The tax gap grew to $688 billion for 2021 according to the Internal Revenue Service (IRS). Headlines suggest that tax cheating is on the rise and that the IRS needs more resources to catch the growing number of tax cheats. 

But, we have to place this new data in context to gain a more complete picture of trends over time in the collection of government revenue, rather than making a snap judgment based upon a snapshot.

Concerningly, this data point could be used to justify straddling tens of millions of people who use Venmo, CashApp, and PayPal to receive payments for goods or services with new income reporting and perhaps even a tax bill.

What Happened

The IRS released tax gap projections for tax years 2020 and 2021. They found that the gross tax gap—comprised of non-filing of taxes, underreporting of taxes, and underpayment of taxes—increased to $688 billion in the tax year 2021–the largest shortfall ever. 

  • The total gap is up $138 billion for the three-year period ending in 2019.
  • The total gap is $192 billion higher than the prior estimates for tax years 2014-2016. 
  • The net tax gap is projected to be $625 billion once late payments and IRS enforcement efforts—projected to generate an additional $63 billion—are complete.

IRS Commissioner Danny Werfel touted the need for more resources to support compliance:

With the help of Inflation Reduction Act funding, we are adding focus and resources to areas of compliance concern, including high-income and high-wealth individuals, partnerships and corporations. “These steps are urgent in many ways, including adding more fairness to the tax system, protecting those who pay their taxes and working to combat the tax gap.”

The IRA greenlighted $80 billion to beef up the IRS with 87,000 new agents. However, conservatives clawed back about $20 billion of that in the recent debt-ceiling deal.  

With the new resources, the agency launched a new division to target high-income individuals and small businesses with more audits.

Something Doesn’t Add Up

The agency is blaming tax cheating for the increased tax gap, a narrative that advocates for a more powerful IRS will latch on to. 

To be fair, everyone should pay their taxes and we don’t tolerate tax cheats. However, for the most part, most Americans actually pay their taxes and pay them on time. For the tax year 2020 and 2021, 85% of taxes were paid voluntarily and on time. That is in line with recent levels according to the IRS. 

After late payments, audits, and other enforcement actions the overall compliance rate is projected to hold steady at 86.3%– relatively in line with recent levels.

So, if Americans are paying their taxes, why has the tax gap widened?

Chris Edwards at the Cato Institute explains that context matters:

… when compared to the size of the economy, the new estimate is not a significant jump. Despite much political rhetoric to the contrary, tax cheating is not a growing problem for the economy.

…

The dollar values of the tax gap have increased over time, but the gap is similar to previous estimates when compared to U.S. gross domestic product, as shown in the chart.

Edwards notes that not only is the U.S. tax gap stable, but it’s smaller than the average tax gap in Europe. 

What This Means to Me

Increased tax enforcement is not just going to hit high-income households, but middle-income individuals and households may be audited, especially those that have small businesses or are entrepreneurs.

Many taxpayers of all income levels stand to be straddled with new tax reporting requirements as well due to policy changes under the Biden Administration.

Most people selling used items online have not had to report their income unless they were making a significant amount. Family members sending each other cash via Venmo or friends reimbursing each other for dinner and tickets through CashApp may also receive new tax paperwork for income reporting. In addition, those engaged in gig work face new reporting paperwork as well.

To fund stimulus checks and other benefits in the American Rescue Plan, President Biden and Democrats on Capitol Hill raised the reporting threshold to capture more online transactions for activities sending as selling items or gig work. Not all transactions should trigger the reporting requirement, but there is likely to be a lot of confusion as individuals receive 1099-K reporting forms from online platforms. We’ve written about it here.

The new reporting requirement was set to begin at the end of 2022 but the IRS delayed it for one year to avoid confusion.

The intent behind lowering the reporting threshold is to capture more gig economy income and online sales. Such a one-size-fits-all approach will inadvertently straddle regular people with red tape for activities that may not even be taxable such as selling used kids’ clothes or furniture, sending cash via Venmo, or engaging in online activities.

Bottom Line

Republicans and Democrats agree that the reporting threshold must be raised to avoid saddling innocent Americans with unnecessary, burdens reporting and increased compliance costs. Unfortunately, reports from the IRS suggesting that tax cheating is on the rise may stymie those legitimate bipartisan efforts to give taxpayers relief.