The Biden administration is proposing tougher tax enforcement to help pay for the $3.5 trillion budget reconciliation package. Collecting legally owed taxes is a laudable goal, but politicians have historically discounted the compliance costs of taxes. History may be repeating itself.
The most controversial enforcement proposal involves banks and other financial institutions reporting all accounts with an annual cash flow over $600. Groups like the American Bankers Association and the U.S. Chamber of Commerce have heavily criticized the proposal. Since we know that business groups sometimes protest too much, how should we evaluate this proposal?
The administration’s interest in enforcement stems from the tax gap, or taxes that should be but are not paid. A tax gap is inevitable since people respond to incentives, including taxes. People respond to taxes with avoidance, or using loopholes to legally reduce one’s liability, and evasion, or not paying taxes legally owed. The tax gap is based on evasion.
The principle of equality before the law implies that everyone should pay as legally obligated. Many Americans view tax evasion as immoral and support efforts to make cheaters pay.
We do not know the exact size of the tax gap because we lack statistics on deliberately hidden income. Economists Natasha Sarin and Lawrence Summers estimated it at $630 billion for 2020, or about 15% of the taxes that should have been paid. Improved enforcement will never deliver the entire $630 billion to Uncle Sam. If we lowered our tax gap to the smallest observed across developed nations, we might raise an extra $300 billion annually. This will not eliminate the current $3 trillion Federal deficit.