A USA Today headline said, "Democratic House Means Changes in Tax Agenda." If so, such changes will be small and subtle. Congressional Democrats might want to reverse the tax cuts of 2003, but they know they can't override a presidential veto. There is no point in appearing eager to raise taxes before the next presidential election, since doing so would just make it easier to lose in 2008. Since most tax cuts expire in 2010 anyway, all the pro-tax Democrats need to do is to lay low, not show their hand and stall for time.

The new chairman of the House Budget Committee, South Carolina's John Spratt, cleverly advised CNBC that Democrats would focus on narrowing "the tax gap." That refers to the difference between taxes owed and taxes actually paid -- as a result of understating income, overstating deductions and credits, not making required payments or failing to file a tax return.

Who could object to closing the tax gap? Certainly not the IRS, which deploys "tax gap" estimates as a reason to keep increasing the agency's $10.6 billion budget. If the House Democrats are simply hoping to fund an even more aggressive and more intrusive IRS, however, the effort may not prove as popular as it sounds.

The Treasury's Office of Tax Policy already issued a "Strategy for Reducing the Tax Gap" in late September. That paper estimated that 71 percent of the gap was due to the individual income tax, 17 percent to payroll tax, 9 percent to the corporate tax and 2 percent to the estate tax. More than 80 percent of the overall gap is caused by underreporting income (particularly small business income) or overstating tax deductions and credits. About 7 percent of the gap is from failing to file tax returns, while another 10 percent is largely due to employers and the self-employed failing to withhold payroll and/or income taxes.

Small business is estimated to account for 32 percent of the tax gap. But there is no reason to assume that the offending taxpayers typically have high incomes. After all, auditing small business accounted for 37 percent of the IRS enforcement expenditure in 2006, and the number of high-income audits more than doubled from 2001 to 2004.

Businesses too tiny to merit such expensive auditing seem more likely to slip by. There may, however, be inherently difficult problems of auditing the huge number of Subchapter S corporations, partnerships and limited liability companies now choosing to be taxed as individuals rather than corporations. If so, the best solution to that problem may be to reduce the corporate tax rate, as nearly all other major nations have done.

Since nearly the entire tax gap is within the individual income tax, rather than corporate tax, we can get a good idea of what makes that gap widen or narrow by looking the "AGI Gap" -- the difference between Adjusted Gross Income (AGI) as reported on individual tax returns and AGI as measured as by the Bureau of Economic Analysis (BEA).

The BEA estimates, based on carefully collected personal income data, are much larger than the amount of AGI that shows up on tax returns. Until very recently, that gap narrowed when the highest, most punitive tax rates were reduced and widened when top tax rates were increased. The AGI gap narrowed from 13.5 percent in 1984 to 9.6 percent in 1988, as the top tax rate fell from 50 percent to 28 percent. With tax rates on extra income sharply reduced, the risk-reward ratio tilted toward honesty. That is one reason tax receipts in 1988-89 turned out much larger than expected. Continued...