Tax Compliance
Opportunities Exist to Reduce the Tax Gap Using a Variety of Approaches Gao ID: GAO-06-1000T July 26, 2006The tax gap--the difference between the tax amounts taxpayers pay voluntarily and on time and what they should pay under the law--has been a long-standing problem in spite of many efforts to reduce it. Most recently, the Internal Revenue Service (IRS) estimated a gross tax gap for tax year 2001 of $345 billion and estimated it would recover $55 billion of this gap, resulting in a net tax gap of $290 billion. When some taxpayers fail to comply, the burden of funding the nation's commitments falls more heavily on compliant taxpayers. Reducing the tax gap would help improve the nation's fiscal stability. For example, each 1 percent reduction in the net tax gap would likely yield $3 billion annually. GAO was asked to discuss the tax gap and various approaches to reduce it. This testimony discusses to what extent the tax gap could be reduced through three approaches--simplifying or reforming the tax system, providing IRS with additional enforcement tools, and devoting additional resources to enforcement--as well as various factors that could guide decision-making when devising a strategy to reduce the tax gap. This statement is based on prior GAO work.
Simplifying the tax code or fundamental tax reform has the potential to reduce the tax gap by billions of dollars. IRS has estimated that errors in claiming tax credits and deductions for tax year 2001 contributed $32 billion to the tax gap. Thus, considerable potential exists. However, these provisions serve purposes Congress has judged to be important and eliminating or consolidating them could be complicated. Fundamental tax reform would be most likely to result in a smaller tax gap if the new system has few, if any, exceptions (e.g., few tax preferences) and taxable transactions are transparent to tax administrators. These characteristics are difficult to achieve, and any tax system could be subject to noncompliance. Withholding and information reporting are particularly powerful tools to reduce the tax gap. They could help reduce the tax gap by billions of dollars, especially if they can make currently underreported income transparent to IRS. These tools have been shown to lead to high, sustained levels of taxpayer compliance. Using these tools can also help IRS better allocate its resources to the extent they help IRS identify and prioritize its contacts with noncompliant taxpayers. As GAO previously suggested, reporting the cost, or basis, of securities sales is one option to improve taxpayers' compliance. However, designing additional withholding and information reporting requirements may be challenging given that many types of income are already subject to reporting, there are many forms of underreporting, and withholding and reporting requirements impose costs on third parties. Devoting additional resources to enforcement has the potential to help reduce the tax gap by billions of dollars. However, determining the appropriate level of enforcement resources for IRS requires taking into account many factors such as how well IRS is currently using its resources, how to strike the proper balance between IRS's taxpayer service and enforcement activities, and competing federal funding priorities. If Congress decides to provide IRS more enforcement resources, the amount the tax gap could be reduced would depend on factors such as the size of budget increases, how IRS manages any additional resources, and the indirect increase in taxpayers' voluntary compliance resulting from expanded enforcement. Increasing IRS's funding would enable it to contact millions of potentially noncompliant taxpayers it identifies but does not have resources to contact. Finally, using multiple approaches may be the most effective strategy to reduce the tax gap, as no one approach is likely to fully and cost effectively address noncompliance. Key factors to consider in devising a tax gap reduction strategy include periodically measuring noncompliance and its causes, setting reduction goals, leveraging technology, optimizing IRS's allocation of resources, and evaluating the results of any initiatives.
GAO-06-1000T, Tax Compliance: Opportunities Exist to Reduce the Tax Gap Using a Variety of Approaches
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Testimony:
Before the Subcommittee on Taxation and IRS Oversight, Committee on
Finance, U.S. Senate:
United States Government Accountability Office:
GAO:
For Release on Delivery Expected at 2:00 p.m. EDT:
Wednesday, July 26, 2006:
Tax Compliance:
Opportunities Exist to Reduce the Tax Gap Using a Variety of
Approaches:
Statement of Michael Brostek:
Director, Tax Issues Strategic Issues Team:
GAO-06-1000T:
GAO Highlights:
Highlights of GAO-06-1000T, a testimony to the Subcommittee on Taxation
and IRS Oversight, Committee on Finance, U.S. Senate
Why GAO Did This Study:
The tax gap”the difference between the tax amounts taxpayers pay
voluntarily and on time and what they should pay under the law”has been
a long-standing problem in spite of many efforts to reduce it. Most
recently, the Internal Revenue Service (IRS) estimated a gross tax gap
for tax year 2001 of $345 billion and estimated it would recover $55
billion of this gap, resulting in a net tax gap of $290 billion. When
some taxpayers fail to comply, the burden of funding the nation‘s
commitments falls more heavily on compliant taxpayers. Reducing the tax
gap would help improve the nation‘s fiscal stability. For example, each
1 percent reduction in the net tax gap would likely yield $3 billion
annually.
GAO was asked to discuss the tax gap and various approaches to reduce
it. This testimony discusses to what extent the tax gap could be
reduced through three approaches”simplifying or reforming the tax
system, providing IRS with additional enforcement tools, and devoting
additional resources to enforcement”as well as various factors that
could guide decision-making when devising a strategy to reduce the tax
gap. This statement is based on prior GAO work.
What GAO Found:
Simplifying the tax code or fundamental tax reform has the potential to
reduce the tax gap by billions of dollars. IRS has estimated that
errors in claiming tax credits and deductions for tax year 2001
contributed $32 billion to the tax gap. Thus, considerable potential
exists. However, these provisions serve purposes Congress has judged to
be important and eliminating or consolidating them could be
complicated. Fundamental tax reform would be most likely to result in a
smaller tax gap if the new system has few, if any, exceptions (e.g.,
few tax preferences) and taxable transactions are transparent to tax
administrators. These characteristics are difficult to achieve, and any
tax system could be subject to noncompliance.
Withholding and information reporting are particularly powerful tools
to reduce the tax gap. They could help reduce the tax gap by billions
of dollars, especially if they can make currently underreported income
transparent to IRS. These tools have been shown to lead to high,
sustained levels of taxpayer compliance. Using these tools can also
help IRS better allocate its resources to the extent they help IRS
identify and prioritize its contacts with noncompliant taxpayers. As
GAO previously suggested, reporting the cost, or basis, of securities
sales is one option to improve taxpayers‘ compliance. However,
designing additional withholding and information reporting requirements
may be challenging given that many types of income are already subject
to reporting, there are many forms of underreporting, and withholding
and reporting requirements impose costs on third parties.
Devoting additional resources to enforcement has the potential to help
reduce the tax gap by billions of dollars. However, determining the
appropriate level of enforcement resources for IRS requires taking into
account many factors such as how well IRS is currently using its
resources, how to strike the proper balance between IRS‘s taxpayer
service and enforcement activities, and competing federal funding
priorities. If Congress decides to provide IRS more enforcement
resources, the amount the tax gap could be reduced would depend on
factors such as the size of budget increases, how IRS manages any
additional resources, and the indirect increase in taxpayers‘ voluntary
compliance resulting from expanded enforcement. Increasing IRS‘s
funding would enable it to contact millions of potentially noncompliant
taxpayers it identifies but does not have resources to contact.
Finally, using multiple approaches may be the most effective strategy
to reduce the tax gap, as no one approach is likely to fully and cost
effectively address noncompliance. Key factors to consider in devising
a tax gap reduction strategy include periodically measuring
noncompliance and its causes, setting reduction goals, leveraging
technology, optimizing IRS‘s allocation of resources, and evaluating
the results of any initiatives.
What GAO Recommends:
GAO is not making any new recommendations but highlights new areas for
possible attention.
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-06-1000T].
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]
Mr. Chairman and Members of the Subcommittee:
I appreciate this opportunity to discuss the tax gap--the difference
between what taxpayers pay in taxes voluntarily and on time and what
they should pay under the law--and what is achievable in reducing the
gap. Most recently, the Internal Revenue Service (IRS) estimated that
for tax year 2001, taxpayers paid about 84 percent of the taxes that
should have been paid on time under the law, resulting in an estimated
gross tax gap of $345 billion. IRS estimated that it would eventually
recover around $55 billion of the 2001 tax gap through late payments
and IRS enforcement actions, leaving a net tax gap of $290
billion.[Footnote 1] Because of taxpayer noncompliance, the burden of
funding the nation's commitments falls more heavily on taxpayers who
willingly and accurately pay their taxes. Reducing the tax gap would
help improve the nation's fiscal stability. For example, based on IRS's
estimate, each 1 percent reduction in the net tax gap would likely
yield nearly $3 billion annually. However, the tax gap has been a
persistent problem in spite of a myriad of congressional and IRS
efforts to reduce it, as the rate at which taxpayers voluntarily comply
with our tax laws has changed little over the past three decades.
Likewise, factors such as globalization and the ever-increasing
complexity of the tax code further challenge IRS's ability to
administer the tax code.
My remarks focus on what is achievable in reducing the tax gap through
a variety of approaches, specifically by (1) simplifying or reforming
the tax system; (2) providing IRS additional enforcement authority and
tools, such as information reporting[Footnote 2] and tax
withholding,[Footnote 3] through changes to the tax laws; and (3)
devoting additional resources to enforcement under the existing tax
laws. I will also discuss various factors that could guide decision
making when devising a strategy to reduce the tax gap. 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 4]
These efforts were conducted in accordance with generally accepted
government auditing standards.
Let me begin by highlighting four major points:
* Simplifying the tax code or fundamental tax reform has the potential
to reduce the tax gap by many billions of dollars. For example, IRS
estimated that errors in claiming tax credits and deductions for tax
year 2001 contributed $32 billion to the tax gap. Reducing the number
of such credits and deductions therefore has some direct potential to
reduce the tax gap. However, these credits and deductions serve
purposes Congress has judged to be important, and eliminating them
likely would be complicated. Fundamental tax reform, such as shifting
to a consumption tax system, would most likely result in a smaller tax
gap if the new system has few, if any, exceptions (e.g., few or no tax
preferences) and taxable transactions are transparent to tax
administrators. These characteristics are difficult to achieve in any
system, and any tax system could be subject to noncompliance.
* Providing IRS with more enforcement tools, particularly withholding
and information reporting, also has the potential to reduce the tax gap
by billions of dollars, especially if those tools help IRS deal with
the largest contributor to the tax gap--underreported income. Tax
withholding and information reporting have been shown to lead to high,
sustained levels of taxpayer compliance because the income taxpayers
earn is transparent to them and IRS. Also, using these tools can help
IRS better allocate its resources by improving its ability to identify
and prioritize noncompliant taxpayers it contacts. For example, we
found that having third parties report to taxpayers and IRS the cost,
or basis, of stocks and mutual funds that taxpayers sell could help
taxpayers improve their voluntary compliance and help IRS allocate its
enforcement efforts concerning these transactions. However, designing
withholding or information reporting requirements to address
underreporting may be challenging given that many types of income are
already subject to such requirements, there are many forms of
underreporting, and any requirements could impose costs and burdens on
the third parties that withhold or report.
* Devoting additional resources to enforcement has the potential to
help reduce the tax gap by billions of dollars. However, determining
the appropriate level of enforcement resources to provide IRS requires
taking into account factors such as how effectively and efficiently IRS
is currently using its resources, how to strike the proper balance
between IRS's taxpayer service and enforcement activities, and
competing federal funding priorities. If Congress were to provide IRS
more enforcement resources, the amount of the tax gap that could be
reduced depends in part on factors such as the size of budget
increases, how IRS manages any additional resources, and the indirect
increase in taxpayers' voluntary compliance resulting from expanded
enforcement. Providing IRS with additional funding would enable it to
contact millions of potentially noncompliant taxpayers it identifies
but currently cannot contact given resource constraints.
* Each approach to reducing the tax gap--simplifying or reforming the
tax code, providing IRS with more enforcement tools, or devoting
additional resources to enforcement--has the potential to reduce the
tax gap, although using multiple approaches may be the most effective
strategy since no one approach is likely to fully and cost effectively
address noncompliance. Some key factors to consider in designing a
strategy to reduce the tax gap include periodically measuring
noncompliance and its causes, setting tax gap reduction goals and
measuring progress against the goals, leveraging technology to enhance
IRS's efficiency, identifying and considering the costs and benefits of
possible approaches, optimizing the allocation of IRS's resources, and
evaluating the results of any initiatives to reduce the tax gap.
Background:
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 paid voluntarily and on time 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 on time.[Footnote
5] IRS's tax gap estimates for each type of noncompliance include
estimates for some or all of the five types of taxes that IRS
administers. As shown in table 1, underreporting of tax liabilities
accounted for most of the tax gap estimate for tax year 2001.
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 because of rounding.
[End of table]
IRS has estimated the tax gap on multiple occasions, beginning in 1979,
relying on its Taxpayer Compliance Measurement Program (TCMP). IRS did
not implement any TCMP studies after 1988 because of concerns about
costs and burdens on taxpayers. Recognizing the need for current
compliance data, in 2002 IRS implemented a new compliance study called
the National Research Program (NRP) to produce such data for tax year
2001 while minimizing taxpayer burden.
IRS has concerns with the certainty of the tax gap estimate for tax
year 2001 in part because some areas of the estimate rely on old data,
IRS has no estimates for other areas of the tax gap, and it is
inherently difficult to measure some types of noncompliance. IRS used
data from NRP to estimate individual income tax underreporting and the
portion of employment tax underreporting attributed to self-employed
individuals. The underpayment segment of the tax gap is not an
estimate, but rather represents the tax amounts that taxpayers reported
on time but did not pay on time. Other areas of the estimate, such as
corporate income tax and employer-withheld employment tax
underreporting, rely on decades-old data. Also, IRS has no estimates
for corporate income, employment, and excise tax nonfiling or for
excise tax underreporting.[Footnote 6] 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 7]
IRS's overall approach to reducing the tax gap consists of improving
service to taxpayers and enhancing enforcement of the tax laws. IRS
seeks to improve voluntary compliance through efforts such as education
and outreach programs and by attempting to simplify the tax process,
such as by revising forms and publications to make them electronically
accessible and more easily understood by diverse taxpayer communities.
IRS uses its enforcement authority to ensure that taxpayers are
reporting and paying the proper amounts of taxes through efforts such
as examining tax returns and matching the amount of income taxpayers
report on their tax returns to the income amounts reported on
information returns it receives from third parties. IRS reports that it
collected over $47 billion in 2005 from noncompliant taxpayers it
identified through its various enforcement programs.
In spite of IRS's efforts to improve taxpayer compliance, the rate at
which taxpayers pay their taxes voluntarily and on time has tended to
range from around 81 percent to around 84 percent over the past three
decades. Any significant reduction of the tax gap would likely depend
on an improvement in the level of taxpayer compliance.[Footnote 8]
Reducing the Tax Gap through Tax Simplification or Tax System Reform
Depends on Their Design and May Have Effects Beyond Tax Compliance:
Tax law simplification and reform both have the potential to reduce the
tax gap by billions of dollars. The extent to which the tax gap would
be reduced depends on which parts of the tax system would be simplified
and in what manner as well as how any reform of the tax system is
designed and implemented. Neither approach, however, will eliminate the
gap. Further, changes in the tax laws and system to improve tax
compliance could have unintended effects on other tax system
objectives, such as those involving economic behavior or equity.
Simplification has the potential to reduce the tax gap for at least 3
broad reasons. First, it could help taxpayers to comply voluntarily
with more certainty, reducing inadvertent errors by those who want to
comply but are confused because of complexity. Second, it may limit
opportunities for tax evasion, reducing intentional noncompliance by
taxpayers who can misuse the complex code provisions to hide their
noncompliance or to achieve ends through tax shelters. Third, tax code
complexity may erode taxpayers' willingness to comply voluntarily if
they cannot understand its provisions or they see others taking
advantage of complexity to intentionally underreport their taxes.
Simplification could take multiple forms. One form would be to retain
existing laws but make them simpler. For example, in our July 2005
report[Footnote 9] on postsecondary tax preferences, we noted that the
definition of a qualifying postsecondary education expense differed
somewhat among some tax code provisions, for instance with some
including the cost to purchase books and others not. Making definitions
consistent across code provisions may reduce taxpayer errors. Although
we cannot say the errors were due to these differences in definitions,
in a limited study of paid preparer services to taxpayers, we found
some preparers claiming unallowable expenses for books.[Footnote 10]
Further, the Joint Committee on Taxation suggested that such dissimilar
definitions may increase the likelihood of taxpayer errors and increase
taxpayer frustration.[Footnote 11]
Another tax code provision in which complexity may have contributed to
the individual tax gap involves the earned income tax credit, for which
IRS estimated a tax loss of up to about $10 billion for tax year
1999.[Footnote 12] Although some of this noncompliance may be
intentional, we[Footnote 13] and the National Taxpayer
Advocate[Footnote 14] have previously reported that confusion over the
complex rules governing eligibility for claiming the credit could cause
taxpayers to fail to comply inadvertently.
Although retaining but simplifying tax code provisions may help reduce
the tax gap, doing so may not be easy, may conflict with other policy
decisions, and may have unintended consequences. The simplification of
the definition of a qualifying child across various code sections is an
example. We suggested in the early 1990s that standardizing the
definition of a qualifying child could reduce taxpayer errors and
reduce their burden.[Footnote 15] A change was not made until
2004.[Footnote 16] However, some have suggested that the change has
created some unintended consequences, such as increasing some
taxpayers' ability to reduce their taxes in ways Congress may not have
intended.
Another form of simplification could be to eliminate or consolidate tax
expenditures. Among the many causes of tax code complexity is the
growing number of preferential provisions in the code, defined in
statute[Footnote 17] as tax expenditures, such as tax exemptions,
exclusions, deductions, credits, and deferrals.[Footnote 18] The number
of these tax expenditures has more than doubled from 1974 through 2005.
Tax expenditures can contribute to the tax gap if taxpayers claim them
improperly. For example, IRS's recent tax gap estimate includes a $32
billion loss in individual income taxes for tax year 2001 because of
noncompliance with these provisions. Simplifying these provisions of
the tax code would not likely yield $32 billion in revenue because even
simplified provisions likely would have some associated noncompliance.
However, the estimate suggests that simplification could have important
tax gap consequences, particularly if simplification also accounted for
any noncompliance that arises because of complexity on the income side
of the tax gap for individuals.[Footnote 19]
However, these credits and deductions serve purposes that Congress has
judged to be important to advance federal goals. Eliminating them or
consolidating them likely would be complicated, and would likely create
winners and losers. Elimination also could conflict with other
objectives such as encouraging certain economic activity or improving
equity.
Similar trade-offs exist with possible fundamental tax reforms that
would move away from an income tax system to some other system, such as
a consumption tax, national sales tax, or value added tax. Fundamental
tax reform would most likely result in a smaller tax gap if the new
system has few tax preferences or complex tax code provisions and if
taxable transactions are transparent. However, these characteristics
are difficult to achieve in any system and experience suggests that
simply adopting a fundamentally different tax system may not by itself
eliminate any tax gap.[Footnote 20] Any tax system could be subject to
noncompliance, and their design and operation, including the types of
tools made available to tax administrators affect the size of any
corresponding tax gap. Further, the motivating forces behind tax reform
likely include factors beyond tax compliance, such as economic
effectiveness, equity, and burden, which could in some cases carry
greater weight in designing an alternative tax system than ensuring the
highest levels of compliance.
Providing IRS with Additional Enforcement Tools Potentially Could
Improve Compliance Significantly, but Identifying and Designing Such
Tools Can Be Challenging:
Changing the tax laws to provide IRS with additional enforcement tools,
such as expanded tax withholding and information reporting, could also
reduce the tax gap by many billions of dollars, particularly with
regard to underreporting--the largest segment of the tax gap. Tax
withholding promotes compliance because employers or other parties
subtract some or all of the taxes owed from a taxpayer's income and
remit them to IRS. Information reporting tends to lead to high of
compliance because income taxpayers earn is transparent to them and
IRS. In both cases, high levels of compliance tend to be maintained
over time. Also, because through withholding and information reporting
IRS can better identify noncompliant taxpayers and prioritize
contacting them by the potential for additional revenue, these tools
can enable IRS to better allocate its resources. However, designing new
withholding or information reporting requirements to address
underreporting can be challenging given that many types of income are
already subject to at least some form of withholding or information
reporting, there are varied forms of underreporting, and the
requirements could impose costs and burdens on third parties.
Taxpayers tend to report income subject to tax withholding or
information reporting with high levels of compliance, as shown in
figure 1, because the income is transparent to the taxpayers as well as
to IRS. Additionally, once withholding or information reporting
requirements are in place for particular types of income, compliance
tends to remains high over time. For example, for wages and salaries,
which are subject to tax withholding and substantial information
reporting, the percentage of income that taxpayers misreport report has
consistently been measured at around 1 percent over time.
Figure 1: Individual Net Income Misreporting Categorized by the Extent
of Income Subject to Withholding and Information Reporting, Tax Year
2001:
[See PDF for image]
Source: IRS.
[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:
* Require more data on information returns dealing with capital gains
income from securities sales. Recently, we reported that an estimated
36 percent of taxpayers misreported their capital gains or losses from
the sale of securities, such as corporate stocks and mutual
funds.[Footnote 21] Further, around half of the taxpayers who
misreported did so because they failed to report the securities' cost,
or basis, sometimes because they did not know the securities' basis or
failed to take certain events into account that required them to adjust
the basis of their securities. When taxpayers sell securities like
stock and mutual funds through brokers, the brokers are required to
report information on the sale, including the amount of gross proceeds
the taxpayer received; however, brokers are not required to report
basis information for the sale of these securities. We found that
requiring brokers to report basis information for securities sales
could improve taxpayers' compliance in reporting their securities gains
and losses and help IRS identify noncompliant taxpayers. However, we
were unable to estimate the extent to which a basis reporting
requirement would reduce the capital gains tax gap because of
limitations with the compliance data on capital gains and because
neither IRS nor we know the portion of the capital gains tax gap
attributed to securities sales.
* 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 report separately
on their tax returns the total amount of payments to independent
contractors.[Footnote 22] IRS's Taxpayer Advocate Service recently
recommended allowing independent contractors to enter into voluntary
withholding agreements.[Footnote 23]
* 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 24] 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 25] and the administration's fiscal year
2007 budget has proposed requiring additional information reporting on
certain good and service payments by federal, state, and local
governments.[Footnote 26]
In addition to improving taxpayer compliance, information reporting can
help IRS to better allocate its resources to the extent that it helps
IRS better identify noncompliant taxpayers and the potential for
additional revenue that could be obtained by contacting these
taxpayers. For example, IRS officials told us that receiving
information on basis for taxpayers' securities sales would allow IRS to
determine more precisely taxpayers' income for securities sales through
its document matching programs and would allow it to identify which
taxpayers who misreported securities income have the greatest potential
for additional tax assessments. Similarly, IRS could use basis
information to improve both aspects of its examination program--
examinations of tax returns through correspondence and examinations of
tax returns face-to-face with the taxpayer. Currently, capital gains
issues are too complex and time consuming for IRS to examine through
correspondence. However, IRS officials told us that receiving cost
basis information might enable IRS to examine noncompliant taxpayers
through correspondence because it could productively select tax returns
to examine. Also, having cost basis information could help IRS identify
the best cases to examine face-to-face, making the examinations more
productive while simultaneously reducing the burden imposed on
compliant taxpayers who otherwise would be selected for examination. As
a result of all these benefits, basis reporting would allow IRS to
better allocate its resources that focus on securities misreporting
across its enforcement programs.
Although withholding and information reporting lead to high levels of
compliance, designing new requirements to address underreporting could
be challenging given that many types of income, including wages and
salaries, dividend and interest income, and income from pensions and
Social Security are already subject to withholding or substantial
information reporting. Also, there are challenges involved with
establishing new withholding or information reporting requirements for
certain other types of income where there is extensive underreporting
of income. Challenges exist because taxable income may be difficult to
determine because of complex tax laws, complex transactions, or the
lack of a practical and reliable third-party source to provide the
information. For example, with regard to reporting securities basis
information, we reported that it would be difficult for brokers to
report information for some types of transactions because of complex
tax laws and that representatives from the securities industry told us
that a set of rules would need to be developed to establish clearly
what types of transactions would be subject to any reporting
requirement.
Likewise, a persistent and large part of the tax gap relates to nonfarm
sole proprietor and informal supplier income.[Footnote 27] As shown in
figure 1, this income is not subject to information reporting, and
these taxpayers misreported about half of the income they earned for
tax year 2001. Although establishing withholding or information
reporting requirements for these forms of income would likely improve
taxpayers' compliance, practical and effective information reporting
mechanisms are difficult to identify. For example, informal suppliers
by definition receive income in an informal manner through services
they provide to a variety of individual citizens or small businesses.
Whereas businesses may have the capacity to perform withholding and
information reporting functions for their employees, it may be
challenging to extend withholding or information reporting
responsibilities to the individual citizens that receive services, who
may not have the resources or knowledge to comply with such
requirements. Consequently, innovative approaches likely will be needed
if tools like withholding and information returns are to be extended to
cover more sources of the tax gap.
Finally, implementing tax withholding and information reporting
requirements generally imposes costs and burdens on the businesses that
must implement them, and, in some cases, on taxpayers. For example,
expanding information reporting on securities sales to include basis
information will impose costs on the brokers that would track and
report the information. Further, trying to close the entire tax gap
with these enforcement tools could entail more intrusive recordkeeping
or reporting than the public is willing to accept. Considering these
costs and burdens should be part of any evaluation of additional
withholding or information reporting requirements.
Although I have focused on information reporting and tax withholding, I
want to mention one other enforcement tool that can potentially deter
noncompliance, which 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 28] 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.
Devoting Additional Resources to Enforcement Likely Could Reduce the
Tax Gap, but to What Extent Is Difficult to Predict:
Devoting more resources to enforcement has the potential to help reduce
the tax gap by billions of dollars in that IRS would be able to expand
its enforcement efforts to reach a greater number of potentially
noncompliant taxpayers. However, determining the appropriate level of
enforcement resources to provide IRS requires taking into account many
factors, such as how effectively and efficiently IRS is currently using
its resources, how to strike the proper balance between IRS's taxpayer
service and enforcement activities, and competing federal funding
priorities. If Congress were to provide IRS more enforcement resources,
the amount of the tax gap that could be reduced depends in part on the
size of any increase in IRS's budget, how IRS would manage any
additional resources, and the indirect increase in taxpayers' voluntary
compliance that would likely result from expanded IRS enforcement.
As I previously mentioned, IRS is able to secure tens of billions of
dollars in tax revenue from noncompliant taxpayers it identifies
through its various enforcement programs. However, given resource
constraints, IRS is unable to contact millions of additional taxpayers
for whom it has evidence on potential noncompliance. With additional
resources, IRS would be able to assess and collect additional taxes and
further reduce the tax gap. In 2002, IRS estimated that a $2.2 billion
funding increase would allow it to take enforcement actions against
potentially noncompliant taxpayers it identifies but cannot contact and
would yield an estimated $30 billion in revenue.[Footnote 29] For
example, IRS estimated that it contacted about 3 million of the over 13
million taxpayers it identified as potentially noncompliant through its
matching of tax returns to information returns. IRS estimated that
contacting the additional 10 million potentially noncompliant taxpayers
it identified, at a cost of about $230 million, could yield nearly $7
billion in potentially collectible revenue. However, we did not
evaluate the accuracy of the estimate, and as will be discussed below,
many factors suggest that it is difficult to estimate reliably net
revenue increases that might come from additional enforcement
efforts.[Footnote 30]
Although additional enforcement funding has the potential to reduce the
tax gap, the extent to which it would help depends on several factors.
First, and perhaps most obviously, the amount of tax gap reduction
would depend in part on the size of any budget increase. Generally,
larger budget increases should result in larger reductions in the tax
gap. IRS prioritizes the cases of potentially noncompliant taxpayers it
reviews through its enforcement programs based on factors, such as the
likelihood that a taxpayer is noncompliant, the potential amount of
additional taxes that could be assessed, and collection potential. As
such, it is likely that IRS would begin to experience diminishing
returns as it began to review additional, lower priority cases of
potentially noncompliant taxpayers. Given the diminishing returns IRS
would likely experience as it moves to working less and less productive
cases, the amount of expected reduction in the tax gap for each
additional dollar of funding would decline. Further, reductions in the
tax gap that could be derived from additional enforcement funding may
not be immediate. The reductions may occur gradually as IRS is able to
hire and train enforcement personnel.
Recently, IRS obtained some additional funding targeted for enforcement
activities that it estimated will result in additional revenue. In its
fiscal year 2006 budget request, IRS requested millions of dollars to
expand its tax return examination and tax collection activities with
the goal of increasing individual taxpayer compliance and addressing
concerns raised by GA[Footnote 31]O and others regarding the erosion of
IRS's enforcement presence and the continued growth in noncompliance.
In estimating the revenue that it would obtain from the increased
funding, IRS took several factors into account, including opportunity
costs because of training, which draws experienced enforcement
personnel away from the field; differences in average enforcement
revenue obtained per full-time employee by enforcement activity; and
differences in the types and complexity of cases worked by new hires
and experienced hires. IRS forecasted that in the initial year after
expanding enforcement activities, the additional revenue it expects to
collect is less than half the amount it expects to collect annually in
later years. This example underscores the logic that if IRS is to
receive a relatively large funding increase, it likely would be better
to provide it in small but steady amounts.
The amount of tax gap reduction likely to be achieved from any budget
increase Congress may choose to provide also depends on how well IRS
can manage the additional resources. As previously mentioned, IRS does
not have compliance data for some segments of the tax gap and others
are based on old data. Periodic measurements of compliance levels can
indicate the extent to which compliance is improving or declining and
provide a basis for reexamining existing programs and triggering
corrective actions, if necessary. Also, regardless of the type of
noncompliance, IRS has concerns with its information on whether
taxpayers unintentionally or intentionally fail to comply with the tax
laws. Knowing the reasons why taxpayers are noncompliant can help IRS
decide whether its efforts to address specific areas of noncompliance
should focus on nonenforcement activities, such as improved forms or
publications, or enforcement activities to pursue intentional
noncompliance. For those portions of the tax gap that rely on old data
and where IRS does not know the reason for taxpayers' noncompliance,
IRS may be less able to target resources efficiently to achieve the
greatest tax gap reduction at the least burden to taxpayers.
As part of an effort to make the best use of its enforcement resources,
IRS has developed rough measures of return on investment in terms of
tax revenue that it assesses from uncovering noncompliance. Generally,
IRS cites an average return on investment for enforcement of 4:1, that
is, IRS estimates that it collects $4 in revenue for every $1 of
funding. Where IRS has developed return on investment estimates for
specific programs, it finds substantial variation depending on the type
of enforcement action. For instance, the ratio of estimated tax revenue
gains to additional spending for pursuing known individual tax debts
through phone calls is 13:1 versus a ratio of 32:1 for matching the
amount of income taxpayers report on their tax returns to the income
amounts reported on information returns. However, in addition to
current returns on investment estimated being rough, IRS also lacks
information on the incremental returns on investment for some
enforcement programs. Developing such measures is difficult because of
incomplete information on all the costs and all the tax revenue
ultimately collected from specific enforcement efforts. Because IRS's
current estimates of the revenue effects of additional funding are
imprecise, the actual revenue that might be gained from expanding
differing enforcement efforts is subject to uncertainty.
Given the variation in estimated returns on investment for differing
types of IRS compliance efforts, the amount of tax gap reduction that
may be achieved from an increase in IRS's resources would depend on
IRS's decisions about how to allocate the increase. Although it might
be tempting to allocate resources heavily toward those areas with the
highest estimated return, allocation decisions must take into account
diverse and difficult issues. For instance, although one enforcement
activity may have a high estimated return, that return may drop off
quickly as IRS works its way through potential noncompliance cases. In
addition, IRS dedicates examination resources across all types of
taxpayers so that all taxpayers receive some signal that noncompliance
is being addressed. Further, issues of fairness can arise if IRS
focuses its efforts only on particular groups of taxpayers.
Importantly, expanded enforcement efforts could reduce the tax gap more
than through direct tax revenue collection, as widespread agreement
exists that IRS enforcement programs have an indirect effect through
increases in voluntary tax compliance.[Footnote 32] The precise
magnitude of the indirect effects of enforcement is not known with a
high level of confidence given challenges in measuring compliance;
developing reasonable assumptions about taxpayer behavior; and
accounting for factors outside of IRS's actions that can affect
taxpayer compliance, such as changes in tax law. However, several
research studies have offered insights to help better understand the
indirect effects of IRS enforcement on voluntary tax compliance and
show that they could exceed the direct effect of revenue
obtained.[Footnote 33]
Various Factors Should Be Considered in Devising Strategies to Reduce
the Tax Gap:
Although closing the entire tax gap is neither feasible nor desirable
due to costs and intrusiveness, reducing the tax gap is worthwhile for
many reasons, including fairness to those who are compliant and also
because it is a means to improve our nation's fiscal position. Each of
the three approaches I have discussed could make a contribution to
reducing the tax gap, although using multiple approaches may be the
most effective strategy since no one approach is likely to address
noncompliance fully and cost effectively. However, in deciding on one
or more of the three broad approaches to use, many factors or issues
could affect strategic decisions. Among the broad factors to consider
are the likely effectiveness of any approach, fairness, enforceability,
and sustainability. Beyond these, our work points to the importance of
the following:
* Measuring compliance levels periodically. Regularly measuring the
magnitude of, and the reasons for, noncompliance provides insights on
how to reduce the gap through potential changes to tax laws and IRS
programs. In July 2005, we recommended that IRS periodically measure
tax compliance, identify reasons for noncompliance, and establish
voluntary compliance goals.[Footnote 34] IRS agreed with the
recommendations and established a voluntary tax compliance goal of 85
percent by 2009. In terms of measuring tax compliance, we have also
identified alternative ways to measure compliance, including conducting
examinations of small samples of tax returns over multiple years,
instead of conducting examinations for a larger sample of returns for
one tax year, to allow IRS to track compliance trends annually.
* Leveraging technology. Better use of technology could help IRS be
more efficient in reducing the tax gap. IRS is modernizing its
technology, which has paid off in terms of telephone service, resource
allocation, electronic filing, and data analysis capability. However,
this ongoing modernization will need strong management and prudent
investments to maximize potential efficiencies.
* Considering the costs and burdens. Any action to reduce the tax gap
will create costs and burdens for IRS; taxpayers; and third parties,
such as those who file information returns. As discussed earlier, for
example, withholding and information reporting requirements impose some
costs and burdens on those that track and report information. These
costs and burdens need to be reasonable in relation to the improvements
expected to arise from new compliance strategies.
* Optimizing resource allocation. As previously discussed, developing
reliable measures of the return on investment for strategies to reduce
the tax gap would help inform IRS resource allocation decisions. IRS
has rough measures of return on investment based on the additional
taxes it assesses. Developing such measures is difficult because of
incomplete data on the costs of enforcement and collected revenues.
Beyond direct revenues, IRS's enforcement actions have indirect revenue
effects, which are difficult to measure. However, indirect effects
could far exceed direct revenue effects and would be important to
consider in connection with continued development of return on
investment measures.
* Evaluating the results. Evaluating the actions taken by IRS to reduce
the tax gap would help maximize IRS's effectiveness. Evaluations can be
challenging because it is difficult to isolate the effects of IRS's
actions from other influences on taxpayers' compliance. Our work has
discussed how to address these challenges, for example by using
research to link actions with the outputs and desired effects.
Concluding Observations:
When taxpayers do not pay all of their taxes, honest taxpayers carry a
greater burden to fund government programs and the nation is less able
to address its long-term fiscal challenges. Thus, reducing the tax gap
is important, even though closing the entire tax gap is neither
feasible nor desirable because of costs and intrusiveness. All of the
approaches I have discussed have the potential to reduce the tax gap
alone or in combination, and no one approach is clearly and always
superior to the others. As a result, IRS needs a strategy to attack the
tax gap on multiple fronts with multiple approaches.
Mr. Chairman and Members of the Subcommittee, this concludes my
testimony. I would be happy to answer any question you may have at this
time.
Contact and Acknowledgments:
For further information on this testimony, please contact Michael
Brostek on (202) 512-9110 or brostekm@gao.gov. Contact points for our
Offices of Congressional Relations and Public Affairs may be found on
the last page of this testimony. Individuals making key contributions
to this testimony include Tom Short, Assistant Director; Jeff Arkin;
Cheryl Peterson; and Jeff Procak.
FOOTNOTES
[1] Throughout this statement, references to the tax gap refer to the
gross tax gap unless otherwise noted.
[2] Information reporting involves the filing of information returns
with IRS and taxpayers that contain information on certain
transactions, such as wage and salary information employers report to
employees and IRS through Form W-2.
[3] An example of tax withholding is when employers withhold taxes on
the wages that employees earn and remit them to IRS.
[4] GAO, Tax Gap: Making Significant Progress in Improving Tax
Compliance Rests on Enhancing Current IRS Techniques and Adopting New
Legislative Actions, GAO-06-453T (Washington, D.C.: Feb. 15, 2006); 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); 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); and 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).
[5] 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 on time.
[6] For these types of noncompliance, IRS maintains that the data are
either difficult to collect, imprecise, or unavailable.
[7] For a more detailed discussion about data sources and methodologies
used in estimating the tax gap, see GAO-05-753.
[8] 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 even
if the level of compliance remains unchanged because the amount of
taxes that should be paid has been reduced. The tax gap would also tend
to increase over time, even if the rate of taxpayer compliance remained
unchanged, because of inflation.
[9] 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).
[10] GAO, Paid Tax Return Preparers: In a Limited Study, Chain
Preparers Made Serious Errors, GAO-06-563T (Washington, D.C.: Apr. 4,
2006).
[11] U.S. Congress, Joint Committee on Taxation, Study of the Overall
State of the Federal Tax System, vol. II, 125-6 (April 2001).
[12] IRS measured the extent of noncompliance with the earned income
tax credit in a study separate from NRP.
[13] GAO-06-208T.
[14] Internal Revenue Service, Taxpayer Advocate Service, National
Taxpayer Advocate 2004 Annual Report to Congress (Washington, D.C.:
Dec. 31, 2004).
[15] See GAO, Tax Administration: Erroneous Dependent and Filing Status
Claims, GAO/GGD-93-60, (Washington, D.C: Mar.19, 1993).
[16] Pub. L. No. 108-311 (2004).
[17] The Congressional Budget and Impoundment Control Act of 1974, Pub.
L. No. 93-344, § 3, 88 Stat. 299 (July 12, 1974) (codified at 2 U.S.C.
§ 622(3)).
[18] 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).
[19] The tax gap for underreported individual income taxes exceeded
$150 billion for tax year 2001. However, IRS does not have data on how
much of this noncompliance arose because of complexity.
[20] For example, in a 2004 report, the National Audit Office in the
United Kingdom reported on the 15.7 percent gap for the value added
tax, which was introduced three decades earlier.
[21] GAO, Capital Gains Tax Gap: Requiring Brokers to Report Securities
Cost Basis Would Improve Compliance if Related Challenges Are
Addressed, GAO-06-603 (Washington, D.C.: June 13, 2006).
[22] GAO, Tax Administration: Approaches for Improving Independent
Contractor Compliance, GAO/GGD-92-108 (Washington, D.C.: July 23,
1992).
[23] Internal Revenue Service, Taxpayer Advocate Service, National
Taxpayer Advocate 2005 Annual Report to Congress (Washington, D.C.:
Dec. 31, 2005).
[24] Taxpayer Relief Act of 1997, Pub. L. No. 105-34 (1997).
[25] Internal Revenue Service, Taxpayer Advocate Service, 2005.
[26] Executive Office of the President, Office of Management and
Budget, Budget of the United States Government, Fiscal Year 2007.
[27] Nonfarm proprietors are self-employed individuals other than
farmers who should file Schedule C with their individual tax returns to
report profits and losses from their businesses. 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. 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
Schedule C.
[28] American Jobs Creation Act of 2004, Pub. L. No. 108-357 (2004).
[29] Commissioner of Internal Revenue Charles O. Rossotti, Report to
the IRS Oversight Board: Assessment of IRS and the Tax System, October
2002.
[30] There are many aspects to the overall tax gap. Thus, if the tax
gap in a specific area is reduced either through congressional actions
like simplifying provisions or through IRS actions, the size of the
overall gap may not be reduced if other portions of the gap increase.
[31] GAO issued a number of products regarding the erosion of IRS's
enforcement presence and a continued growth in noncompliance. See GAO,
Internal Revenue Service: Assessment of Fiscal Year 2005 Budget Request
and 2004 Filing Season Performance, GAO-04-560T (Washington, D.C: Mar.
30, 2004); Internal Revenue Service: Assessment of Fiscal Year 2004
Budget Request and 2003 Filing Season Performance to Date, GAO-03-641T
(Washington, D.C: Apr. 8, 2003); Internal Revenue Service: Assessment
of Fiscal Year 2003 Budget Request and Interim Results of the 2002 Tax
Filing Season, GAO-02-580T (Washington, D.C: Apr. 9, 2003); Tax
Administration: Impact of Compliance and Collection Program Declines on
Taxpayers, GAO-02-674 (Washington, D.C.: May 22, 2003); Compliance and
Collection: Challenges for IRS in Reversing Trends and Implementing New
Initiatives, GAO-03-732T (Washington, D.C.: May 7, 2003); IRS
Modernization: Continued Progress Necessary for Improving Service to
Taxpayers and Ensuring Compliance, GAO-03-796T (Washington, D.C.: May
20, 2003); High Risk Series: An Update, GAO-05-207 (Washington, D.C.:
January 2005); and our products on the tax gap mentioned earlier in
this statement, GAO-06-453T, GAO-06-208T, GAO-05-753, and GAO-05-527T.
[32] Two types of indirect effect are (1) the increase in voluntary
compliance in the larger population resulting from examinations or
other enforcement and nonenforcement actions on targeted taxpayers, and
(2) the increase in voluntary compliance of the targeted taxpayer in
subsequent years.
[33] Economists have estimated the indirect effect of an examination on
voluntary compliance to range from 6 to 12 times the amount of proposed
tax adjustments. See Alan H. Plumley, The Determinants of Individual
Income Tax Compliance: Estimating The Impacts of Tax Policy,
Enforcement, and IRS Responsiveness, Publication 1916 (Rev. 11-96)
(Washington, D.C.: November 1996), 2, 35-36; Jeffrey A. Dubin, Michael
J. Graetz and Louis L. Wilde, "The Effect of Audit Rates on the Federal
Individual Income Tax, 1977-1986," 43 National Tax Journal, (1990),
395, 396, 405; and Jeffrey A. Dubin, "Criminal Investigation
Enforcement Activities and Taxpayer Noncompliance" (paper written for
the IRS Research Conference, June 2004), [Hyperlink,
http://www.irs.gov/pub/irs-soi/04dubin.pdf] (downloaded July 1, 2005).
[34] GAO-05-753.
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