The Tax Gap's Many Shades of Gray

The “tax gap”— the difference between the amount of taxes owed and the amount of tax actually paid — has garnered widespread attention in recent months. Much of the commentary on the subject equates the tax gap with “tax evasion,” a term broadly understood to connote intentional (and potentially criminal) underreporting . This paper cautions against conflating the tax gap with tax evasion. The tax gap includes substantial gray areas where the law is ambiguous and the Internal Revenue Service’s (IRS’s ) determination of true tax is debatable. T he IRS’s methodology for measu ring the tax gap also includes upward adjustments that are recommended by frontline examiners but reversed on administrative appeal or judicial review. Moreover, a substantial portion of the estimated tax gap is derived from a statistical technique called “detection controlled estimation” that potentially magnifies the impact of later-reversed recommendations on the ultimate tax gap measure. Weighing in the opposite direction, the IRS’s approach to measuring the tax gap excludes some amounts that clearly constitute tax evasion (most significantly, underreporting of tax on illegal-source income). Understanding the tax gap’s shades of gray can inform discussions of tax law and policy. We explain how proposals to use the tax gap as a performance target may produce perverse incentives for the IRS. We further explain how additional IRS funding —though necessary to improve the agency’s ability to enforce tax laws— may have counterintuitive effects on tax gap estimates. We also illustrate — using examples from the taxation of passthrough entities — how legislative reforms can reduce the size and scope of gray areas in the tax code that