Podcast - Tax & Tequila Talks: The Tax Gap
In this episode of our Public Policy & Regulation Group's "The Eyes on Washington Podcast" series, tax attorneys Nicole Elliott, Josh Odintz and Chris Armstrong discuss the tax gap. They explain what the tax gap is, how it came to be and its present day implications. Our hosts also touch on the ProPublica leak and how it might impact the ability of the IRS to shrink the tax gap.
Nicole Elliott: Hi, everyone, welcome to your monthly shot of Tax & Tequila, where we aim to bring you entertaining tax tidbits with a wedge of random information about tequila on the side. My name is Nicole Elliott and I'm joined by my colleagues Josh Odintz and Chris Armstrong. Today, we're going to talk to you about the tax gap. What is it? Why you should care and what we can do about it.
Josh Odintz: Nicole, thank you. Before we jump in, I'd like to share a cocktail fact. So we're switching from tequila to a cocktail. As we get into summer, one of my favorite cocktails to sip is a Manhattan. It's a fairly basic cocktail of bourbon or rye. I prefer rye, sweet vermouth and bitters. It sounds very simple, right? Well, what's not simple is the history of the cocktail. So there's a really funny tale or interesting tale, that is, it was invented by a bartender at the Manhattan Club in New York in the 1880s for Winston Churchill's mother, Lady Randolph Churchill. It's likely false though, because at the time that she allegedly ordered the cocktail, she was in London and pregnant. So it was definitely impossible for her to be there at the time. Another possible origin is that in the 1880s. A man named Black created it at a bar on Houston Street, ten doors down from Broadway. But either way, the truth is lost to history. But the Manhattan emerges in literature and newspapers in the 1880s, so we know it's at least as old as the 1880s.
Chris Armstrong: When does our podcast about the long history of alcohol and taxes, because it's a long absolutely, absolutely interesting history. I just want to raise, that's its own podcast one day. I think we really ought to do.
What is the Tax Gap?
Nicole Elliott: Yes. There is a large history with taxes, with tequila, with Manhattans. And I think we're going to touch on that a little bit later with respect to the tax gap. But let's first talk about a little bit what the tax gap is. Believe it or not, taxpayers don't always pay their taxes. And the delta of that amount is called the tax gap. That is, it's the amount that is owed when taxpayers do one of three things. First, they neglect to file their income, their tax returns, and that is the non filing taxpayers. The second category that is makes up the tax gap is those that file a return to report a tax due but underestimate the tax that they actually owe under federal law. That is, these are the underreporting taxpayers. And the third category is those who file a tax return to report a tax due and do so accurately, but fail to send in a check. And these guys are called the underpaying taxpayers. And interestingly, if you look at the numbers, the biggest portion of the tax gap is made up of those tax payers, the individual taxpayers, I should say, who follow in the second category. That is, they file a return to report a tax due, but underestimate the actual amount that they need to pay under federal tax law. The tax gap and the fact that there is one represents an enormous amount of money. And it was put into the spotlight recently when IRS commissioner, during a hearing before Congress, provided his opinion that this tax gap, this delta, was somewhere in the range of one trillion dollars. This was news, of course, because the last time the IRS estimated the amount of the tax gap, it was around a third or a half of this amount. Well, we are not exactly sure what the final number is, the fact that the tax gap is approaching even anywhere near this one trillion dollar mark caught the attention, as you can imagine, of many. One trillion dollars can buy you a lot of tequila.
A Brief History of the Tax Gap
Josh Odintz: Yes it can Nicole. Well very much like the Manhattan, there's a lot of history underlying the tax gap. This is not our first go around with the tax gap. If you rewind the clock to 2004 the tax gap caught fire, you might say. The Senate Finance Committee, then chaired by Senator Grassley and then ranking member Max Baucus, requested the Joint Committee on Taxation to study the tax gap and prepare options. And then in 2006, ranking member Baucus put a hold on Treasury nominee Eric Solomon, who was universally loved but put a hold on him until Treasury delivered its tax gap plan. So if you look at the JCT options which are available on the JCT website, you will see an emphasis on reporting. So JCT proposed basis reporting on securities, reporting on mortgage interest payments, which are mortgage interest amounts that taxpayers paid and would later claim as deductions, and then also reporting on offshore bank accounts. So FATCA has its genesis in both the JCT report and also investigations of the Permanent Subcommittee on Investigations. Besides reporting, there is also an emphasis on substantive provisions where JCT thought taxpayers might have been using provisions that it didn't like and one area where JCT recommended some tightening of the law is in 163J. And ultimately it took more than a decade, but eventually changes were made to 163J to make it tighter. When I was at Senate Finance in 2007, in 2009, I unfortunately spent every single Friday with a team of my counterparts, Republican staff, finance, Democrats, JCT and Treasury staff. And we spent every Friday coming up with tax gap proposals to close the tax gap. It's a tremendous amount of work. It was, in some respects, torture on a Friday afternoon. But a lot of those provisions eventually became law. We took what JCT gave us, refined them, and they ended up becoming law. So, Chris, nothing's new, but I think we do have some new starters in the Green Book. Did you want to talk about what we're seeing as part of the fiscal year 2022 green book?
The Tax Gap and The FY 2022 Green Book
Chris Armstrong: Sure, yeah. It's interesting. The Green Book includes a kind of it's essentially two buckets, right. Compliance and also administration. So in compliance, it includes about $6.7 billion purely on program and efforts. It includes I think it's about to be $3 billion on just kind of an IRS funding at large. The most interesting thing under compliance is there's a broad proposal to increase information reporting from banks to the IRS and as it's in the Green Book, any account that has a gross flow threshold, I believe over $600. And so that's a huge expansion. And I think that the recent events, as we'll talk about next will be a challenge on that. But the Green Book estimates that that proposal alone would raise $463 billion over 10 years. On tax administration, it has, of course, kind of oversight paid preparers, which has long been an IRS goal, was the issue of the Loving case back in 2009 includes other aspects, like increasing the statute of limitations on listed transactions from its current range of three years to six years. Look, this is always an issue that Congress looks at as well, I mean this is easy money and it's not easy money, right? If it was easy, we'd already have it right? I mean, I was always doing kind of oversight and investigations on stuff like tax matters under the ways and means and under Chairman Hatch and Grassley as well over on finance. And the hard part about the tax gap is that a lot of this is is this income at the individual level? And that's hard to do oversight of. And this is outside of the tax gap you know, illegal income or simple kind of tax avoidance that's not really against the law. So those are kind of two different issues that are often talked about as if it's one issue.
Josh Odintz: You know, Chris, it's really important also to note that a lot of the proposals for the tax gap, as you pointed out, are focused on reporting and that will disproportionately fall on businesses. And it's very costly to implement new systems for reporting. In some cases, the data may not exist. So not everyone collects tens for every single transaction, for example. And so it will require programmers to understand what needs to be collected, create the systems, implement the systems, but also talk with the customers and collect that information. Because the first time a customer logs on or interacts and sees, wait a second, I've got to provide my Social Security number, why would I want to do that? So it's very much a you know, there needs to be significant transition. Businesses need to have the opportunity to make the programming changes. So once again, a lot of the tax gap compliance side will fall on business to help the IRS close the gap.
Chris Armstrong: Exactly right.
The ProPublica Leak: Potential Implications on IRS Resources
Josh Odintz: Maybe it would be helpful to turn to an unrelated issue that does relate to how the IRS will be able to address the tax gap. So recently, ProPublica wrote an article. It received taxpayer information. We think it's taxpayer confidential information, but we don't know the source, but possibly came from the IRS. And ProPublica wrote a story describing how certain high net worth individuals have low effective tax rates. I don't think there's anything illegal that's been described in these articles. It is tax planning, how wealthy individuals are taxed, if they have significant securities and do not trigger gains, they're not paying tax until they have a realization of that. But I think the more interesting piece is how ProPublica received the information and if it did receive the information from an IRS leak or somewhere else in the government that could have consequences for IRS funding and resources, which the IRS will need to address the tax gap. If you think about the volume of information reporting, the IRS needs systems to process the information. It may need artificial intelligence to provide analytics to see if there's an audit risk for certain individuals or entities, and then it will need a workforce to go out and enforce. So, Chris, what are your thoughts about the ProPublica leak?
Chris Armstrong: Sure. So it's interesting. Look at the outset, we have no idea the source of this tax info. If it came in an outside breach of the IRS, that's obviously a huge issue. And it's an issue Congress will take a lot of interest in. If it came inside the IRS, it's even a bigger issue. At a time when a huge push towards tax compliance is information reporting. It could not have come at a worse time for the IRS. I mean, this will be, you know, every time I encountered either an alleged leak or an alleged attack, outside attack, on the IRS, in my time on the Hill, it resulted in at times a month long, in times a year’s long investigation on our end as well and others. And I have to imagine that happens here as well.
Closing the Tax Gap
Nicole Elliott: I think part of closing the tax gap is, in my opinion, about giving the IRS more resources. The IRS has been historically underfunded with their IT to staff across the board, and increasingly they are required to do and enforce complex laws. Even with the COVID response, for example, we saw a requirement that the IRS had to send folks economic stimulus checks and now with the advanceable child tax credit, the idea that the IRS is really going to almost transform into a social welfare agency and will have to send out checks to those eligible on a regular basis is a really significant lift. And I felt that before the ProPublica story ran, there was some bipartisan growing support to fund the IRS at a higher level. And I think you're right Chris, unfortunately, this cloud of where did this information come from? Is it the IRS? Are we giving the IRS too much power if we give them more money will stymie that momentum, I fear, to better fund that agency.
I think part of closing the tax gap is, in my opinion, about giving the IRS more resources. The IRS has been historically underfunded with their IT to staff across the board, and increasingly they are required to do and enforce complex laws.
Chris Armstrong: Right. I think that's a really, really important point. Too often, Congress looks at the IRS as a magic wand. It can do anything and it can't. It doesn't have enough money. It has a hard time because it has a lot of IT needs and it only has uncertain annual budgets. And so it's hard to undertake large scale IT projects in that way. And that's always been a challenge at the IRS.
Josh Odintz: But just following up on that point, the IRS, not only do they have to do more in times of crisis, whether it's stimulus checks, which we did 2008, 2009, or healthcare reform, which was a very significant tax reform bill. A lot of the ACA does run through the code and required a lot of implementation, as Nicole knows. But then also we had TCJA in 2017. We've changed how partnerships are audited, in BBA. So we have a lot of seat changes and yet the headcount decreased by 20 percent as the IRS was asked to do more and let's face it, the world got a lot more complicated. So we are putting a lot of strain on the service and part of, I think, part of also fixing the tax gap in one area that probably doesn't receive as much attention other than from Treasury Inspector General or the taxpayer advocate, is taxpayer service and how the individuals interact with the IRS. We all have to interact with the IRS every year, at least once, some of us more often. And it would be helpful to have an interface system where it is easy to touch base with the IRS to see your transcript in real time, to have the resources to be able to place a call and ensure that someone will pick up very quickly, not in 45 minutes or three hours later. That all requires money. So once again, that's a different way of addressing the tax gap, is to engage taxpayers. That is more behavioral and the taxpayer advocate has written extensively about different ways to get people to proactively engage with the IRS.
A different way of addressing the tax gap, is to engage taxpayers. That is more behavioral and the taxpayer advocate has written extensively about different ways to get people to proactively engage with the IRS.
Chris Armstrong: The IRS is a hard place here because a lot of the actions that it would take to actually shrink the gap would be challenging politics. Right? There's a lot of cash heavy, for example, restaurant, other smaller businesses are a part of this issue. And that's hard to tackle if you're the IRS.
Josh Odintz: No, I agree and while people back in the 1990s, we had the rock hearings where there's a focus on IRS bad behavior, and a lot of that turned out to be just politics and not actually accurate. But I'll just point out, our IRS is nothing compared to tax authorities in other jurisdictions where an audit begins with a raid and machine guns drawn, seizing of servers, those of you do business in some European jurisdictions are probably aware of what an Italian raid is like. And so that is, that's correct. The IRS, it needs to be able to audit more. It needs those resources. And that's why I think this ProPublica leak could negatively impact the IRS's ability to get more funding.
The IRS, it needs to be able to audit more. It needs those resources. And that's why I think this ProPublica leak could negatively impact the IRS's ability to get more funding.
Chris Armstrong: Yeah, I just want to add as well, because, look, I spent about 12 years doing oversight of the IRS and there were a lot of those. But the takeaway I had after all of that time was easy 99 times out of 100 or more, it's hard working, amazing people working hard. I walked away with a completely positive impression of the actual IRS workers. They're underfunded. They are given extremely, extremely complex laws and often extremely short time frames. And that's a challenge that it's not only the IRS for that.
Nicole Elliott: Well, I think we're at the end of our time together. I hope we have peaked your interest in tax and in this really important issue of the tax gap. Stay tuned for our next episode where we will take seemingly mundane issues of tax and try our best to entertain and educate you.
Josh Odintz: Stay tuned and stay tax compliant and please drink sensibly.