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Opinion: The "tax gap". Bureaucrats favourite weapon against taxpayers.

November 10, 2017

 

In the article below I explain:

  • What the tax gap is, and why it is important for bureaucrats

  • How the tax gap is calculated in the US

  • Why the math doesn't add up for the tax gap estimate in the US

  • Why Canada should not waste its tax dollars on computing the tax gap

Summary

The tax gap is a dollar amount governments use to determine how much tax revenue is lost to tax cheats in a particular year. In the US, the National Research Program (NRP) is used to provide much of the statistical data used in computing the tax gap amount . 

 

The IRS NRP audits taxpayers (who would have otherwise not been selected for audit), and audits every line of their tax return.  The auditor will adjust each line even if it is only a penny off of what the taxpayer reported. The selection of these returns is subject to bias, and undermines the spirit of a true statistical sample. I call NRP audits the "audit from hell".

 

The IRS extrapolates the NRP audit data and creates the "tax gap" from the differences in the audited returns against what the taxpayer reported. The IRS admits the data used is not exact and subject to error, to the point that they are even unable to calculate "standard errors, confidence intervals, and statistical comparisons across years" (see citation below in article).  

 

Many media organizations also lump in legal tax avoidance with illegal tax evasion when reporting on the tax gap. The tax gap only calculates lost revenue due to illegal tax evasion. Lumping in tax avoidance with tax evasion places all taxpayers who want to reduce their tax bill in a bad light. 

 

Calculating the tax gap is nearly impossible accurately compute, and wastes taxpayer dollars. It also puts affluent and smart tax payers in a bad light. 

 

So the next time someone uses the tax gap as a basis for their argument, be wary of their logic. 

 

Article

 

While I was commuting into work this morning, I came across an interesting article written by Terrence Corcoran of the Financial Post titled "How big is Canada's tax gap and who's not paying their fair share? You'd be surprised" (Link here). My article compliments Terrence's article, and I recommend reading his article as well.  

 

The "tax gap" is commonly used by governments such as:

...to estimate how much tax they are losing each year through people illegally reducing their tax  obligations.

 

So, if the tax gap is $400 billion dollars, then the logic is that the government is losing $400 billion dollars each year to tax cheats. If everyone paid the amount of tax they were legally obligated to pay- the tax gap would be zero, as everyone would be paying their legal share of tax. 

 

This "tax gap" is an easy sell to congress or parliament on why the taxing authority needs more money to continue to funnel billions of dollars to their respective tax agencies.

 

For example, Nina Olson, IRS National Taxpayer Advocate reported to congress in 2013:

"the IRS’s limited resources to conduct outreach and education to taxpayers (particularly small businesses) and to enforce the laws also contribute to its inability to close the annual tax gap."Source: National Taxpayer Advocate 2013 report to congress.

https://www.irs.gov/newsroom/national-taxpayer-advocate-delivers-2012-annual-report-to-congress

 

The sell is simple: The government loses hundreds of billions of dollars each year to tax cheats- give the IRS/CRA/HMRC/Etc. more money to audit more people and we will reduce the tax gap- giving you more money to give to your constituents.

 

More audits=more compliant taxpayers.

More compliant taxpayers=less tax gap.

Less tax gap=more funding to constituents.

 

When I was a newly minted IRS Revenue Agent, the "tax gap" was heralded as a significant reason we were all needed as auditors. It was often said "tax cheats are stealing billions of dollars every year from all of us, and it is our responsibility to close in the tax gap, to that all taxpayers pay their fair share". It was a good sell to us auditors. 

 

I do not doubt that a tax gap exists. I just disagree that it is an amount that can be estimated, and worry about the assumptions it can create.

 

How does the government figure out what this "tax gap" number is? 

 

In the US, a key component of determining the tax gap comes from the IRS' National Research Program (NRP). This expensive program "randomly" selects taxpayers to undergo the audit from hell. 

 

Aren't all IRS audits hell? 

 

Yes, and no. They are- but compared to an NRP audit, a regular field audit is a walk in the park. If you are unlucky enough to be selected for a "normal" audit, the agent will have a list of issues they are obligated to look at. This means that the auditor will typically only look at the large, unusual, or questionable items on the return, and leave you alone for the other items on your return. 

 

An NRP audit is worse as they will audit everything on the return. If there is an error of even a penny, they will adjust. The IRS does this to generate data from the audited return to represent a typical taxpayer within a particular tax demographic. They then extrapolate the differences in the return, and assume that each taxpayer within that tax demographic would have had the same errors on their return. 

 

Sound logic, eh? I don't think so either. The logic gets even weaker below. 

 

The IRS uses computers to randomly select taxpayers to be selected for an NRP audit. Once the return is selected, it gets sent to a classifier (typically an auditor on assignment) to see if it should continue onto audit, or go back. The IRS says (in IRM Section 4.22.3.1.2 (point 2)) that "Quality and consistency of classification will be stressed" when a classifier is looking at the return. On the facethat seems ok, but deeper down it places humans with bias (either known, or unknown) into the mix, seriously undermining the statistical validity of the sample. 

 

See below for an image the IRS uses in the Internal Revenue Manual explaining the process:

 Source: IRM section 4.22

 

The classifiers are also required to send returns to audit based on certain criteria. For example, if you filled your return as head of household, it would get pushed to an auditor (IRM 4.22.3.2.2.4). Placing restrictions on the selection of the sample data makes the data biased- throwing out the logic of a true unbiased statistical sample, which is what the tax gap data is based on. 

 

The IRS even admits this data is bad! In an explanation, the IRS states:

 

"Each approach is subject to nonsampling error; the component estimates that are based on samples are further subject to sampling error. The uncertainty of the estimates is not readily captured by standard errors that typically accompany estimates based on sample data. For that reason, standard errors, confidence intervals, and statistical comparisons across years are not reported" 

Source: IRS Tax Gap Estimates https://www.irs.gov/pub/newsroom/tax%20gap%20estimates%20for%202008%20through%202010.pdf

 

So the IRS is using bad processes to create wild estimates, and putting innocent taxpayers through hell in the process.

 

Some media organizations take the tax gap data and erroneously state that the tax gap represents the amount taxpayers legally avoid, and paint sophisticated and affluent taxpayers in a bad light. One example is from the Toronto Star, "In the wake of the Panama Papers revelations, calls have proliferated for the government to measure just how much tax is being lost to tax evasion and avoidance"

https://www.thestar.com/news/world/2016/07/01/cra-releases-first-tax-gap-estimate.html

 

The tax gap covers revenue lost to illegal tax evasion, not legal tax avoidance

 

Most of us employ tax avoidance strategies every day, such as using chartable donations, medical expenses, or higher education costs to reduce the amount of tax we have to pay. Doing this makes us smart taxpayers, not criminals. 

 

Another issue which comes with the "tax gap" is that it can do the exact opposite thing that it was intended to do. Tax cheats could use the amount of the tax gap as confidence that the IRS may not ever catch them, as there are so many other taxpayers who are getting away with it. 

 

Tax gap research is a waste of money creating useless data. It also further demonizes wealthy taxpayers who pay the majority of income taxes already.

 

Want to be protected in case of an IRS audit? We offer free IRS audit defence (subject to limitations and restrictions) on all individual US tax returns we prepare. We also offer IRS audit defence services to firms who prepare US tax returns for individuals living abroad. 

 

Questions? feel free to contact us

 

www.ustaxresources.ca

 

About the author: Ian Davis is currently Canada’s only former IRS auditor; and Founder and President of US Tax Resources Inc. A Canadian firm whose mission is to provide stress relief from US tax through simple and affordable tax preparation and advisory services.

 

Ian is a dual US/Canadian citizen living with his family in Canada.

 

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