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. 


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.

  1. Clarify the circumstances in which employee leasing companies and their clients can be held jointly liable for Federal employment taxes.
  2. Require debit and credit card issuers to report to the IRS gross reimbursements paid to certain businesses.
  3. Require increased information reporting for certain non-wage payments made by Federal, State and local governments to procure property and services.
  4. Amend collections procedures applicable to Federal employment taxes.
  5. 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. 


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. 


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. 


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. 


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. 


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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