Tax Gap

Taxpayers fail to pay hundreds of billions of dollars in taxes every year. This tax gap—the difference between tax amounts that taxpayers should pay and what they actually pay voluntarily and on time—has been a persistent problem for decades. The size of the tax gap can fluctuate as a result of taxpayer behavior, Internal Revenue Service (IRS) enforcement activities, updated methods for estimating the tax gap, changes in economic activity, and changes in tax law and administration. 

IRS's Annual Average Tax Gap Estimate for Tax Years 2014-2016 

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The tax gap occurs when taxpayers, whether intentionally or inadvertently, fail to accurately report tax liabilities on tax returns (underreporting), fail to pay taxes due from filed returns (underpayment), or fail to file a required tax return altogether or on time (nonfiling).

Estimated Average Annual Gross Tax Gap by Type of Noncompliance and Tax (Tax Years 2014-2016)

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Reducing the tax gap will require multiple improvement strategies in areas such as IRS audits and taxpayer services. However, IRS faced decreased budget and staffing levels in the 2010s and increases in responsibilities over time (e.g., administering stimulus payments during the COVID-19 pandemic). To help, in 2022 Congress provided IRS with tens of billions of dollars over 10 years to modernize taxpayer services and enforce tax laws. 

But there are still a number of actions that Congress and the IRS could take to reduce the tax gap.

For example: 

• Paid preparers. Congress could grant IRS the explicit authority to establish professional requirements for paid preparers to help increase the accuracy of tax returns. IRS does not have the authority to establish professional requirements for all paid tax preparers, so it created a program to educate preparers who submit returns with tax credit errors. IRS's program aims to improve the accuracy of tax returns, but it can only reach a small fraction of paid preparers. 
• Math error authority. Congress could provide IRS with the authority (with appropriate safeguards) to correct math errors and discrepancies between what the taxpayer reported and other sources of information (such as government databases). Doing so would enable IRS to correct obvious noncompliance in a manner that is less intrusive and burdensome to taxpayers than audits—and could also help taxpayers who underclaim tax benefits to which they are entitled. 
• Business to business transactions. Congress could require businesses to report the amounts they paid to other businesses. These payments could include amounts to nonemployees (such as contractors) who are supposed to report this income on their own taxes—and often do not. If these transactions were reported, they would be more likely to be claimed on taxes. 
• Rental real estate. Only some rental real estate property owners must file returns, which can lead to confusion and underpayment of required taxes (such as payments real estate owners make to service providers). Congress may wish to consider requiring all taxpayers with rental real estate property to file returns. 
• Audit equity. The IRS is examining potential systemic biases in how it chooses which returns to audit. Research estimates that Black taxpayers are audited at higher rates than taxpayers of other races. Even though IRS doesn’t collect data on taxpayers’ race or ethnicity, some of its methods could lead to disparities. For example, IRS uses an automated system to select returns that claim refundable credits, such as the Earned Income Tax Credit, for audit. While IRS regularly reviews this system, it doesn’t consider potential unintended bias in the data and assumptions the system uses to make selections. 
• Sole proprietors. IRS estimates that sole proprietors—e.g., gig workers, social media influencers, and trade workers in business for themselves—underreport taxes by about $80 billion annually. IRS should take steps to assess the risk of this type of noncompliance, analyze relevant data to understand noncompliance, and develop and implement a communications plan focused on outreach and education. Congress could also require an IRS tax gap strategy to include plans to address this type of noncompliance. In addition, Congress could require IRS to implement tax withholding that is voluntary for companies facilitating payments for sole proprietors and for taxpayers who choose to participate. This could ease taxpayer burden and facilitate voluntary compliance. 
• Large Partnerships. The number of large partnerships has grown significantly over time. IRS identified large, complex partnerships as an enforcement priority and should develop guidance defining large, complex partnerships and implement measures for tracking audits of them. 
• High-Income Individuals. IRS uses several computer models to select high-income/high-wealth returns to audit but has not fully evaluated these models. Without understanding the effectiveness of these models, IRS may be unnecessarily burdening compliant taxpayers and missing opportunities to address noncompliance. 
• Third-party data. IRS receives information from employers, banks, and other third parties about taxpayers. The extent to which individual taxpayers accurately report their income is closely aligned with whether third parties (e.g., employers) report income information to these taxpayers and to IRS. IRS should work to expand third-party information reporting to improve compliance—especially related to self-employed individuals who continue to represent the largest share of the individual underreporting tax gap. 
• Digitized data. The Return Review Program is one of IRS's key systems for detecting tax fraud and preventing bad refunds. IRS monitors the program's performance and adjusts it to address new threats, but it could improve and expand use of the program. For example, it could increase the amount of data available to the program, including digitizing paper returns. Congress could also require that tax returns prepared electronically but filed on paper include a scannable code printed on the return. 
• Increasing Confidence. When estimating the tax gap, IRS uses a statistical technique to account for compliance that examiners do not detect during audits. IRS has not taken steps to understand the specific causes of undetected noncompliance and does not know if the technique over or underestimates noncompliance. IRS could develop and report on analyses that would increase confidence in the methods used to estimate undetected noncompliance, and information on its root causes. 
• Setting goals. IRS previously set specific, numeric goals for improving taxpayer compliance, but has moved away from that approach. Re-establishing such quantitative goals could help improve voluntary compliance. IRS also wants to improve taxpayer experiences and services, which could help improve voluntary compliance by educating taxpayers. However, it does not have performance goals specifying desired improvements. For example, one IRS division has broad plans to monitor the taxpayer experience and address identified issues. But it does not have performance goals with measures that would indicate whether the taxpayer experience has improved—e.g., a goal of reducing telephone assistance wait times by a specified amount. 
• Modernizing systems. The agency could also improve its management of IT systems and investments that use data. For example, IRS’s key system that processes taxpayer account data, has been in operation since the 60’s. IRS reported that modernizing this system is critical to providing taxpayers with a better experience by allowing IRS employees to have quick access to data for enhanced customer service, compliance, and fraud detection services. However, IRS has been working to modernize and retire this system for over two decades. IRS recently announced its plans to retire the system in FY 2028.