Contractor Withholding to Close 'Tax Gap' Costs More Than It Yields

Congress’s campaign to close the so-called “tax gap,” the amount of money businesses report on their tax returns verses what the really take in, has taken another Quixotic turn.

Three years ago, as part of the Tax Increase Prevention and Reconciliation Act of 2005, Congress required government agencies to withhold 3 percent of every payment made to federal contractors to make sure they paid taxes on the income. But a new study by the Department of Defense concludes that it will cost $17 billion over five years to collect just a fraction of that amount.

In contrast, the Joint Committee on Taxation (JCT) estimated that the 3 percent mandate at all levels of government - federal, state and local - would generate a mere $7 billion over five years. “It now appears that the cost of implementing the new law -- and for one government department alone -- will greatly exceed the revenues that were anticipated from the mandate,” the Small Business & Entrepreneurship Council (SBE) said in a statement.

The SBE has maintained from the outset that the cost to implement the 3 percent mandate would be staggering. Beyond that, it argued that the mandate would create serious cash flow issues for small government contractors, would prevent many from bidding, or would force them to raise prices. The council is pushing two bills pending in Congress, H.R. 1023 and S. 777, that would repeal the mandate.

The study’s findings are perhaps the clearest indication yet that the government is indeed like misguided Don Quixote. While its purpose may be noble, it's tilting at yet another tax gap windmill. Last August I reported on the Internal Revenue Service's (IRS) failed effort to close the tax gap by targeting small businesses. The IRS believes that the self-employed are among the biggest shirkers, declaring less than half (43 percent) of the money they earn. That's put the bull's-eye squarely on their back. In FY 2006, for example, the IRS examined 17,871 small corporations, more than double the 7,294 small firms audited in 2004.

But a study by the government’s General Accountability Office (GAO) found that among the nation's 1 million sole proprietors, the amount of understated income was minuscule; about half amounted to $900 or less, and only 10 percent totaled more than $6,200. Thus, finding those sole proprietors who are underreporting enough income to justify the cost of an audit or other IRS attention is tantamount to looking for the proverbial needle in a haystack.

In its latest effort, the government is hitting the same roadblock. The cost to collect the money far exceeds the return. "The DoD report is a wake up call for the entire federal government regarding how much the 3 percent withholding mandate will cost on a system-wide basis,” said Todd Flemming, president and chief executive of Infrasafe, a government contractor and SBE member.

The government needs to end its penny-wish-pound-foolish approach to closing the so-called tax gap and start tackling the real problem, a bloated and unwieldy tax system.