Diving into the U.S. Tax Gap

In case you missed it, the IRS recently released new data on the federal tax gap, indicating that US taxes owed but unpaid totaled an estimated $700 billion in 2022. After late payments and enforcement, the net gap is estimated to be around $606 billion, accounting for 2.7% of US GDP. At these numbers, even small improvements in compliance rates would have tremendous revenue potential, but despite IRS efforts to improve compliance, the estimated voluntary tax compliance rate in the US has remained steady for the last decade at around 85%. Why? In today’s blog, we’ll do a deep dive into the new data in order to understand what fuels the US tax gap, why compliance rates remain where they are, and what the IRS can (and can’t) do about it.

Diving into the Gap

First, let’s look at what comprises the $696 billion gross tax gap. The IRS breaks it into three major categories: Those who filed tax returns on time but underreported their income; those who filed returns on time but did not pay their taxes owed; and those who either filed late or not at all. It’s clear from the data that those who under reported their earnings were by far the largest contributor to the tax gap:

• $539 billion (77%): Underreported liabilities on returns filed on time
• $94 billion (14%): Unpaid liabilities on timely filed returns
• $63 billion (9%): Tax owed on late or unfiled returns

Now, let’s look at the tax gap by type of tax owed. The IRS data breaks this into four categories:  individual income taxes, corporate income taxes, employment taxes and estate taxes. Slicing the data this way, it’s evident that individual taxes owed are by far make the largest portion of the tax gap:

• Individual taxes owed: $514 billion (77%)
• Employment taxes owed: $127 billion (18%)
• Corporate income taxes owed: $50 billion (7%)
• Estate taxes owed: $5 billion (1%)

Next, let’s look at the $539 billion portion of the tax gap caused by underreporting, and further break this down into the type of underreporting that is occurring. Based on the two previous data sets, it makes sense that individuals are likely to comprise a large portion of underreporting. Indeed, the IRS data indicates that individual underreporting makes up over 70% of this segment. In fact, individual underreporting comprises over half of the total 2022 tax gap (55%), at $381 billion. Individual underreporting is followed by employment tax underreporting at $111 billion or 16%, corporate underreporting at $44 billion or 6%, and estate tax underreporting at $2 billion, or less than half of one percent.

Let’s dive further into this individual underreporting segment constituting 55% of our total tax gap. Within the $381 billion individual underreporting segment, the largest contributor is the underreporting of individual business income, which contributed $194 billion to the total tax gap in 2022. This equates to roughly 28% of the total tax gap!

Within this category, individual business income is followed by non-business income underreporting ($87 billion or 13%), and several smaller contributors. The individual business income category is by far the largest component of the individual underreporting sub-segment, as well as the underreporting segment overall – making it the largest contributor to the total tax gap. Almost one-third of the total 2022 US tax gap stems from individuals underreporting their business income.

This data aligns with other IRS data regarding underreporting among the US population. The percentage of US individuals who underreport their income on tax returns is estimated to vary by income type and taxpayer category, but according to IRS studies, underreporting of income is concentrated primarily among business owners and high-income individuals. Specifically:

• For individual taxpayers overall, underreporting is more prevalent among those who operate businesses or engage in self-employment. Small business income     (like sole proprietorships) is particularly prone to underreporting, with audits showing that as much as 54% of sole proprietorship income goes unreported.
• In general, up to 25-30% of taxpayers underreport some form of income on their returns. This issue is less frequent among wage earners, whose income is subject to third-party reporting (e.g., W-2s and 1099 forms based on USD payments), resulting in relatively high compliance. In contrast, individuals with pass-through business income, rental income, cash-based businesses, and freelance earnings that are paid in cash or cryptocurrency are more likely to underreport, as these income streams are not always subject to the same degree of reporting oversight.
• At the top end of the income spectrum, high-net-worth individuals and businesses often employ complex strategies to reduce their taxable income, making detection harder despite higher audit rates among these groups.

Why is Underreporting so Prevalent?

The high rate of underreporting among individuals is often due to factors other than the obvious motivation to avoid paying taxes: many well-meaning individuals are unaware of tax regulations, or do not understand them. The leading drivers for underreporting are:

1. Complexity and Informality
   Many individual businesses, especially small enterprises, freelancers, and gig economy workers, operate in less formal sectors. With inconsistent bookkeeping and a lack of third-party reporting (e.g., W-2s for salaried employees), these businesses have more room to underreport income or inflate deductions. The IRS notes in its report that wherever third-party reporting is not required, compliance is notably lower, concluding that a lack of third-party reporting contributes significantly to the tax gap. In fact, the IRS estimates that 55% of income generated where there is little or no information reporting is misreported.
2. Cash-Based Transactions
   Some businesses, such as those in the sports memorabilia business as well as those in service industries (restaurants, contractors, and personal services), rely heavily on cash transactions, making it easier to omit portions of their income from tax filings. Inaccurate bookkeeping further complicates reporting.
3. Lack of Awareness or Intentional Non-Compliance
       As previously noted, many small business owners are simply unaware of     their tax obligations, while others intentionally evade taxes by omitting     business revenue based on the limited visibility of the actual income to     the IRS. The lack of tax compliance is increasingly common in emerging or     digital economies, where individuals operating short-term rentals, selling     goods or services on various eCommerce platforms, operating cash-based     businesses or trading in cryptocurrencies may not even care pr be aware of     tax compliance requirements. As the digital economy continues to grow, so     will this challenge.
4. Challenges in IRS Auditing
   With limited resources, the IRS must be highly selective and strategic about where to apply its resources. With current IRS tools and approaches, 50% of all IRS audits end with “no change”, effectively wasting key audit operational capacity.  As a result, many underreporting cases go undetected or un-audited due to limited IRS audit resources, especially in sectors with limited third-party reporting.    

The factors contributing to underreporting make it clear why compliance rates remain stubborn. And with the IRS strapped by limited resources, identifying individual underreporting is a challenge, thanks to the informality common in many existing and emerging sectors, as well as the lack of third-party reporting.

Tackling Tax Underreporting in the Digital Age

With this baseline understanding of what fuels the US tax gap and why compliance rates remain where they are, let’s look at what the IRS can (and can’t) do about it.

· Given limited resources, efficiency must be a top consideration. Compliance efforts requiring large investments of time, money, or staff will fail before they have a chance to succeed.

· Given the high prevalence of underreporting, targeting the highest-impact players is required. A randomized, needle-in-the-haystack approach is both inefficient and ineffective.

· Given the informal and often anonymous nature of the sectors where underreporting most often occurs(such as rental income, gig economy work, cash-based businesses, and crypto trading), relying on traditional methods of detection are not effective. 

To successfully address these challenges, the IRS needs access to new technologies and different methodologies that can enable a new approach to closing the tax gap.

This is where tax tech innovators like IVIX can help. IVIX leverages Open-SourceIntelligence (aka OSINT, or publicly available data), alongside specially trained AI and machine learning tools tailored to detect and analyze business activity in specific markets where tax noncompliance is most likely to occur, including short-term rentals, cash-based businesses, the gig economy, cryptocurrency, and eCommerce, among others.

This gives tax authorities better visibility into true business activity in these sectors, which can then be automatically matched against internal data to reveal discrepancies between reported income and actual business activity, significantly boosting efficiency and reducing false positives. Upon identifying potential instances of tax noncompliance, IVIX delivers these leads to tax authorities, ranked by potential impact, so those with the greatest impact can be prioritized.

This proactive, targeted approach leverages the digital economy to deter the noncompliance it enables. Several state and federal tax authorities within and outside the US are using IVIX’s solutions with promising results.

As noted by one US tax authority, "The IVIX leads include taxpayers who have not filed with us or who may have substantially under-reported their income, expanding our reach to more noncompliant taxpayers to recover more tax revenue and hopefully increase voluntary tax compliance going forward.”  

Conclusion

The IRS’ new data on the 2022 tax gap reveals the critical role of individual business income underreporting in the federal tax shortfall, fueling nearly one-third of the total gap.

Given the nature of individual underreporting, what factors contribute to stubborn noncompliance rates, and the IRS’ limited resources, the IRS can no longer rely solely on traditional methods for detection and enforcement.

Innovative new tax compliance solutions offer a proactive, targeted approach, helping tax authorities see beyond the tip of the iceberg to identify non-compliance quickly and prioritize audits more effectively.

Tax authorities who have put these new tools into practice are seeing promising results that, in the long run, can not only help recover lost revenue but also foster compliance, benefiting both businesses and the government.

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