According to press reports, Democrats in Congress are planning a major effort to reduce the so-called tax gap. This consists of money owed to the federal government but not paid. According to the Internal Revenue Service, in 2001 the gross tax gap was $345 billion, which fell to $290 billion after enforcement efforts. This suggests that about 14 percent of all taxes that are owed are not paid annually—a figure no higher today than in the 1980s.
These figures are primarily for individual income and payroll taxes; the IRS has not updated its research on corporate tax compliance for decades. One reason is that the line between tax evasion and legal tax avoidance in the corporate sector is very, very murky. For many corporations, it’s not worth the bother to evade taxes when there are so many legal tax avoidance opportunities available.
To a certain extent, this is true of individuals as well. When I do radio shows, I often hear from callers who believe their taxes are much too high. But when I question them about whether they participate in their employer’s 401(k) plan, whether they are contributing the maximum to an Individual Retirement Account, whether they have considered investing in tax-free municipal bonds, whether they are taking advantage of the Earned Income Tax Credit and other legal methods of tax avoidance easily available to all taxpayers, very often the answer is “no.” In effect, many taxpayers are voluntarily paying more taxes than necessary.
If a taxpayer truly wished to avoid paying income taxes altogether, he could probably arrange his affairs to make that possible. But that would require a lot of work that might not pay off in tax savings or actions that would reduce his overall income. For instance, someone in the 15 percent tax bracket could buy municipal bonds to avoid paying any taxes on his interest income, but this would make no economic sense because the spread between interest rates on corporate and municipal bonds is greater than 15 percent. Lately, the spread has been about 22 percent. Therefore, it only makes economic sense to buy municipals if one’s marginal tax rate is greater than 22 percent.
Yet many ordinary Americans still cheat on their taxes, mainly by not reporting income. And almost all of that comes from business activities. According to the IRS, only eight percent of the individual income tax gap came from unreported wages, salaries and tips. Just five percent came from unreported capital gains and another five percent from unreported pensions, annuities and IRA distributions. Less than three percent of the tax gap was accounted for by unreported interest and dividends.
Bruce Bartlett is a former senior fellow with the National Center for Policy Analysis of Dallas, Texas. Bartlett is a prolific author, having published over 900 articles in national publications, and prominent magazines and published four books, including Reaganomics: Supply-Side Economics in Action.
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