House Tax Gap Briefing on March 2, 2007

March 2, 2007

Good morning, my name is Bob Kerr and I am the Senior Director of Government Relations at the National Association of Enrolled Agents (NAEA), which represents enrolled agents--the 46,000 tax practitioners who are licensed by the Treasury Department to represent taxpayers before all administrative levels of the IRS. NAEA is committed to increasing the professionalism of our industry, improving the integrity of the nation’s tax administration system, and protecting the representation rights of taxpayers. While CPAs and attorneys are also licensed to practice before IRS, enrolled agents are the only practitioners for whom IRS directly attests their competency and ethical behavior.

Throughout my career, I have observed tax administration from a variety of vantage points: from within the IRS function charged with measuring the tax gap, from one of the tax writing committees here on the Hill; and as an advocate for tax practitioners and taxpayers.

I’ve heard it said that 2007 is the year of the tax gap. The term ‘tax gap’ seems rather vogue and somewhat highbrow. At the same time, the concept is not new; it is a quite straightforward measure of overall tax compliance. Any compliance rate of less than 100% results in what could be termed a ‘tax gap.’ The tax gap is a measure of the “leaks” we have in our tax system.

IRS considers the tax gap to have three different parts (see table 1 provided):

  1. filing compliance—did the taxpayer file her return
  2. payment compliance—did the taxpayer submit full payment with her return
  3. reporting compliance—did the taxpayer accurately report her income and expenses

When considering the tax gap, particularly in your positions here on the Hill, I believe it essential to consider two concepts. The first is that the lion’s share of the tax gap comes from misreporting. Now the noteworthy thing about reporting compliance is that the more information reporting and withholding is required, the greater a taxpayer’s reporting compliance (see table 2 provided). This stands to reason, because when income is subject to information reporting, IRS will have been informed that the taxpayer has received the income in question.

The second concept that I believe is critical to any discussion of the tax gap is intent, by which we distinguish the confused from the corrupt. Simply put, did the taxpayer know, or should she have known, her return was inaccurate?

Many of those who misreport their incomes do so in spite of their best intentions. I can imagine your offices getting a barrage of calls from constituents terrified of IRS and wanting to know, for instance, whether the $1,800 they earned from working part-time for a painter is subject to self-employment tax.

On the other hand, there are those who knowingly cheat on their taxes and have no intent of reporting their obligations accurately. It is certainly not too far a stretch to imagine a closely-held company whose high-salary principals insist on dipping into petty cash for clearly non-business expenses (say, a Christmas bonus for their co-op doorman or personal mortgage payments).

While intending to cheat is in my opinion far more egregious than accidentally misreporting, both nevertheless contribute to the tax gap. I believe that addressing the tax gap requires considering different treatment for those who are intentionally bilking the government and those who are simply bewildered.

I would like to discuss three tax gap proposals that seem to have some legs recently, each of which NAEA generally supports, and each of which will increase reporting accuracy.

  • Basis Reporting for Publicly-Traded Securities would likely result in more accurate reporting of capital gains income and/or loss. For a variety of reasons, many EA clients struggle when asked to provide cost bases for securities they sold. In most cases, brokerage firms are well-placed to provide this information.
  • Reporting for Real Estate Taxes would lead to more accurate deducted amounts. Many taxpayers do not differentiate between taxes and assessments when calculating their deduction. Further, this proposal would provide for IRS document matching. .
  • Reporting Auction Sales Proceeds would increase compliance among a fast-growing group of taxpayers (or people who should be taxpayers). A 2005 Nielsen study found that 724,000 eBay sellers rely on eBay sales as their primary or secondary source of income – an increase of 68 percent over two years. Another 1.5 million individuals supplement their income with eBay sales. In 2005, eBay users sold $44.3 billion of merchandise, none of which was directly reported to the IRS on behalf of the individual sellers. (N.B. I use eBay for illustrative purposes only as the firm provides a high profile example of the extent to which online auction commerce has increased in recent years.)

Each of these proposals increases reporting, which has been demonstrated to be effective in helping to close the tax gap. None of them are perfect. For instance, the basis reporting would create administrative challenges for brokerage firms and need to be prospective, and therefore of limited utility in early years. The sale of a residence during a tax year may cause both inaccurate reporting and difficulty for IRS document matching programs.

As policymakers, I suggest to you that the amount of additional burden on taxpayers will vary among whatever proposals you are considering -- but not necessarily in proportion to the amount of revenues likely to be recovered. NAEA believes it is important to balance taxpayer burden with proportionate gains in compliance. Perhaps this could be achieved by including burden estimates and revenue scores along with descriptions of the proposals.

I would like to close with a handful of personal observations:

  1. The tax gap will NEVER be zero.
  2. Policymakers need to make it easier for those who want to comply to do so and more difficult for those who do not want to comply to get away with it.
  3. For taxpayers who want to comply, education, assistance, and simplification should help tremendously and without a lot of pain.
  4. For the intentional tax cheats, we’ve got to change the audit roulette odds: the threat of a visit from a competent, well-trained and well-resourced revenue agent must be credible.
  5. IRS needs the resources to meet its dual goals of providing customer service and enforcing the tax code.
  6. Over 50% of returns are completed by paid preparers. While you need a license to perform a manicure or to cut hair, you do not need one to prepare a tax return. Regulation of paid preparers will help protect taxpayers from both the incompetent and the corrupt.
  7. The tax code is horribly complex and in need of real simplification.
  8. Simplification requires more than a single flat rate; it also requires eliminating a myriad of complex, narrowly-focused exemptions and deductions as well as confusing and counterintuitive phaseouts (PEP, Pease, Roth IRA, child care credits, lifetime learning credits and so on).

Thank you for your attention. I look forward to answering any questions you may have.