This Appendix represents our first revision of the document published in connection with our Tax Notes article on March 2, 2020. The principal change is a revision of the projected revenue phase-in to be consistent with the more detailed timeline described in Appendix B, published in connection with our second Tax Notes article entitled Recover $1.6 Trillion, Modernize Tax Compliance and Assistance, The How To, published on September 14, 2020.
We estimated the revenue gain from implementing the TCAM proposal using published IRS data and compliance studies. In addition, we used IRS data and other government data to project revenue estimates over a 10-year budget window for the years 2020 through 2029. We used IRS historical data and benchmarks and experience from other organizations to estimate the cost impact.
This Appendix documents the methodology and the resulting calculations. Each exhibit notes the specific source of the data used in the calculations.
As the author, I’m responsible for the estimates. I was ably assisted in these calculations by Michael Udell of the District Economics Group and by other highly qualified experts in tax and advanced technology.
Our methodology was to do a detailed estimate of the revenue impact of each proposal for one tax year, using the most recent data available. We then applied standard revenue projecting factors to estimate the impact for each year of the 10-year budget period from 2020 through 2029.
Our projection includes the impact of an assumed phase-in period and taxpayer response, which we have now revised. Our end result is summarized in Exhibit 1, Projection of Gains from TCAM, Revision One, July 27, 2020.
The sections below discuss the methodology for each proposal, followed by a discussion of the 10-year projections and cost estimates. Each section refers to exhibits which contain spreadsheets and backup data.
Table of Contents
Reduction in tax gap from additional third-party reporting, taxpayer reconciliation schedule and modernized compliance process and technology
Individuals with unreported income
The TCAM proposal describes reforms for individuals with income that is not currently reported by third parties. The reforms include increased reporting by banks of deposits and disbursements in the bank accounts used by taxpayers for their business activities, a schedule attached to the taxpayer’s return to reconcile the bank reporting with the tax return and a modernized technology-supported compliance program to make use of all available data.
See Exhibit 3 for details of calculations used for this proposal.
We based our estimates of the revenue gains under this proposal on the most recent IRS compliance study for the years 2011 through 2013.
After allowing for the exemption in required reporting for individuals with less than $25,000 in receipts and taking into account the amounts that IRS existing enforcement activities already collect, the net gain from these proposed TCAM reforms in the 2011 through 2013 period of the IRS study would be $71 billion per year, if the proposal were fully effective in that year.
This is equivalent to $97 billion for fiscal year 2019.
The IRS study showed $109 billion of tax lost from individual returns with underreported income of the type that has “little or no information reporting.” An additional $15 billion is lost from related self-employment income, for a total of $124 billion. (The IRS study identified a total of $45 billion of tax loss from self-employment income, but we only included a proportion that we could relate directly to the underreported business income.) For this category of income, 55 percent of the income that should have been reported was not reported.
The same IRS study showed that the categories of income that had “some information reporting” had only 17 percent underreporting.
We estimate that TCAM proposals will move the $124 billion category of underreported income to the “some information reporting” category. With additional reporting and IRS follow up, this move to the “some information reporting” category would reduce the underreporting percentage from 55 percent to 17 percent.
In addition, using a similar approach, $36 billion of underreported income identified in the IRS study would be moved from the “some information reporting” category to the “substantial reporting” category, thereby reducing the underreporting percentage from 17 percent to 5 percent.
The calculation of the revenue lost from the exemption of taxpayers with less than $25,000 business income takes into account the additional revenue lost because of taxpayers who initially avoid the bank reporting requirement by reporting less than the $25,000 exemption amount, even though their actual receipts exceed the exemption threshold. As noted in the TCAM proposal, certain IRS compliance tools will be needed to address this compliance issue.
A modernization of the IRS compliance program, making use of modern advanced analytical models to use additional data recommended by the TCAM proposal, would be an essential aspect of realizing the potential revenue that could be generated. This is explained in more detail in the section of the TCAM main proposal “How the modernized compliance and assistance program would work.”
In estimating the revenue gain, we’ve assumed a conservative curve that converges over 10 years. This estimate is discussed below in the section on projections.
Mid-sized Passthroughs: S Corporations and Partnerships
For the reasons discussed in the TCAM proposal, we did not include any estimate of revenue gains from passthroughs with over $25 million receipts. Although there are significant compliance issues with these large businesses, a different set of compliance tools is needed to address them. These are beyond the scope of TCAM.
TCAM proposes reforms for the compliance program for mid-sized passthrough businesses that’s similar to that for individuals with business income.
This includes increased reporting by banks of deposits and expenditures in the bank accounts used by taxpayers for their business activities, a schedule provided to the IRS to reconcile the bank reporting with the tax return and a modernized compliance program supported by advanced technology together with some focused field audits. The same exemption amount of $25,000 is assumed.
See Exhibit 4 for details of the calculations for this proposal.
We estimated the revenue gain from this proposal based on the only available IRS compliance study of S corporations and the latest IRS tax gap study for 2011 through 2013.
The IRS tax gap study provided data on the amount of underreported tax (NMA) and the percentage of underreported tax (NMP) by visibility category. Business income of sole proprietors fell into the lowest visibility category with an NMP of 55 percent.
The IRS study of S corporations found that those with under $200,000 receipts (2004 dollars) were comparable to small proprietors, while those over that level had an NMP that was half that amount.
Using these statistics, and SOI tax year 2016 data on the income of the mid-sized passthroughs, we calculated the net gain in tax in the same manner as described above for individuals with underreported income.
We then adjusted the gain for the amount that would be collected through existing enforcement.
For all unreported income, enforced and late payments are 14 percent of the gap. In the case of these entities, there’s negligible direct enforcement, but assuming that some unreported income is detected in audits of individuals, we assumed that half of this general ratio is collected.
These calculations result in a net gain in tax year 2016 of $52 billion if the proposal were fully effective in that year. This is equivalent to $64 billion in 2019 dollars.
We assume that the taxpayer response and phase-up curve of compliance would be the same as discussed above for individuals with business income. This phase-in methodology is discussed further in the section on projections.
As discussed above, the revenue gain from proposed reforms under TCAM was estimated for a baseline year, using the best available and most recent data.
This estimate was then projected forward for the 10-year period 2020 through 2029 using a convention that the reforms were passed into law in 2019 and made effective as of January 1, 2020.
Using this convention, the estimates in this report could readily be revised for an assumption about any later start year. The projection includes assumptions about realistic phase-in periods and other adjustments as discussed below.
Any multi-year projection is subject to error because of variations in the forecast of underlying macroeconomic variables, such as GDP and total tax receipts. We used the latest Congressional Budget Office (CBO) projections for these variables and therefore our projections contain the same level of likely variations as the CBO projections, which are also used to project tax revenue in the existing tax system. On a relative basis, we do not know of any reason that the revenue results under our reform proposal would vary more or less than those the CBO makes for the current tax system.
We applied the same methodology for the tax gap proposals for individuals with business income and medium-sized passthroughs.
We projected forward the estimated tax gain from the base year of 2013 using CBO’s projection of total federal tax receipts. We used this index because the tax gap itself is a calculation of the shortfall in receipts from taxes that are due but not paid. The tax gap ratio to total receipts has been reasonably steady over the last several compliance studies.
We then adjusted the projected gain downward to reflect a phase-in period over the 10-year period.
As discussed in our TCAM proposal, we believe the level of compliance will generally follow an upward curve converging to the limit. Some initial voluntary compliance will occur for the reasons discussed.
The timeline for the start-up of the program is based on the following key milestones:
- Authorizing legislation passed (assumed 2019).
- First year of TCAM (2020). IRS issues guidance to taxpayers, and preparers for taxpayers with more than $25,000 of business income not otherwise reported, to list their bank accounts in connection with their tax year 2019 returns, and to so notify their banks.
- Second year of TCAM (January/ February 2021). Banks provide IRS universal bank account file. Banks provide IRS and taxpayers new 1099s on taxpayer-designated accounts.
- Second year of TCAM (Filing Season 2021). Taxpayers file returns with new reconciliation schedule.
- Second year of TCAM (2021). IRS initiates traditional examinations of returns with new schedules.
Beginning in the second year, a modest amount of enforced compliance will occur, and then will increase as the IRS builds its enhanced technology-enabled compliance program. Compliance gains will then level off and only increase gradually as fewer new enforcement cases will occur.
These ratios are shown in Exhibit 1, Revision One, as the voluntary compliance ratio and the enforced compliance ratio.
Our assumption is that the voluntary compliance ratio will start at 20% percent, which means that 20% of the difference between the lower visibility category and the next lowest would be reported.
Two factors support the assumption of some initial increase in voluntary reporting.
First, about 35% of the sole proprietor tax gap is from taxpayers with relatively large amounts of business income, over $55,000 in 2019 dollars. It would be difficult and risky for these taxpayers to avoid the reporting requirement.
Second, history shows that when additional specific supporting documentation is required from taxpayers, compliance increases. See Exhibit 5 for the effect of additional reporting in the Tax Reform Act of 1986.
Some revenue will be received in the first full year of the program (assumed 2020), because taxpayers with business income must file quarterly estimates and are subject to penalties for underpayment.
At the end of the 10-year period, nearly the full projected tax gain is achieved.
This assumption does NOT imply 100 percent compliance in reported income. It only implies that misreporting will be reduced to the misreporting percentage associated with the next higher level of visibility of income. For example, misreporting by individuals with income in the lowest visibility category, which is 55 percent, would drop to 17 percent misreporting associated with the next visibility category. In other words, in this example, even after 10 years of increased reporting and enhanced 100 percent technology processing of returns, it assumes that the tax on 17 percent of the business income still would not be reported. This level of underreporting is more than 3 times the level of misreporting for income such as dividends and interest that receive 1099 reports (which is 5%).
Overall, during the 10-year period, the TCAM proposals would steadily shrink the tax gap as compared to its current unmitigated trajectory. By 2029, it would reduce the gap by approximately $273 billion, a 29% reduction.
While we have not estimated what would happen after the first 10-year period, we believe the gradual progress in shrinking the gap would continue. Even after the projected gains in the first 10-year period, 71% of the tax gap would remain to be addressed. Some staff resources could be reassigned from cases with business returns to non-business returns and non-filing cases. The nature of the process proposed by TCAM is one of continuous improvement, using data gathered to improve the models and the process. This would enable increasingly precise assessments of non-compliance in specific returns and increasing efficient communications with taxpayers.