents) into family units.  Impute common deductions and tax credits.  Calculate balance due. OVERVIEW OF THE TAX GAP | 8 JUNE

Individual Income Tax Underreporting Gap Methodology  National Research Program (NRP)  Audits of a small representative sample of returns each year  Reported and corrected amounts for each line  However, audits do not detect all understated income.  Detection-Controlled Estimation (DCE)  Statistical technique that accounts for variation in $ detected across auditors for a given category of income.  Need to pool 3 annual NRP samples to gain sufficient data  DCE amounts imputed to NRP cases  Net understatement of tax recomputed from adjusted NRP OVERVIEW OF THE TAX GAP | 8 JUNE

Other Underreporting Gap Methodologies  Data  No NRP available.  Use results of regular (no-random) operational audits.  Methods  Statistical techniques to control for non-random audit selection  No method to account for undetected income, so we base estimates on the tax adjustment proposed by the auditors— not the amount ultimately assessed. OVERVIEW OF THE TAX GAP | 8 JUNE

Underpayment Gap Methodology  Tabulate from IRS population databases  Tax reported on timely filed returns  Amount of that tax that is paid on time  Underpayment gap is the difference  Tabulate by type of tax and by tax year OVERVIEW OF THE TAX GAP | 8 JUNE

Late Payments Estimation Methodology  Tabulate tax paid late from IRS population databases  By type of tax  By tax year of liability and fiscal year of payment  Estimate future payments for a tax year  Observe decline in historical payments in successive fiscal years for a given tax year.  Use the same relationship to project future payments for more recent tax years. OVERVIEW OF THE TAX GAP | 8 JUNE

OVERVIEW OF THE TAX GAP | 8 JUNE

Effect of Information Reporting on Individual Income Tax Reporting Compliance, Tax Years 2008–2010 OVERVIEW OF THE TAX GAP | 8 JUNE

Uses of Tax Gap Estimate  Not a performance measure  Not observable; too much uncertainty  Many annual fluctuations caused by factors beyond tax agency.  Not a basis for allocating enforcement resources  Need to allocate resources based on their cost-effectiveness.  Largest gap components generally large because enforcement there is not very cost-effective.  Good check on the tax system overall  Good guide for developing compliance legislation  Way to identify priorities for researching cost-effective administrative interventions OVERVIEW OF THE TAX GAP | 8 JUNE