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Here's Where Most of the Tax Gap Comes From

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What You Need to Know

  • The biggest contributor to the tax gap is underreporting.
  • Unpaid estate taxes account for a very small part of the overall gross tax gap.
  • The tax gap has recently gotten the attention of lawmakers.

The largest portion of the gross tax gap — 58% of it — comes from unpaid or underpaid business and self-employment income taxes, the vast majority of which comes from pass-through entities such as sole proprietorships, partnerships and S-corporations, according to a just-released analysis by the Committee for a Responsible Federal Budget.

“By far the biggest contributor” to tax gap — which is what taxpayers should pay and what they actually pay on time — is underreporting, “or when an individual or business files a tax return that incorrectly underreports the taxes it owes in a given year,” the committee said.

For the 2011-2013 period, the latest data available, the underreporting gap averaged $352 billion per year, or 80% of the annual gross tax gap, the report states.

Of the $352 billion in estimated underreporting, $245 billion comes from individual income taxes, $69 billion from payroll taxes, $37 billion from corporate income taxes, and $1 billion from the estate tax.

The committee notes that according to the Internal Revenue Service, 9% of the gross tax gap comes from non-filing, 11% from underpayment, and 80% from underreporting — with at least 38% due to underreporting of income and at least 15% due to over-reporting or misreporting of adjustments (the remaining 27% is not defined).

Unpaid estate taxes, the committee said, account for “a very small part of the overall gross tax gap.”

In 2011-2013, unpaid estate taxes contributed approximately $3 billion per year to the annual gross tax gap, or less than 1%.

“Unlike most other categories of tax, most unpaid estate taxes are due to non-filing, representing $2 billion per year. Another $1 billion per year in unpaid estate taxes come from underreporting, and less than $500 million comes from underpayment.”

Also, unlike most other categories of tax, the majority of estate taxes that were not paid in a timely manner — 55% or an average of $2 billion per year — were eventually collected through late payments or enforcement activities.

“This means that just over $1 billion (less than one half of one percent) of the $381 billion annual net tax gap from 2011-2013 came from estate taxes,” the Committee said. “The net tax gap attributable to unpaid excise taxes averaged less than $500 million per year during that period.”

The tax gap has recently gotten the attention of lawmakers.

Sen. Chris Van Hollen, D-Md., and Rep. Don Beyer, D-Va., reintroduced on June 10 the Millionaires Surtax Act, legislation that would apply an additional 10% tax to incomes above $2 million for married couples or above $1 million for individuals.

IRS Commissioner Charles Rettig also told members of the Senate Finance Committee in recent testimony that the agency plans to use its fiscal 2022 budget to hire specialized agents who will crack down on wealthy tax cheats.

Rettig told the Senate Finance Committee in mid-April that the actual annual tax gap possibly exceeds $1 trillion per year, if trading in cryptocurrencies, foreign-sourced income, and business income improperly passed through as individual income were included.

The vast majority of the tax gap, the committee reported, “is associated with income or tax breaks where there is no withholding and little information reporting.”

The committee estimates “only 18% of the tax gap comes from taxation of wages, salaries, government benefits, and other ordinary income, even though this category covers the majority of taxable income and taxes paid.”

Another 15% of the tax gap comes from credits, deductions, filing status and other adjustments, and about 9% comes from unpaid or underpaid taxes on capital income, according to the committee.