Tax Evasion and the Tax Gap

How much tax goes uncollected because of evasion, why people evade taxes, and what tools governments use to close the gap.

The tax gap is the difference between the tax that should be paid under the law and the tax actually collected. It arises from underreporting income, not filing returns and not paying on time.

How large is it?

In the United States, the Internal Revenue Service estimated the gross tax gap at over 600 billion dollars a year in recent years, around 15 percent of taxes owed. Estimates for developing countries are often higher as a share of revenue, though harder to measure.

Why people evade

Economic models of tax evasion, starting with work by Michael Allingham and Agnar Sandmo in 1972, treat evasion like a gamble: people weigh the money saved against the chance of being caught and the penalty. But real behaviour also depends on:

Opportunity: income that is not reported by others, such as cash business income, is easier to hide.
Tax morale: people’s sense of duty and whether they trust the government to use taxes well.
Social norms: whether others are believed to pay.

Third-party reporting

The most powerful tool against evasion is third-party reporting: when employers, banks or others report income directly to tax authorities. Research by Henrik Kleven and colleagues in Denmark found that evasion was very low for income subject to third-party reporting, such as wages, but much higher for self-reported income.

This is why wage earners, whose income is reported by employers, generally pay what they owe, while evasion is concentrated among self-employed and cash-based businesses.

India’s efforts

India has expanded third-party reporting through TDS, the Annual Information Statement, which compiles information on bank interest, investments, property purchases and large transactions, and GST’s digital invoice systems. Demonetisation in 2016 and digital payments were also presented as steps against untaxed cash.

Why wage earners rarely evade

An office worker's salary is reported by her employer, and tax is deducted at source. Hiding income would be nearly impossible. A shopkeeper paid largely in cash has far more opportunity to underreport sales. This difference in reporting, not honesty alone, explains much of who evades.

Other tools

Audits, penalties, simplified tax systems and building trust in government through visible public services also help. Nudges, such as letters telling taxpayers that most people pay on time, have been found to increase compliance modestly.

Thinking evasion is only about honesty

Opportunity matters enormously. Where income is reported by third parties, evasion is low regardless of individual attitudes. Designing systems that reduce the opportunity to hide income is often more effective than relying on honesty alone.

Key takeaways

The tax gap is the difference between tax owed and tax collected.
The U.S. gross tax gap has been estimated at over 600 billion dollars a year.
Third-party reporting sharply reduces evasion, which is concentrated in self-reported income.
India uses TDS, the Annual Information Statement and GST invoices to expand reporting.