IRS steps up efforts to close 'tax gap'

Around this time each year, Americans dutifully send in what they owe in federal taxes – or at least about 84 percent of it.

The government would like to get the other 16 percent. Growing concern about this "tax gap" – underpayment due to a combination of cheating or failing to understand a complicated tax code – means that audits are on the rise and new rules could be on the way.

IRS scrutiny is greatest for high-income tax filers and people who put small-business income on their returns. But even average taxpayers saw audit rates edge up last year to levels last seen in the late 1990s.

Forget brushing up on Shakespeare. This spring is the season for being sure you know the latest rules on credits and deductions.

In addition to stepped-up examinations, momentum is building for new reporting requirements – on stock brokerage firms, for example – to determine who owes what.

Such steps won't fully recover an estimated $290 billion or more in lost revenue. But analysts say such moves are important – if only to prevent the compliance gap from growing bigger.

"If at least it's coming down and not growing, then I think that would give people more confidence in the tax system," says Mark Luscombe, an analyst at CCH, a provider of tax information in Riverwoods, Ill. "They really need to get this tax gap under control, so that the majority of people feel that they should comply."

The danger is that, if more people believe their neighbors are cheating and getting away with it, the compliance problem could grow. Last year, researchers at Youngstown State University in Ohio suggested that this psychology is already at work: Many people feel justified in cheating a little, in part because they believe the system is unfair and that worse evaders are going undetected.

Of course, the notion of getting tougher as a way to build public trust in the tax system – and in the agency that represents it – is a tricky proposition. Policymakers are trying to balance the need for greater compliance against the risk of simply adding to public frustration.

The tax gap is, to some degree, a symptom of the tax code's exasperating complexity. Millions of Americans struggle hard to pay what they owe, and still fail.

"It is easy to look at a $290 billion tax gap and see a pot of gold," Scott Hodge of the conservative Tax Foundation said at a March 9 Treasury Department roundtable. "But for many taxpayers, efforts to close that gap could become a mountain of paperwork."

From President Bush to Democrats in Congress, leaders are calling for a simplification of the tax code, not just enforcement. But action has proved difficult. One reason is that voters like their special tax breaks, and politicians like to dole them out.

"All these complications are in the code for a reason," says Mr. Luscombe.

In the late 1990s, in part because of pressure from a Republican-controlled Congress, the IRS adopted a friendlier demeanor. The focus was on customer-service, not crackdowns. The agency is trying to maintain that tone, and experts say better customer service is one way to boost compliance.

But there's also a growing emphasis on other measures to collect what's due:

• The number of audits, and the amount of money collected from those audits, has been rising. In 2005 and 2006, the IRS examined more than 6 percent of returns from filers whose income exceeded $1 million, up from a 5 percent rate in 2004.

• In its recent 2008 budget proposal, the White House proposed expanding enforcement spending by about 5 percent from 2006 levels. The president's plan also calls for additional compliance measures that could enable the IRS to collect another $29 billion in taxes over 10 years.

• Many in the Democratic-controlled Congress would like to see even more done. Sen. Carl Levin (D) of Michigan began pushing legislation in February that would make it harder for individuals to escape taxes by setting up offshore accounts.

"With a $345 billion annual tax gap and a $248 billion annual deficit, we cannot tolerate a $100 billion drain on our Treasury each year from offshore tax abuses," Senator Levin said at the time.

The bill's backers, including Sens. Barack Obama (D) of Illinois and Norm Coleman (R) of Minnesota, argue that the measure is needed to restore the tax system's lost sense of fairness.

The bill would impose new limits on tax shelters used by some America's wealthiest filers. US authorities would assume that an offshore trust is controlled by the American who set it up, unless he or she proves otherwise. This reverses the current burden of proof.

To better enforce current laws, tax experts say the IRS could use more auditors. And some say the biggest need is for a wider flow of information to the tax agency.

"Congress would have to add a number of reporting responsibilities" to make a big dent in the tax gap, says Charles Davenport, a professor of tax law at the Rutgers University campus in Newark, N.J.

For example, if stock-brokerage firms had to tell the IRS the original cost of clients' shares, not just the sale price when they are sold, it would be easier to know if people's tax returns show the right capital gains. Other possible rules could rake in more data about the income of independent contractors or the proceeds from items sold in eBay auctions. The problem right now, Mr. Davenport says, is "there's no big incentive to get it right."