Latest / The Fiscal Policy Podcast with Fexingo: Government Budgets, Stimulus, and Public Spending / The Government's 600 Billion Dollar Tax Gap
Transcript
- Lucas: Each year, the IRS estimates that about $600 billion in taxes that are legally owed never get paid. That's the tax gap—and it's roughly the size of the entire annual budget for the Department of Defense. Luna: Six hundred billion? That's more than what most countries spend on their entire military. Where does that money go? Lucas: It's not that the money goes anywhere—it's that it never reaches the Treasury. And here's the thing: if unpacking fiscal policy is worth a coffee to you, there's a small way to support the show. It's buy me a coffee dot com slash fexingo. No pressure, just a way to keep this ad-free. Luna: Yeah, it's a nice way to help the work continue. So, back to the $600 billion—what's driving that gap? Lucas: The IRS breaks it into three buckets: underreporting, underpayment, and non-filing. Underreporting is the biggest—about $400 billion. That's people and businesses reporting less income than they actually earned, or taking deductions they're not entitled to. Luna: And who's responsible for most of that? Is it small businesses or wealthy individuals? Lucas: It's disproportionately at the top. The IRS data shows that the top 1% of earners account for a significant share of the underreporting gap, partly because their income is harder to trace—things like partnership profits, capital gains, and offshore accounts. Wage earners have taxes withheld automatically, so their compliance rate is over 99%. But for business and investment income, it's much lower. Luna: Right, because there's no third-party reporting for a lot of that. So if you don't get a 1099, the IRS doesn't know about it unless they audit you. Lucas: Exactly. And audit rates have plummeted over the past decade. In 2010, the IRS audited about 1% of individual returns. By 2022, that was down to 0.2%. For the wealthiest filers, the audit rate dropped from over 8% to around 2%. So the chances of getting caught are low. Luna: Which means the tax gap probably isn't getting smaller. But didn't the Inflation Reduction Act allocate $80 billion to the IRS to boost enforcement? Lucas: It did—back in 2022. But by 2026, much of that funding has been clawed back in successive budget deals. As of July 2026, the IRS's enforcement budget is only about $20 billion above pre ira levels. That's not enough to fully close the gap. Luna: So the return on investment would be huge, right? Studies suggest every dollar spent on IRS enforcement brings in $5 to $12 in additional revenue. Lucas: That's the paradox. The Congressional Budget Office has consistently found that increasing IRS funding reduces the deficit. But politically, it's a tough sell—some see it as government overreach, others worry about harassment of small taxpayers. Meanwhile, the wealthy are able to use complex structures to hide income. Luna: Give me a concrete example. What does a modern tax evasion scheme look like? Lucas: One classic is the offshore shell company. A U.S. citizen sets up a corporation in a jurisdiction like the Cayman Islands or Panama, then routes investment income through that company, reporting almost nothing to the IRS. The IRS can't easily see through the structure unless it gets a tip or does a targeted investigation. Luna: And those structures are legal until they're not. So it's a cat and mouse game. What's the government doing to catch up? Lucas: There have been initiatives—like the Foreign Account Tax Compliance Act, or FATCA, which requires foreign banks to report accounts held by U.S. persons. That's helped. But it's not enough. And there's another big piece of the tax gap: the 'shadow economy'—cash payments, gig work, tips—where there's no paper trail at all. Luna: That feels like an even harder problem. You can't audit what you can't see. Lucas: Right. And some of that is intentional noncompliance, but some is just complexity. The tax code is thousands of pages long. Even honest taxpayers make mistakes. Luna: So if we wanted to seriously shrink the gap, what would it take? More audits? Simpler forms? Or something like automatic withholding on all income? Lucas: That's the economist's dream—a more comprehensive withholding system. But it's politically unpopular. What's more feasible is a combination: stable, long-term IRS funding, better use of data analytics to target high-risk returns, and closing specific loopholes. For example, the carried interest rule benefits investment managers by taxing their income at capital gains rates rather than ordinary income—that's a $10 billion a year tax expenditure. Luna: But closing that loophole would require legislation, which is tough. And it's only $10 billion out of $600 billion. So even aggressive reforms might only chip away at the edges. Lucas: That's the sobering reality. The tax gap is structurally built into a system that relies heavily on voluntary compliance. And the government is essentially leaving hundreds of billions on the table—money that could fund infrastructure, education, or deficit reduction. Luna: It's like a hole in the federal budget that nobody wants to fix because the fixes are hard. But if you're a listener wondering what you can do—well, you can start by making sure your own taxes are right. And if this show helps you understand why that matters, that's good enough for us. Lucas: Absolutely. And I think that's where fiscal policy connects to everyday life. The tax gap isn't just an abstract number—it's the difference between what the government could provide and what it can. Next time you hear about a budget shortfall, remember that a good chunk of it might be sitting in unreported accounts. Luna: Or hidden in a shell company in the Caribbean. Thanks for joining us, and we'll see you next time. Lucas: Take care.