What is Tax Gap and How to Close It?

Every year around April 15, you’ll hear grownups of all ages clamoring about "tax day." That’s because federal and state income tax season has finally arrived. Now you have to start with tax preparation and remove all the bills and cash statements of the whole year.

You know taxes keep evolving around you! For instance, you purchase something from a retail store along with the product rate you will have to pay sales tax. If you own property, you have to pay property tax. But have you ever wondered why taxes are essential?

In every country, government bodies need some fund to perform certain civil operations, and how they collect funds, via taxes. As there are so many aspects in tax operations, let’s have a look at the most commonly overlooked aspect- Tax Gap!

What is the tax gap?

To simply put across, the tax gap (tax evasion) is the difference between the yearly amount of taxes payable and the actual amount paid on the due date. According to IRS estimates approx. 86% of all federal income tax due is paid voluntarily as per due date every year, which clearly defines that tax gap is increasing every day and now on an average, it is around $350 billion annually.

What is the reason behind tax gaps?

The core reason for tax gaps involves three areas of non-compliance with the tax law namely underpayment of taxes, underreporting of taxable income, and non-filing of returns. Typically, tax gaps transpire because of the taxpayers who don’t adhere to IRS rules and manipulate the regulations for saving money.

• 80% taxpayer contribute to the category of underreporting as they either underreport their income or overstate expenses
• 80% taxpayer who correctly file their income tax return, usually understate their income rather than overstating tax deductions
• Small business activities are primary contributors to the understated incomes.

Because of such tax gaps, IRS increases the tax rates that only cost thousands to cheaters, but even the honest taxpayers unnecessarily end up paying a higher amount of tax. In general, honest taxpayers pay 20% more in taxes when IRS finds tax gaps or cheating.

More so, collecting the underpaid taxes consumes time and cost a lot to the honest taxpayers. Besides all this, tax gaps severely impact national federal deficit, which further increases tax rates and also condenses the level and quality of services offered by the federal government.

What strategies have been executed by the federal government to control or close tax gaps in the country so far?

IRS reported that they are implementing some strategies to control the tax gaps by collecting the tax gap taxes owed within the set timeframe, since 2001. IRS has uplifted its enforcement proceeds around 28% from $33.8 billion in 2001 to $43 billion in 2004.

They started knocking the doors of a high taxpayer whose earnings are $1, 00,000 and above that surpassed 1, 95,000 in the financial year 2004, which is twice the earning of 2001. Summing up all the audits of taxpayers the ratio surpassed 1 million in 2004, which is 37% higher from 2001.

However, to completely get control over the tax gap or close tax gap is impossible, but IRS can narrow it by taking some steps:

1. Enhance Customer Services

The IRS took significant steps for refining customer service within the country. They are making use of the Internet, redesigning customer support centers, and a lot more. More so, developments to customer service have one goal-facilitate both condense the tax gap and tax paying, exclusively the percentage which is responsible for underpayments and stemmed out from inadvertent errors.

2. Enforcement Budget

The IRS should bestow more resources to enforcement counting collecting taxes and auditing that are payable. In recent years, the IRS inspections of high-income entities have fallen radically. Considering the fallen audit ratios, frontal audits has decreased from 2.9% of high-income tax filers in the year 1992 to 0.38% in the year 2009 and then flowed down to 0.35% in the year 2004.

Besides, IRS has recognized $10 billion underpayments that are impossible to collect because of inadequate resource availability. And in 2010, the enforcement staff has knockout as it dropped to 23% and audits, investigations, convictions are reduced to an extent.

3. Spot the Major Cause of the Tax Gap - Underreporting

Many small businesses, sole proprietors, S corporations, and partnerships underreported their business earnings so much that they botched to pay $125 billion in individual income tax slab on an average in between the year 2008 and 2010, as per IRS data. That year, this became the most substantial sole cause tax gap in federal history.

For instance, sole proprietors underreported their income by 63% and on the other hand businesses underpaid self-employment taxes by $65 billion. When you combine both the ratios, it solely accounts for 41% of the tax gap.

4. Tax Simplification

It would be one of the best steps to blend an array of rules and definitions in the tax code to more far-reaching reforms that could moderate the non-compliance rate and possibly raise tax returns without an upsurge in tax rates.

For example, offers that would amalgamate current tax credits and deductions, or that would evade certain tax spurs, could prominently streamline tax code.

5. Paid Tax Preparers

Many individuals and businesses hire a tax preparation company to make the process seamless. As the changing reforms confuse the taxpayers and they fail to keep themselves updated on the same. However, paid taxpayers keep themselves updated with every changing tax regulation and use cutting-edge technology to prepare your taxes.

Wrapping up

The determined tax gaps that subsist in developing countries are renowned and yet a headstrong challenge. It is recommended that tax administrators should ensure that there is a prompt and effective discussion of information with taxpayers on changes in the tax laws.

Gia Glad holds the position of Business Content Writer at Cogneesol - an outsourcing firm offering finance and accounting services along with other value-added services to the small and mid-sized businesses globally.