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Accounting Information > Income Taxes > The Tax Gap

The Tax Gap

             You may have heard the term “tax gap.”  What does it mean?  The Internal Revenue Service discusses the tax gap as the difference between the amount of tax that should be paid by taxpayers and the amount that is actually paid.  There are basically three components that make up the tax gap.  These are nonfiling, underreporting, and underpayment.

             Nonfiling simply means that taxpayers that should be filing a return based on filing requirements do not file a return, or do not file their return on time.  Obviously, this means that the income of those taxpayers is not being reported by them to the IRS, and the income tax is not being collected on that income.


             Underreporting means that taxpayers simply understate their income or overstate their credits, deductions, and exemptions on their income tax return.  Again, if the correct amount of income is not reported, the IRS is not going to receive the full amount of tax that should be due.  Underreporting is also common in the area of employment taxes, and also other taxes.  Underreporting accounts for the majority of the tax gap.

             Underpayment is the occurrence of taxpayers filing their returns but not making their tax payment on time.  When the payments are made, the tax gap is reduced..

            It is believed that a large portion of the tax gap due to underreporting comes from self-employed individuals, such as those filing Schedule C to report their business income and expenses.  Many of these individuals do not report all of their business income, and claim expenses and deductions that they do not qualify to claim, or claim an overstated amount for these expenses and deductions.

             In 2001, to better understand and evaluate the tax gap, the IRS established the National Research Program (NRP).  The NRP began by trying to evaluate taxpayer reporting compliance just for 2001.  For the next three years, over 45,000 returns were randomly picked for review, with most of the reviews completed by the end of 2004.  Most of the returns reviewed were high income returns.  A large number of returns with Schedule Cs were examined.  The results of this analysis allows the IRS and NRP to make some assumptions regarding the tax gap.

             According to the preliminary results, it appears that for the tax year 2001, approximately 83 to 85% of taxpayers paid their tax on time.  The tax gap for 2001 was computed as $312 to $353 billion for all tax types.  This means that there was a difference of over $300 billion between the correct amount of taxes owed and the amount of taxes paid on time.  The noncompliance rate comes out to be from 15% to 16.6% of the actual tax liability.

             How can we and the IRS close the tax gap?  Portions of the tax gap are recovered by late payments received, audits, and collection activities, as well as by IRS enforcement and compliance programs.

             It is clear that compliance is at a higher level when third-party reporting and/or withholding is involved.  For example, since a taxpayer knows that the IRS receives a copy of their W-2, they are more likely to report their W-2 income.

             The IRS and the NRP continue to study the tax gap.  As they learn more about the problem areas, they can put into place features to improve reporting by taxpayers, and continue to reduce the tax gap.         

                       If you need help with figuring out your income taxes, including which schedules you might need to file and which expenses are allowed as deductions, you are in the right place.  Try out the CPA search feature on this website to find a qualified professional to assist you with all your tax and accounting needs.

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