Repealing Tax Administration

The U.S. Federal Tax Gap: Size, Causes, and Debates About How to Reduce It

U.S. Internal Revenue Service (IRS) recently increased its estimate of the annual gross tax gap (Gross Tax Gap),^[1] that is, the amount of underpaid taxes, for the 2014-16 tax period to $496 billion. The estimate of the gap for 2017-19 is $540 billion per year.^[2]

The gross tax gap 2014–16 comprises three components:^[3]

• Nonfiling (tax not paid on time by those who do not file on time, $39 billion).
• Underreporting (tax understated on timely filed returns, $398 billion).
• Underpayment (tax that was reported on time, but not paid on time, $59 billion).

A common explanation for the growing U.S. tax gap appeals to underfunding of the IRS and a reduction in the number of employees.  

For example, according to Forbs over the past decade, the IRS’s budget has increased only 9% (from approximately $12.4 billion in the fiscal year ending September 30, 2011[4] to $13.7 billion in fiscal 2021).[5] Over the same period, the agency’s civil and criminal enforcement efforts have been negatively impacted by:

• The number of special agents who conduct criminal investigations dropped by 23% (from 2,618 in 2011 to 2,004 in 2021),
• The number of revenue agents who handle audits falling by 40% (from 13,969 to 8,321), and
• The number of revenue officers who process collection matters plummeted by 50% (from 5,621 to 2,783).

Moreover, the IRS’s budgetary woes have forced the agency to make do with antiquated technology and undermanned call centers that result in long wait times for taxpayers seeking guidance on their tax compliance.^[6]

As a result, the 117th U.S. Congress passed the Inflation Reduction Act (IRA; P.L. 117–169),^[7] which, among other things, is designed to close the federal tax gap. President Biden signed it into law on Aug. 16, 2022. Under the law, the IRS receives nearly $79 billion in mandatory funding for its core operations through the end of the fiscal year 2031:

• $45.6 billion for tax enforcement, including hiring more agents,
• $25.3 billion for operating expenses,
• $4,75 billion for the modernization of IRS business systems, and
• $3.2 billion to improve taxpayer services, including pre-filing assistance.

This represents the first time Congress has approved multiyear funding for the IRS, which is supposed to disclose a plan for using this money in February 2023.^[8]

The Republicans, who won a majority in the U.S. Congress in November 2022, sharply opposed the increase in funding, proposing an alternative approach.

Republican Proposal

Republicans propose a radical change in the concept of taxation, eliminating the income (profit) tax, self-employment taxes, payroll taxes, estate, and gift taxes, and replacing them with a national sales tax (consumption tax). The sales tax is much easier to administer because it is simply calculated and does not require filing tax returns by consumers of goods.

Instead of solving the problem with the existing tax gap, the proposal is aiming to eliminate its source—several difficult for administering taxes. Accordingly, it eliminates the need for additional IRS funding. To implement this initiative, Republicans have introduced two bills:

• The ‘‘Family and Small Business Taxpayer Protection Act’’ proposes to eliminate some of the funding provided to the IRS by the Inflation Reduction Act.^[9]
• The “FairTax Act of 2023” proposes “to promote freedom, fairness, and economic opportunity by repealing the income tax and other taxes [payroll taxes, estate, and gift taxes], abolishing the Internal Revenue Service, and enacting a national sales tax to be administered primarily by the States.[10]

Many sources and commentators refer to the Republican proposals as a repeal of the IRS. Putting aside the emotion that rages in the debate, we can highlight the following key aspects of this initiative.

Simplification of the Tax Code

Republicans are calling for a simplified tax code. Its complexity results in both higher costs to taxpayers and the IRS, and a larger tax gap. To close the tax gap, the IRS is asking for additional funding and making enforcement more and more complicated. The result is a closed loop.

To solve this problem, many think about simplifying reporting, pre-filling tax returns, or not filing returns at all. Republicans have gone much further. Repealing taxes that are difficult to administer eliminates the painful processes of filing returns, tax audits, and payment of deductions (refunds).

Replacement of Income Tax with Sales Tax

Can a sales tax (consumption tax) replace an income tax? In terms of the state income, most likely yes. An additional rate must be added to the state tax to provide revenue for the federal budget. By understanding the taxes collected by the states, the government can easily do the math.

Section 101 of the “FairTax Act of 2023” requires the sales tax at a rate of 23% of the gross payments for taxable property or services. “Gross payment” is the payment for taxable property or services plus federal taxes (Sec 2(a)(5)). Which works out to a regular sales tax rate of 29.87% (23 divided by 77).

The negative effect of the introduction of this tax will be an increase in the retail street prices of goods and services.

With sales taxes in 45 states ranging from 2.9% to 7.25%[11] — retail prices there could rise by up to 22 percent or more. In the remaining states, by 30 percent or higher. Therefore, some sellers will be tempted to sell for cash and not give receipts. This will give them a competitive advantage through lower prices. The same problem exists with the sale of any excise goods, where the excise tax is also a consumption tax.

Rising prices of goods and services will significantly increase inflation and may create political risks for the country’s leadership. Consumers see price tags in stores every day, but they file a tax return once a year. Moreover, in the case of the sales tax, they do not have to file it at all.

The corporate income tax deduction system motivates B2B buyers to demand proof documents from sellers to deduct expenses that reduce profits. This results in higher income tax for sellers as their income is verified through buyers’ returns. Doing away with this tax would require restoring the right to demand a fiscal check and increasing the value of the check to retail buyers. This would require developing and enforcing a deduction system for the consumption tax, which currently does not exist for the sales tax. The system should not require IRS resources to verify deductions and should be fully automated.

The income tax is often used to promote “social justice. Those who earn more can, in theory, pay more taxes, including on a progressive scale. At the same time, it’s easy to forget that the rich have the means to bring in expensive tax advisers. They are aware of the features of the tax code that allow them to pay less. Donald Trump’s tax returns are an example of this reality.^[12]

The consumption tax has a similar problem. Its introduction would lead to an increase in spending outside the country. Citizens will travel to Canada for everyday goods, just as residents of Sweden drive across the bridge to Denmark for alcohol. Or as residents of Switzerland travel to supermarkets in neighboring countries. It will become more profitable to fly around the world for real estate and luxury goods. In the end, the state will still have to figure out how to reduce the profitability of such actions. In addition, the consumption tax will reduce consumption itself, and increase savings and investments, which will also probably have to be taxed additionally.

In summary, on the one hand, the Republican idea is worthy of deep and detailed analysis. On the other hand, it is so radical that it essentially “explodes” the market for preparing and filing returns. “Repealing” the IRS under a Republican initiative may look sympathetic from a taxpayer’s perspective. But what initiative can cancel the $14 billion market[13] of software vendors and certified public accountants who help prepare and file U.S. tax returns?

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[1] We discuss the concept of the tax gap in detail in the article “The Tax Gap. Definition and Essentials”. Digital Tax Technologies. URL: https://taxtech.digital/2021/11/02/the-tax-gap-definition-and-essentials/  

[2] IRS updates tax gap estimates; new data points the way toward enhancing taxpayer service, compliance efforts. IR-2022-192, October 28, 2022. URL: https://www.irs.gov/newsroom/irs-updates-tax-gap-estimates-new-data-points-the-way-toward-enhancing-taxpayer-service-compliance-efforts

[3] Tax Gap Estimates for Tax Years 2014–2016. IRS Publication 5365 (Rev. 10–2022) Catalog Number 73349K. URL: https://www.irs.gov/pub/irs-pdf/p5365.pdf

[4] Internal Revenue Service Data Book, 2011. URL: https://www.irs.gov/pub/irs-soi/11databk.pdf

[5] Internal Revenue Service Data Book, 2021. URL: https://www.irs.gov/pub/irs-pdf/p55b.pdf

[6] Jeremy Temkin. The Reality of Increased IRS Funding. URL: https://www.forbes.com/sites/insider/2022/10/20/the-reality-of-increased-irs-funding/

[7] H.R. 5376 – Inflation Reduction Act of 2022. 117th Congress (2021-2022). URL: https://www.congress.gov/bill/117th-congress/house-bill/5376/text

[8] Gary Guenther. Congressional Research Service (CRS). Federal Tax Gap: Size, Contributing Factors, and the Debate over Reducing It. Updated January 4, 2023. URL: https://crsreports.congress.gov/product/pdf/IF/IF11887

[9] H.R. 9092; Family and Small Business Taxpayer Protection Act. A Bill to rescind certain balances made available to the Internal Revenue Service. URL: https://docs.house.gov/billsthisweek/20230102/BILLS-118HRPIH-IRS-repeal.pdf

[10] H.R. 25; FairTax Act of 2023. A Bill to promote freedom, fairness, and economic opportunity by repealing the income tax and other taxes, abolishing the Internal Revenue Service, and enacting a national sales tax to be administered primarily by the States. URL: https://www.congress.gov/bill/118th-congress/house-bill/25?s=1&r=18 

[11] Worldwide Tax Summaries. PwC. URL: https://taxsummaries.pwc.com/united-states/corporate/other-taxes

[12] David Goldman, Jeremy Herb, Jeanne Sahadi and Maegan Vazquez, CNN. Key takeaways from six years of Donald Trump’s federal tax returns. URL: https://edition.cnn.com/2022/12/30/politics/donald-trump-tax-returns-released/index.html

[13] Tax Preparation Services in the US – Market Size 2004–2029. IBISWorld. URL: https://www.ibisworld.com/industry-statistics/market-size/tax-preparation-services-united-states/