Tax Compliance
Inflation Has Significantly Decreased the Real Value of Some Penalties Gao ID: GAO-07-1062 August 23, 2007Civil tax penalties are an important tool to encourage taxpayer compliance with the tax laws. A number of civil tax penalties have fixed dollar amounts--a specific dollar amount, a minimum or maximum amount--that are not indexed for inflation. Because of Congress's concerns that civil penalties are not effectively achieving their purposes, we agreed to (1) determine the potential effect of adjusting civil tax penalties for inflation on the Internal Revenue Service's (IRS) assessment and collection amounts and (2) describe the likely administrative impact of regularly adjusting civil tax penalties on IRS and tax practitioners. GAO examined IRS data on civil tax penalties and conducted interviews with IRS employees and tax practitioners.
Adjusting civil tax penalties for inflation on a regular basis to maintain their real values over time may increase IRS collections by tens of millions of dollars per year. Further, the decline in real value of the fixed dollar amounts of civil tax penalties may weaken the deterrent effect of these penalties and may result in the inconsistent treatment of taxpayers over time. If civil tax penalty fixed dollar amounts were adjusted for inflation, the estimated increase in IRS collections would have ranged from $38 million to $61 million per year from 2000 to 2005. Almost all of the estimated increase in collections was generated by four penalties. These increases result because some of the penalties were set decades ago and have decreased significantly in real value--by over one-half for some penalties. According to those we interviewed, the likely administrative burden associated with adjusting the fixed dollar amounts of civil tax penalties for inflation on a regular basis would not be significant for IRS and would be low for tax practitioners. However, officials from the Office of Penalties, a relatively small office that would be responsible for coordinating the required changes among multiple IRS divisions, said that such adjustments might be considerable depending on the number of penalties being adjusted and would require a reprioritization of work. IRS officials said that the work required would be easier to implement with each subsequent update.
RecommendationsOur 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.
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Report to the Committee on Finance, U.S. Senate:
United States Government Accountability Office:
GAO:
August 2007:
Tax Compliance:
Inflation Has Significantly Decreased the Real Value of Some Penalties:
Tax Compliance:
GAO-07-1062:
GAO Highlights:
Highlights of GAO-07-1062, a report to the Committee on Finance, U.S.
Senate.
Why GAO Did This Study:
Civil tax penalties are an important tool to encourage taxpayer
compliance with the tax laws. A number of civil tax penalties have
fixed dollar amounts”a specific dollar amount, a minimum or maximum
amount”that are not indexed for inflation. Because of your concerns
that civil penalties are not effectively achieving their purposes, we
agreed to:
(1) determine the potential effect of adjusting civil tax penalties for
inflation on the Internal Revenue Service‘s (IRS) assessment and
collection amounts and
(2) describe the likely administrative impact of regularly adjusting
civil tax penalties on IRS and tax practitioners. GAO examined IRS data
on civil tax penalties and conducted interviews with IRS employees and
tax practitioners.
What GAO Found:
Adjusting civil tax penalties for inflation on a regular basis to
maintain their real values over time may increase IRS collections by
tens of millions of dollars per year. Further, the decline in real
value of the fixed dollar amounts of civil tax penalties may weaken the
deterrent effect of these penalties and may result in the inconsistent
treatment of taxpayers over time. If civil tax penalty fixed dollar
amounts were adjusted for inflation, the estimated increase in IRS
collections would have ranged from $38 million to $61 million per year
from 2000 to 2005. Almost all of the estimated increase in collections
was generated by four penalties. These increases result because some of
the penalties were set decades ago and have decreased significantly in
real value”by over one-half for some penalties.
Table: Estimated Increase in IRS Assessments and Collections from
Inflation Adjusting of Penalties Assessed, 2000-2005:
Dollars in millions.
Assessment year: 2000;
Penalty adjusted assessment increase: $100.4; Penalty adjusted
collections increase: $38.2.
Assessment year: 2001;
Penalty adjusted assessment increase: 254.9; Penalty adjusted
collections increase: 42.1.
Assessment year: 2002;
Penalty adjusted assessment increase: 165.3; Penalty adjusted
collections increase: 47.9.
Assessment year: 2003;
Penalty adjusted assessment increase: 267.1; Penalty adjusted
collections increase: 53.2.
Assessment year: 2004;
Penalty adjusted assessment increase: 320.9; Penalty adjusted
collections increase: 61.0.
Assessment year: 2005;
Penalty adjusted assessment increase: 280.5; Penalty adjusted
collections increase: 60.3.
Source: GAO analysis of IRS data.
[End of figure]
According to those we interviewed, the likely administrative burden
associated with adjusting the fixed dollar amounts of civil tax
penalties for inflation on a regular basis would not be significant for
IRS and would be low for tax practitioners. However, officials from the
Office of Penalties, a relatively small office that would be
responsible for coordinating the required changes among multiple IRS
divisions, said that such adjustments might be considerable depending
on the number of penalties being adjusted and would require a
reprioritization of work. IRS officials said that the work required
would be easier to implement with each subsequent update.
What GAO Recommends:
Congress should consider requiring IRS to periodically adjust for
inflation, and round appropriately, the fixed dollar amounts of civil
tax penalties to account for the decrease in real value over time and
so that penalties for the same infraction are consistent over time. IRS
provided technical comments on a draft of this report that have been
incorporated where appropriate.
[hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-07-1062].
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]
Contents:
Letter:
Results in Brief:
Background:
Adjusting Civil Tax Penalties for Inflation May Increase IRS
Assessments and Collections:
Administrative Impact of Implementing Inflation Adjustment to Civil
Penalties Is Expected to Be Low:
Concluding Observations:
Matter for Congressional Consideration:
Agency Comments:
Appendix I: Scope and Methodology:
Appendix II: GAO Contact and Staff Acknowledgments:
Tables:
Table 1: Estimated Increase in IRS Assessments and Collections from
Inflation Adjusting of Penalties Assessed, 2000-2005:
Table 2: 2004 Estimated Increase in IRS Collections from Inflation
Adjusting of Four Penalties:
Table 3: 2007 Inflation-Adjusted Values of Four Civil Tax Penalties
with Fixed Dollar Amounts, by Increase in Collection Amount:
Abbreviations:
CPI-U: Consumer Price Index-Urban:
ERIS: Enforcement Revenue Information System:
GDP: Gross Domestic Product:
IRC: Internal Revenue Code:
IRS: Internal Revenue Service:
SB/SE: Small-Business/Self-Employed division:
W&I: Wage and Investment division:
United States Government Accountability Office:
Washington, DC 20548:
August 23, 2007:
The Honorable Max Baucus:
Chairman:
The Honorable Charles E. Grassley:
Ranking Member:
Committee on Finance:
United States Senate:
Civil tax penalties are an important tool to encourage taxpayer
compliance with the tax laws.[Footnote 1] The Internal Revenue Code
(IRC) has over 150 civil penalties that potentially deter taxpayer
noncompliance. For some of the penalties, the amount of the penalty is
determined as a percentage of tax liability. For others, the amount of
the penalty is a specific dollar amount. Still other penalties have
minimum or maximum amounts that are specified in dollars. These
specific dollar amounts are not indexed for inflation and decline in
real value over time because of inflation, which may weaken their
deterrent effect. Because of your concerns that civil tax penalties are
not effectively achieving their purposes, we agreed to (1) determine
the potential effect of adjusting civil tax penalties for inflation on
assessment and collection amounts and (2) describe the likely
administrative impact on the Internal Revenue Service (IRS) and tax
practitioners of regularly adjusting civil tax penalties.
To determine the potential effect of adjusting civil tax penalties for
inflation on assessment and collection amounts, we analyzed IRS civil
tax penalty assessment and collection data using the Consumer Price
Index-Urban as a basis for inflation adjustments. To gather information
on the likely administrative impact on IRS officials and tax
practitioners of regularly adjusting civil tax penalties, we
interviewed officials across IRS and a limited number of tax
practitioners affiliated with relevant professional organizations. Our
interviews with tax practitioners cannot be used to make inferences
about the effect of regular penalty adjustments on the work of all
practitioners and those we interviewed were giving personal opinions,
not the views of the professional associations of which they are
members. We determined that the civil tax penalty assessment and
collection data are sufficiently reliable for our purposes. We
conducted our work from September 2006 through July 2007 in accordance
with generally accepted government auditing standards. For a more
detailed description of our scope and methodology, as well as
limitations of the penalty data, see appendix I.
Results in Brief:
Adjusting civil tax penalties for inflation on a regular basis to
maintain their real values over time may increase IRS assessments and
collections by tens of millions of dollars per year. Further, the
decline in real value of the fixed dollar amounts of civil tax
penalties may weaken the deterrent effect of these penalties and may
result in the inconsistent treatment of taxpayers over time. Based on
our analysis, if the fixed dollar amounts of civil tax penalties had
been adjusted for inflation, the potential increase in IRS collections
would have ranged from an estimated $38 million to $61 million per year
from 2000 to 2005. Almost all of the estimated increase in collections
was generated by the following four penalties: (1) failure to file tax
returns, (2) failure to file correct information returns, (3) various
penalties on returns by exempt organizations and by certain trusts, and
(4) failure to file partnership returns. For example, our analysis
showed that these four penalties would account for 99 percent of the
estimated $61 million in additional IRS collections for assessments
made in calendar year 2004. These estimated increases result because
some of the penalties were set decades ago and have decreased
significantly in real value--by over one-half for some penalties.
According to IRS officials and tax practitioners we spoke with, the
likely administrative burden associated with adjusting the fixed dollar
amounts of civil tax penalties for inflation on a regular basis would
not be large for all but one affected unit within IRS and would be low
for tax practitioners. Officials from IRS's relatively small Office of
Penalties, which has responsibility for coordinating the changes among
multiple IRS divisions, said that such adjustments might be
considerable depending on the number of penalties being adjusted and
would require a reprioritization of their work. IRS officials from all
other affected units, who are responsible for implementing other
periodic updates to IRS databases and documents, said that the changes
required by regular updates to the fixed dollar amounts of civil
penalties would not be significant and some added that changes would be
most burdensome initially and easier to carry out with each subsequent
update. The limited number of tax practitioners that we spoke with also
expected the impact on their work from inflation adjustments to be
relatively low.
We believe that Congress should consider requiring IRS to periodically
adjust for inflation, and round appropriately, the fixed dollar amounts
of civil tax penalties to account for the decrease in real value over
time and so that penalties are consistent over time.
We provided a draft of this report to the Acting Commissioner of
Internal Revenue. IRS provided technical comments, which have been
incorporated where appropriate.
Background:
Although Congress has not established mechanisms for regularly
adjusting for inflation the fixed dollar amounts of civil tax penalties
administered by IRS, it has done so for penalties administered by other
agencies. When the Federal Civil Penalties Inflation Adjustment Act of
1990 (Inflation Adjustment Act)[Footnote 2] was enacted, Congress noted
that inflation had weakened the deterrent effect of many civil
penalties. The stated purpose of the 1990 act was "to establish a
mechanism that shall (1) allow for regular adjustment for inflation of
civil monetary penalties; (2) maintain the deterrent effect of civil
monetary penalties and promote compliance with the law; and (3) improve
the collection by the Federal Government of civil monetary penalties."
Congress amended the Inflation Adjustment Act in 1996[Footnote 3] and
required some agencies to examine their covered penalties at least once
every 4 years thereafter and, where possible, make penalty
adjustments.[Footnote 4] The Inflation Adjustment Act exempted
penalties under the IRC of 1986,[Footnote 5] the Tariff Act of 1930,
the Occupational Safety and Health Act of 1970, and the Social Security
Act.
As stated earlier, some civil tax penalties are based on a percentage
of liability and therefore are implicitly adjusted for inflation. For
example, the penalty for failure to pay tax obligations is 0.5 percent
of the tax owed per month, not exceeding 25 percent of the total tax
obligations. However, other civil penalties have fixed dollar amounts,
such as minimums or maximums, which are not linked to a percentage of
liability. For example, a minimum penalty of $100 exists for a taxpayer
who fails to file a tax return.[Footnote 6]
Adjusting Civil Tax Penalties for Inflation May Increase IRS
Assessments and Collections:
Adjusting civil tax penalties for inflation on a regular basis to
maintain their real values over time may increase IRS assessments and
collections. Based on our analysis,[Footnote 7] if the fixed dollar
amounts of civil tax penalties had been adjusted for inflation, the
increase in IRS assessments potentially would have ranged from an
estimated $100 million to $320 million and the increase in collections
would have ranged from an estimated $38 million to $61 million per year
from 2000 to 2005, as shown in table 1.[Footnote 8]
Table 1: Estimated Increase in IRS Assessments and Collections from
Inflation Adjusting of Penalties Assessed, 2000-2005:
Dollars in millions.
Assessment year: 2000;
Dollars in millions: Penalty adjusted assessment increase: $100.4;
Penalty adjusted collections increase: $38.2.
Assessment year: 2001;
Dollars in millions: Penalty adjusted assessment increase: 254.9;
Penalty adjusted collections increase: 42.1.
Assessment year: 2002;
Dollars in millions: Penalty adjusted assessment increase: 165.3;
Penalty adjusted collections increase: 47.9.
Assessment year: 2003;
Dollars in millions: Penalty adjusted assessment increase: 267.1;
Penalty adjusted collections increase: 53.2.
Assessment year: 2004;
Dollars in millions: Penalty adjusted assessment increase: 320.9;
Penalty adjusted collections increase: 61.0.
Assessment year: 2005;
Dollars in millions: Penalty adjusted assessment increase: 280.5;
Penalty adjusted collections increase: 60.3.
Source: GAO analysis of IRS data.
Note: Fluctuations in the assessment amounts are largely due to
variations with the failure to file partnership returns penalty, for
which assessments fluctuate by several hundred million dollars per
year. However, collections do not fluctuate in a similar way because
only a small portion of the assessed amounts for this penalty are
collected.
[End of table]
The majority of the estimated increase in collections from adjusting
these penalties for inflation was generated from the following four
types of penalties: (1) failure to file tax returns, (2) failure to
file correct information returns, (3) various penalties on returns by
exempt organizations and by certain trusts, and (4) failure to file
partnership returns. The estimated increases in collections associated
with these penalties for 2004 are shown in table 2. We highlight 2004
data because, according to IRS officials, approximately 85 percent of
penalties are collected in the 3 years following the assessment. The
same four penalty types account for the majority of the estimated
increase in collections for the prior years. Our analysis showed that
these four penalties would account for approximately 99 percent of the
estimated $61 million in additional IRS collections for assessments
made in calendar year 2004.
Table 2: 2004 Estimated Increase in IRS Collections from Inflation
Adjusting of Four Penalties:
Dollars in millions.
Penalty: Failure to file tax returns (IRC 6651);
2004 increase in collections: $37.9;
Effective year of latest penalty adjustment: 1982.
Penalty: Failure to file correct information returns (IRC 6721);
2004 increase in collections: 18.3;
Effective year of latest penalty adjustment: 1989.
Penalty: Various penalties on returns by exempt organizations and by
certain trusts (IRC 6652(c));
2004 increase in collections: 3.1;
Effective year of latest penalty adjustment: 1996.
Penalty: Failure to file partnership returns (IRC 6698);
2004 increase in collections: 0.9;
Effective year of latest penalty adjustment: 1979.
Penalty: Total;
2004 increase in collections: $60.2;
Effective year of latest penalty adjustment: [Empty].
Source: GAO analysis of IRS data.
[End of table]
Because penalty amounts have not been adjusted for decades in some
cases, the real value of the fixed dollar amounts of these penalties
has decreased. For example, the penalty for failing to file a
partnership return was set at $50 per month in 1979, which is
equivalent to about $18 today, or a nearly two-thirds decline in value,
as shown in table 3. If the deterrent effect of penalties depends on
the real value of the penalty, the deterrent effect of these penalties
has eroded because of inflation. In addition, not adjusting these
penalties for inflation may lead to inconsistent treatment of otherwise
equal taxpayers over time because taxpayers penalized when the amounts
were set could effectively pay a higher penalty than taxpayers with the
same noncompliance pay years later. Finally, if the real value of
penalties declines, but IRS's costs to administer them do not, imposing
penalties becomes less cost-effective for IRS and could lead to a
decline in their use.[Footnote 9]
Table 3: 2007 Inflation-Adjusted Values of Four Civil Tax Penalties
with Fixed Dollar Amounts, by Increase in Collection Amount:
Penalty: Failure to file tax returns (IRC 6651);
Penalty amount not adjusted for inflation[A]: $100 minimum;
Equivalent dollar amount of current penalty, in year of latest
adjustment (rounded): $47 minimum;
2007 penalty amount if adjusted for inflation (rounded): $214 minimum;
Effective year of latest penalty adjustment: 1982.
Penalty: Failure to file correct information returns (IRC 6721);
Penalty amount not adjusted for inflation[A]: $15, $30, or $50/return;
Equivalent dollar amount of current penalty, in year of latest
adjustment (rounded): $9, $18, or $30/return;
2007 penalty amount if adjusted for inflation (rounded): $25, $50, or
$83/return;
Effective year of latest penalty adjustment: 1989.
Penalty: Various penalties on returns by exempt organizations and by
certain trusts (IRC 6652(c));
Penalty amount not adjusted for inflation[A]: $20 or $100/day;
Equivalent dollar amount of current penalty, in year of latest
adjustment (rounded): $15 or $76/day;
2007 penalty amount if adjusted for inflation (rounded): $26 or
$131/day;
Effective year of latest penalty adjustment: 1996.
Penalty: Failure to file partnership returns (IRC 6698);
Penalty amount not adjusted for inflation[A]: $50/partner;
per month;
Equivalent dollar amount of current penalty, in year of latest
adjustment (rounded): $18/partner per month;
2007 penalty amount if adjusted for inflation (rounded): $145/partner;
per month;
Effective year of latest penalty adjustment: 1979.
Source: GAO analysis.
[A] The information return penalty amounts vary depending on how late
the taxpayer files the return. If the information return is filed 30
days late, the penalty is $15 per return, rising to $30 per return if
filed 60 days late, and finally to $50 per return if filed after August
1. In the case of the penalties on returns by exempt organizations and
by certain trusts, the penalty is $20 per day for organizations with
gross receipts under $1,000,000, and increases to $100 per day for
organizations with gross receipts over $1,000,000.
[End of table]
In the past, Congress has established fixed penalty amounts, increased
fixed penalty amounts, or both in order to deter taxpayer noncompliance
with the tax laws. For example, the $100 minimum for failure to file a
tax return was created in 1982 because many persons who owed small
amounts of tax ignored their filing obligations. In addition, Congress
increased penalties for failure to file information returns in 1982
because it believed that inadequate information reporting of nonwage
income was a substantial factor in the underreporting of such income by
taxpayers.[Footnote 10] As recently as 2006, IRS's National Research
Program confirmed Congress's belief that compliance is highest where
there is third-party reporting.[Footnote 11] Congress has also recently
adjusted some civil penalties that have fixed dollar amounts. For
example, the minimum penalty for a bad check was raised from $15 to $25
in May 2007, and the penalty for filing a frivolous return was raised
from $500 to $5,000 in December 2006.
Administrative Impact of Implementing Inflation Adjustment to Civil
Penalties Is Expected to Be Low:
We spoke with officials from offices across IRS whose workloads would
be affected if regular adjustments of penalties occurred. IRS officials
from all but one unit said that regularly updating the fixed dollar
amounts of civil tax penalties would not be a significant burden.
Officials from one relatively small office--the Office of Penalties--
said that such adjustments might be considerable depending on the
number of penalties being adjusted and would require a reprioritization
of their work since their office would have lead responsibility for
monitoring the administrative steps necessary to implement the
adjustments and coordinating tasks among a wide range of functions
within IRS. In addition, the limited number of tax practitioners we
interviewed told us that the administrative burden associated with
adjusting these penalties for inflation on a regular basis would be
low.
Administrative Impact on IRS Expected to Be Relatively Low:
Officials from all but one unit we spoke to within IRS said that
regularly adjusting civil tax penalties for inflation would not be
burdensome. Some officials added that adequate lead time and minimally
complex changes would reduce the administrative impact. For example,
officials from the Office of Forms and Publications and the Office of
Chief Counsel said that adjustments to civil penalty amounts would not
affect their work significantly. While each office would have to
address the penalty changes in documents for which they are
responsible, in some cases these documents are updated regularly
already. Similarly, officials responsible for programming IRS's
computer systems explained that these changes would not require out of
the ordinary effort, unless they had little lead time in which to
implement the changes.
However, officials from the Office of Penalties within the Small
Business/Self-Employed division (SB/SE)--the unit which would be
responsible for coordinating IRS's implementation of any adjustments to
penalties among a wide range of functions within IRS--felt that the
administrative burden associated with these changes might be
considerable depending on the number of penalties being adjusted. The
Office of Penalties, which currently consists of 1 manager and 10
analysts, provides policies, guidelines, training, and oversight for
penalty issues IRS-wide, not just within SB/SE. When legislation
affecting penalties is enacted, the Office of Penalties creates an
implementation team that helps determine what IRS needs to do to
implement the new legislation. In the case of adjusting penalties for
inflation, the Office of Penalties would work with numerous other IRS
units to coordinate the necessary changes to forms, training materials,
computer systems, and guidance, among other things. Regularly changing
four penalties would take less effort than regularly changing all
penalties. In addition, the ability of the office to make these changes
would require reprioritization of its work or receiving more resources.
While the Office of Penalties has not done a formal analysis of the
resources needed, an official stated that the additional work would not
require a significant increase in staffing, such as a doubling of the
size of the office. As a result, the amount of additional resources
necessary for the penalty adjustment do not appear to be of sufficient
scale to have a large impact on IRS overall.
Further, officials we interviewed from other IRS units who would
perform the work described by the Office of Penalties said that the
administrative burden would not be significant for them. Some IRS
officials who oversee the implementation of other periodic updates to
IRS databases and documents said that the legislative changes requiring
regular updates are most burdensome initially but become less of an
issue in each subsequent year. Some officials also said that with
enough advance notice, they would be able to integrate the necessary
changes into routine updates. For example, program changes could be
integrated into the annual updates that some Modernization and
Information Technology Service programs receive. Other areas in IRS,
such as the Office of Forms and Publications, already conduct annual
and in some cases quarterly updates of their forms, and according to
officials, a change to the tax penalty amount could easily be included
in these regularly scheduled updates.
IRS has a variety of experiences that may provide guidance that would
be relevant to adjusting civil tax penalties with fixed dollar amounts
for inflation. IRS has extensive procedures for implementing statutory
changes to the tax code. Further, IRS has experience implementing
inflation adjustment calculations. For example, tax brackets, standard
deduction amounts, and the itemized deduction limit are among the
inflation adjustments conducted annually by IRS. In addition, the
administrative changes associated with regular updates to the interest
rate have some similarities to the types of changes that an inflation
adjustment may require. For example, the Office of Chief Counsel issues
quarterly guidance on interest rates and the Communications & Liaison
Office provides regular updates on interest changes to the tax
professional community, including practitioner associations. Changes to
the civil tax penalty fixed dollar amounts could be handled in a
similar manner.
Tax Practitioners Expected Administrative Impact to Be Relatively Low:
The limited number of tax practitioners that we spoke with also
expected the impact on their work from adjustments to the fixed dollar
amounts of civil tax penalties for inflation to be relatively low. For
example, one tax practitioner said that he expected to spend more time
explaining different penalty amounts to clients, particularly in
situations where taxpayers who receive the same penalty in different
tax years may not understand why different penalty amounts were
applied. In addition, three other practitioners we spoke with said that
the changes may lead to an increased reliance on software programs that
tax preparers often use to assist them with determining penalty amounts
since making the calculations involving inflation adjustments could
become more onerous for the tax practitioners to do without software.
Concluding Observations:
The real value and potential deterrent effect of civil tax penalties
with fixed dollar amounts has decreased because of inflation. Periodic
adjustments to the fixed dollar amounts of civil tax penalties to
account for inflation, rounded appropriately, may increase the value of
collections by IRS, would keep penalty amounts at the level Congress
initially believed was appropriate to deter noncompliance, and would
serve to maintain consistent treatment of taxpayers over time.
Regularly adjusting the fixed dollar amounts of civil tax penalties for
inflation likely would not put a significant burden on IRS or tax
practitioners.
Matter for Congressional Consideration:
Congress should consider requiring IRS to periodically adjust for
inflation, and round appropriately, the fixed dollar amounts of the
civil penalties to account for the decrease in real value over time and
so that penalties for the same infraction are consistent over time.
Agency Comments:
On July 30, 2007, we sent a draft of this report to IRS for its
comment. We received technical comments that have been incorporated
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 date. At that time, we will send copies of this report to
appropriate congressional committees and the Acting Commissioner of
Internal Revenue. We also will make copies available to others upon
request. In addition, the report will be available at no charge on the
GAO Web site at [hyperlink, http://www.gao.gov].
If you or your staff have any questions concerning this report, please
contact me at (202) 512-9110 or at brostekm@gao.gov. Contact points for
our Offices of Congressional Relations and Public Affairs may be found
on the last page of this report. GAO staff who made major contributions
to this report are listed in appendix II.
Signed by:
Michael Brostek:
Director, Tax Issues Strategic Issues Team:
[End of section]
Appendix I: Scope and Methodology:
To determine the potential effect that adjusting civil tax penalties
for inflation would have on the dollar value of penalty assessments and
collections, we used the Consumer Price Index-Urban (CPI-U) to adjust
actual penalty assessment and collection information contained in the
Enforcement Revenue Information System (ERIS), which was created to
track Internal Revenue Service (IRS) enforcement revenues.
We provided inflation-adjusted estimates for penalties that had been
assessed for at least $1 million in any one year from 2000 to 2005 and
had either a fixed minimum or set amount. This excluded less than two
one-hundredths of a percentage of all assessments each year. In
addition, we assumed that assessment rates and collection rates would
stay the same regardless of penalty amount. This assumption may bias
our estimates upwards because higher penalties may encourage taxpayers
to comply with tax laws and, therefore, IRS would not assess as many
penalties. However, improved compliance could also increase revenues.
For collections, we assumed that a particular collection would increase
the inflation-adjusted penalty amount only if the unadjusted penalty
assessment had been paid in full. For example, if a taxpayer paid $50
of a $100 penalty assessment, we assumed that the $50 collected was all
that would have been collected even with a higher assessment, and
therefore did not adjust the collection amount. We made this assumption
in order to avoid overstating the effect that adjusting penalties for
inflation would have on collections because the data did not tell us
why a penalty was partially collected. To the extent that taxpayers who
paid the unadjusted penalty amount in full would not pay the adjusted
penalty amount in full, our estimates would overstate additional
collections. One reason for a partial collection is that it is all the
taxpayer can afford.
We did not include penalties that are percentage based but have a fixed
maximum in our inflation adjustments. Two penalty categories in the
ERIS data set that we received have fixed maximums and had total
assessments of over $1 million for at least 1 year from 2000 to 2005.
In both cases, we could not determine how much a penalty assessment for
the current maximum would have risen if the maximum had been higher.
However, we estimated an upper bound for the potential increase in
collections due to adjusting the maximums for inflation by assuming
that penalties assessed at the current maximum would have increased by
the full rate of inflation. As a result, we concluded that at most,
collections would have risen by approximately $196,000 over the years
2000 to 2005 if these maximums had been adjusted for inflation. We also
did not include penalties that are based solely on a percentage of tax
liability in our analysis because they are implicitly adjusted for
inflation.
The data contained in the ERIS database were reliable for our purposes,
but some limitations exist. To assess the reliability of the data, we
reviewed relevant documentation, interviewed relevant IRS officials,
and performed electronic data testing. One limitation of the ERIS data
is that it does not include penalties that are self-assessed and paid
at the time of filing. IRS officials estimated that this is about 6 to
7 percent of all penalty assessments, but that a large majority of
these are percentage based with no fixed dollar amount. For example,
many people self-assess and pay the penalty for withdrawing money from
their Individual Retirement Accounts early. Further, IRS officials
acknowledged that some penalties were incorrectly categorized in the
database making it impossible for us to determine which penalties were
being assessed. We determined that 0.4 percent to 1.4 percent of
assessments per year from 2000 to 2005 were incorrectly categorized.
For example, in 2000, over $144 million in assessments and over $28
million in collections were incorrectly categorized. In 2005, over $343
million in assessments and over $86 million in collections were
incorrectly categorized. These two limitations may bias our estimates
downwards.
The federal government produces several broad measures of price
changes, including the CPI-U and the Gross Domestic Product (GDP) price
deflator. The CPI-U measures the average change over time in the prices
paid by consumers for a fixed market basket of consumer goods and
services. The GDP price deflator measures changes over time in the
prices of broader expenditure categories than the CPI-U. We used the
CPI-U for the purposes of this analysis because it is used currently in
the tax code to make inflation adjustments to several provisions, such
as the tax rate schedule, the amount of the standard deduction, and the
value of exemptions.[Footnote 12]
To determine the likely effect that regularly adjusting penalties for
inflation would have on the administrative burden of IRS officials, we
interviewed officials in offices across IRS who would be affected if
regular adjustments of penalties occurred. These offices are the:
* Office of Penalties within the Small Business/Self Employed division
(SB/SE);
* Learning and Education within SB/SE;
* Wage and Investment division (W&I);
* Tax Exempt/Government Entity division;
* Large and Mid-Size Business division;
* Research, Analysis and Statistics division;
* Legislative Analysis Tracking and Implementation Services;
* Office of Chief Counsel;
* Business Forms and Publications within W&I;
* Enforcement Revenue Data;
* Communications and Liaison; and:
* Modernization and Information Technology Services, including
officials who work on the Business Master File, the Financial
Management Information System, the Automated Trust Fund Recovery
system, Report Generation Software, Automated Offers in Compromise,
Penalty and Interest Notice Explanation, Integrated Data Retrieval
System, and the Payer Master File Processing System.
To determine the likely effect that regularly adjusting penalties for
inflation would have on the administrative burden of tax practitioners,
we interviewed tax practitioners affiliated with the American Institute
of Certified Public Accountants, the National Association of Enrolled
Agents, the National Society of Tax Professionals, and the American Bar
Association. In total, we spoke with 28 practitioners. Results from the
nongeneralizable sample of practitioners we selected cannot be used to
make inferences about the effect of regular adjustments of penalties on
the work of all tax practitioners. Additionally, those we spoke with
presented their personal views, not those of the professional
associations through which they were contacted.
We conducted our work from September 2006 through July 2007 in
accordance with generally accepted government auditing standards.
[End of section]
Appendix II: GAO Contact and Staff Acknowledgments:
GAO Contact:
Michael Brostek, (202) 512-9039 or brostekm@gao.gov:
Acknowledgments:
In addition to the contact named above, Jonda Van Pelt, Assistant
Director; Benjamin Crawford; Evan Gilman; Edward Nannenhorn; Jasminee
Persaud; Cheryl Peterson; and Ethan Wozniak made key contributions to
this report.
[End of section]
Footnotes:
[1] For the purposes of this report, civil penalties are defined as any
penalties that are not criminal in nature.
[2] Pub. L. No. 101-410 (1990).
[3] Pub. L. No. 104-134 (1996).
[4] GAO has suggested that Congress consider amending the Inflation
Adjustment Act because several provisions of the act prevented some
agencies from fully adjusting their penalties for inflation. One of
GAO's suggestions was to permit agencies with exempt penalties to
adjust them for inflation. See GAO, Civil Penalties: Agencies Unable to
Fully Adjust Penalties for Inflation Under Current Law, GAO-03-409
(Washington, D.C.: Mar. 14, 2003).
[5] There is no explanation in the legislative history of the Inflation
Adjustment Act for the exclusion of the civil tax penalties.
[6] The penalty for failing to file a tax return is 0.5 percent of the
amount owed per month, for up to 5 months, but not more than 25 percent
of the amount owed, with a $100 minimum.
[7] For the limitations of our analysis and the data set, see app. I.
[8] Some periods over which the analysis was conducted were periods of
relatively low inflation. If inflation rates had been higher, the real
value of fixed penalties would have decreased at a greater rate and we
would expect the impact on collections to be greater.
[9] We will be reviewing this and other issues related to civil tax
penalties as we continue our work for the Senate Committee on Finance.
[10] In 1989, as part of the Omnibus Budget Reconciliation Act of 1989
(Pub. L. No. 101-239), IRC 6721 was substantially changed and the
values reaffirmed. Thus, we consider 1989 the year of last penalty
adjustment for the failure to file information returns penalties.
[11] GAO has reported that providing IRS with more enforcement tools,
particularly withholding and information reporting, has the potential
to reduce the tax gap by billions of dollars. See GAO, Tax Compliance:
Opportunities Exist to Reduce the Tax Gap Using a Variety of
Approaches, GAO-06-1000T (Washington, D.C.: July 26, 2006).
[12] Historically, inflation as measured by the CPI-U has tended to
outpace inflation as measured by the GDP price deflator. As a result,
if the GDP deflator had been used instead in this analysis, the
estimated revenue effect of indexing fixed penalties would likely have
been somewhat smaller.
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