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What is the Tax Gap?

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Document date: October 22, 2007
Released online: October 22, 2007

The nonpartisan Urban Institute publishes studies, reports, and books on timely topics worthy of public consideration. The views expressed are those of the authors and should not be attributed to the Urban Institute, its trustees, or its funders.

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Abstract

In this paper Toder addresses issues related to measurement of the tax gap—the difference between tax liability under the current Federal tax law and taxes paid. He discusses how the tax gap is defined, reviews the main components of the tax gap, and describes how the IRS estimates it, as well as some of the major methodological issues in and weaknesses of current estimates. Toder concludes with some brief observations on the use and potential misuse of tax gap estimates and how compliance data might lead to better tax law administration.


Introduction

"The art of taxation consists in so plucking the goose as to obtain the largest possible amounts of feathers with the smallest possible amount of hissing."
Jean Baptiste Colbert (1619-1683), French Economist and Minister of Finance under King Louis XIV.

Judging only from his famous quotation on taxation, one can doubt whether Minister Colbert would have cared much about the tax gap. After all, in his view, the purpose of taxation was to extract as much money as possible from the citizenry to serve the sovereign with the least possible fuss and bother. That which could not be collected—at least not without a lot of "hissing" and other unpleasantness—was best left undisturbed.

Yet as citizens of a democracy we, or at least some of us, expect that the burden of financing the public services that we as citizens demand should be allocated in a fair way among the population. Tax experts differ on the details, but most believe tax liability should be allocated in some way based on people’s economic capacity or ability to pay tax. Fewer of us believe that the tax laws our elected representatives have enacted meet our standards of fairness, efficiency or simplicity, but even critics of our tax laws usually believe they merit obedience and respect as the product of representative government. Thus, we do care about taxes owed but not reported or paid, even if they are difficult to identify and collect and, if we are intellectually consistent, we should also care about taxes paid but not owed, even though overpaid taxes benefit the sovereign.

This paper addresses issues related to measurement of the tax gap—the difference between tax liability under the current Federal tax law and taxes paid. First, I discuss how the tax gap is defined, review the main components of the tax gap, and discuss how the IRS estimates it. I then review some major methodological issues in estimating the tax gap and some weaknesses of the current estimates. The United States leads the world in tax gap estimation (some might consider this a dubious honor), but estimating that which does not happen (taxes that theoretically should be paid, but are not) is inherently much more difficult than estimating observed quantities such as GDP, employment or revenues actually collected. So while tax gap estimates can certainly be improved, there will always be significant uncertainty attached to any tax gap estimate. The final section of the paper includes some brief observations on the use and potential misuse of tax gap estimates and how better compliance data might lead to better tax law administration.

(End of excerpt. The entire paper is available in PDF format.)



Topics/Tags: | Economy/Taxes


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