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TAX GAP: WHICH WAY?

April 07, 2005

The IRS came out with some figures last week to illustrate the size of the "tax gap," or the difference between what taxes should be paid under the laws and what is paid. The IRS says more should be paid than is.

TaxGuru.net says that the figure is overblown. He says that taxpayers he sees tend to overpay, before they come to him. I don't doubt that, as he's a smart and able guy, but he isn't getting a representative sample. The people he sees care whether they pay the right tax. The ones that don't care - the restaurant owner who doesn't ring up his cash sales, the e-bay seller who doesn't report his earnings, the multi-level marketer who deducts his personal expenses on Schedule C - these folks don't visit CPAs, or if they do, they don't mention their off-the-books income.

The IRS measured the "gap" based on it's "National Research Project," aka "Audits from Hell." The TaxGuru doubts the numbers, calling them "just the standard IRS tactic for tax season." The numbers don't seem out of line, though, because the existence of a tax gap is probably what you would expect from a population of rational economic actors.

James Surowiecki, author of "The Wisdom of Crowds," says the best evidence shows that some people will always try to comply with the tax laws, and some people will always try to cheat. The largest group is in the middle - people who will comply if it isn't unreasonably difficult, and if they don't think they are being chumps to do so. The existence of a significant hard core of non-compliers probably makes a tax gap in some amount almost inevitable, even without assuming "the premise that everyone is a tax cheat."

Professor Maule's take has a lot of wisdom:

Thus, I think that noncompliance increases in direct correlation to the extent taxpayers perceive the tax law as unfair. The more disporportionate a tax law's complexity is to the complexity of the context in which the law applies, the more unfairness will be perceived by more taxpayers.

If the tax law gets to be too hard to comply with, people at some point just throw up their hands. The tax law sure hasn't been getting simpler, so more folks drift to the dark side of the tax law. The IRS gets overwhelmed as the rules get too hard for most IRS agents to figure out. While reducing the gap to some extent depends on increasing IRS enforcement, more agents can only do so much. Easier compliance is worth a lot more than a few extra IRS agents.

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