Closing the Tax Gap through Modern Information Technology

PictureBy Sam Hampton

Congratulations—you just hit a $5000 jackpot on a slot machine! Would you be more likely to report this income on your 1040 (as you should) if you knew the casino would report the winnings to the IRS? Would you be more likely to report a cash tip income if you found out that a waiter had been prosecuted for tax fraud for failure to report his tips? A recent New York Times article suggests that taxpayers are much more likely to report in either of these situations—and modern information technology provides new avenues for both auditing and monitoring taxpayers.

The so-called tax gap is a hot topic in tax circles. It is defined as the difference between taxes legally due and those actually reported; the Service has estimated the tax gap to be $450 billion in 2006 (about 83% compliance). To put that number in context, the 2015 defense budget is about $582 billion; 2015 Medicare expenditures were about $539 billion. It is almost as large as the federal deficit. Underreporting is the largest component of the tax gap.

Auditing is one means of closing this gap, though recent funding cuts to the agency have contributed to some of the lowest audit rates in history. The IRS selects returns to potentially audit by scoring them through an automated process, and choosing those most likely to have underreporting. Aggregated digital data on individuals could be a powerful and cost effective predictive tool in selecting returns for auditing through this process, especially as resources dwindle.

Moreover, this digital data could be used to provide friendly reminders to likely under reporters. If your Facebook profile says you are a waiter, perhaps a friendly reminder that tips are includible income appears in your newsfeed. If your profile states you are a sole proprietor, one of the largest contributors to underreporting, maybe a story about a tax fraud prosecution appears as you surf the web. This targeting could substantially increase compliance according to studies.

Finally, modern technology presents treasure troves of data for information reporting, either through third parties or digital records. If digital records of communications and transactions were reported to the IRS about income from your eBay transactions, would you be more likely to report this on your 1040? Increasing third party reporting is the first in a series of recommendations in a report by GAO in narrowing the tax gap. Where substantial information is reported, e.g. your W-2, underreporting is very infrequent—about 1%. Where there is little or no reporting, the underreporting skyrockets to 56%.

The proceeding raises the question of the proper balance to strike between informational privacy and the need to collect revenues legally due. Although these concerns are a bit speculative at this time, a recent article says the IRS has invested in technology to obtain cellphone location data. The service clearly desires useful data in carrying out its function, and political pressures to close the tax gap may lead to substantial increases in the use of digital records in auditing tax returns.

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