On Measuring The Extraction Costs Of Taxation

A couple of months prior to leaving office as Secretary of the Treasury, John Snow acknowledged before a congressional subcommittee what taxpayers have known for years: The Internal Revenue Code is incomprehensible and unintelligible even to the experts who prepare the tax returns, enforce the law and collect the taxes.

Because the tax code is incomprehensible and unintelligible even to the experts, there is a large gap—the so-called Tax Gap—between the amounts of revenue the federal government theoretically should collect under the tax law and the amount of revenue it actually collects. In 2001 (the latest year for which data are available), the IRS estimated this Tax Gap to equal $345 billion, about 3.4 percent of GDP. By comparison, the total federal budget deficit in fiscal year 2001 amounted to $128.2 billion, or 1.3 percent of GDP. Therefore, if the tax gap is interpreted to measure the inefficiency of the federal tax system, tax inefficiency constituted a fiscal problem more than 2 ½ times greater than the federal budget deficit in 2001. As this study will illustrate, that is a considerable underestimate of the tax system’s inefficiency.

The Tax Gap is real but there are several important questions that must be asked regarding it before its true meaning can be understood or before it can provide a useful measure of the efficiency of the federal tax system: 1) What does the Tax Gap really measure; 2) How comprehensively does the Tax Gap, as currently constructed, measure the overall efficiency of the tax system; 3) Why does the Tax Gap exist?

Answering these questions accurately is doubly important in the current environment as illustrated by the remarks of the IRS Deputy Commissioner for Services and Enforcement, Mark Matthews. Speaking before a session of the American Bar Association Section on Taxation, Matthews said he was “slightly taken aback by the recent obsession throughout the tax community with the tax gap.” Matthews called it “Tax Gap Fever,” warned Congress against developing an undue focus on the Tax Gap and criticized an increasing tendency to “look at the IRS budget through a tax gap lens.”

This study proposes a more complete measurement of the costs of extracting reveune under the existing Internal Revenue Code and for alternative tax systems, including a national retail sales tax. Download the complete study here. . .

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