UPDATE 3-Paulson says most of U.S. 'tax gap' uncollectible

(Rewrites first paragraph, adds comments from Q-and-A period)

By Glenn Somerville

WASHINGTON, April 18 (Reuters) - U.S. Treasury Secretary Henry Paulson said on Wednesday it would require "draconian" measures to significantly narrow the gap between the taxes Americans owe and what they pay.

The Internal Revenue Service, a part of the Treasury Department, estimated that in the 2001 tax year, the gross tax gap was $345 billion, mostly because people underreported their income. Paulson suggested a lot of it will never be collected.

"I have come to the conclusion that there is a big part of the tax gap we simply won't be able to reach without adding draconian and painful requirements on all taxpayers," Paulson told the Senate Finance Committee.

His testimony drew an angry response from some lawmakers who protested that the Treasury needed to develop better plans to ensure the tax burden is fairly shared.

"The idea that we can't do better is a little bit insulting," said Democratic Sen. Charles Schumer of New York. He called it "inexcusable that we have let tax avoidance and evasion get to this level."

WARNS OF DISRESPECT

Committee Chairman Sen. Max Baucus of Montana said permitting such a huge tax gap to exist without action "breeds disrespect for the law" and needs to be dealt with quickly.

Baucus said that since 2001 some $2 trillion that should have been collected by the IRS had gone uncollected.

The hearing was held one day after the deadline for American taxpayers to file their 2006 tax returns.

Democrats, who now control both houses of Congress, have focused on the tax gap issue as one that deprives the government of revenues. But Paulson said that substantially improving taxpayer compliance would put a burden on those who do pay what they owe as well as those who don't.

"I don't believe any of us really want to do that," he said. "We must remember that the tax gap is simply not a pot of gold that we can dip into every time we want to pay for a new or expanded program."

The IRS estimate of the tax gap in 2001 concluded that 83.7 percent of taxpayers voluntarily complied with their requirement to pay taxes. It said that if taxes that were paid late, as well as IRS recoveries, were counted, the net tax gap was about $290 billion in 2001 for about an 86.3 percent compliance rate.

BOOST COMPLIANCE

Baucus said the Treasury must adopt a goal of achieving 90 percent taxpaying compliance within the next 10 years and dueled with Paulson over whether he had a realistic plan.

Paulson said the Treasury had developed a strategy for increasing compliance that focused on measures like determining why taxpayers underreported their income and targeting enforcement actions more efficiently.

He derided some proposals that have been offered as "unnecessarily painful, expensive and time-consuming," like requiring individuals to file forms with the IRS reporting their transactions with doctors, auto mechanics and dry cleaners who might not report the fees they charge.

Baucus urged Paulson to develop a plan within three months to ensure 90 percent compliance, saying what has been proposed so far lacked credibility.

"I would like to be able to say with some credibility and without fooling people that there is a clear path to 90 percent," Paulson said.

"I can't see the steps we can take and I haven't heard from you or anyone else a set of steps that could be taken ...to close that gap all the way to 90 percent," Paulson added. (Additional reporting by David Lawder)