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Closing the Tax Gap

As the Senate Budget Committee discusses the tax gap, it must also be aware of the gap between the wealthiest and the less-so.

The Senate Budget Committee met today to consider strategies for reducing the growing tax gap. Every year there is a gap between what some Americans owe and what they pay. In 2001, the IRS estimated the tax gap at $345 billion—that’s 16.3 percent of total revenue. After the $55 billion that the IRS expects to eventually recover, the net tax gap would be $290 billion. President Bush has done little to close tax gaps, even as they lead to taxes that are higher than need be for millions of honest taxpayers.

The majority of Americans pay their taxes in full and on time. But about half of lost revenue comes from individuals who underreport income.

But this is only one of the gaps facing the average American family. The other is the gap between the wealthiest taxpayers and those in lower tax brackets. Recent changes in the tax system give an annual average cut of more than $100,000 to Americans with incomes over $1 million, while middle-income families with incomes between $26,000 and $45,000 receive about $650, and lower-income families even less. These changes have exacerbated the existing inequalities in incomes while also neglecting to meet the financial needs of middle and lower income families.

One way to help close this second gap while making the tax code simpler would be to reform the Child Tax Credit and Earned Income Tax Credit.

Making the Child Tax Credit refundable to all families with a payroll tax liability—regardless of the amount they pay in federal taxes—will immediately make the credit available to more low-income families. Low-income families with minimal federal tax liabilities currently receive limited help from the Child Tax Credit, yet many of these families still have significant payroll tax liabilities—more than 95 percent of Americans in the bottom 20 percent of the population pay more in payroll tax than in federal income tax.

The Earned Income Tax Credit can also be improved to make it fairer for low income Americans by:

  • Reducing the marriage penalty that can cause more than half of low-income married couples to have lower benefits.
  • Tripling the small credit for childless workers in order to increase the work incentive for disadvantaged young adults. This change would benefit about four million people, yielding an average tax savings of about $750 annually.
  • Creating an additional credit for families with three or more children. The amount that families receive increases with family size up to two children, but there is no additional credit for families with three or more. Adding additional credits would benefit about three million low income families.

Already, almost 50 percent of Americans believe that lower-income people pay too much money in taxes. Seven out of 10 Americans say their taxes are too complicated. And six out of 10 Americans from all age, income, and education groups believe the tax code is unfair.

Not only would these changes make the tax code fairer, but changing the EITC would cost only around $7 billion annually, which is a mere two percent of the annual tax gap. In a 2002 report, Charles Rossotti, a former commissioner of the IRS, estimated that the IRS could collect an extra $30 billion each year with only a two percent growth in staff. That extra money could be used to fund changes that would lead to a simpler, fairer tax code.

This hearing is a good first step toward tax reform. Americans deserve a tax system that is simple, fair, and modern.

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