Lawmakers see pot of gold in tax gap

For members of Congress, thinking up bright ideas for spending tax dollars comes as naturally as breathing. But, constrained by big deficits and a pledge not to make them any bigger, lawmakers find themselves in an uncomfortable bind.

That’s why Washington has suddenly discovered a new buzzword -- the “tax gap” -- and the roughly $300-billion pot of untouched gold that it promises. That’s how much the Internal Revenue Service says taxpayers owe the government annually but, for various reasons, never pay.

The chances of significantly narrowing that gap appear slim. But as Congress gets ready to receive President Bush’s 2008 budget Monday, Democrats and Republicans alike are talking it up as a way to fund politically appealing initiatives -- and bring down the deficit to boot.

“Closing the tax gap has got to be one of our top priorities,” said Senate Budget Committee Chairman Kent Conrad (D-N.D.).

The IRS is probably low-balling its estimate of the tax gap, he said, and there should be more than $300 billion available.

To boost efforts to harvest it, the chairman and the top Republican member of the Senate’s tax-writing finance committee, Sens. Max Baucus of Montana and Chuck Grassley of Iowa, took the unusual step last week of visiting the IRS and asking some of its top bureaucrats about the tax gap -- and presumably ways it might be closed.

Though the existence of the tax gap is real enough, the likelihood that any substantial part of it can be collected is more hope than fact. The gap has been around as long as there have been taxes, and past efforts to close it have yielded meager results.

“If the tax gap was easy to close, the IRS would already have done it,” said Mark Zandi, chief economist at Moody’s Economy.com.

For one thing, the IRS would have to use tougher tactics to get more revenue -- and that would make taxpayers squawk. The last time Congress addressed the subject of tax collection methods, in 1998, it reined in overzealous IRS agents.

“The 1998 act tilted the table in tax disputes in favor of taxpayers suspected of noncompliance,” wrote Max B. Sawicky, an economist at the Economic Policy Institute, in his book “Bridging the Tax Gap.”

Collecting more would also require spending more for audits and investigations. In fact, the IRS last year had a smaller enforcement staff, and it conducted fewer audits -- fewer than one individual return in 100 -- than a decade earlier.

“You can ask for more audits, income-tax withholding and reporting of income to the IRS,” said Mel Schwarz, a partner in the Washington office of the accounting firm Grant Thornton. “All of this would be invasive on a lot of taxpayers, many of whom already pay their taxes.”

And as Robert D. Reischauer, president of the Urban Institute, pointed out, a lot of the money is owed by people who have gone bankrupt or moved overseas to escape the IRS’ reach.

Also largely beyond the tax collectors’ grasp is the huge underground cash economy, whose transactions go unreported to any financial authorities. It would take an American equivalent of the KGB to bring that into compliance with the U.S. tax code.

Measuring the tax gap is as much art as science. To find out what taxpayers should have paid on their 2001 income, the IRS conducted reviews of a random sample of 46,000 individual returns.

The IRS estimates that taxpayers still owed $345 billion after most 2001 tax payments were due. A combination of voluntary late payments and IRS enforcement actions shaved that figure to $290 billion. That means taxpayers paid 86.6% of the $2.157 trillion they owed -- the vast majority of it voluntarily.

Like just about everything else with a dollar sign in front of it, the $290-billion tax gap has probably grown since 2001. Even if it stayed the same, it would be enough to balance this year’s budget, with about $50 billion left over.

Underpayment of individual income taxes dominates the tax gap. The IRS estimated that individuals accounted for 71% of the 2001 tax gap, with the rest coming from underpayments of corporate income taxes, payroll taxes for Social Security and Medicare, and estate taxes.

The IRS traced most of the gap to taxpayers who underreported their taxable income, either by failing to report some income or by taking more deductions and credits than they were entitled to. Failure to file tax returns and failure to pay taxes owed accounted for much less.

Some of the tax gap is the result of honest mistakes on tax forms, which grow more complex every year as Congress adds new wrinkles to the tax code. The IRS can’t say how big this category is.

But one thing is apparent from the IRS’ research: The government has a much better chance of collecting the money it is owed if a portion of it is withheld in advance and if the income is reported by two sources -- taxpayers and their employers.

In 2001, for example, taxpayers failed to pay taxes on only 1.2% of income in cases in which employers reported substantial information to the IRS and withheld at least some taxes from their workers’ paychecks. But when substantial information was reported to the IRS but no taxes were withheld -- as with interest and dividend income -- the noncompliance rate nearly quadrupled, to 4.5%. And when the IRS received little or no independent information, the noncompliance rate was 53.9%, meaning it received less than half the taxes owed.

More withholding, or at least more reporting when money changes hands, would undoubtedly mean a smaller tax gap. But it wouldn’t always be easy to arrange. It’s one thing to ask a huge corporation to withhold taxes from its employees; it has a brigade of accountants to take care of that.

But the IRS would set off the modern equivalent of the Boston Tea Party if it required families to withhold taxes or file a report with the IRS every time they paid the plumber or bought an apple at the corner market. Short of a technological breakthrough, it will be the responsibility of the plumber and the corner grocer to report their full income.

Of course, tax cheating can grow to a scale far beyond the local plumber or grocer.

Two recent examples: A North Carolina man was sentenced to 41 months in prison for not reporting $850,000 in commissions that he paid himself for investments he solicited in a company he started. And a Washington state man got a year and a day in prison for failing to report at least $1 million in income from the U.S. Postal Service for installing and maintaining mailboxes.

A favorite tax dodge involves transferring funds to banks in countries with little or no income taxes and arranging the books so that all the profits seem to have been made there. Sen. Conrad said a single five-story building in the Cayman Islands, a notorious tax haven, was listed as the local address of 12,000 U.S. companies.

Conrad said that while he was North Dakota’s tax commissioner, he found an oil company that showed losses at every step of the marketing chain in the United States -- but made up for it and then some in the Cayman Islands, even though it has only one employee there.

“That man is really a hard worker,” Conrad said. “He’s down there producing millions in profits when thousands of employees in the United States produce none.”

joel.havemann@latimes.com