The formidable task of administering and enforcing the tax code falls on the Internal Revenue Service (IRS), an entity that processed a staggering 245 million tax returns, collected a substantial $3.4 trillion in taxes, and issued refunds to over 120 million households in the year 2017. As the Tax Cuts and Jobs Act ushered in a new era of tax legislation, questions arose regarding its impact on the IRS's administrative duties, particularly in the context of addressing the persistent issue of the tax gap.
Unveiling Motivations: Intrinsic vs. Extrinsic
Understanding taxpayer behavior requires delving into the motivations behind tax compliance. Broadly categorized, individuals pay their taxes due to intrinsic or extrinsic motivation. Intrinsic motivation stems from a sense of civic virtue, while extrinsic motivation involves the fear of punishment. The IRS, recognizing the importance of comprehending these motivations, invests significant resources in studying taxpayer attitudes. The Comprehensive Taxpayer Attitude Survey (CTAS) serves as a crucial tool, offering insights into taxpayer preferences and sentiments.
Results from the 2017 CTAS revealed that the majority of taxpayers view cheating on income taxes as unacceptable. Additionally, almost all respondents affirmed a belief in their civic duty to pay their fair share of taxes. Despite these positive attitudes and a seemingly government-friendly stance, the IRS estimated an annual tax gap of approximately $450 billion. The tax gap signifies the disparity between taxes paid and taxes owed, primarily attributed to non-filing, underreporting, and underpayment, collectively representing around 15% of total tax liabilities each year.
The Role of Audits in Addressing the Tax Gap
The IRS employs various mechanisms to combat the tax gap, with audits being a prominent deterrent. Contrary to popular belief, the IRS audits only 1% of all returns filed annually. Furthermore, the number of individual and partnership audits has witnessed a decline in recent years, with the IRS auditing 0.6 percent of individual income tax returns and 1.0 percent of corporate income tax returns in 2016.
Audits are strategically selected using a discriminate index formula (DIF), which helps identify frequently misreported income. For instance, returns with Schedule C attachments are more likely to be flagged compared to those solely reporting W-2 earnings. Notably, income reported through Form W-2 and Form 1099, representing earned and unearned income, respectively, leaves minimal room for manipulation, with only 1% of income underreported when adequate withholding and information reporting are in place.
Impact of Tax Reform on Opportunities for Manipulation
With the passage of the Tax Cuts and Jobs Act, practitioners argue that manipulation opportunities have diminished. The new law doubles the standard deduction and caps state and local tax deductions, resulting in fewer taxpayers itemizing deductions and a higher reliance on the standard deduction. The Tax Policy Center predicts a decrease from 46 million to 21 million households itemizing deductions under the new law.
However, opposing viewpoints contend that the incentive to establish pass-through businesses, benefiting from the section 199A business deduction, may exacerbate the tax gap. Income generated by these entities often escapes withholding and information reporting, creating fertile ground for misreporting. The divergence in opinions sets the stage for the IRS to consider multiple strategies in its quest to address the tax gap under the new legislation.
Crafting Strategies for Closing the Tax Gap
In formulating strategies, the IRS may consider allocating more resources to pass-through entity returns, focusing on areas with increased potential for manipulation. Simultaneously, a reduction in corporate income tax audits may be balanced by an uptick in individual and partnership audits, potentially reversing the declining audit trend of recent years.
As the IRS grapples with short-term decisions, data collected over the coming years will likely emphasize the decrease in itemized filers juxtaposed with the rise in pass-through entities. This information can be instrumental in refining the DIF formula over the long term, enabling more strategic audits aligned with the intricacies of the new tax law.
Author Insight: Tara Fisher
The article's insights are provided by Tara Fisher, a seasoned professional with over 15 years of experience in international tax. Her rich background includes roles with the U.S. Congress Joint Committee on Taxation, PricewaterhouseCoopers' national tax practice, the University of Pittsburgh, and American University in Washington D.C. Tara Fisher's expertise adds depth to the exploration of tax dynamics post the Tax Cuts and Jobs Act, shedding light on potential paths for bridging the persistent tax gap.
Evolving Strategies in the Face of Tax Reform
The evolving landscape of tax regulations demands a dynamic approach from the IRS, prompting the need for adaptive strategies to effectively navigate the post-tax reform era. The Tax Cuts and Jobs Act has introduced a paradigm shift, influencing taxpayer behavior and presenting challenges in enforcing tax compliance. As the IRS endeavors to bridge the substantial tax gap, a multi-faceted strategy is essential, encompassing audits, resource allocation, and a nuanced understanding of emerging trends.
Audits as a Deterrent and Educational Tool
While audits serve as a potent deterrent, deterring potential non-compliance, they also function as an educational tool. Understanding the psychology behind taxpayer decisions is integral to crafting effective audit strategies. By leveraging the discriminate index formula (DIF) to identify areas prone to misreporting, the IRS can strategically deploy audits to address specific vulnerabilities in the tax system.
However, the declining trend in audit rates raises questions about the efficacy of this traditional enforcement mechanism. As the number of audits diminishes, the IRS may need to explore alternative approaches to maintain a robust deterrent effect. This could involve enhancing educational outreach programs to instill a sense of civic virtue and foster intrinsic motivation for tax compliance.
Adapting to Changing Filing Trends
The shift in filing trends post-tax reform, with a significant decrease in itemized deductions, necessitates a recalibration of audit strategies. Pass-through entities, buoyed by the section 199A business deduction, emerge as potential focal points for audits. The IRS must stay ahead of these evolving trends, allocating resources judiciously to areas where manipulation risks are elevated.
As the Tax Policy Center predicts a substantial decrease in households itemizing deductions, the IRS's data-driven approach should consider the implications for compliance patterns. This insight can guide the IRS in refining the DIF formula, ensuring it remains attuned to the changing dynamics of tax filings under the new legislation.
Leveraging Technology for Enhanced Oversight
In an era marked by technological advancements, the IRS has an opportunity to leverage data analytics and artificial intelligence for more effective oversight. These tools can analyze vast datasets, identifying patterns and anomalies that may elude traditional audit methods. By embracing technology, the IRS can enhance its capacity to detect and address potential non-compliance, contributing to a more streamlined and efficient enforcement process.
Collaborative Approaches and Public-Private Partnerships
Addressing the tax gap requires a collaborative effort that extends beyond the IRS's individual capabilities. Public-private partnerships can play a crucial role in fostering tax compliance. Collaborations with tax professionals, industry stakeholders, and educational institutions can lead to the development of proactive strategies, educational initiatives, and policy recommendations. By tapping into external expertise, the IRS can benefit from a diverse range of insights, contributing to a more comprehensive and effective approach to closing the tax gap.
Continuous Evaluation and Adaptation
The dynamic nature of the tax landscape demands continuous evaluation and adaptation of strategies. The IRS should embrace a culture of agility, where policies and approaches are subject to iterative refinement based on ongoing assessments of their impact. Regular evaluations of the effectiveness of audit strategies, educational programs, and technological interventions will empower the IRS to stay responsive to evolving taxpayer behaviors and emerging challenges.
Navigating a Complex Tax Landscape
As the IRS navigates the complexities of the tax landscape post-tax reform, a multifaceted strategy is indispensable. From recalibrating audit approaches to leveraging technology and fostering collaborations, the IRS must embrace a holistic and adaptive mindset. Tara Fisher's insights underscore the significance of understanding taxpayer motivations and trends, providing a foundation for strategic decision-making.
The journey toward closing the tax gap requires not only regulatory acumen but also a keen understanding of the human factors influencing taxpayer compliance. By combining data-driven approaches with innovative strategies, the IRS can embark on a path that not only addresses the challenges posed by tax reform but also sets the stage for a more resilient and effective tax administration system.