Closing the Tax Gap
The recently enacted Housing and Economic Recovery Act illustrates the slow pace in closing the tax gap.
August 14, 2008
by Annette Nellen, CPA/Esq.
Since the early 1980s, there has been a plethora of recommendations about how to reduce the tax gap. Many changes have been enacted, yet the gap grows. Proposals requiring additional information reporting or withholding are usually overlooked despite evidence that these techniques result in a low tax gap for wage earners. However, a significant information reporting rule was enacted in 2008. Its enactment though, seems to be more a result of its revenue potential than its role in a comprehensive tax gap reduction strategy.
Below, we'll review the tax gap and the recently enacted credit card information reporting provision, and explain reasons for the slow approach.
Tax Gap History
According to a 1994 GAO study, Tax Gap — Many Actions Taken, But a Cohesive Compliance Strategy Needed (GGD-94-123 (PDF)), the gross income tax gap for 1981 was $76 billion and $127 billion for 1992. By 2001, the tax gap had grown to $345 billion (IR-2006-28).
The 1994 GAO report noted: "Information returns are a proven way to promote compliance and help IRS find noncompliance." The GAO observed that Congress could do more to help improve compliance such as requiring: withholding on payments to independent contractors, 1099s for payments made to corporations, and basis reporting on 1099s for stock sales.
Many proposals have been made to reduce the tax gap. The 1994 GAO study lists 61 reports it issued from 1982 through 1993 on various aspects of the tax gap and compliance (Appendix II (PDF)). Proposals have also been made by the IRS, Treasury (PDF), the National Taxpayer Advocate, legislators, the AICPA and others.
The growing tax gap and need for revenue have led to greater focus on effective ways to reduce it. These activities include:
A conference by the AICPA, ABA, TEI, American Tax Policy Institute and American College of Tax Counsel held in June 2007 to discuss ideas to reduce the tax gap.
A tax compliance forum (PDF) held by the CBO, GAO and Joint Committee on Taxation in September 2007.Sixteen tax compliance proposals are included in the President's 2009 revenue proposals (PDF). These measures include:
We have seen tax gap proposals included as revenue offsets to various tax bills. For example, Congressman Rangel's tax reform bill, HR 3970 (110th Congress) included basis reporting on 1099s for stock sales. This proposal was also included in a housing bill HR 5720 as well as a stand-alone bill, HR 878.
New Information Reporting Requirement
When a merchant allows a customer to pay with a credit or debit card, an entity, such as a bank, must process the transaction to enable the merchant to receive the funds. According to Treasury, the failure of some merchants to "accurately report their gross income, including income derived from payment card transactions, represents a significant part of the tax gap." (General Explanations of the Administration's Fiscal Year 2007 Revenue Proposals (PDF))
President Bush's budget proposals starting with FY2007 have included calling for regulations on information reporting of reimbursements made to merchants on credit cards, plus backup withholding. This information reporting idea finally made it into law via a statutory change. The Housing and Economic Recovery Act of 2008 (PL 110-289; July 2008) created IRC §6050W, Returns Relating to Payments Made in Settlement of Payment Card and Third Party Network Transactions. This rule requires payment settlement entities to file information returns with the IRS and the merchant. These returns are to include the merchant's name, address, taxpayer identification number (TIN), and the gross amount of the transactions the entity processed for the merchant. The provision covers credit and debit cards and third party payment networks, such as online payment systems.
As described in the Administration's FY2007 report (PDF), requiring the payment card issuers to file information returns should pose only a minimal burden because these issuers already provide the information to merchants. Backup withholding is viewed as leading to "material improvements in the compliance rates" of the merchants "without imposing a significant burden on the card issuers."
A de minimis exception provides that third party settlement organizations are only required to file returns regarding third party network transactions if the aggregate value of a merchant's transactions exceed $20,000 and the aggregate number of transactions exceeds 200.
Penalties are imposed for failure to file (IRC §6724). Backup withholding is required if a merchant does not provide a TIN (IRC §3406); effective for amounts paid after December 31, 2011. IRC §6050W is effective for calendar years beginning after December 31, 2010. For further details, see §6050W and the Joint Committee explanation (JCX-63-08 (PDF)).
Revenue reality: The Administration's FY2007 report (PDF) estimated that regulations calling for information reporting on payment cards would generate $225 million over 10 years. In the FY 2008 report (PDF), the estimate was up to $10.7 billion and for FY 2009 (PDF), $18.7 billion. The Joint Committee on Taxation (JCX-64-08 (PDF)) estimate for §6050W is $9.5 billion. This range of estimates likely reflects the challenges of measuring the tax gap, as well as the effect of a measure on compliance and enforcement.
Additional benefits: In testimony on the Administration's tax gap proposals, Treasury Assistant Secretary Eric Solomon made the following observations on additional benefits of credit card reporting (April 2007 testimony):
"[T]he proposed information reporting would assist the IRS by providing the merchant's overall volume of payment card sales in relation to expenses claimed and cash transactions reported. The reporting would also assist the IRS in analyzing the accuracy of reporting for payment card sales."
Complexities: In his 2007 testimony, Mr. Solomon also noted complexities in the credit card system due to the number of parties that can be involved in the reimbursement cycle. Refunds and cash back arrangements also pose problems. These issues should be addressed in regulations.
Small business concerns: In June 2008, the House Committee on Small Business held a hearing on electronic payment information reporting. Issues raised by those testifying included privacy, security, cost, the need for some entities to obtain new computer programming to comply, transaction complexity that will lead to inaccurate reporting or information that is not useful to verify gross receipts and not addressing unreported cash receipts instead.
Picking Up the Pace
Despite what appears to be increased concern over the tax gap, a comprehensive strategy for addressing it remains elusive. PAYGO (PDF) rules are the likely driver of piecemeal remedies. The information reporting provision that made it into the Housing Act had only weeks before being included as a revenue offset in an AMT relief bill (HR 6275).
A comprehensive approach to addressing the tax gap should yield a better result than the piecemeal, revenue targeting approach. Congress and Treasury could identify which measures would best address the most serious non-compliance problems. This approach likely would have led to enactment of measures to address non-reporting of cash transactions rather than credit card ones that already have audit trails. A comprehensive, strategic approach would likely have addressed causes of underreporting of payment card transactions. Many small businesses, particularly those that sometimes arise from online transactions, need guidance on recordkeeping and business reporting.
The piecemeal approach will likely remain for the 110th Congress as it works on AMT relief and extenders. The strategic approach will likely have to await tax reform activities in the 111th Congress.
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Annette Nellen,, CPA, Esq., is a tax professor and Director of the MST Program at San José State University and an Irvine Fellow at the New America Foundation. Nellen is an active member of the tax sections of the ABA and AICPA. She has several reports on federal and state tax reform and a blog.