Tax Gap
Making Significant Progress in Improving Tax Compliance Rests on Enhancing Current IRS Techniques and Adopting New Legislative Actions
Gao ID: GAO-06-453T February 15, 2006
The Internal Revenue Service's (IRS) most recent estimate of the difference between what taxpayers timely and accurately paid in taxes and what they owed was $345 billion. IRS estimates it will eventually recover some of this tax gap, resulting in an estimated net tax gap of $290 billion. The tax gap arises when taxpayers fail to comply with the tax laws by underreporting tax liabilities on tax returns; underpaying taxes due from filed returns; or nonfiling, which refers to the failure to file a required tax return altogether or in a timely manner. The Chairman and Ranking Minority Member of the Senate Committee on the Budget asked GAO to present information on the causes of and possible solutions to the tax gap. This testimony addresses the nature and extent of the tax gap and the significance of reducing the tax gap, including some steps that may assist with this challenging task. For context, this testimony also addressed GAO's most recent simulations of the long-term fiscal outlook and the need for a fundamental reexamination of major spending and tax policies and priorities.
Our nation's fiscal policy is on an imprudent and unsustainable course. As long-term budget simulations by GAO show, over the long term we face a large and growing structural deficit due primarily to known demographic trends, rising health care costs, and lower federal revenues as a percentage of the economy. GAO's simulations indicate that the long-term fiscal challenge is too big to be solved by economic growth alone or by making modest changes to existing spending and tax policies. Rather, a fundamental reexamination of major policies and priorities will be important to recapture our future fiscal flexibility. Underreporting of income by businesses and individuals accounted for most of the estimated $345 billion tax gap for 2001, with individual income tax underreporting alone accounting for $197 billion, or over half of the total gap. Corporate income tax and employment tax underreporting accounted for an additional $84 billion of the gap. Reducing the tax gap would help improve fiscal sustainability. Given the tax gap's persistence and size, it will require considering not only options that have been previously proposed but also new administrative and legislative actions. Even modest progress would yield significant revenue; each 1 percent reduction would likely yield nearly $3 billion annually. Reducing the tax gap will be a challenging long-term task, and progress will require attacking the gap with multiple strategies over a sustained period. These strategies could include efforts to regularly obtain data on the extent of, and reasons for, noncompliance; simplify the tax code; provide quality service to taxpayers; enhance enforcement of tax laws by utilizing enforcement tools such as tax withholding, information reporting, and penalties; leverage technology; and optimize resource allocation.
GAO-06-453T, Tax Gap: Making Significant Progress in Improving Tax Compliance Rests on Enhancing Current IRS Techniques and Adopting New Legislative Actions
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Testimony:
Before the Committee on Budget, U.S. Senate:
United States Government Accountability Office:
GAO:
For Release on Delivery Expected at 10:00 a.m. EST:
Wednesday, February 15, 2006:
Tax Gap:
Making Significant Progress in Improving Tax Compliance Rests on
Enhancing Current IRS Techniques and Adopting New Legislative Actions:
Statement of David M. Walker: Comptroller General of the United States:
GAO-06-453T:
GAO Highlights:
Highlights of GAO-06-453T, a testimony before the Committee on the
Budget, U.S. Senate:
Why GAO Did This Study:
The Internal Revenue Service‘s (IRS) most recent estimate of the
difference between what taxpayers timely and accurately paid in taxes
and what they owed was $345 billion. IRS estimates it will eventually
recover some of this tax gap, resulting in an estimated net tax gap of
$290 billion. The tax gap arises when taxpayers fail to comply with the
tax laws by underreporting tax liabilities on tax returns; underpaying
taxes due from filed returns; or nonfiling, which refers to the failure
to file a required tax return altogether or in a timely manner.
The Chairman and Ranking Minority Member of the Senate Committee on the
Budget asked GAO to present information on the causes of and possible
solutions to the tax gap. This testimony addresses the nature and
extent of the tax gap and the significance of reducing the tax gap,
including some steps that may assist with this challenging task. For
context, this testimony also addressed GAO‘s most recent simulations of
the long-term fiscal outlook and the need for a fundamental
reexamination of major spending and tax policies and priorities.
What GAO Found:
Our nation‘s fiscal policy is on an imprudent and unsustainable course.
As long-term budget simulations by GAO show, over the long term we face
a large and growing structural deficit due primarily to known
demographic trends, rising health care costs, and lower federal
revenues as a percentage of the economy. GAO‘s simulations indicate
that the long-term fiscal challenge is too big to be solved by economic
growth alone or by making modest changes to existing spending and tax
policies. Rather, a fundamental reexamination of major policies and
priorities will be important to recapture our future fiscal
flexibility.
Underreporting of income by businesses and individuals accounted for
most of the estimated $345 billion tax gap for 2001, with individual
income tax underreporting alone accounting for $197 billion, or over
half of the total gap. Corporate income tax and employment tax
underreporting accounted for an additional $84 billion of the gap.
Reducing the tax gap would help improve fiscal sustainability. Given
the tax gap‘s persistence and size, it will require considering not
only options that have been previously proposed but also new
administrative and legislative actions. Even modest progress would
yield significant revenue; each 1 percent reduction would likely yield
nearly $3 billion annually. Reducing the tax gap will be a challenging
long-term task, and progress will require attacking the gap with
multiple strategies over a sustained period. These strategies could
include efforts to regularly obtain data on the extent of, and reasons
for, noncompliance; simplify the tax code; provide quality service to
taxpayers; enhance enforcement of tax laws by utilizing enforcement
tools such as tax withholding, information reporting, and penalties;
leverage technology; and optimize resource allocation.
IRS‘s Tax Year 2001 Gross Tax Gap Estimates by Type of Noncompliance
and Type of Tax:
[See Table 1]
What GAO Recommends:
GAO is not making any new recommendations but discusses some past
recommendations and highlights some new areas for possible attention.
www.gao.gov/cgi-bin/getrpt?GAO-06-453T.
To view the full product, including the scope and methodology, click on
the link above. For more information, contact Michael Brostek at (202)
512-9110 or brostekm@gao.gov.
[End of section]
Chairman Gregg, Senator Conrad, and Members of the Committee:
I appreciate this opportunity to discuss the annual tax gap--the
difference between what taxpayers timely and accurately pay in taxes
and what they should pay under the law--and how reducing that gap can
help the nation cope with its large and growing long-term fiscal
challenges. The Internal Revenue Service (IRS) most recently estimated
a gross tax gap that reached $345 billion for tax year 2001. IRS
estimated that it would recover around $55 billion through late
payments and IRS enforcement actions, resulting in a net tax gap of
around $290 billion.[Footnote 1] The tax gap arises when taxpayers
intentionally or unintentionally fail to comply with the tax laws.
Their failure to pay taxes increases the burden of funding the nation's
commitments for those taxpayers who voluntarily pay their taxes.
For context in considering the tax gap, I will first provide the
committee with an overview of the federal government's fiscal condition
and the challenges we will face in funding our nation's commitments.
Next, I will discuss the size and components of the tax gap. Finally, I
will discuss the significance of reducing the tax gap and various means
to achieve that goal, including measuring the extent of, and reasons
for, noncompliance; simplifying the tax code; improving taxpayer
service; enhancing IRS enforcement through the use of tools such as
withholding, information reporting, and penalties; leveraging
technology; and optimizing resource allocation.
My remarks are based on our previous work on a variety of issues, in
particular, recent testimonies and a report on reducing the tax
gap.[Footnote 2] These efforts were conducted in accordance with
generally accepted government auditing standards.
Let me begin by highlighting three major points:
* GAO's long-term budget simulations show that over the long term we
face large and growing structural deficits due primarily to known
demographic trends, rising health care costs, and lower federal
revenues as a percentage of the economy. Continuing on this
unsustainable fiscal path will gradually erode, if not suddenly damage,
our economy, our standard of living, and ultimately our national
security. Our current path also will increasingly constrain our ability
to address emerging and unexpected budgetary needs and increase the
burdens that will be faced by our children, grandchildren, and future
generations. Reducing the current tax gap would contribute to our
fiscal sustainability while simultaneously improving fairness for those
citizens who fully and timely meet their tax obligations.
* Underreporting of income by businesses and individuals accounted for
most of the estimated $345 billion tax gap for 2001, with individual
income tax underreporting alone accounting for $197 billion, or over
half of the total gap. Corporate income tax and employment tax
underreporting accounted for an additional $84 billion.
* Given the persistence and size of the tax gap, we need not only to
consider options that have been previously proposed but also explore
new administrative and legislative approaches to reducing the tax gap.
Even modest progress would yield significant revenue; each 1 percent
reduction would likely yield nearly $3 billion annually. Reducing the
tax gap will be a challenging, long-term task and progress will require
attacking the gap on multiple fronts and with multiple strategies over
a sustained period. These strategies could include efforts to regularly
obtain data on the extent of, and reasons for, noncompliance; simplify
the tax code; provide quality services to taxpayers; enhance
enforcement of the tax laws by utilizing enforcement tools such as tax
withholding, information reporting, and penalties; leverage technology;
and maximize resource allocation.
Long-term Fiscal Challenge Provides Impetus to Reexamine Tax Policies
and Compliance:
The federal government's financial condition and long-term fiscal
outlook present enormous challenges to the nation's ability to respond
to emerging forces reshaping American society, the United States' place
in the world, and the future role of the federal government. Over the
next few decades as the baby boom generation retires and health care
costs continue to rise, federal spending on retirement and health
programs--Social Security, Medicare, Medicaid, and other federal
pension, health, and disability programs--will grow dramatically.
Absent policy changes on the spending and/or revenue sides of the
budget, a growing imbalance between expected federal spending and tax
revenues will mean escalating and eventually unsustainable federal
deficits and debt that will threaten our future economy, standard of
living, and, ultimately, our national security. Ultimately, the nation
will have to decide what level of federal benefits and spending it
wants and how it will pay for these benefits.
GAO's long-term simulations illustrate the magnitude of the fiscal
challenges associated with an aging society and the significance of the
related challenges the government will be called upon to address.
Indeed, the nation's long-term fiscal outlook is daunting under many
different policy scenarios and assumptions. For instance, under a
fiscally restrained scenario, if discretionary spending grew only with
inflation over the next 10 years and all existing tax cuts expire when
scheduled under current law, spending for Social Security and health
care programs would grow to consume over 80 percent of federal revenue
by 2040. (See fig. 1.) On the other hand, if discretionary spending
grew at the same rate as the economy in the near term and if all tax
cuts were extended, by 2040 federal revenues may just be adequate to
pay only some Social Security benefits and interest on the growing
federal debt. (See fig. 2.)
Figure 1: Composition of Spending as a Share of GDP Under Baseline
Extended:
[See PDF for image]
Note: In addition to the expiration of tax cuts, revenue as a share of
GDP increases through 2016 due to (1) real bracket creep, (2) more
taxpayers becoming subject to the AMT, and (3) increased revenue from
tax-deferred retirement accounts. After 2016, revenue as a share of GDP
is held constant.
[End of figure]
Figure 2: Composition of Spending as a Share of GDP Assuming
Discretionary Spending Grows with GDP After 2006 and All Expiring Tax
Provisions are Extended:
[See PDF for image]
Note: This includes certain tax provisions that expired at the end of
2005, such as the increased AMT exemption amount.
[End of figure]
Addressing the projected fiscal gaps shown here will require
policymakers to examine the advisability, affordability, and
sustainability of existing programs, policies, functions, and
activities throughout the entire federal budget--spanning discretionary
spending, mandatory spending, including entitlements, and tax policies
and programs. Neither slowing the growth of discretionary spending nor
allowing tax cuts to expire--nor both options combined--would by
themselves eliminate our long-term fiscal imbalance. Additional
economic growth is critical and will help to ease the burden, but the
projected fiscal gap is so great that it is wholly unrealistic to
expect that we will grow our way out of the problem. The President's
2007 budget released last week included some proposals to reduce the
growth in Medicare spending. Whether or not these proposals are
adopted, they should serve to raise public awareness of the importance
of health care costs to both today's budget and tomorrow's. This could
also serve to jump start discussion about appropriate ways to control a
major driver of our long-term fiscal outlook--health care spending.
Clearly, tough choices will be required. Changes in existing budget
processes and financial, fiscal, and performance metrics will be
necessary to facilitate these choices.
Early action to change existing programs and policies would yield the
highest fiscal dividends and provide a longer period for prospective
beneficiaries to make adjustments in their own planning. The longer we
wait, the more painful and difficult the choices will become and the
less transition time we will have. By waiting, an important window is
lost during which today's relatively large workforce can increase
saving and begin preparing for the necessary changes in fiscal policy,
Social Security, and health care as well as other reforms that may be
necessary parts of the solution to this coming fiscal crunch. However,
the long-term challenge is fast becoming a short-term one as the
retirement of the baby boomers' generation will begin as early as 2008
and since overall workforce growth has already begun to slow. While our
long-term fiscal imbalance cannot be eliminated with a single strategy,
reducing the tax gap is one approach that could help address the
looming fiscal challenges facing the nation.
Underreporting Accounted for Most of the Tax Gap Estimate:
The tax gap is an estimate of the difference between the taxes--
including individual income, corporate income, employment, estate, and
excise taxes--that should have been timely and accurately paid and what
was actually paid for a specific year. The estimate is an aggregate of
estimates for the three primary types of noncompliance: (1)
underreporting of tax liabilities on tax returns; (2) underpayment of
taxes due from filed returns; and (3) nonfiling, which refers to the
failure to file a required tax return altogether or timely.[Footnote 3]
Estimates for each type of noncompliance include estimates for some or
all of the five types of taxes that IRS administers.
IRS develops its tax gap estimates by measuring the rate of taxpayer
compliance--the degree to which taxpayers fully and timely complied
with their tax obligations. That rate is then used, along with other
data and assumptions, to estimate the dollar amount of taxes not timely
and accurately paid. For instance, IRS most recently estimated that for
tax year 2001, 83.7 percent of owed taxes were paid voluntarily and
timely, which translated into an estimated gross tax gap of $345
billion. IRS developed these estimates using compliance data collected
through the National Research Program (NRP).[Footnote 4]
Using its recently collected compliance data, IRS has estimated that
underreporting of income represented over 80 percent of the tax gap for
2001 (an estimated $285 billion out of a gross tax gap estimate of $345
billion), as indicated in table 1.
Table 1: IRS's Tax Year 2001 Gross Tax Gap Estimates by Type of
Noncompliance and Type of Tax:
Dollars in billions.
Type of noncompliance: Underreporting;
Type of tax: Individual income tax: $197;
Type of tax: Corporate income tax: $30;
Type of tax: Employment tax: $54;
Type of tax: Estate tax: $4;
Type of tax: Excise tax: No estimate;
Type of tax: Total: $285.
Type of noncompliance: Underpayment;
Type of tax: Individual income tax: $23;
Type of tax: Corporate income tax: $2;
Type of tax: Employment tax: $5;
Type of tax: Estate tax: $2;
Type of tax: Excise tax: $1;
Type of tax: Total: $34.
Type of noncompliance: Nonfiling;
Type of tax: Individual income tax: $25;
Type of tax: Corporate income tax: No estimate;
Type of tax: Employment tax: No estimate;
Type of tax: Estate tax: $2;
Type of tax: Excise tax: No estimate;
Type of tax: Total: $27.
Type of noncompliance: Total;
Type of tax: Individual income tax: $244;
Type of tax: Corporate income tax: $32;
Type of tax: Employment tax: $59;
Type of tax: Estate tax: $8;
Type of tax: Excise tax: $1;
Type of tax: Total: $345.
Source: IRS.
Note: Figures may not sum to totals due to rounding.
[End of table]
Within the underreporting estimate, IRS attributed about $197 billion,
or about 57 percent of the total tax gap, to individual income tax
underreporting, including underreporting of business income, such as
sole proprietor,[Footnote 5] informal supplier,[Footnote 6] and farm
income (about $109 billion); nonbusiness income, such as wages,
interest, and capital gains (about $56 billion); overstated credits
(about $17 billion); and overstated income adjustments, deductions, and
exemptions (about $15 billion). Underreporting of corporate income tax
contributed an estimated $30 billion, or about 10 percent, to the 2001
tax gap, which included both small corporations (those reporting assets
of $10 million or less) and large corporations (those reporting assets
of over $10 million).
Employment tax underreporting accounted for an estimated $54 billion,
or about 16 percent, of the 2001 tax gap and included several taxes
that must be paid by self-employed individuals and employers. Self-
employed individuals are generally required to calculate and remit
Social Security and Medicare taxes to the U.S. Treasury each quarter.
Employers are required to withhold these taxes from their employees'
wages, match these amounts, and remit withholdings to Treasury at least
quarterly. Underreported self-employment[Footnote 7] and employer-
withheld employment taxes, respectively, contributed an estimated $39
billion and $14 billion to IRS's tax gap estimate. The employment tax
underreporting estimate also includes underreporting of federal
unemployment taxes (about $1 billion).
Taxpayers who do not file their tax returns on time or at all and
otherwise do not pay their tax liabilities accounted for the remainder
of the 2001 tax gap--around $61 billion. For example, nonfiling and
underpayment noncompliance by individual taxpayers alone contributed an
estimated $48 billion to this portion of the tax gap.
IRS has concerns with the certainty of the overall tax gap estimate in
part because some areas of the estimate rely on old data and IRS has no
estimates for other areas of the tax gap. For example, IRS used data
from the 1970s and 1980s to estimate underreporting of corporate income
taxes and employer-withheld employment taxes. For large corporate
income tax underreporting, IRS based its estimate on the amount of tax
recommended from operational examinations rather than the tax
ultimately assessed as part of the total tax liability.[Footnote 8]
According to IRS officials, IRS relies on the amount of tax recommended
because it is difficult to determine the true tax liability of large
corporations due to complex and ambiguous tax laws that create
opportunities for differing interpretations and that complicate the
determination. These officials further stated that because these
examinations are not randomly selected and are not focused on
identifying all tax noncompliance, the estimate produced from the
examination data is not representative of the tax gap for all large
corporations. They also explained that due to these complexities and
the costs and burdens of collecting complete and accurate data, IRS has
not systematically measured large corporation tax compliance through
statistically valid studies, even though the officials acknowledged
that such studies would be useful in estimating the related tax
gap.[Footnote 9]
IRS has no estimates for corporate income, employment, and excise tax
nonfiling or for excise tax underreporting. For these types of
noncompliance, IRS maintains that the data are either difficult to
collect, imprecise, or unavailable. In addition, it is inherently
difficult for IRS to observe and measure some types of underreporting
or nonfiling, such as tracking cash payments that businesses make to
their employees, as businesses and employees may not report these
payments to IRS in order to avoid paying employment and income taxes,
respectively.[Footnote 10]
IRS's overall approach to reducing the tax gap consists of improving
service to taxpayers and enhancing enforcement of the tax laws.
Recently, IRS has taken a number of steps that may improve its ability
to reduce the tax gap. Favorable trends in staffing of IRS enforcement
personnel; examinations performed through correspondence, as opposed to
more complex face-to-face examinations; and the use of some enforcement
sanctions such as liens and levies are encouraging. Also, IRS has made
progress with respect to abusive tax shelters through a number of
initiatives and recent settlement offers that have resulted in billions
of dollars in collected taxes, interest, and penalties. In addition,
IRS has successfully prosecuted a number of taxpayers who have
committed criminal violations of the tax laws.
Reducing the Tax Gap Will Require Expanding Existing Approaches and
Considering New Legislative Actions:
Given its persistence and size, we need not only to consider expanding
current approaches but also explore new legislation to help IRS in
reducing the tax gap.[Footnote 11] Although IRS has made a number of
changes in its methodologies for measuring the tax gap over the past
three decades, which makes comparisons difficult, regardless of
methodology the voluntary compliance rate that underpins the gap has
tended to range from around 81 percent to around 84 percent. Thus,
although the dollar amounts of the tax gap have changed, IRS has
consistently reported a persistent, relatively stable portion of the
taxes that should have been timely and accurately paid were not paid.
As we have reported in the past,[Footnote 12] closing the entire tax
gap may not be feasible nor desirable, as it could entail more
intrusive recordkeeping or reporting than the public is willing to
accept or more resources than IRS is able to commit. However, given its
size, even small or moderate reductions in the net tax gap could yield
substantial returns, which could improve the government's fiscal
position. For example, based on IRS's most recent estimate, each 1
percent reduction in the net tax gap would likely yield nearly $3
billion annually. Thus, a 10 percent to 20 percent reduction of the net
tax gap would translate into from roughly $30 billion to $60 billion in
additional revenue annually.[Footnote 13]
However, reducing the tax gap will be challenging[Footnote 14] and it
must be attacked on multiple fronts and with multiple strategies, some
of which follow.
Regularly Measure Compliance and Set Compliance Goals:
A critical step toward reducing the tax gap is to understand the
sources and nature of taxpayer noncompliance. Regularly measuring
compliance, including the reasons why taxpayers are not compliant, can
offer many benefits, including helping IRS identify new or growing
types of noncompliance, identify changes in tax laws and regulations
that may improve compliance, understand the effectiveness of its
programs to promote and enforce compliance, more effectively target
examinations of tax returns, and determine its resource needs and
allocations. Likewise, regularly measuring compliance can provide IRS
with information against which to set goals for improving compliance
and measure progress in achieving such goals.
In our July 2005 report on reducing the tax gap, we made
recommendations to IRS to develop plans to periodically measure tax
compliance; take steps to improve its data on the reasons why taxpayers
do not comply; and establish long-term, quantitative goals for
voluntary compliance levels with an initial focus on individual income
tax underreporting and total tax underpayment. Taken together, these
steps can help IRS build a foundation to understand how its taxpayer
service and enforcement efforts affect compliance and make progress on
reducing the tax gap. The Commissioner of Internal Revenue agreed with
our recommendations, highlighted challenges associated with them, and
commented on various steps IRS would take to implement each
recommendation. We are encouraged that according to IRS's Fiscal Year
2007 Congressional Budget Justification, IRS has recently established a
voluntary compliance goal, with a target of 85 percent voluntary
compliance by 2009, and plans to periodically measure progress against
this goal.
Simplify the Tax Code:
Efforts to simplify the tax code and otherwise alter current tax
policies may help reduce the tax gap by making it easier for
individuals and businesses to understand and voluntarily comply with
their tax obligations. Among the many causes of tax code complexity is
the growing number of preferential provisions in the tax code, such as
exemptions and exclusions from taxation, deductions, credits, deferral
of tax liability, and preferential tax rates.[Footnote 15] Tax
expenditures--as they are known by statute[Footnote 16]--can be a tool
to further some federal goals and objectives, such as financing higher
education or funding research and development. However, their aggregate
number contributes to the complexity that taxpayers face in doing their
taxes and planning their financial decisions. As figure 3 shows, the
number of tax expenditures reported by the Department of the Treasury
has more than doubled since 1974. Figure 4 shows the Revenue Loss
Estimates for the Five Largest Tax Expenditures Reported for Fiscal
Year 2005.
Figure 3: Number of Tax Expenditures Reported by Treasury, 1974-2005:
[See PDF for image]
Note: The number of tax expenditures reflects all provisions reported
by Treasury, including those enacted but effective for future fiscal
years. For example, Treasury's last list included tax expenditures
enacted in 2005 that will be effective in fiscal years 2006 and later.
The trend also reflects changes in Treasury's income tax baseline that
defines a tax expenditure.
[End of figure]
Figure 4: Revenue Loss Estimates for the Five Largest Tax Expenditures
Reported for Fiscal Year 2005:
[See PDF for image]
Note: "Tax expenditures" refers to the special tax provisions that are
contained in the federal income taxes on individuals and corporations.
OMB does not include forgone revenue from other federal taxes such as
Social Security and Medicare payroll taxes.
[A] If the payroll tax exclusion were also counted here, the total tax
expenditure for employer contributions for health insurance premiums
would be about 50 percent higher or $177.6 billion.
[B] This is the revenue loss and does not include associated outlays of
$14.6 billion.
[End of figure]
The multiple tax preferences for education assistance illustrate the
consequences of the proliferation of tax expenditures. In our July 2005
report[Footnote 17] on postsecondary tax preferences, we found that
hundreds of thousands of taxpayers do not appear to make optimal
decisions when selecting education-related tax preferences. One
explanation of these taxpayers' choices may be the complexity of
postsecondary tax preferences, which experts have commonly identified
as difficult for tax filers to use. Also, many argue that complexity
creates opportunities for tax evasion, through vehicles such as tax
shelters. Simplification may reduce opportunities for taxpayers to
avoid taxes through the creation of complex and abusive tax shelters.
Another area of the tax system that may deserve additional exploration,
although not directly related to the tax gap, is whether the federal
income-based tax system is sustainable and administrable in a global
economy and how we should tax the income of U.S. multinational
corporations that is earned outside of the United States.[Footnote 18]
Every year, U.S.-based multinational corporations transfer hundreds of
billions of dollars of goods and services between their affiliates in
the United States and their foreign subsidiaries.[Footnote 19] Such
transactions may be a part of normal business operations for
corporations with foreign subsidiaries. However, it is generally
recognized that given the variation in corporate tax rates across
countries, an incentive exists for corporations with foreign
subsidiaries to reduce their overall tax burden by maximizing the
income they report in countries with low income tax rates, and
minimizing the income they report in or repatriate to countries with
high income tax rates. Various studies have suggested that U.S.-based
multinational corporations appear to engage in transactions such as
these that shift income from their affiliates in high-tax countries to
subsidiaries in low-tax countries to take advantage of the differences
in tax rates in foreign countries.[Footnote 20]
The growth in multinational corporate transactions and structures has
also introduced increasing complexity in administering the tax code.
The loss of highly skilled technical employees at IRS who can examine
compliance issues arising from globalization, such as transfer pricing,
underscores the challenge that IRS faces in ensuring it has sufficient
staff with adequate skills to address these complex issues.
Enhance Services to Taxpayers:
Providing quality services to taxpayers is an important part of any
overall strategy to improve compliance and thereby reduce the tax gap.
One method of improving compliance through service is to educate
taxpayers about confusing or commonly misunderstood tax
requirements.[Footnote 21] For example, if the forms and instructions
taxpayers use to prepare their taxes are not clear, taxpayers may be
confused and make unintentional errors. One method to ensure that forms
and instructions are sufficiently clear is to test them before use.
However, we reported in 2003 that IRS had tested revisions to only five
individual forms and instructions from July 1997 through June 2002,
although hundreds of forms and instructions had been revised in 2001
alone.[Footnote 22]
Enhance Enforcement Tools Available to IRS:
In terms of enforcement, IRS will need to use multiple strategies and
techniques to identify and deter noncompliance. As figure 5 shows, one
pair of tools have been shown to lower levels of noncompliance--
withholding tax from payments to taxpayers and having third parties
report information to IRS and the taxpayers on income paid to
taxpayers. For example, banks and other financial institutions provide
information returns (Forms 1099) to account holders and IRS showing the
taxpayers' annual income from some types of investments. Similarly,
most wages, salaries, and tip compensation are reported by employers to
employees and IRS through Form W-2. Findings from NRP indicate that
around 98.8 percent of these types of income are accurately reported on
individual returns.
Figure 5: Individual Income Tax Underreporting Categorized by Amount
Subject to Withholding and Information Reporting, 2001:
[See PDF for image]
[End of figure]
In the past, we have identified a few specific areas where additional
withholding or information reporting requirements could serve to
improve compliance:[Footnote 23]
* Requiring tax withholding and more or better information return
reporting on payments made to independent contractors. Past IRS data
have shown that independent contractors report 97 percent of the income
that appears on information returns, while contractors that do not
receive these returns report only 83 percent of income. We have also
identified other options for improving information reporting for
independent contractors, including increasing penalties for failing to
file required information returns, lowering the $600 threshold for
requiring such returns, and requiring businesses to separately report
on their tax returns the total amount of payments to independent
contractors.[Footnote 24] IRS's Taxpayer Advocate Service recently
recommended allowing independent contractors to enter into voluntary
withholding agreements.[Footnote 25]
* Requiring information return reporting on payments made to
corporations. Unlike payments made to sole proprietors, payments made
to corporations for services are generally not required to be reported
on information returns. IRS and GAO have contended that the lack of
such a requirement leads to lower levels of compliance for small
corporations. Although Congress has required federal agencies to
provide information returns on payments made to contractors since
1997,[Footnote 26] payments made by others to corporations are
generally not covered by information returns. The Taxpayer Advocate
Service has recommended requiring information reporting on payments
made to corporations,[Footnote 27] and the Administration, in its
fiscal year 2007 budget, has proposed requiring additional information
reporting on certain goods and service payments by federal, state, and
local governments.[Footnote 28]
* Requiring more data on information returns dealing with capital gain
income. Past IRS studies have indicated that much of the noncompliance
associated with capital gains is a result of taxpayers overstating an
asset's "basis," the amount of money originally paid for the asset.
Currently, financial institutions are required to report the sales
prices, but not the purchase prices, of stocks and bonds on information
returns. Without information on purchase prices, IRS cannot use
efficient and effective computer-matching programs to check for
compliance and must use much more costly means to examine taxpayer
returns in order to verify capital gain income. The Taxpayer Advocate
Service has recommended requiring financial institutions to track cost
basis information and report it to IRS and taxpayers.[Footnote 29]
Although withholding and information reporting are highly effective in
encouraging compliance, such additional requirements generally impose
costs and burdens on the businesses that must implement them. However,
continued reexamination of opportunities to expand information
reporting and tax withholding could increase the transparency of the
tax system. Opportunities to expand information reporting and tax
withholding could be especially relevant toward improving compliance in
areas that are particularly complex or challenging to administer, such
as with net income and losses passed through from "flow-through"
entities such as S corporations and partnerships to their shareholders
and partners.[Footnote 30]
Another enforcement tool that can potentially deter noncompliance is
the use of penalties for filing inaccurate or late tax and information
returns. Congress has placed a number of civil penalty provisions in
the tax code. However, as with civil penalties related to other federal
agencies, inflation may have weakened the deterrent effect of IRS
penalties. For example, the Treasury Inspector General for Tax
Administration has noted that the $50 per partner per month penalty for
a late-filed partnership tax return, established by Congress in 1978,
would equate to $17.22 in 2004 dollars. In its fiscal year 2007 budget,
the administration has proposed expanding penalty provisions applicable
to paid tax return preparers to include non-income tax returns and
related documents. In addition, Congress recently increased certain
penalties related to tax shelters and other tax evasion
techniques.[Footnote 31] Given Congress's recent judgment that some tax
penalties were too low and concerns that inflation may have weakened
the effectiveness of the civil penalty provisions in the tax code,
additional increases may need to be considered to ensure that all
penalties are of sufficient magnitude to deter tax noncompliance.
Leverage Technology:
Leveraging technology to improve IRS's capacity to receive, process,
and utilize taxpayer returns could help IRS better determine how to
allocate its resources to reduce the tax gap and would seem to be a
prudent investment. IRS has invested heavily in modernizing its
technology and those investments have paid off. Telephone service has
improved and taxpayers are much more likely to get through to IRS and
obtain assistance from IRS than before IRS upgraded its technology.
Further, electronic filing has grown substantially. Tax information
submitted to IRS electronically enables faster, more accurate
processing and quicker interactions between IRS and taxpayers.
Electronically filed returns are processed as they are received,
therefore giving IRS access to more timely and accurate tax
information, which can be used for better data analysis capability and
quicker focus on issues that need resolution. IRS estimates it saves
$2.15 on every individual tax return that is processed electronically.
According to IRS data, electronic filing has allowed IRS to use more
than a 1,000 fewer staff years to process paper returns, resources that
can then be dedicated to other service or enforcement work.[Footnote
32]
However, IRS's Business Systems Modernization project, through which
the agency is modernizing its outdated technology, is far from
complete. IRS needs to continue to strengthen management of this effort
and make prudent technology investments to maximize the efficiencies
that can be gained in IRS operations and services to taxpayers.
Optimize Resource Allocation:
Sound resource allocation is another tool for addressing the tax gap.
The more effectively IRS can allocate its resources, the more progress
should result. The new NRP data, for example, are to be used to better
identify which tax returns to examine so that fewer compliant taxpayers
are burdened by unnecessary audits and IRS can increase the amount of
noncompliance that is addressed through its enforcement activities. As
part of its attempt to make the best use of its enforcement resources,
given budget constraints, IRS has developed rough measures of return on
investment in terms of tax revenue that is directly assessed from
uncovering noncompliance. Developing such measures is difficult because
of incomplete information on all the costs and all the tax revenue
ultimately collected from specific enforcement efforts, as well as on
the indirect tax revenues generated when current enforcement actions
prompt voluntary compliance improvements in the future. Continuing to
develop the return on investment measures could help officials make
more informed decisions about allocating resources, particularly during
periods of budget constraints. Even with better data, however,
officials will need to make judgments that take into account
intangibles, such as how to achieve an equitable enforcement presence
across the various taxpayer groups.
Concluding Observations:
Our nation's fiscal imbalance and challenges have created an imprudent
and unsustainable path that needs to be addressed. While our long-term
fiscal imbalance is too large to be corrected by one strategy, reducing
the tax gap can help address the looming fiscal challenges. Collecting
the billions of dollars that already should be paid, for example, would
help ease the many difficult decisions that need to be made about our
spending programs as well as the rest of the tax system. However, the
tax gap itself has been large and pervasive over the years and
therefore, reducing the gap will not only require expansions of current
efforts, but also new and innovative solutions. While IRS takes the
lead in continuing to find ways to significantly reduce the tax gap,
support from Congress will be essential since legislation will likely
be needed to implement many of the tax gap reduction ideas offered
today. We look forward to continuing to work with Congress and IRS on
these issues.
Chairman Gregg, Senator Conrad and members of the committee, this
concludes my testimony. I would be happy to answer any questions you
may have at this time.
Contact and Acknowledgments:
Contact points for our Offices of Congressional Relations and Public
Affairs may be found on the last page of this testimony. For further
information on this testimony, please contact Michael Brostek on (202)
512-9110 or brostekm@gao.gov. Individuals making key contributions to
this testimony include Tom Short, Assistant Director; Jeff Arkin;
Elizabeth Fan; and Cheryl Peterson.
FOOTNOTES
[1] Throughout this statement, references to the tax gap refer to the
gross tax gap unless otherwise noted.
[2] GAO, Tax Compliance: Reducing the Tax Gap Can Contribute to Fiscal
Sustainability but Will Require a Variety of Strategies, GAO-05-527T
(Washington, D.C.: Apr. 14, 2005); Tax Gap: Multiple Strategies, Better
Compliance Data, and Long-Term Goals Are Needed to Improve Taxpayer
Compliance, GAO-06-208T (Washington, D.C.: Oct. 26, 2005); and Tax
Compliance: Better Compliance Data and Long-term Goals Would Support a
More Strategic IRS Approach to Reducing the Tax Gap, GAO-05-753
(Washington, D.C.: July 18, 2005).
[3] Taxpayers who receive filing extensions, pay their full tax
liability by payment due dates, and file returns prior to extension
deadlines are considered to have filed timely.
[4] NRP replaced the Taxpayer Compliance Measurement Program, which
last measured compliance for individuals for 1988 but then was canceled
because of concerns about costs and burdens on taxpayers. GAO, Tax
Administration: New Compliance Research Effort Is on Track, but
Important Work Remains, GAO-02-769 (Washington, D.C.: June 27, 2002);
and GAO, Tax Administration: Status of IRS' Efforts to Develop Measures
of Voluntary Compliance, GAO-01-535 (Washington, D.C.: June 18, 2001)
discuss the development of the NRP study.
[5] Sole proprietors are self-employed individuals who should file a
Schedule C with their individual tax return to report profits and
losses from their business. Sole proprietors include those who provide
services, such as doctors or accountants; produce goods, such as
manufacturers; and sell goods at fixed locations, such as car dealers
and grocers.
[6] Informal suppliers are sole proprietors who work alone or with few
workers and, by definition, operate in an "informal" manner. Informal
suppliers include those who make home repairs, provide child care, or
sell goods at roadside stands. These taxpayers should report business
profits or losses on a Schedule C.
[7] As employment taxes and income taxes for self-employed taxpayers
are largely assessed on the same income, self-employed individuals who
underreport their income consequently underreport the employment tax
due on that income.
[8] IRS continually examines tax returns from about 1,100 of the
nation's largest corporations, all of which have assets of more than
$250 million. For fiscal year 2002, IRS examined around 7 percent of
all large corporations.
[9] GAO, Tax Administration: Compliance Measures and Audits of Large
Corporations Need Improvement, GAO/GGD-94-70 (Washington, D.C.: Sept.
1, 1994); Tax Administration: Factors Affecting Results from Audits of
Large Corporations, GAO/GGD-97-62 (Washington, D.C.: Apr. 17, 1997);
and Tax Administration: IRS Measures Could Provide a More Balanced
Picture of Audit Results and Costs, GAO/GGD-98-128 (Washington, D.C.:
June 23, 1998).
[10] For a more detailed discussion about data sources and
methodologies used in estimating the tax gap, see GAO-05-753.
[11] We have suggested similar steps for the entire tax system as well
as all major spending programs in order to confront the nation's fiscal
challenge through a fundamental review, reexamination, and
reprioritization of government's capacity to align itself with the
needs and demands of the 21st century. See GAO, 21st Century
Challenges: Reexamining the Base of the Federal Government, GAO-05-
325SP (Washington, D.C.: February 2005).
[12] GAO, Taxpayer Compliance: Analyzing the Nature of the Income Tax
Gap, GAO/T-GGD-97-35 (Washington, D.C.: Jan. 9, 1997).
[13] Any significant reduction of the tax gap would likely depend on an
improvement in the level of taxpayer compliance. In some instances, the
amount of the tax gap can change without a corresponding change in the
level of compliance. For example, a reduction in marginal tax rates
could result in a smaller tax gap simply because the amount of tax that
should be paid has been reduced, even if the level of compliance
remains unchanged.
[14] Recognizing these challenges, we have long been concerned about
tax noncompliance and IRS's efforts to address it. Since 1990, we have
had various aspects of tax noncompliance on our high-risk list, and
last year we have affirmed our broad concern by consolidating two prior
high-risk areas into one--Enforcement of Tax Laws. See GAO, High-Risk
Series: An Update, GAO-05-207 (Washington, D.C.: January 2005).
[15] GAO, Government Performance and Accountability: Tax Expenditures
Represent a Substantial Federal Commitment and Need to be Reexamined,
GAO-05-690 (Washington, D.C.: Sept. 23, 2005).
[16] The Congressional Budget and Impoundment Control Act of 1974, Pub.
L. No. 93-344, Sec. 3, 88 Stat. 299 (July 12, 1974) (codified at 2
U.S.C. sec. 622(3)).
[17] GAO, Student Aid and Postsecondary Tax Preferences: Limited
Research Exists on the Effectiveness of Tools to Assist Students and
Families through Title IV Student Aid and Tax Preferences, GAO-05-684
(Washington, D.C.: July 29, 2005).
[18] Although not necessarily a solution to the tax gap, given the
challenges facing our income-based tax system, some have suggested
moving more towards a consumption-based tax system. Our recent report
on understanding the tax reform debate discusses a number of topics
that tax experts have identified as those that should be considered
when evaluating tax policy. See GAO, Understanding the Tax Reform
Debate: Background, Criteria, & Questions, GAO-05-1009SP (Washington,
D.C.: September 2005).
[19] GAO, International Taxation: Information on Federal Contractors
with Foreign Subsidiaries, GAO-04-293 (Washington, D.C.: Feb. 2, 2004).
[20] A survey of studies that examine income shifting by multinational
corporations appears in Department of the Treasury, Office of Tax
Policy, The Deferral of Income Earned Through U.S. Controlled Foreign
Corporations (Washington, D.C.: December 2000), 197-213.
[21] GAO/T-GGD-97-35.
[22] GAO, Tax Administration: IRS Should Reassess the Level of
Resources for Testing Forms and Instructions, GAO-03-486 (Washington,
D.C.: Apr. 11, 2003).
[23] GAO, Tax Gap: Many Actions Taken, but a Cohesive Compliance
Strategy Needed, GAO/GGD-94-123 (Washington, D.C.: May 11, 1994).
[24] GAO, Tax Administration: Approaches for Improving Independent
Contractor Compliance, GAO/GGD-92-108 (Washington, D.C.: July 23,
1992).
[25] Internal Revenue Service, Taxpayer Advocate Service, National
Taxpayer Advocate 2005 Annual Report to Congress (Washington, D.C. Dec.
31, 2005).
[26] Taxpayer Relief Act of 1997, Pub. L. No. 105-34 (1997).
[27] National Taxpayer Advocate 2005 Annual Report to Congress.
[28] Executive Office of the President, Office of Management and
Budget, Budget of the United States Government, Fiscal Year 2007.
[29] National Taxpayer Advocate 2005 Annual Report to Congress.
[30] Partnerships and S corporations are businesses commonly referred
to as flow-through entities, as they do not generally pay taxes on
income. Instead, they distribute net income and losses to partners,
shareholders, and beneficiaries, who are subsequently required to
report net income or losses on their individual tax returns and pay any
applicable taxes.
[31] American Jobs Creation Act of 2004, Pub. L. No. 108-357 (2004).
[32] Some state and federal tax experts have recognized that mandatory
electronic filing for certain categories of tax practitioners is one
remaining option with the potential to significantly increase
electronic filing. However, mandatory electronic filing would likely
impose some costs and burdens on tax practitioners.