Two classes of people understand the phrase – Mind the Gap. Those two are (1) frequent subway commuters and (2) American taxpayers. On second thought, if you consider the Internal Revenue Service as a class of people, that number becomes three.

On a personal note, there is one other group, sadly, who understands the term – families directly affected by adolescent cancer. But that is a story for another post.

For commuters, the term refers to that space between the train platform and the floor of the train car one is trying to enter or exit. For American taxpayers, the term refers to the difference between tax revenue estimated to be collected and the amount actually paid in. That difference is called the “tax gap.”

The IRS defines the tax gap as the amount of tax liability faced by taxpayers that is not paid on time. Because the IRS collects over $2 trillion annually, estimating the difference is a critical, yet difficult and time consuming undertaking.

Imagine, if you will, a gap at a train platform that stretches ten, fifteen, even twenty feet. You could envision would-be passengers leaping to their death as they try to get on the train. With respect to the tax gap, that imagery is not so far-fetched. The Federal deficit for 2006 approximated $250 billion (that’s one-quarter TRILLION dollars.) Claims of the actual deficit range from a low of $198 billion to a high of $4.6 Trillion! (No Alice, that is not a typo!)

By comparison, the 2006 tax gap is estimated to exceed $400 billion. Even after late collections, including payment of penalties and interest, the "net" tax gap approximates $385 billion.

Seems straightforward to me! Close the gap, eliminate the deficit!

Continuing with our train platform analogy, the solution is not to keep rerouting the rails, so that they are even farther from the platform, nor is chipping away the brick and concrete at the edge. While engineers could employ stop gap (pardon the pun) spans to “bridge the gap”, these would be ineffective and temporary (It's hard to lay a permanent structure with one end anchored on a moving object.) at best. More importantly, these spans would be unsafe, and randomly so. Those passengers who are younger, and more fleet-of-foot, could more easily take advantage of these measures.

Likewise, temporary legislative stop-gap measures (we actually employ these - called "patches") cannot fix the mess that is our tax code. Nor can they effectively reduce the tax gap.

The tax gap can be divided into three components: non-filing, under-reporting and underpayment.

Under-reporting income remains the biggest contributing factor to the tax gap. Under-reporting accounted for an estimated $376 billion of the gross tax gap in 2006. Tax non-filing accounted for $28 billion in 2006, while underpayment of tax contributed $46 billion to the gap.

Understandably, overall compliance is highest where there is third-party information reporting and/or withholding. For example, wages are reported by employers on Forms W-2 and are subject to withholding. As a result, less than 1% of wage income is misreported. But amounts subject to little or no information reporting, including self-employment income and capital gains, had an estimated 56% net misreporting rate in 2006.

According to many experts, the easiest option to shrink this gap would be to make the tax code simpler and eliminate the likelihood of mistakes. Tax professionals have noted that an overly complex tax code opens the door to tax avoidance, as taxpayers search for loopholes and ambiguities hidden within its 9,000 pages. Not only do errors result from the complexity, but more complexity leads to more confusion, with the IRS increasingly unable to meet taxpayer support demands.

In 2006, the U.S. Department of the Treasury, Office of Tax Policy, released a report titled “A Comprehensive Strategy for Reducing the Tax Gap.” One of the strategies enumerated was Reform and Simplify the Tax Law. The authors wrote that “Simplifying the tax law would reduce unintentional errors caused by a lack of understanding. Simplification would also reduce the opportunities for intentional evasion and make it easier for the IRS to administer the tax laws." Amen.

Despite this remarkable concurrence of opinion, the complexity firmly embedded within our tax code has continued to get worse.

In her  FY2005 Annual Report to Congress, the National Taxpayer Advocate stated, “Our tax code has grown so complex it creates opportunities for taxpayers to make inadvertent mistakes as well as to game the system…Thus begins an endless cycle—complexity drives inadvertent error and fraud, which drive increased enforcement or new legislation, which drives additional complexity. In short, complexity begets more complexity.”

It’s easy to blame taxpayers who, whether knowingly or unknowingly, understate their income. But, like so may of the problems in our tax system, we should turn our anger, and our attention, on the tax code itself. Until we get meaningful reform, reform that produces a simpler, fairer tax system, we will face a recurrence of this problem. Until our tax code is taken out of its current position as a dam to competitiveness, our economy is damned.

For those not familiar with the digital currency called “bitcoin”, this digital phenomena has given a whole new meaning to the word mine. Bitcoins are “mined.” That is to say they are produced on private computers across the globe, using very complicated algorithms. They are mining for bitcoins! America would be well served to change the London subway logo to adopt a more modern approach.

We have to mine this gap. Greater enforcement is not the answer. We don’t need bigger pickaxes and stamp mills. We do not require more miners panning the creeks for tax dollars. We need a smaller tax code; we need a simpler tax code.

So much of our tax code is unfair. Unfair to taxpayers in every socio-economic group. But ask who you think suffers the most. If you said middle-class wage earners, go to the head of the class. Those with income less than $50,000 often end up paying little or no federal tax. Those who earn more than $250,000, particularly those who have substantial capital gains income, typically incur a total federal tax bill less than 15% of their income. Those who earn, say, $125,000, all of which is wage income, generally pay over 20% in federal taxes.

To compound this problem, while I am not encouraging cheating on ones taxes, those with only wage income are subsidizing the tax gap generated by those with other sources of income. All of their income is reported, so they cannot game the system. Others can - and do!

Our tax code is damming the river of opportunity. Our economy is damned. Wage earners are damned if they do and damned if they don’t.

Damn if I won’t have another round!

AuthorDoug Spiker