The IRS is reporting the tax gap (amount of money that taxpayers are not settled with the Federal tax authority or the true tax liability versus the paid tax on time) amounts to around $668 billion for 2021. The breakdown is as follows (per IRS blog), comprising three components:
- Nonfiling, which means tax not paid on time by those who do not file on time:
- $77 billion in tax year 2021, up from $41 billion in tax years 2017-2019.
- Underreporting, which reflects tax understated on timely filed returns.
- $542 billion in tax year 2021, up from $445 billion in tax years 2017-2019.
- Underpayment, or tax that was reported on time, but not paid on time).
- $68 billion in tax year 2021, up from $64 billion in tax years 2017-2019.
Note that US Federal revenue oscillates depending on the sources from $4.5 billion to $5 billion in 2022 (range of 13%-15% not paid). Based on IRS estimates, around 85% of taxes paid voluntarily and on time and probably the vast majority of individuals pay and file on time, but the major issue is the underreporting which accounts for over 80% of the tax gap.
From a 2018 underreporting study form Penn Wharton, the majority of the underreported income (around 70%) was linked to Schedule C (sole proprietorship and one member LLC filings – relatively low complex entities), while there is around 13% for more complex entities (Partnerships and S Corporations) and around 11% regarding financial income (capital gains, interest income and dividend income). This report from 2018, it appears that the micro or small business (which includes gig economy, or having side hustle on the side) are mainly causing the underreported income as Schedule C is usually not used by large or complex entities, even wealthy taxpayers does not use this type of filing if receiving appropriate tax advice.
However, a more recent post from September 2021 titled The Case for a Robust Attack on the Tax Gap from the U.S. Department of the Treasury, even if the amount of tax gap is in line with current estimations “… Today, the “tax gap”—the difference between taxes that are owed and collected—totals around $600 billion annually…“, the post points to the high earners as the responsible for the majority of tax evasion – “… In part, tax evasion is concentrated toward the top of the income distribution because higher-income taxpayers have the ability to tap into the services of accountants and tax preparers who help shield them from bearing their true income tax liability.” Again, this reports considers the entities as the wealthy taxpayers as responsible for the majority of the wealth gap, stating “… higher earners—like partnership income, proprietorship income, and rental income—noncompliance can reach 55 percent.”
As a tax professional, it is interesting to see how relatively similar data can generate to completely different outcome results, one that around 70% of the underreporting is generated by Schedule Cs (Penn Wharton study), while on the other half of the income gap is associated to “… proprietorships, partnerships, and S-corporations.” associated to high level income individuals. We should keep in mind that certain tools allowed in the IRS tax code are used by wealthier clients such as 1031 exchanges, tax opportunity zone deferrals, use of trusts, lower taxation on capital gains than earned income (wages), etc. which are all appropriate tax avoidance methods.
Additionally, we should keep in mind that wealthier people pay significantly more taxes than other groups and higher tax brackets (even if the effective tax bracket could be lower if for example the income is related to capital taxes). In fact, you can read different articles on how more than 40% of households will owe no federal income tax in 2022 (it was 59.3% in 2020 and 56% in 2021) like different CNBC articles. Note that does not mean that those households do not pay Social security or Medicare or other types of taxes (like Sales tax when purchasing goods) as stated on the Urban institute document named “Five Myths about the 47 Percent” from 2012. Readers be aware, data might be the same, but the conclusions might defer significantly depending on political, economic and other motivations.