Comment: U.S. owed $1T in unpaid taxes; here’s how to collect it

By Karl W. Smith / Bloomberg Opinion

The U.S. budget deficit for fiscal 2023 ending Sept. 30 was an eye-watering $1.7 trillion. Any pragmatic politician knows that reducing such a massive shortfall will require some combination of higher taxes and spending cuts. But before we demand more from hard-working families and individuals, we need to ask a fundamental question: Is Uncle Sam doing his best to collect what’s already due?

The latest Internal Revenue Service estimates are the that almost $700 billion in taxes went unpaid in 2021. This figure, called the tax gap, is the difference between what Americans owed and what the government collected. This estimate, however, is based on outdated assumptions about how the economy runs. Former IRS Commissioner Charles Rettig puts the true tax gap at more than $1 trillion, which is more than half of what the U.S. needs to close the budget deficit.

Here’s the pinch of salt in our fiscal wound: Half of this tax gap is tied to so-called pass-through entities, such as sole proprietorships, partnerships and LLCs. Unlike corporations, these entities aren’t required to file a single tax return that covers their business. Instead, the owner or owners are expected to report business income on their own individual tax returns. It’s unclear why this group is underpaying its taxes, but the reasons probably range from outright cheating to issues related to complexity in filling out returns.

When the rules for pass-through entities were created, the thinking was that they would mostly apply to small businesses that couldn’t afford to comply with the same complex tax filing rules designed for big corporations. Times have changed. Back in 1980, pass-through entities represented just over 20 percent of business income; by 2015, that figure had ballooned to more than 60 percent. Global manufacturing giants and Wall Street hedge funds are structured as pass-through entities, in large part because such entities enjoy easier reporting requirements and lower tax rates than corporations.

The Trump tax cuts were supposed to even the playing field by cutting the corporate tax rate. But, in a last-minute deal, pass-through entities were given an across-the-board deduction, slashing their tax by almost 20 percent. Reversing this blanket deduction would go a long way toward discouraging large businesses from structuring as pass-throughs.

That would only be a start. Picture this: It’s tax season, and instead of grappling with a maze of documents and jargon, Americans receive a pre-filled tax return. If everything looks good, they get a refund or send the government a check for what’s due. If not, they can amend what’s wrong through a few clicks online. Sound like a dream? It’s the potential of automatic filing.

A fair chunk of the tax gap, or around 15 percent, comes from individuals juggling credits and deductions. Some might be bending the rules, but many are genuinely lost in the complex labyrinth otherwise known as the U.S. tax code labyrinth. It’s unnecessary. The IRS has all the information it needs to complete a tax return for many Americans automatically. The big reason we don’t is because tax preparation services like H&R Block Inc. and Intuit Inc. have lobbied heavily against automatic filing, standing in the way of reforms that could help shrink the deficit without raising tax rates.

Automatic filing can also ease the burden on small businesses, which could authorize their banks to report their sales and expenses to the IRS each month and let the government take it from there. This wouldn’t be a requirement, but rather an option for businesses. Indeed, the IRS has started a pilot program to explore online filing without taxpayers have to go through a middleman. While a good start, it’s a long way from the aggressive commitment to online filing that American taxpayers need.

The Biden administration has passed legislation that gives the IRS increased funding for audits and the technology necessary to catch tax cheats. But that’s like applying a Band-Aid to a gushing wound. By plugging the pass-through leakage and embracing the simplicity of automatic filing, the U.S. government could transform the taxpaying experience, making it less, well, taxing while shrinking the deficit.

Karl W. Smith is a Bloomberg Opinion columnist. Previously, he was vice president for federal policy at the Tax Foundation and assistant professor of economics at the University of North Carolina.