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TAX GAP
BACKGROUND
One of the reasons for
the Republican losses in the 2006 midterm election is public
unease with the federal deficit. After all, the party was
swept into power in 1994 in part due to its commitment to
balance the federal budget. However, since balancing the
budget in 1997, and producing a surplus during the subsequent
years, the party has sought to have the best of both worlds,
ie: cutting taxes and increasing spending. The results of
this mindset has produced massive deficits since 2001.
While the federal
deficit has been reduced considerably from its peak of $421
billion in 2004, it remains uncomfortably high at $247.7
billion. In an effort to address the deficit without raising
taxes or making draconian cuts to federally run programs, the
Bush Administration’s fiscal year 2007 budget focused
considerably on addressing the tax gap.
The tax gap is defined
as the difference between the amount of revenue due to the
Treasury Department and the amount of money actually
collected. While it would seem that this definition would
produce a clear dollar amount and the issue seems fairly
straight-forward. However, there has been considerable
ambiguity since the 2007 budget was released.
First, there is
confusion about the size of the tax gap. This is largely due
to the Internal Revenue Service (IRS) putting forth two
different numbers. The IRS estimates that for 2001 the
gross tax gap is $345 billion with a compliance rate of
about 83.7 percent. However, the net tax gap, that is
the amount after late payments and audits are accounted for,
stands at $290 billion with a compliance rate of 86.3
percent. One can immediately see how this solution to the
deficit is very appealing. If the government were able to fix
the tax gap, it would erase the federal deficit without having
the need to either raise taxes or cut federal programs.
2007 BUDGET
In its budget for fiscal
year 2007, the Administration set forth five specific
proposals to help close the tax gap. These solutions included
both enforcement and education, but mostly focused on
education.
- Clarify
the circumstances in which employee leasing companies and
their clients can be held jointly liable for Federal
employment taxes.
- Require
debit and credit card issuers to report to the IRS gross
reimbursements paid to certain businesses.
- Require
increased information reporting for certain non-wage
payments made by Federal, State and local governments to
procure property and services.
- Amend
collections procedures applicable to Federal employment
taxes.
- Expand
return preparer identification and penalty provisions.
The Administration also
announced that the Treasury Department would study the
standards used to distinguish between employees and
independent contractors (ICs) for purposes of withholding and
paying Federal employment taxes.
2005 TAX RECONCILIATION
On May 17, 2006,
President Bush signed into law
H.R. 4297, the Tax Increase Prevention and Reconciliation
Act of 2005. While the focus of this bill centered on
continuing the important tax relief that has stimulated our
economy, it also put into law one of the Administration’s tax
gap proposals. Specifically, it requires the government to
withhold three percent on all their payments to government
contractors.
While this provision
only applies to government contractors, it will be a
particularly onerous burden on small businesses. Since most
small businesses are dependant on a steady cash flow, any
disruption to their business revenue could have a very
negative effect.
Fortunately, there is
time to resolve this issue before any real damage is done.
The provision applies to payments made after December 31,
2010. However, getting this issue done soon will allow
businesses to better plan for the future without fear of a
pending government burden.
2008 BUDGET
In its budget for fiscal
year 2008, the Administration again set forth several
proposals to help close the tax gap. Of all the proposals
included in the budget, three stand out as being demonstrably
more burdensome. The first proposal would require information
reporting on payments to corporations that provide services.
This would be a significant burden on small businesses as it
would require businesses to file a Form 1099 for payments to
corporations that provide a service to the small business,
valued at $600 or more in a calendar year. Significantly,
instead of targeting non-compliant individuals, this proposal
would target corporations that already file diligently. It
also targets business to business transactions, not business
to consumer transactions. The data the IRS uses to justify
this proposal are actually much older than the NRP data and
therefore are out of date.
The second proposal
would require businesses to obtain a certified Taxpayer
Identification Number (TIN) from contractors (including
corporations). While businesses now have the option to verify
TINs, this proposal would make verification mandatory, thereby
adding an additional administrative burden. We believe that
the burden of verifying the TIN should fall on the contractor,
if on anyone; as it is their number. We believe if this
proposal goes forward there needs to be an easily accessible,
accurate, and real-time TIN verification system.
Finally, we have serious
concerns with the proposed requirement of information
reporting on merchant payment card reimbursements. While this
burden does not appear to fall on small businesses, since it
requires merchant payment processors to report, we believe
that this proposal will lead to inaccurate information about
the small businesses. For instance, small businesses do not
distinguish between card payment transactions and cash
transactions when it reports income. Yet somehow, the IRS
hopes to be able to use the information from card companies to
discern how much money the small business took in. We are
also concerned that the costs placed on the merchant payment
processor will be passed along to small businesses.
ANALYSIS
It is clear that the tax
gap exists and is a problem that needs to be solved. Aside
from the budget ramifications, there are competitive concerns
as well. If an organization is willfully underreporting its
taxes, it is giving itself a competitive advantage over honest
businesses.
That said, it is
difficult to construe from the given data how much of the tax
gap is the result of willful noncompliance and how much is the
result of an overly complex tax code. No one would dispute
the notion that the U.S. tax code is too complex. Every year
the IRS sends out eight billion pages of forms and
instructions which, if laid from end to end, would circle the
earth 28 times. The IRS publishes roughly 480 tax forms, and
280 publications just to explain the 480 forms. There are
7,000 individual Internal Revenue Code Sections, 10,000 pages
of text, hundreds of thousands of pages of regulations and
other pronouncements, and an equally weighty compendium of
court opinions interpreting the law.
Given this complexity it
should not be any wonder that there is a tax gap. And while
certainly there are a few who will be dishonest and try to
avoid paying their fair share of taxes, it is poor policy to
punish the law-abiding citizens who want to do the right
thing. Instead of blaming the very businesses that keep
people employed and generate tax revenue, the IRS should make
things easier on these businesses to comply with the tax
code.
LEGISLATION
Last Congress,
legislation was introduced in both the House of
Representatives and Senate that would completely repeal the
withholding provision contained in H.R. 4297. However,
neither bill garnered much support, since the provision does
not go into affect until 2010.
OUTLOOK
Senator Max Baucus
(D-MT), Chair of the Finance Committee, has made it clear
that closing the tax gap is one of his top priorities.
Congress is now also
governed by “pay-go” budgeting rules. Under these rules,
tax relief or spending increases must be offset by
comparable spending cuts and/or tax increases. Under this
scenario, any proposal to close part of the tax gap will
become an attractive offset.
There are three steps that we must take to protect small
business’s interests in the tax gap debate. The first step
is education. Whether we are trying to shape initiatives to
close the tax gap as a matter of principle, stave off tax
gap solution offsets, or undo past gap closers such as the
government contractor provision, we need to seize the
playing field. To do this we need to help Congressional
staffers understand the issue better and how these proposed
policies will hurt small businesses. The second step is to
identify solutions, which are palatable to small businesses,
to close parts of the tax gap. The tax gap will not just
disappear as an issue. The third step is to deal with
specific, narrow problems, such as the government contractor
withholding provision. In this new environment, some sort
of compromise may be necessary in order to stave off the
full effect of the withholding provision. Fixing this
provision is not impossible, but we have to be realistic
about the work ahead. The key to success will be
education. Many Members and their staff do not know much,
if anything, about this issue. Therefore, it is incumbent
on us to clearly make the case to repeal this provision
.
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