The Tax-Gap Myth

On September 7, 2021, the Treasury Department released a story titled “The Case for a Robust Attack on the Tax Gap.” The piece, written by deputy assistant secretary Natasha Sarin, is the third installment in a series designed to win support for a massive increase in IRS enforcement capabilities. The Treasury Department presses the case for increasing the IRS’s budget by $80 billion over the next ten years, claiming that the “investment” — read: “government spending” — will generate “an estimated $320 billion in additional tax collections” over that period.

Parenthetically, even if this were true, the additional revenue would not be sufficient to cover the federal government’s operating deficit for just one year. The article also pushes the case for the administration’s proposal to engage in massive spying on citizens through our nation’s banks and financial institutions. I discussed this proposed at length in National Review earlier this week.

The department suggests that the blizzard of new information reporting required under President Biden’s plan will not “impos[e] any burden on taxpayers whatsoever.” Nothing could be further from the truth. It is undisputed that banks and other financial institutions will pass on to their customers the high cost of complying with the plan’s mandated annual reporting.

Take the American Bankers Association, which opposes the Biden plan. They are concerned about several consequences it poses for both individual and businesses taxpayers, including the assault on privacy and the threat to security. Chief among the reasons for their opposition, though, is the increased costs to their customers due directly to the burdens imposed by the massive reporting envisioned under the plan. The association is calling on its member bankers to oppose the plan, too.

The central thesis of Treasury’s article is that business owners are the primary source of all tax cheating in the U.S. According to the article, “about half of the individual income tax gap accrues to income streams from proprietorships, partnerships, and S-corporations, where there is either little or no information available to the IRS to verify the veracity of tax filings.” Put differently: Unless the IRS has third-party information to verify the claims made by self-employed people, they will systematically cheat on their tax returns.

 It is well-documented that the IRS’s audit results are wrong between 60 to 90 percent of the time, depending on the issue. Moreover, because IRS auditors are themselves undertrained in tax law, they often misapply the proper legal standards to their audit decisions. Even worse, auditors routinely use tactics of bluff and intimidation, misinformation, and disinformation, and even outright lie to citizens during audits to coerce taxpayers into accepting audit results that are simply not accurate.

The author of the article continues to advance the party line that Biden’s tax plan will not affect anyone earning less than $400,000 per year. Consider this statement:

It is important to understand what this improved information reporting proposal is not: It is not about using new financial account information reports to increase enforcement scrutiny on lower-income taxpayers. The Administration has been clear that audit rates will not rise relative to recent years for those with under $400,000 in actual income. Instead, these proposals are about targeting enforcement actions where they belong: on higher earners who do not fully report their tax liabilities.

In light of the claim that the underreporting is attributable to “proprietorships, partnerships, and S-corporations,” it is — to use a kind word — disingenuous to suggest that self-employed individuals operating under one of these entity forms will not be targeted for enforcement action. The vast majority of self-employed people operate under one of these entities, and the vast majority of them earn under $400,000 annually. The reality is that, as a whole, the money in America is largely in the hands of the middle class. You can be sure, then, that’s where the IRS attacks will be targeted.

Propaganda is what it is, and so I was unsurprised to read in the article the claim that we have a “two-tiered tax system.” The author claims that our tax system contains “two sets of rules: one for regular wage and salary workers who report virtually all the income they earn; and another for wealthy taxpayers, who are often able to avoid a large share of the taxes they owe.”

This is not so. There are absolutely not two sets of rules in the tax code. The Internal Revenue Code applies to all taxpayers equally. A person earning a small amount of income must report all of it and pay whatever tax is owed after the application of allowed deductions, credits, etc. The same is true for high-income people.

This is merely a thinly veiled attempt to use class envy as a device to persuade lower-income people that while they must pay through the nose on their taxes, high-income people are permitted to systematically cheat on theirs. In that case, the former will likely countenance any plan to attack the latter without considering the possibility that they also might be harmed. But that’s exactly what will happen since there are simply not enough high-income earners available to raise the revenue needed to support the trillions of dollars in proposed spending and deficits.

Another dubious contention in the article is the idea that lawmakers are somehow hamstrung in their policy-making by the failure of some to pay all the tax they owe. The author argues:

The tax gap also has meaningful implications for fiscal policy. These unpaid taxes mean policymakers must choose between rising deficits, lower spending on important priorities, or further tax increases to compensate for lost revenue — which will only be borne by compliant taxpayers.

This suggests that the taxes of honest people go up when others don’t pay what they owe. In truth, though, your taxes are high and getting higher for one reason only: Congress spends way too much of your money, without any incentive to stop.

Moreover, throughout the national spending debate we’ve witnessed over the past 18 months, there’s been no discussion whatsoever of who, when, or even how the many trillions in new spending will be paid for. Congressional Democrats frankly do not care whether their gravy train of spending will ever be financed. To suggest that policy-makers engage in some level of intellectual “give and take” over the friction between higher deficits and lower spending is complete nonsense.

Anybody who’s spent any time studying these policy issues knows full well that Congress sets its spending agenda first. That agenda is determined by the social and political issues of the day. It then sets tax policy based on the same considerations. At no point does Congress say: “We have X dollars to spend, so how do we allocate those funds?”

That discussion takes place in every boardroom and at every kitchen table in America, but never in congressional hearing rooms. If it did, there’s no way we would have nearly $30 trillion — and growing — national debt. Make no mistake about it: The fact that your taxes are high has nothing whatsoever to do with whether the rich guy living on the hill is paying all of his taxes or not. The blame lies solely and exclusively with irresponsible government.

And make no mistake about this: The IRS is gearing up for an attack on America’s business owners, relying on obfuscation and scare tactics. This is their word — right there, in the title of their report — not mine. For the sake of our vibrant, entrepreneurial economy, let’s hope we can all see through it.