The U.S. tax gap, representing the difference between taxes owed and those paid on time, has surged to an alarming $688 billion for the tax year 2021. This figure marks a significant leap from previous estimates, reflecting an increase of over $192 billion from the 2014-2016 period and a rise of $138 billion from the revised projections for 2017-2019. The Internal Revenue Service (IRS) has now shifted to providing tax gap projections annually, with 2021 being the inaugural year for such single-year estimates.
The tax gap's expansion underscores the urgency of bolstering IRS compliance measures in critical areas. IRS Commissioner Danny Werfel emphasized the significance of the Inflation Reduction Act funding, which will bolster focus and resources on areas of compliance concern. These areas include high-income individuals, partnerships, and corporations. Werfel stated, "These steps are urgent in many ways, including adding more fairness to the tax system, protecting those who pay their taxes, and working to combat the tax gap."
The $688 billion gross tax gap can be broken down into three primary components:
- Nonfiling: Taxes not paid on time by those who fail to file on time. This amounted to $77 billion in 2021, a substantial increase from the $41 billion recorded between 2017 and 2019.
- Underreporting: Taxes understated on timely filed returns, which reached $542 billion in 2021, up from $445 billion during 2017-2019.
- Underpayment: Taxes reported on time but not paid punctually. This component stood at $68 billion in 2021, a slight increase from the $64 billion observed between 2017 and 2019.
Late payments and IRS enforcement efforts are projected to recoup an additional $63 billion for the 2021 tax year. This would result in a net tax gap of $625 billion. The IRS highlighted that the tax gap estimates and projections might not capture all noncompliance types. The projections are primarily based on compliance behavior estimated from audits completed for the 2014-2016 tax years.
The voluntary compliance rate has remained relatively consistent, with the 2020 and 2021 tax gap projections translating to approximately 85% of taxes being paid voluntarily and punctually. After accounting for IRS compliance efforts, the projected share of taxes eventually paid is 86.3% for 2021, a slight dip from the 87.0% recorded between 2014 and 2016.
The IRS is leveraging resources from the Inflation Reduction Act to enhance voluntary compliance. This will be achieved by improving taxpayer services and introducing new technological tools, complemented by additional compliance work. In 2022, the IRS collected over $4.9 trillion in taxes, penalties, interest, and user fees.
Historically, tax gap studies have consistently shown that third-party income reporting significantly boosts voluntary compliance. This compliance is further enhanced when income payments are also subject to withholding. The IRS has also initiated various taxpayer service programs to support accurate tax filing and address the tax gap.
The U.S. tax system's voluntary compliance rate is crucial for the nation. A mere one-percentage-point increase in voluntary compliance would result in an additional $46 billion in tax receipts.
The tax gap estimates offer insights into the historical scale of tax compliance and the persistent sources of low compliance. However, given the tax system's complexity and available data, the projections might not fully represent potential non-compliance, especially in areas like offshore activities, digital assets, and pandemic credits.
