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Underreporting Fuels Tax Shortfall

$300 Billion a Year Goes Unpaid

By Albert B. Crenshaw
Washington Post Staff Writer
Wednesday, March 30, 2005; Page E02

Americans fail to pay more than $300 billion in taxes they owe each year, with underreporting of income by small businesses and self-employed individuals the largest single component of this "tax gap," the Internal Revenue Service said yesterday.

Those two categories -- when employers don't report wage information to the government -- accounted for as much as $100 billion of the shortfall in 2001, the year the IRS studied. That was substantially more than the $50 billion or so in non-business income, such as dividends and capital gains, that people failed to report, and the $25 billion to $30 billion accounted for by inflated deductions, credits and the like, the study found.

Of the total underpaid, the IRS eventually recovers about $55 billion, mostly through enforcement actions, leaving a loss to the federal Treasury of $257 billion to $298 billion. That compares with last year's federal deficit of $412 billion.

The overall gap was slightly higher than what the IRS had projected earlier, Commissioner Mark W. Everson said. He said the overall "compliance rate" by American taxpayers is about 85 percent, which he called "high overall." But "a quarter-trillion dollars is way too much to leave on the table," he said. The study did not cover unpaid taxes on illegal income.

Senate Finance Committee Chairman Charles E. Grassley (R-Iowa) and senior Democratic member Max Baucus (Mont.) had pressed the IRS to produce an updated tax-gap figure for a hearing set for April 15. "The causes for non-payment might be tax-code complexity for some and outright cheating by others. Regardless of the cause, we have to fix this and stop making chumps out of those who pay their share," Grassley said in a statement.

In total, the tax gap consists of $250 billion to $292 billion in underreported income from all taxpayers, including corporations and estates and trusts, about $30 billion owed by people and businesses that filed no return, and $32 billion for those who filed a return but did not pay the taxes owed.

Of that, underpayments by people of their income taxes accounted for between $150 billion and $187 billion. Underpaid self-employment taxes added $51 billion to $56 billion.

Underpayments by corporations, which were not included in the new study, are estimated at only $30 billion. The agency conceded that the corporate figure is derived from older, weaker data, but noted that even if the actual amount were double the estimate, it would not have a major impact on the overall tax gap.

The survey results, which the IRS said were preliminary, are the first attempt at a comprehensive analysis of taxpayer compliance in nearly 20 years. The periodic audits the agency once used, in which 100,000 taxpayers were forced to verify every entry on their returns, were outlawed by Congress as too intrusive in the late 1990s.

The new research program looked at a statistically representative sample of 46,000 returns from 2001 in varying degrees of detail. The agency combined data it already had with information it could get from other sources to refine its questions in ways that minimized the invasiveness of the audits. Everson said the agency has a high degree of confidence in the results but cautioned that the agency is still analyzing the data and that the results could change.

The additional analysis, which Everson said should be complete by year-end, will also be used to discover how much of the underpayment is the result of errors and how much is intentional. The agency will also seek to refine its understanding of incorrect deductions and sources of unreported income.

Among the survey's findings:

• Wages, salaries and other pay accounted for $13 billion to $15 billion of the $42 billion to $57 billion in non-business income that goes unreported each year. The amount seems large but only because the amount of such earnings is vast. Only 1.2 to 1.4 percent of it goes unreported.

• Unreported capital gains totaled between $6 billion and $9 billion.

• Incorrectly reported alimony income accounted for less than $1 billion, but 21 to 23.8 percent of it was reported incorrectly.

• Inflated deductions accounted for $15 billion to $18 billion; incorrect credits accounted for $11 billion to $14 billion.

Everson said the results of the study will be used to "update the statistical tools" that the agency uses to select returns for audit.

The agency's next step will be to conduct a similar study of "flow-through entities," such as partnerships, in which gains and losses are not taxed at the entity level but are passed through to the owners and reported on their returns.

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