Using Data from the Internal Revenue Service's National Research Program to Identify Potential Opportunities to Reduce the Tax Gap
Gao ID: GAO-07-423R March 15, 2007
The Internal Revenue Service (IRS) most recently estimated that the gross tax gap--the difference between what taxpayers pay in taxes voluntarily and on time and what they should pay under the law--reached $345 billion for tax year 2001. The tax gap arises when taxpayers fail to comply with their individual income, corporate income, employment, estate, or excise tax obligations through (1) underreporting of tax liabilities on tax returns; (2) underpayment of taxes due from filed returns; or (3) nonfiling, which refers to the failure to file a required tax return altogether or on time. IRS's tax gap estimates are based on a variety of data sources. Recently, IRS studied individual taxpayer compliance through the National Research Program (NRP), and used the resulting compliance data to estimate the tax gap for individual income tax underreporting and the portion of employment tax underreporting attributed to self-employment taxes for tax year 2001. NRP, which involved reviewing around 46,000 individual tax returns, has yielded very important new information on taxpayer compliance for the first time since IRS's previous compliance measurement study was undertaken for tax year 1988. Compliance measurement studies such as NRP have the potential to identify ways to improve taxpayer compliance, which could in turn reduce the tax gap and improve the nation's fiscal stability. For example, each 1 percent reduction in the net tax gap would likely yield around $3 billion annually. Given its potential to improve individual taxpayer compliance, you asked us to review the results of the 2001 NRP study. In response, we agreed to identify (1) specific areas of individual taxpayer noncompliance that are promising targets for additional research to improve reporting compliance, and (2) opportunities, if any, found through the course of our work to improve future NRP studies.
Areas of individual taxpayer noncompliance that are promising targets for additional research to improve reporting compliance include: income/losses from partnerships and S corporations, income/losses from rental real estate, sole proprietor income/losses, income/losses from farming, other income--net operating losses, gambling income/losses, capital gains for assets other than securities, other gains/losses, Earned Income Tax Credit, Additional Child Tax Credit, deduction for charitable contributions, deduction for medical and dental expenses, deduction for job expenses and most other deductions, and exemptions. IRS could benefit from electronically capturing complete NRP examination case files. Although IRS creates an electronic record for each tax return reviewed for NRP, these records do not contain all of the information contained in the corresponding hard copy examination case files. For example, information taxpayers provide to IRS during examinations is only included in the paper case file and not in the electronic records. Furthermore, some paper case files are not obtainable. For a prior review on the capital gains tax gap for securities, IRS was not able to provide 11 percent of NRP examination case files we requested because complete files could not be located or were being used by IRS units. Having complete electronic NRP examination case files would make it easier for IRS to get the full value from NRP studies because the files could be assessed more easily than hard copy files. Additionally, complete electronic case files would lower the risk of lost files and would allow files to be accessed simultaneously by multiple users. According to IRS research and examination officials, the cost and timing of electronically capturing complete examination case files would vary by how they are made electronic.
Recommendations
Our recommendations from this work are listed below with a Contact for more information. Status will change from "In process" to "Open," "Closed - implemented," or "Closed - not implemented" based on our follow up work.
Director:
James R. White
Team:
Government Accountability Office: Strategic Issues
Phone:
(202) 512-5594
GAO-07-423R, Using Data from the Internal Revenue Service's National Research Program to Identify Potential Opportunities to Reduce the Tax Gap
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March 15, 2007:
The Honorable Max Baucus:
Chairman:
Committee on Finance:
United States Senate:
The Honorable Charles E. Grassley:
Ranking Minority Member:
Committee on Finance:
United States Senate:
Subject: Using Data from the Internal Revenue Service's National
Research Program to Identify Potential Opportunities to Reduce the Tax
Gap:
The Internal Revenue Service (IRS) most recently estimated that the
gross tax gap--the difference between what taxpayers pay in taxes
voluntarily and on time and what they should pay under the law--reached
$345 billion for tax year 2001.[Footnote 1] The tax gap arises when
taxpayers fail to comply with their individual income, corporate
income, employment, estate, or excise tax obligations through (1)
underreporting of tax liabilities on tax returns; (2) underpayment of
taxes due from filed returns; or (3) nonfiling, which refers to the
failure to file a required tax return altogether or on time.
IRS's tax gap estimates are based on a variety of data sources.
Recently, IRS studied individual taxpayer compliance through the
National Research Program (NRP), and used the resulting compliance data
to estimate the tax gap for individual income tax underreporting and
the portion of employment tax underreporting attributed to self-
employment taxes for tax year 2001.[Footnote 2] NRP, which involved
reviewing around 46,000 individual tax returns, has yielded very
important new information on taxpayer compliance for the first time
since IRS's previous compliance measurement study was undertaken for
tax year 1988.[Footnote 3] Compliance measurement studies such as NRP
have the potential to identify ways to improve taxpayer compliance,
which could in turn reduce the tax gap and improve the nation's fiscal
stability. For example, each 1 percent reduction in the net tax gap
would likely yield around $3 billion annually.
Given its potential to improve individual taxpayer compliance, you
asked us to review the results of the 2001 NRP study. In response, we
agreed to identify (1) specific areas of individual taxpayer
noncompliance that are promising targets for additional research to
improve reporting compliance, and (2) opportunities, if any, found
through the course of our work to improve future NRP studies.
To identify specific areas of individual taxpayer noncompliance that
are promising targets for additional research to improve reporting
compliance, we examined IRS's tax gap estimates for tax year 2001 and
the underlying data from NRP upon which IRS based its estimates. We
determined that IRS's tax gap and compliance estimates were
sufficiently reliable for the purposes of this engagement based on our
previous reviews of the tax gap and NRP data. For a fuller description
of how we selected promising targets, see enclosure 1. To identify
opportunities, if any, found through the course of our work to improve
future NRP studies, we identified weaknesses in NRP that we found
during this and other GAO reviews that used NRP data and, based on
discussions with IRS research and compliance officials, identified
opportunities to address any such weaknesses. We conducted our work
from September 2006 through February 2007 in accordance with generally
accepted government auditing standards.
On February 28, 2007, we briefed your staff on the results of our work.
This report formally conveys the information provided during that
briefing (which appears in enclosure 1).
Results:
Areas of individual taxpayer noncompliance that are promising targets
for additional research to improve reporting compliance include:
² income/losses from partnerships and S corporations,
² income/losses from rental real estate,
² sole proprietor income/losses,
² income/losses from farming,
² other income--net operating losses,
² gambling income/losses,
² capital gains for assets other than securities,
² other gains/losses,
² Earned Income Tax Credit,
² Additional Child Tax Credit,
² deduction for charitable contributions,
² deduction for medical and dental expenses,
² deduction for job expenses and most other deductions, and:
² exemptions.
Our process for selecting these areas and further information on these
areas appears in enclosure 1.
IRS could benefit from electronically capturing complete NRP
examination case files. Although IRS creates an electronic record for
each tax return reviewed for NRP, these records do not contain all of
the information contained in the corresponding hard copy examination
case files. For example, information taxpayers provide to IRS during
examinations is only included in the paper case file and not in the
electronic records. Furthermore, some paper case files are not
obtainable. For a prior review on the capital gains tax gap for
securities,[Footnote 4] IRS was not able to provide 11 percent of NRP
examination case files we requested because complete files could not be
located or were being used by IRS units. Having complete electronic NRP
examination case files would make it easier for IRS to get the full
value from NRP studies because the files could be assessed more easily
than hard copy files. Additionally, complete electronic case files
would lower the risk of lost files and would allow files to be accessed
simultaneously by multiple users. According to IRS research and
examination officials, the cost and timing of electronically capturing
complete examination case files would vary by how they are made
electronic.
Conclusion:
NRP is an important research program that could help IRS identify ways
to reduce taxpayer noncompliance and the tax gap. An evaluation of NRP
data revealed a variety of areas of noncompliance where further
research could provide information on how to address noncompliance.
However, IRS cannot maximize the value of information it collects
through NRP if it cannot locate or efficiently access examination case
files.
Recommendation for Executive Action:
To ensure that IRS maximizes its return on investment from future NRP
studies, IRS should develop a plan for capturing complete NRP
examination case files that:
(1) determines the most cost effective means for capturing information
electronically and (2) lays out a schedule for when it will begin to
capture information electronically.
Agency Comments and Our Evaluation:
In commenting on a draft of this report, the Commissioner of Internal
Revenue concurred with our recommendation (see enclosure II for the
full text of IRS's comments). IRS also provided separate comments on
several technical issues, which we incorporated into this report where
appropriate.
As agreed with your offices, unless you publicly announce its contents
earlier, we plan no further distribution of this report until 30 days
from its issue date. At that time, we will send copies to the Chairman
and Ranking Minority Member, House Committee on Ways and Means; the
Secretary of the Treasury; the Commissioner of Internal Revenue; and
other interested parties. We will also make copies available to others
upon request. In addition, this letter will be available at no charge
on the GAO Web site at http://www.gao.gov.
If you or your staff have any questions, please contact me on (202) 512-
9110 or whitej@gao.gov. Contact points for our offices of Congressional
Relations and Public Affairs may be found on the last page of this
letter. Individuals making key contributions to this report are listed
in enclosure III.
Signed by:
James R. White:
Director, Tax Issues:
Strategic Issues Team:
Enclosures:
[End of section]
Enclosure I: Congressional Briefing on NRP Data:
Using Data from The Internal Revenue Service's National Research
Program to Identify Potential Opportunities to Reduce the Tax Gap:
Briefing for the Senate Committee on Finance:
February 28, 2007:
Engagement Objectives:
Analyze data from the Internal Revenue Service's (IRS) National
Research Program (NRP) Tax Year 2001 study of individual taxpayer
compliance to identify:
* specific areas of individual taxpayer noncompliance that are
promising targets for additional research to improve reporting
compliance:
* opportunities, if any, found through the course of our work to
improve future NRP studies:
Background: Taxpayer Noncompliance and the Tax Gap:
The tax gap is the difference between tax amounts that should have been
paid voluntarily and on time and what was actually paid for a
particular year, and is the result of three types of taxpayer
noncompliance:
* Underreporting-when taxpayers misreport tax liabilities on tax
returns filed on time:
* Underpayment-when taxpayers fail to pay on time the taxes due from
tax returns filed on time:
* Nonfiling-when taxpayers fail to file a return altogether or on time:
Background: IRS's Most Recent Tax Gap Estimate Is Based on NRP:
IRS reviewed tax returns from tax year 2001 for about 46,000 individual
taxpayers, most of whom were subject to a face-to face examination:
NRP has yielded very important and new information on taxpayer
compliance for the first time since IRS's previous compliance
measurement study was undertaken for tax year 1988:
* NRP data allowed IRS to update its tax gap estimates for
underreporting of individual income taxes and the portion of employment
taxes from self employment:
* IRS will use NRP data to improve examination selection beginning with
tax returns filed in 2006:
Background: IRS's Tax Gap Estimate for Tax Year 2001:
[See PDF for image]
Source: IRS.
[End of figure]
IRS estimates its enforcement activities, coupled with other late
payments, will recover about $55 billion of the tax gap, leaving a net
tax gap of $290 billion for tax year 2001:
Background: Tax Gap Details:
IRS estimates the tax gap for some specific line items from the
individual tax return and in aggregate for other broad categories, such
as tax credits and deductions:
For each line item or broad category, IRS estimates include:
* the amount of the tax gap in dollars:
* net misreporting percentage (NMP), which is the net amount
misreported on a given line item or category expressed as a percentage
of the sum of the absolute values of the amounts that should have been
reported for that item or category:
Background: Components of the 2001 Tax Gap for Individual Income Tax
Underreporting:
Type of income or offset: Business income;
Tax gap amount (dollars in billions): $109;
Net misreporting percentage: 43.
Type of income or offset: Nonbusiness income;
Tax gap amount (dollars in billions): $56;
Net misreporting percentage: 4.
Type of income or offset: Credits;
Tax gap amount (dollars in billions): $17;
Net misreporting percentage: 26.
Type of income or offset: Deductions;
Tax gap amount (dollars in billions): $14;
Net misreporting percentage: 5.
Type of income or offset: Exemptions;
Tax gap amount (dollars in billions): $4;
Net misreporting percentage: 5.
Type of income or offset: Adjustments;
Tax gap amount (dollars in billions): $-3;
Net misreporting percentage: -21.
Total;
Tax gap amount (dollars in billions): $197;
Net misreporting percentage: 18.
Source: IRS.
[End of table]
Background: 2001 Individual Income Tax Gap - Business Income:
Type of income: Farm income;
Tax gap amount (dollars in billions): $6;
Net misreporting percentage: 72.
Type of income: Sole proprietor (nonfarm);
Tax gap amount (dollars in billions): $68;
Net misreporting percentage: 57.
Type of income: Rental real estate, royalties;
Tax gap amount (dollars in billions): $13;
Net misreporting percentage: 51.
Type of income: Partnerships, S corporations, estates, and trusts;
Tax gap amount (dollars in billions): $22;
Net misreporting percentage: 18.
Total business income;
Tax gap amount (dollars in billions): $109;
Net misreporting percentage: 43.
Source: IRS.
[End of table]
Background: 2001 Individual Income Tax Gap - Nonbusiness Income:
Type of income: Other income;
Tax gap amount (dollars in billions): $23;
Net misreporting percentage: 64.
Type of income: Other gains/losses;
Tax gap amount (dollars in billions): $3;
Net misreporting percentage: 64.
Type of income: Capital gains;
Tax gap amount (dollars in billions): $11;
Net misreporting percentage: 12.
Type of income: State income tax refunds;
Tax gap amount (dollars in billions): $1;
Net misreporting percentage: 12.
Type of income: Unemployment compensation;
Tax gap amount (dollars in billions): $