Resident Scholar Kevin A. Hassett

The hot concept inside the Beltway these days is the “tax gap,” and you reveal yourself to be a total loser at a D.C. cocktail party if you don’t know what it is. Everybody who is anybody has their own idea about how to close the gap. What’s yours?

The tax gap is the total difference between taxes owed and taxes paid. For most of us, the gap is zero. We honest folks fill out our forms accurately and pay what the law says we owe. But a disturbingly large number of Americans engage in one form of tax dodge or another. Some people sell assets and then lie about the tax basis for the sale. This allows them to understate the capital gain, and pay less tax.

There are many different ways to cheat the tax man, and the scale of the endeavor is mind-boggling. Americans are pretty good at apple pie and baseball, but they are terrific at dodging taxes.

According to the latest estimates by the Internal Revenue Service, the gross tax gap amounted to about 16 percent of total revenue in 2001. In 2006, total federal taxes were about $2.4 trillion. If the normal amount of evasion occurred, then the IRS collected $391 billion less than it could have if folks played by the rules.

Instant Surplus

To put that number in perspective, the federal deficit in 2006 was, according to the latest estimate, $247 billion. If all taxpayers paid what they owed, there would have been a surplus of $144 billion instead.

Alternatively, we could have held the deficit where it was, and reduced marginal tax rates across the board by a large percentage.

The enormous revenue potential associated with closing the tax gap has hung over Congress like fruit over Tantalus for decades. But just as the fruit disappeared when Tantalus reached for it, the tax gap continues to be massive, despite efforts to close it.

That doesn’t stop politicians from trying. Indeed, the big stakes explain the current hotness of the concept. Democrats promised voters they would be more fiscally responsible than Republicans and are eager to reduce the deficit. If they can close the tax gap, they can move in the right direction without boosting tax rates.

Find the Leaks

To identify a fix, you first need to understand where the leaks are. By far the biggest component of the tax gap, again according to IRS estimates, is underreported business income.

There are any number of ways small businesses can hide income. The fellow who sells you firewood can fail to declare the income. Business can deduct expenses that are actually for personal use. All told, such activities account for almost a third of underpayments.

When tax cheats keep more of their money, the federal government has to take more from law abiding citizens. Thus, it is hard not to get behind efforts to enforce the current code better.

The problem is, what can we really do to stop the cheats? We already have laws that require them to pay taxes. They have chosen to ignore them. If we adopt new laws, it is a safe bet that the cheats will sidestep them as well.

The most promising measures would either raise penalties or increase the IRS’s ability to identify cheats, without imposing too much cost on the rest of us.

Bizarre Code

The problem with stricter penalties is that the tax code is so bizarre that virtually anyone could be found guilty of failing to respect the letter of the law. If we put convicted tax cheats to death in order to discourage evasion, we would inevitably wipe out many innocents as well.

Tax geeks at the IRS probably wouldn’t care too much about all that carnage, so let’s give them an argument they will understand. The revenue loss from all the dead innocents would probably dwarf the revenue gain from improved compliance.

Informational fixes are, therefore, the preferred approach. So far, only one such change appears to be gathering legislative steam. President George W. Bush suggested a measure that would require stockbrokers to report to the IRS the basis cost of any shares that are sold by one of their clients. That way, the IRS can check the accuracy of reported capital gains.

A Pat on the Back

Underreporting of capital gains is one contributor to the tax gap, and likely cost the IRS about $12 billion in revenue in 2006. But the Treasury’s own staff predicts that this measure would only raise about $1 billion a year after full implementation, in part because much of the capital-gains problem occurs with other types of assets.

That low revenue hasn’t stopped Democrats and Republicans from congratulating themselves over this new law. It is a sign of the times that Washington could be so giddy over a fix that addresses 1/391th of the problem. It might be that other similar fixes can be found. With luck, our leaders may even invent enough reforms to fix 3/391ths, thereby setting a record for congressional efficiency.

But when they are done, you can be sure that the tax gap will remain. Like a great dog, the tax gap will always be there for you.

Which makes aiming for a little understanding of the issue a very shrewd investment for those who fancy themselves Washington insiders. It will be the topic of conversation at D.C. cocktail parties for many years to come.

Kevin A. Hassett is a resident scholar at AEI.