by Thomas Kirchner, CFA
Tax gap to bring in $175 bn in annually.
Questionable calculations vastly overstate tax gap.
Pandora papers show few U.S. taxpayers hide income.
Spending hoped-for collections from a nonexistant tax gap will increase government debt.
Filling the so-called tax gap is one of the pillar's of the administration's plans for paying for its proposed spending largesse. However, the tax gap is based on faulty assumptions. A reality check suggests that it does not exist at all.
The tax gap mirage
The tax gap refers to the amount of taxes that by some estimates are supposed to be collected and compares them to the actual collections. The difference is a gap amounting to $175 billion annually [i]. Over 10 years, that if that money were collected, it would pay for almost $2 trillion in extra spending.
The problem is that nobody knows what the taxes are the IRS is supposed to collect. We only know what taxpayers declare, and what audits later find in undeclared income. But how much are the audits missing? Academics have found a simple formula, that, in our opinion, is far too simplistic and yields fantasy results. The estimate looks at the income group with the highest discrepancy between declared income and what audits determine the actual income was. For incomes in the 30th to 50th percentile of the distribution, the audits find that between 5 and 6% of overall incomes are unreported. Of all income groups, these middle percentiles have the highest rate of evasion. In the top 0.01 percentile of the income distribution, audits find that only about 0.5% of overall income is unreported [i].
The proponents of the tax gap then make a strong assumption: the high rate of tax evasion of between 5 and 6% found in the middle of the income distribution is the same for higher incomes. It simply goes undetected in the audits.
If you apply this high rate of 5-6% to the top end of the income distribution, then you reach said $175 billion per year in theoretically undetected tax evasion.
There is one obvious fallacy in the approach: not all income groups will have the highest rate of evasion. The reason can easily be seen when you look at why middle incomes appear to evade so much in their taxes: Schedule C, business income. The vast majority of tax evasion is detected in business income of middle income taxpayers. For higher income groups, evasion of business income becomes much smaller. The likely cause for this evasion is not malfeasance, but the difficulty of figuring out how much in taxes is due: business income is hard to calculate when you have to deal with depreciation schedules and revenue recognition. Many small businesses who make $40k per year probably don't want to incur the expense of a business accountant, who may charge $1k or 2k for their services. So they try to do their own taxes – and get it wrong. The IRS doesn't have a category for “incorrect completion of a tax return.” They only know taxes paid or taxes evaded. So all these errors on Schedule C end up being counted as tax evasion. And clearly, many simply make mistakes due to the complexity of business taxes, or simply out of ignorance.
As you go up the income ladder, taxpayers have the means to afford an accountant to do their business taxes. Therefore, fewer errors are made, which would have counted as “evasion” in IRS statistics. The audits detect fewer errors, which leads to a lower reported “evasion”.
The proponents of the alleged fantastically large tax gap claim that foreign tax evasion is the reason why tax evasion by the rich does not get caught by the IRS audits. Fortunately, we have a way to test the plausibility of that claim.
Pandora Papers are a non-event
We can test the plausibility of foreign tax evasion in high income groups by looking at some recent leaks of data from offshore legal firms whose services are alleged to be used for tax evasion. Two such major leaks have occurred in recent years: the Panama Papers in 2016, and this year the Pandora Papers. If the ultra-wealthy engage in tax evasion of trillions of dollars, we would expect to find the traces in these documents. The names of a dozens, if not hundreds of wealthy Americans must pop up in these leaks if there really is $175 billion each and every year in offshore tax evasion by the nation's wealthiest.
Spoiler alert: there's next to nothing.
The Pandora Papers, a collection of documents leaked to the International Consortium of Investigative Journalists (ICIJ) from 14 providers of offshore vehicles, shows surprisingly few Americans among the many wealthy individuals and politicians using offshore entities. If offshore tax evasion were a major problem, we would have expected to see headline-grabbing lists of billionaire members of the Forbes list. After all, of the 2,755 billionaires currently counted by Forbes, America's 724 billionaires outnumber those of any other country. China is next with 698 [ii]. The only billionaire named by ICIJ so far is Robert F. Smith, and his his involvement with offshore entities is not even news. He settled tax evasion charges with prosecutors, as ICIJ point out, last year without being charged. The New York Times reports that the settlement, one of the largest ever in a tax evasion case, amounted to $139 million on untaxed income of $200 million over 15 years. This is not exactly an earth-shattering amount: had $200 million been taxed at the top rate of currently 37%, it would have brought in only $74 million, or a little more than half the amount of the settlement.
So the only U.S. billionaire that surfaces in what is billed as one of the largest leaks of otherwise secret offshore tax evasion documents is one who was already in the crosshairs of the IRS.
First, that tells us that IRS audits are actually effective. Second, this makes it absolutely implausible that tax evasion is endemic among Americas wealthiest. Moreover, if this case amounted to only $74 million over 15 years, then it is even more implausible that the administration will be able to raise trillions through stepped-up enforcement.
We also note that American names are similarly sparse in the 11.5 million leaked documents of the Panama Papers published by ICIJ in 2016.
Two large leaks of alleged proof of offshore tax evasion turn out to be big nothing burgers. We can only conclude that offshore tax evasion is far from being endemic. It is a fringe phenomenon and clearly not sufficient to bring in $175 billion in extra tax revenue each year.
Swiss cheese
The absence of U.S. wealthy among tax evaders is no big surprise. First of all, penalties for non-compliance are severe. More importantly, the tax code is so complex that it has more holes than a Swiss cheese. There are plenty of legal ways to minimize taxes.
Moreover, trust law is well established in the U.S., giving taxpayers plenty of flexibility . For most Americans, here is no need to enter into far-flung offshore structures. They can get the same treatment at home, where it is fully transparent to the IRS. Which in turn means that there is probably very little in hidden income that the IRS can put a legitimate tax claim on.
Income worth half a trillion
Another way to look at the numbers: at a marginal top rate of 37%, a tax gap of $175 billion corresponds to roughly half a trillion of income. That corresponds to an economy the size of Austria or Sweden. And the IRS supposedly does not catch that so much money secretly sneaks out of the U.S. every year ? We find this not just implausible, but outright ridiculous.
Tax gap folklore
Talk of the tax gap to plug budget holes is no more than political folklore, a theater to justify spending plans. While we will not dispute that stepped-up enforcement may bring in additional revenue to the IRS, we simply cannot see how this can come anywhere near the hoped-for $175 billion every year. However, if this revenue is counted on and spent before it is received, this simply means that government debt will go even further through the roof. Government debt is estimated to have reached 125% of GDP in Q2 [iv] and may raise to 202% of GDP by 2051 [v]. If we spend income from a non-existant tax gap, we will get there a lot faster.
[i] John Guyton, Patrick Langetieg, Daniel Reck, Max Risch, Gabriel Zucman: “Tax Evasion at the Top of the Income Distribution:Theory and Evidence.” NBER Working Paper 28542, March 2021.
[ii] www.forbes.com/billionaires/.
[iii] Matthew Goldstein: “A Buyout Fund C.E.O. Got in Tax Evasion Trouble. Here’s Why Investors Shrugged.” The New York Times, March 12, 2021.
[iv] Federal Debt: Total Public Debt as Percent of Gross Domestic Product. Series GFDEGDQ188S, Federal Reserve Bank of St. Louis.
[v] David Lawder: “U.S. debt burden to rise to 202% of GDP in 2051, CBO projects” Reuters, March 4, 2021.
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Thomas Kirchner, CFA, has been responsible for the day-to-day management of the Camelot Event Driven Fund (EVDIX, EVDAX) since its 2003 inception. Prior to joining Camelot he was the founder of Pennsylvania Avenue Advisers LLC and the portfolio manager of the Pennsylvania Avenue Event-Driven Fund. He is the author of 'Merger Arbitrage; How To Profit From Global Event Driven Arbitrage.' (Wiley Finance, 2nd ed 2016) and has earned the right to use the CFA designation.
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