Although you wouldn’t know it by the weather, April is fast approaching. And that means in the coming weeks, millions of Americans will be breaking out their W-2s and their favorite tax software to figure out exactly how much money they owe their government. Of course, in an economy as large and complex as America’s there are plenty of folks who don’t pay exactly what they owe. These people can range from those engaged in illicit activities like drug dealing to legitimate service industry workers, like babysitters, who are paid in cash. The difference between what is legally owed the federal government and what it actually collects in taxes each year is called the “tax gap,” which the IRS recently estimated reached $385 billion in 2006. Other studies have placed that figure higher — at upwards of $600 billion.
So who owes this money and why? The single biggest contributor to the tax gap — accounting for 84% of it — are people who simply under-report their income. This doesn’t usually happen to folks whose employers withholds taxes from their paychecks, as 99% of people in that position end up paying their income taxes in full and on time. The biggest headache for the IRS is collecting business income from the self employed, who must voluntarily report their earnings, and may — accidentally or on purpose — omit items such as income received through bartering, debt cancellation, or kickbacks. The IRS says only 44% of taxes owed on such business income end up getting collected by the agency.
Actually recouping much of this money, however, may be tougher than it sounds. Often the resources needed to collect unpaid taxes outweigh the extra revenue that would be collected. But many believe that merely simplifying the tax code would enable the IRS to collect a greater percentage of taxes owed. This is the approach advocated by Susan Striz in a 2010 West Virginia Law Review article. She points to a 2002 study by the Government Accountability Office which showed that “fifty-six percent of [tax] returns prepared by a paid preparer had errors in comparison to only forty-seven percent prepared by the taxpayer.” And these errors didn’t only include returns that claimed too big a refund, but those that caused the filer to overpay the government. In other words, the tax code is so complicated that even paid professionals screw up more than half the time, and this is a major factor leading to a higher tax gap.
But the tax gap isn’t just a product of the complexity of the tax code. According to a 2011 study by economists Edgar Fiege and Richard Cebula, tax compliance in the U.S. tends to go up during periods of economic growth, and fall during recessions. It also tends to rise when taxes are lower and fall when tax rates are higher. And this hypothesis is supported by a look at tax compliance rates across developed countries. Despite the hundreds of billions in taxes the U.S. government fails to collect each year, it has one of the highest tax compliance rates of any developed country. This can partly be explained by America’s relatively low tax rates and effective tax collection regime. But another big factor determining compliance rates is culture: In some countries like the U.S., it’s simply standard behavior to pay your taxes, while in others, tax compliance is much less common.
Behavioral economists call the cultural tendency to pay duties, “tax morale.” As James Suroweicki of The New Yorker defines it:
“In most developed countries, tax-compliance rates are much higher than a calculation of risks would imply. We don’t pay our taxes just because we’re afraid of getting caught; we also feel a responsibility to contribute to the common good. But that sense of responsibility comes with conditions . . . we’ll chip in as long as we have faith that our fellow-citizens are doing the same, and that our government is basically legitimate. Countries where people feel that they have some say in how the state acts, and where there are high levels of trust, tend to have high rates of tax compliance. That may be why Americans, despite being virulently anti-tax in their rhetoric, are notably compliant taxpayers.”
So while Americans may pay, in total, far less in taxes than we collectively owe, we’re actually much more inclined to pay our dues than most other people in the world. That is probably a product of our relatively low-tax system, but also a product of culture. That being said, we could probably make our tax collection apparatus much more effective by simplifying the tax code — as evidenced by the fact that even well-paid tax professionals have trouble not making mistakes.