The Tax Gap's Many Shades of Gray

37 Pages Posted: 19 Oct 2021 Last revised: 24 Nov 2021

See all articles by Daniel J. Hemel

Daniel J. Hemel

New York University School of Law

Janet Holtzblatt

Tax Policy Center

Steve Rosenthal

Urban-Brookings Tax Policy Center

Date Written: September 30, 2021

Abstract

The “tax gap”—the difference between the amount of “true tax” and the amount of tax actually paid—has garnered widespread attention in recent months. Much of the commentary on the subject equates the tax gap with “tax evasion,” a term broadly understood to connote intentional (and potentially criminal) underreporting. This paper cautions against conflating the tax gap with tax evasion. The tax gap includes substantial gray areas where the law is ambiguous and the IRS’s determination of “true tax” is debatable. On top of that, the IRS’s methodology for measuring the tax gap includes upward adjustments that are recommended by front-line examiners but reversed on administrative appeal or judicial review. Moreover, a substantial portion of the estimated tax gap is derived from a statistical technique called “detection controlled estimation” that potentially magnifies the impact of later-reversed recommendations on the ultimate tax gap measure. Weighing in the opposite direction, the IRS’s approach to measuring the tax gap excludes some amounts that clearly constitute tax evasion (most significantly, underreporting of tax on illegal-source income).

Understanding the tax gap’s shades of gray can inform discussions of tax law and policy. We explain how proposals to use the tax gap as a performance target may produce perverse incentives for the IRS. We further explain how additional IRS funding—though necessary to improve the agency’s ability to enforce the tax laws—may have counterintuitive effects on the estimates of the tax gap. We also illustrate—using examples from the taxation of passthrough entities—how legislative reforms can reduce the size and scope of legal gray areas that contribute to the tax gap. Our analysis highlights the importance of increased IRS funding levels and substantive tax law changes as complementary strategies for improving tax compliance.

Keywords: tax gap, tax evasion, tax compliance, tax administration

JEL Classification: K34, H26

Suggested Citation

Hemel, Daniel J. and Holtzblatt, Janet and Rosenthal, Steve, The Tax Gap's Many Shades of Gray (September 30, 2021). University of Chicago Coase-Sandor Institute for Law & Economics Research Paper No. 938, Available at SSRN: https://ssrn.com/abstract=3934044 or http://dx.doi.org/10.2139/ssrn.3934044

Daniel J. Hemel (Contact Author)

New York University School of Law ( email )

Janet Holtzblatt

Tax Policy Center ( email )

Urban Institute
2100 M Street NW
Washington, DC 20009
United States

Steve Rosenthal

Urban-Brookings Tax Policy Center ( email )

Urban Institute
2100 M Street NW
Washington, DC 20009
United States
202-261-5511 (Phone)

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