Mind The [Tax] Gap

“We all know that forecasting the future yields only one guaranteed result: You’re wrong the minute you make the forecast.”
— David Kotok

Full disclosure, it was hard to find objective data for this blog post. This was originally a reflection on the Build Back Better Act, and while that Bill failed, its various measures have been resurrected via other pieces of legislation. Which bring us to the Inflation Reduction Act of 2022. According to the initial Congressional Budget Office (CBO), this latest Bill is projected reduce the deficit by more than $300 billion through 2031. Sounds pretty good, right? When you’re dealing in the world of estimates, forecasts, and pontifications, (a.k.a. politics) it’s hard to pull everything back down to reality. Nonetheless, lets dive into the details of the Inflation Reduction Act.

There is roughly $591 billion in “revenue-generating” measures that will offset $370 billion in various clean energy initiatives and $98 billion in health care spending. Like prior reconciliation bills, such as the Act that shall not be named in front of Senator Manchin—the Build Back Better Act—this legislation would reduce deficits via higher taxes and enhanced “IRS Tax Enforcement.” The Inflation Reduction Act, just like its predecessor, proposes $80 billion in new funding for the IRS; and according to the CBO, these additional resources would help the IRS generate an additional $204 billion in tax revenue over the next 10 years, resulting in a net surplus of $124 billion.

[Note: this does not account for the fact that some of the new IRS funding will likely be utilized to help enforce the new tax rules in the Act, such as the 15% Corporate Alternative Minimum Tax (the biggest revenue line item at ~$258 billion). But, as highlighted later, the IRS’ success rate at auditing large business is quite poor.]

Source: https://www.crfb.org/blogs/inflation-reduction-act-would-reduce-tax-gap

CBO Estimates Regarding IRS-Related Funding in the Inflation Reduction Act

 
 

Devil in the Details: Closing the Tax Gap by $[insert wild estimate here]

The additional $204 billion in tax revenue would come from closing what is known as the “tax gap,” or the difference between taxes paid and taxes legally owed.

According to the IRS, the tax gap has ranged between 15-18% of total taxes owed over the past 30 years. The most recent IRS data on the issue was released in 2019 and covered tax filings from 2011–13; in that report, the IRS calculated an annual gross tax gap of $441 billion (~16% of total tax liability), and a net gap of $381 billion when factoring in the $60 billion later received through voluntary late payments and additional enforcement.[i]

Just for comparison’s sake, the U.S. Treasury Department had estimated that Build Back Better (BBB) would close the tax gap by a net $400 billion over 10 years…with the same proposed $80 billion outlay to the IRS! Per U.S. Treasury estimates, with $80 billion in new funding, the IRS would be able to collect an additional $320 billion in taxes via enhanced enforcement and a further $160 billion via increased voluntary compliance, otherwise known as “tax deterrence.” Tax deterrence is a theory that states individuals and businesses are more likely to fully disclose information on tax returns when there is a heightened risk of audit, enforcement, and penalties. Digging deeper into the fine print, the IRS actually believed it could generate an additional $320 billion on tax deterrence alone. However, the Treasury Department ultimately landed on $160 billion because, in reality, it’s impossible to estimate:[ii]

“The deterrent effect associated with different types of [IRS] enforcement activities varies, and these effects can be challenging to identify.”
— DEPARTMENT OF THE TREASURY OFFICE OF TAX POLICY

As the Treasury Department acknowledged, research on tax deterrence varies significantly; some studies are more optimistic than the IRS’ estimates, while other research actually suggests more audits lowers compliance.[iii]  

Opportunity Lost: The Cost of Tax Compliance

Speaking of compliance, it’s important to address the opportunity cost borne by taxpayers for complying with the IRS—a figure that’s not factored into the economic impact estimates of the Inflation Reduction Act.

In 2016, based on data from the Office of Information and Regulatory Affairs (OIRA), it was estimated that Americans spent more than 8.9 billion hours complying with IRS tax filing requirements. The non-partisan Tax Foundation translated that into a cost of $409 billion each year in lost productivity.[iv] While the amount of time spent complying with the IRS has declined over the years (to an estimated 6.081 billion hours in 2020), the cost remains enormous; based on average hourly compensation per worker, the opportunity cost of filing taxes in the U.S. was more than $220 billion in 2020.[v] I think you’d be hard-pressed to argue this number will drop as a reinvigorated IRS steps up its enforcement efforts.

Source: https://www.ntu.org/foundation/detail/tax-complexity-2021-compliance-burdens-ease-for-third-year-since-tax-reform

Mind the Tax Gap

Unsurprisingly, Treasury Secretary Janet Yellen did not bring up the tax gap when endorsing the current legislation like she did when touting Build Back Better:

In fairness to the CBO, their estimates between the two bills are consistent with respect to closing the tax gap (the CBO does not include an estimate on the deterrent effect). Further, “official” deficit reduction estimates, per Congress’ budget reconciliation rules, cannot include revenues generated from closing the tax gap…though that rarely stops politicians from using it to promote the Bill. Absent the $204 billion in tax-gap revenue, the Inflation Reduction Act would merely reduce our deficit by $90.5 billion over 10 years. Drop in the bucket when the deficit now runs in the trillion-dollar-plus range per year.

Still, is it within reason to expect the IRS to collect an additional $200+ billion through enhanced enforcement over the next 10 years? Sadly, the IRS does not have a great track record when it comes to screening for potential tax evasion. Per the Treasury Inspector General for Tax Administration, 55% of large businesses that were systematically flagged by the IRS between 2015-2018 ended up owing no additional taxes.[vi]

Are you more likely to be Audited?

Of course the question taxpayers everywhere now have is how much likely are they to be audited? Chances are low and have been declining for years, particularly for individuals relative to corporations (see latest annual IRS audit numbers here), but it’s fair to assume that the declining audit rates will reverse. Predictions on whom will get caught in the IRS crosshairs appear heavily biased based on political leanings, so take those with a grain of salt.

One can only hope that $80 billion in new funding will help fix the IRS’ inefficiencies and no honest taxpayers get caught in their crosshairs. Past performance is no guarantee of future results but, for taxpayers everywhere, at least they can be forewarned so to be forearmed.

Best Regards,

Adam J. Packer, CFA®, CAIA®

Chief Investment Officer | SineCera Capital

 
Disclaimer: The information provided is for educational purposes only. The views expressed here are those of the author and may not represent the views of SineCera Capital. Neither SineCera Capital nor the author makes any warranty or representation as to the accuracy, completeness or reliability of this information. Please be advised that this content may contain errors, is subject to revision at all times, and should not be relied upon for any purpose. Under no circumstances shall SineCera Capital be liable to you or anyone else for damage stemming from the use or misuse of this information.SineCera Capital, LLC (“SineCera”) is a registered investment advisor. Advisory services are only offered to clients or prospective clients where SineCera and its representatives are properly licensed or exempt from licensure. The information provided is for educational and informational purposes only and does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor's particular investment objectives, strategies, tax status or investment horizon. You should consult your attorney or tax advisor.
Family Wealth, TaxesAdam J. Packer, CFA®, CAIA®SineCera CapitalEstate Planning, Taxes, Build Back Better, Government