Close the annual IRS tax gap of $696 billion, help Department of Defense (DoD) address its significant internal control weaknesses and avoid the 8% proposed defense cut and get the US to recognize its $40 trillion of off-balance sheet unfunded entitlements
Let us begin by making the obvious point: there is waste or inefficiency in government, and we need to rationally address this problem. The IMF states that US government spending is around 36% of US GDP. But where should one begin? I suggest three areas that have not been as discussed as much.
1.0 Close the IRS tax gap
The Internal Revenue Service (IRS) publishes an estimate of the so-called tax gap every year. The tax gap is the amount of true tax liability that is not paid voluntarily and in a timely manner by taxpayers. For the latest available year, TY (tax year) 2022, the projected annual gross tax gap by the IRS is $696 billion. The TY 2022 gross tax gap comprises of three components:
- Nonfiling (tax not paid on time by those who do not file on time) $63 billion,
- Underreporting (tax understated on timely filed returns) $539 billion, and
- Underpayment (tax that was reported on time but not paid on time) $94 billion.
Cut a different way, the voluntary compliance rate is the “tax paid voluntarily and timely” divided by an estimate of “total true tax.” The projected voluntary compliance rate is 85 percent. The IRS estimates that the bulk of the gap is attributable to individual income tax ($514 billion). Corporate taxes, contrary to popular belief, is relatively small ($50 billion). The next largest line item is employment tax of $127 billion.
1.1 How can the tax gap be closed?
It is somewhat shocking that the last publication on reducing the tax gap that I could find on the IRS’ website was from July 2009! Back in 2006, US Department of Treasury looked at how we could reduce the tax gap. Four ideas were proposed: targeted legislative and administrative changes, taxpayer service, and enforcement efforts and of course congress can work on minimize tax burdens.
The biggest investment that the IRS needs is in information technology (reportedly $2.5 billion) and in enforcement agents. I suspect every dollar we put into information technology would pay for itself many times over. In this regard, I am not sure firing IRS agents helps in closing the tax gap.
How many boards in the private sector would turn down management’s request to spend $2.5 billion in spending to address an annual $700 billion opportunity? Even if the spending closes the tax gap by a $100 billion annually, the present value of that saving at a treasury bill rate of 5%, is close to $2 trillion (100/.05)!
2.0 Department of Defense (DoD)
In 2024, the DoD’s auditors issued a disclaimer audit opinion, meaning auditors could not express opinions on the financial statements because the financial information was not sufficiently reliable. The auditors flag significant deficiencies with framework of risk management, accounts receivable, non-compliance with several regulations and laws. In total, the audit unearthed 50 material weaknesses in several processes (budget to report, hire to retire, procure to pay, plan to stock and acquire to retire). Fifteen of these weaknesses were new and two were resolved from the opening balance of weaknesses. The numbers involved are big: the DoD had assets has $4.1 trillion and liabilities in $4.3 trillion. The cost of operations in 2023 is around $1.17 trillion.
None of these are easy fixes. But if we really care about improving efficiency and cutting waste, addressing these weaknesses and deficiencies would help immensely. The administration has explored an annual 8% cut in the defense budget. Addressing these internal control weaknesses might help recover some, if not most, of the money that an 8% cut would save, without affecting our defense preparedness.
3.0 Stop cash accounting for the US government
The US government uses an outdated, inaccurate accounting system that contributes greatly to America’s fiscal irresponsibility: cash accounting. In essence, the US government books cash that comes in via tax receipts as revenues ($4.9 trillion in 2024) and cash outlays for defense needs, social security payments and medical bills today as expenses ($7.4 trillion in 2024). Cash accounting produces a highly inaccurate budget number that does not acknowledge bills that we know we must pay in the future like tax cuts, increases in benefits payable to federal employees or new obligations incurred due to promised Social Security, Medicare and Medicaid or the absence of assets or funds set aside for promises we have already promised to citizens.
The quality of financial reporting practiced by the U.S. would make Enron blush. The U.S. government is using accounting practices that we do not recommend or endorse even in a first-year business school class.
To put this another way, the Treasury bills owed by the U.S. — or the debt number often referred to in casual conversations — stands at around $28 trillion. But if you look at what the nation really owes, especially related to Social Security, Medicare and Medicaid, that liability number, on a present value basis, is pushed closer to $78 trillion over the next 75 years. Even if you cut that number by half to recognize unfunded obligations that have already been promised to current citizens over the next 30 years or so, we are looking at an obligation of roughly $200,000 per citizen ($67 trillion of obligations for 340 million citizens).
You may ask how would accounting for this in reported deficit number solve anything. That is exactly what the big three Detroit car makers used to argue when they were asked by the FASB to report unfunded pensions and healthcare promises in their financial statements. Reporting these obligations forced cuts in these benefits and greatly improved the competitiveness of our big three car makers. Accounting for the true deficit stops us from lying to ourselves.
These are not new problems precisely because they are hard to fix. But fresh eyes and energy that the DOGE can bring to these chronic issues would help the country for decades to come.