[House Hearing, 105 Congress]
[From the U.S. Government Publishing Office]



 
  INTERNAL REVENUE SERVICE'S 1995 EARNED INCOME TAX CREDIT COMPLIANCE 
                                 STUDY

=======================================================================

                                HEARING

                               before the

                      COMMITTEE ON WAYS AND MEANS
                        HOUSE OF REPRESENTATIVES

                       ONE HUNDRED FIFTH CONGRESS

                             FIRST SESSION

                               __________

                              MAY 8, 1997

                               __________

                             Serial 105-26

                               __________

         Printed for the use of the Committee on Ways and Means


                               


                    U.S. GOVERNMENT PRINTING OFFICE
 49-502 CC                 WASHINGTON : 1998



                      COMMITTEE ON WAYS AND MEANS

                      BILL ARCHER, Texas, Chairman

PHILIP M. CRANE, Illinois            CHARLES B. RANGEL, New York
BILL THOMAS, California              FORTNEY PETE STARK, California
E. CLAY SHAW, Jr., Florida           ROBERT T. MATSUI, California
NANCY L. JOHNSON, Connecticut        BARBARA B. KENNELLY, Connecticut
JIM BUNNING, Kentucky                WILLIAM J. COYNE, Pennsylvania
AMO HOUGHTON, New York               SANDER M. LEVIN, Michigan
WALLY HERGER, California             BENJAMIN L. CARDIN, Maryland
JIM McCRERY, Louisiana               JIM McDERMOTT, Washington
DAVE CAMP, Michigan                  GERALD D. KLECZKA, Wisconsin
JIM RAMSTAD, Minnesota               JOHN LEWIS, Georgia
JIM NUSSLE, Iowa                     RICHARD E. NEAL, Massachusetts
SAM JOHNSON, Texas                   MICHAEL R. McNULTY, New York
JENNIFER DUNN, Washington            WILLIAM J. JEFFERSON, Louisiana
MAC COLLINS, Georgia                 JOHN S. TANNER, Tennessee
ROB PORTMAN, Ohio                    XAVIER BECERRA, California
PHILIP S. ENGLISH, Pennsylvania      KAREN L. THURMAN, Florida
JOHN ENSIGN, Nevada
JON CHRISTENSEN, Nebraska
WES WATKINS, Oklahoma
J.D. HAYWORTH, Arizona
JERRY WELLER, Illinois
KENNY HULSHOF, Missouri

                     A.L. Singleton, Chief of Staff

                  Janice Mays, Minority Chief Counsel



Pursuant to clause 2(e)(4) of Rule XI of the Rules of the House, public 
hearing records of the Committee on Ways and Means are also published 
in electronic form. The printed hearing record remains the official 
version. Because electronic submissions are used to prepare both 
printed and electronic versions of the hearing record, the process of 
converting between various electronic formats may introduce 
unintentional errors or omissions. Such occurrences are inherent in the 
current publication process and should diminish as the process is 
further refined.



                            C O N T E N T S

                               __________

                                                                   Page

Advisory of May 1, 1997, announcing the hearing..................     2

                               WITNESSES

Internal Revenue Service, Hon. Michael P. Dolan, Deputy 
  Commissioner; accompanied by Ted F. Brown, Assistant 
  Commissioner, Criminal Investigation; and John Dalrymple, 
  Deputy Chief, Taxpayer Service.................................     7
U.S. Department of Treasury, Hon. John Karl Scholz, Deputy 
  Assistant Secretary, Tax Analysis..............................    23
U.S. General Accounting Office, Hon. Lynda D. Willis, Director, 
  Tax Policy and Administration Issues, General Government 
  Division.......................................................    68

                       SUBMISSIONS FOR THE RECORD

American Institute of Certified Public Accountants, statement and 
  attachments....................................................    85
Center for Law and Human Services, Michael A. O'Connor, letter 
  and attachment.................................................    92
Community Tax Aid, Inc., Jeffrey S. Gold, statement and 
  attachments....................................................    94
Community Tax Law Project, Richmond, VA, Nina E. Olson, statement    97
Joint Committee on Taxation, statement...........................    77
National Association of Enrolled Agents, Gaithersburg, MD, Judy 
  E. VandeZandschulp, statement..................................   100



  INTERNAL REVENUE SERVICE'S 1995 EARNED INCOME TAX CREDIT COMPLIANCE 
                                 STUDY

                              ----------                              


                         THURSDAY, MAY 8, 1997

                          House of Representatives,
                               Committee on Ways and Means,
                                                    Washington, DC.
    The Committee met, pursuant to notice, at 10:05 a.m., in 
room 1100, Longworth House Office Building, Hon. Bill Archer 
(Chairman of the Committee) presiding.
    [The advisory announcing the hearing follows:]

ADVISORY

FROM THE COMMITTEE ON WAYS AND MEANS

FOR IMMEDIATE RELEASE                          CONTACT: (202) 225-1721
May 1, 1997
No. FC-8

                    Archer Announces Hearing on the

                 Internal Revenue Service's 1995 Earned

                   Income Tax Credit Compliance Study

    Congressman Bill Archer (R-TX), Chairman of the Committee on Ways 
and Means, today announced that the Committee will hold a hearing to 
examine the Earned Income Tax Credit (EITC) Compliance Study released 
by the Internal Revenue Service (IRS) on April 21, 1997. The hearing 
will take place on Thursday, May 8, 1997, in the main Committee hearing 
room, 1100 Longworth House Office Building, beginning at 10:00 a.m.
      
    Oral testimony at this hearing will be from invited witnesses only. 
Witnesses will include, among others, officials from the IRS, the 
Department of the Treasury, and the General Accounting Office. However, 
any individual or organization not scheduled for an oral appearance may 
submit a written statement for consideration by the Committee and for 
inclusion in the printed record of the hearing.
      

BACKGROUND:

      
    Under present law, the amount of EITC that an eligible taxpayer may 
claim depends on whether the taxpayer has one, more than one, or no 
qualifying children and is determined by multiplying the credit rate by 
the taxpayer's earned income up to an earned income threshold. The 
maximum amount of the credit is the product of the credit rate and the 
earned income threshold. For taxpayers with earned income (or adjusted 
gross income (AGI), if greater) in excess of the phaseout threshold, 
the credit amount is reduced by the phaseout rate multiplied by the 
amount of earned income (or AGI, if greater) in excess of the phaseout 
threshold. For taxpayers with earned income (or AGI, if greater) in 
excess of the phaseout limit, no credit is allowed.
      
    In recent years, Congress has enacted several changes to the 
credit's eligibility requirements in order to better target the program 
to low-income workers. In addition, changes have been enacted to 
enhance the IRS's ability to enforce compliance with the credit, 
including a provision authorizing the IRS to treat a taxpayer's failure 
to provide a valid Social Security number for EITC qualifying children 
as a mathematical error.
      
    Despite these changes, noncompliance in the EITC program remains at 
high levels. Last week, the IRS released a study entitled ``Study of 
EITC Filers for Tax Year 1994.'' This study was based on a sample of 
1994 returns claiming the EITC and received by the IRS between January 
15 and April 21, 1995. The study found that taxpayers erroneously 
claimed approximately $4.4 billion of EITC, which was 25.8 percent of 
the total EITC claimed in the 1995 filing season. Adjusting for changes 
in IRS enforcement practices made for the 1995 filing season, the net 
error rate would have been 23.5 percent. The study also found that had 
the procedural changes enacted in the Personal Responsibility and Work 
Opportunity Reconciliation Act of 1996 (P.L. 104-193) been in effect 
during the 1995 filing season, the error rate would have been 20.7 
percent.
      
    In announcing the hearing, Chairman Archer stated: ``The results of 
the IRS's EITC compliance study are extremely troubling. Despite the 
Government's best efforts, EITC fraud and errors are still shockingly 
high. We have an obligation to the nation's taxpayers to ask whether 
the benefits of delivering the EITC through the tax system justifies 
the loss of $5 billion a year in fraudulent and erroneous payments.''
      

FOCUS OF THE HEARING:

      
    The Committee will receive testimony from Ted F. Brown, Assistant 
Commissioner of the IRS, Criminal Investigation, regarding the findings 
of the EITC Compliance Study and the types of fraudulent claims and 
errors identified by the IRS. The Committee will also hear Treasury 
officials regarding legislative options recently advanced by the 
Department for improving EITC compliance, and from the General 
Accounting Office regarding work they have done on EITC administration 
and compliance issues.
      

DETAILS FOR SUBMISSION OF WRITTEN COMMENTS:

      
    Any person or organization wishing to submit a written statement 
for the printed record of the hearing should submit at least six (6) 
copies of their statement and a 3.5-inch diskette in WordPerfect or 
ASCII format, with their address and date of hearing noted, by the 
close of business, Thursday, May 15, 1997, to A.L. Singleton, Chief of 
Staff, Committee on Ways and Means, U.S. House of Representatives, 1102 
Longworth House Office Building, Washington, D.C. 20515. If those 
filing written statements wish to have their statements distributed to 
the press and interested public at the hearing, they may deliver 200 
additional copies for this purpose to the Committee office, room 1102 
Longworth House Office Building, at least one hour before the hearing 
begins.
      

FORMATTING REQUIREMENTS:

      
    Each statement presented for printing to the Committee by a 
witness, any written statement or exhibit submitted for the printed 
record or any written comments in response to a request for written 
comments must conform to the guidelines listed below. Any statement or 
exhibit not in compliance with these guidelines will not be printed, 
but will be maintained in the Committee files for review and use by the 
Committee.
      
    1. All statements and any accompanying exhibits for printing must 
be typed in single space on legal-size paper and may not exceed a total 
of 10 pages including attachments. At the same time written statements 
are submitted to the Committee, witnesses are now requested to submit 
their statements on a 3.5-inch diskette in WordPerfect or ASCII format.
      
    2. Copies of whole documents submitted as exhibit material will not 
be accepted for printing. Instead, exhibit material should be 
referenced and quoted or paraphrased. All exhibit material not meeting 
these specifications will be maintained in the Committee files for 
review and use by the Committee.
      
    3. A witness appearing at a public hearing, or submitting a 
statement for the record of a public hearing, or submitting written 
comments in response to a published request for comments by the 
Committee, must include on his statement or submission a list of all 
clients, persons, or organizations on whose behalf the witness appears.
      
    4. A supplemental sheet must accompany each statement listing the 
name, full address, a telephone number where the witness or the 
designated representative may be reached and a topical outline or 
summary of the comments and recommendations in the full statement. This 
supplemental sheet will not be included in the printed record.
      
    The above restrictions and limitations apply only to material being 
submitted for printing. Statements and exhibits or supplementary 
material submitted solely for distribution to the Members, the press 
and the public during the course of a public hearing may be submitted 
in other forms.

      
    Note: All Committee advisories and news releases are available on 
the World Wide Web at `HTTP://WWW.HOUSE.GOV/WAYS__MEANS/'.
      

    The Committee seeks to make its facilities accessible to persons 
with disabilities. If you are in need of special accommodations, please 
call 202-225-1721 or 202-226-3411 TTD/TTY in advance of the event (four 
business days notice is requested). Questions with regard to special 
accommodation needs in general (including availability of Committee 
materials in alternative formats) may be directed to the Committee as 
noted above.
      

                                

    Chairman Archer. The Committee will come to order.
    Good morning, everyone, on this beautiful spring day. We 
are not too far removed from April 21, when the IRS released a 
study it conducted during the 1995 filing session relating to 
the level of compliance in the Earned Income Tax Credit, EITC, 
Program. Their study concluded that the error and fraud rate 
for the EITC Program was an unacceptably high 20.7 percent and 
that we are paying out to people who are not legally entitled 
to it more than $5 billion a year.
    The purpose of today's hearing is to learn more from the 
IRS and Treasury about the high level of fraud and errors 
associated with the EITC and what more can be done to address 
this problem.
    I consider the EITC to be a very important program to help 
low-income working families. This program has long enjoyed 
bipartisan support, and deservedly so. To protect the long-term 
future of this helpful program, we have got to stop the fraud 
and the errors. Hardworking taxpayers will not support welfare 
programs like the EITC if we cannot get the errors and fraud 
under control. We have an obligation both to the credit's 
legitimate recipients and to the Nation's taxpayers to stop 
this waste.
    This is not the first time that this Committee has 
addressed concerns about the IRS' vulnerability to tax refund 
fraud and the EITC noncompliance problems. In 1994, the 
Subcommittee on Oversight held two hearings to examine the 
issue. In part, due to concerns raised at those hearings, the 
IRS put into place a revenue protection strategy during the 
1995 filing session which was designed primarily to identify 
returns with questionable claims for the EITC.
    Congress has also enacted several changes to enhance the 
IRS' ability to improve compliance in the EITC Program, 
including a provision authorizing the IRS to treat a taxpayer's 
failure to provide a valid Social Security number for EITC 
qualifying children as a math error. Despite these changes, the 
EITC remains subject to massive leaks of money.
    Treasury has advanced a package of eight legislative 
proposals for improving EITC compliance. However, until we know 
more about the root causes of the fraud and errors that were 
identified by the IRS, it is impossible for the Committee to 
assess whether the Treasury's proposals get at the real causes 
of noncompliance to actually make a difference.
    For that reason, I have asked the Joint Committee on 
Taxation to request the Treasury Department to provide it with 
all of the underlying data and findings from the IRS study so 
that it can give this Committee its analysis of the problems 
and potential solutions. I encourage Treasury to comply as 
quickly as possible with that request.
    Taxpayers have a right to know why EITC is so abused and 
prone to error. Fixing this valuable program should be a 
priority both for the Congress and for the administration.
    [The opening statement follows:]

Statement of Hon. Bill Archer, A Representative in Congress from the 
State of Texas

    On April 21st, the Internal Revenue Service released a 
study it conducted during the 1995 filing season relating to 
the level of compliance in the Earned Income Tax Credit 
program. The study concluded that the error and fraud rate for 
the EITC program is an unacceptably high 20.7 percent, and that 
we are wasting more than $5 billion a year. The purpose of 
today's hearing is to learn more from the IRS and Treasury 
about the high level of fraud and errors associated with the 
EITC, and what more can be done to address this problem.
    I consider the EITC to be a very important program to help 
low-income working families. This program has long enjoyed 
bipartisan support, and deservedly so. To protect the long term 
future of this helpful program, we've got to stop the fraud and 
errors. Hardworking taxpayers won't support welfare programs 
like the EITC if we can't get the errors and fraud under 
control. We have an obligation both to the credit's legitimate 
recipients and to the nation's taxpayers to stop the waste.
    This is not the first time that this Committee has 
addressed concerns about the IRS's vulnerability to tax refund 
fraud and EITC noncompliance problems. In 1994, the 
Subcommittee on Oversight held two hearings to examine this 
issue. In part due to concerns raised at those hearings, the 
IRS put into place a revenue protection strategy during the 
1995 filing season which was designed primarily to identify 
returns with questionable claims for the EITC.
    Congress has also enacted several changes to enhance the 
IRS's ability to improve compliance in the EITC program, 
including a provision authorizing the IRS to treat a taxpayer's 
failure to provide a valid Social Security number for EITC 
qualifying children as a math error. Despite these changes, the 
EITC remains subject to massive leaks of money.
    The Department of the Treasury has advanced a package of 
eight legislative proposals for improving EITC compliance. 
However, until we know more about the root causes of the fraud 
and errors that were identified by the IRS, it is impossible 
for the Committee to assess whether the Treasury's proposals 
get at the real causes of noncompliance to actually make a 
difference.
    For that reason, I have asked the Joint Committee on 
Taxation to request the Treasury Department to provide it with 
all of the underlying data and findings from the IRS study so 
that it can give this Committee its analysis of the problems 
and potential solutions. I encourage Treasury to comply as 
quickly as possible with that request.
    The taxpayers have a right to know why EITC is so abused 
and prone to error. Fixing this valuable program should be a 
priority with both Congress and the Administration.
    [Prepared Text. Spoken Remarks May Differ.]
      

                                

    Chairman Archer. I now recognize Mr. Rangel for any 
statement he might like to make on behalf of the Minority, and 
without objection, all Members will have the right to insert 
written statements in the record at this point.
    [The opening statements follow:]

Opening Statement of Hon. Barbara B. Kennelly, a Representative in 
Congress from the State of Connecticut

    As a long-time champion of the EITC, and someone who has 
worked to simplify it as necessary over the years, I firmly 
believe in this program but fraud and abuse is unacceptable in 
any form.
    Therefore, we must take two steps. First, we must insist 
that the IRS combat fraud and abuse--something they frankly 
have not been doing. When the IRS finds a taxpayer has made up 
a child or falsified income in order to increase the EITC, 
clear instances of fraud and abuse in anyone's mind, it should 
do three things--deny the credit, prosecute to the full extent 
of the law and, tag that return in the computer as a future 
fraud prevention measure.
    Second, we need to get a better handle on where the fraud 
and abuse occurs. We have worked for years to simplify the 
credit. We still have an error problem. But for the moment, the 
outright fraud and abuse seems more serious. Treasury has taken 
some steps administratively to address this problem. But there 
may be additional legislative steps we need to take. This is 
something I intend to work on. Perhaps we should conform the 
personal exemption and EITC to reduce fraud and abuse.
    We must remember that this program only benefits working 
families. In 1995, the EITC lifted 3.7 million families out of 
poverty. In fact, there were 2.4 million persons over age 16 
who lived in poverty and worked full-time year-round in 1995.
      

                                

Opening Statement of Hon. Jim Ramstad, a Representative in Congress 
from the State of Minnesota

    Mr. Chairman, thank you for holding this critical hearing 
on the administration of the Earned Income Tax Credit.
    The recent IRS study of EIC filers for the 1994 tax year 
revealed a startling and sobering level of fraud and errors in 
the EIC program. With the projected cost of the EIC program in 
FY 1997 at $25 billion, this could amount to between 5 and 6 
billion dollars of waste. This is simply unacceptable.
    The EIC program was intended to help the working poor, and 
we need to ensure the EIC meets this mission without costing 
taxpayers billions of dollars in fraud, abuse, error and waste.
    I look forward to hearing about compliance issues from our 
panel of witnesses today, and to exploring solutions to the 
high level of fraudulent and erroneous payments in the EIC 
program.
    Again, Mr. Chairman, thank you for your leadership in 
convening this important hearing.
      

                                

    Chairman Archer. Mr. Rangel.
    Mr. Rangel. Mr. Chairman, I would like to support your 
opening statement in its entirety. There is no program that I 
think that this Congress, or no policy has been adopted that 
has been more effective than the program we are talking about. 
This is a program about which liberals and conservatives agree, 
that people who work hard every day should not be getting less 
than those people who choose not to work or find themselves on 
welfare.
    To encourage this work activity, we have this refundable 
tax that keeps people with their pride and their family, and 
encourages them to enter the mainstream without the stigma of 
having to go on welfare.
    I do not think there is a better supporter of the Internal 
Revenue Service than I, and I think that a lot of accusations 
about the EITC have been unfair because nobody likes a tax 
collector. But this program is so vital. What are the reasons 
why we find so many mistakes? Why are you so prone to allow 
people to say that it is fraud and tax cheating? Are there 
other programs where we find this gap between effective 
collection of taxes due the U.S. Government? Do you find a 
large number of people in this particular category making 
mistakes, whether they are losing money or whether, in this 
case, they are gaining money?
    If you cannot do this job, for God's sake, do not let 
everything fall on the recipient of the program. Let us know 
how we can be more effective. I am really concerned, and I have 
seen large tax shortfalls in other areas, why in this area the 
language is cheating and fraud, because if that is true, then 
we may have to take another look at the program. If it is not 
true, we should take another look at the IRS.
    Thank you, Mr. Chairman.
    Chairman Archer. Thank you, Mr. Rangel.
    We do have with us today Michael Dolan, Deputy Commissioner 
of IRS, representing the Internal Revenue Service, Ted Brown, 
Assistant Commissioner of Criminal Investigation of the IRS, 
and John Karl Scholz, Deputy Assistant Secretary for Tax 
Analysis with the Treasury Department.
    Mr. Dolan, I understand that you are our leadoff witness, 
so welcome to the Committee. We would be pleased to receive 
your statement.

   STATEMENT OF HON. MICHAEL P. DOLAN, DEPUTY COMMISSIONER, 
    INTERNAL REVENUE SERVICE; ACCOMPANIED BY TED F. BROWN, 
   ASSISTANT COMMISSIONER, CRIMINAL INVESTIGATION, INTERNAL 
  REVENUE SERVICE, AND JOHN DALRYMPLE, DEPUTY CHIEF, TAXPAYER 
               SERVICE, INTERNAL REVENUE SERVICE

    Mr. Dolan. Thank you, Mr. Chairman. I am pleased to be 
here.
    Knowing what an auspicious gathering this was going to be, 
I added a little more horsepower to my team. I have at my right 
John Dalrymple, who is essentially the Deputy Chief of 
Operations and who presides over the full spectrum of areas 
that I think the Committee will be interested in.
    With your permission, I would like to have my formal 
statement submitted and maybe just recap a few of the points.
    Chairman Archer. Without objection, your entire written 
statement will appear in the record, and if you will synopsize 
verbally and shorten the statement, we would appreciate it.
    Mr. Dolan. For starters, I would make the observation that 
the formal testimony that the Treasury Department is submitting 
does an excellent job of laying out the history of earned 
income credit, EIC, and this Committee does not need any kind 
of instruction from me on the various developments of EIC, so I 
am going to proceed from the background that the Internal 
Revenue Service essentially feels like it has a couple of 
missions in the area of the earned income tax credit.
    On one hand, it is our responsibility to help those who are 
eligible know their rights and know how to claim the credit. On 
the other hand, it is our responsibility to ensure that only 
those who are eligible claim and are granted the credit. Some 
people have observed that this creates a tension or a dynamic 
that somehow is inherently dysfunctional.
    I think this Committee understands that that is the 
inherent tension, a constructive tension, in the Internal 
Revenue Service mission in general: we typically worry about 
both components that create this tension. On the front end, we 
worry about education and outreach. We worry about our ability 
to inform taxpayers of their rights and their obligations so 
that those who are intent on complying with the law feel 
equipped to do so. And those who are inclined to game or scheme 
the system--hopefully--feel deterred from doing so.
    On the back end, then, it is our responsibility to employ 
enforcement or compliance mechanisms that attempt to detect 
those instances where somebody erroneously claimed benefits 
under any provision of the tax law and took an advantage to 
which they were not entitled.
    My formal statement includes some particular references to 
the kinds of efforts we have made at outreach, and I think you 
will see some things in the statement with which you are quite 
familiar. Fortunately we have had the opportunity to work with 
a lot of civic groups, churches, and many of your offices. Many 
Congressional offices have helped us on outreach efforts to 
make sure that taxpayers know about EIC, how to qualify, what 
the rules of the game are, and, quite frankly, some of the 
issues that have surfaced over the last 3 or 4 years that have 
gotten all of the press attention.
    The one area that I would say with respect to outreach on 
the earned income credit--with which we are less than satisfied 
and continue to look for ways to improve and to take all the 
help we can get--is in the area of the advanced earned income 
tax credit. That is a concept where we have found that we want 
to encourage people to take the advanced EIC. It not only is 
available to them year round but it also helps on the back end 
in some of the areas that have been most troublesome to us in 
the overclaims.
    With respect to the enforcement, as this Committee is well 
aware, an earned income tax credit claim processes through the 
normal tax processing pipeline just like every other asset of 
the 100 million-plus individual tax returns that we receive 
every year. As a consequence, all of the filters and all of the 
processes of that pipeline work on the earned income tax credit 
claim just like they do the other provisions of the 1040 and 
the schedules that are attendant to it.
    One of the things we did early on as a result of some 
experience we had with overclaim is we have done a reasonably 
vigorous attempt during the last four filing seasons to add to 
our detection and compliance process elements that we thought, 
in the first instance, identified the correct returns, because 
what we want to do is get the correct returns identified and 
get them through the system and not bog it down.
    Second, we want to identify the returns that, on the face 
of them, look as if they raise questions.
    Third, we want to mine those returns not only for what may 
or may not be erroneous claims but so we can use that data to 
establish filters and screens and systematic ways to detect in 
the future the issues that appear on the face of a return and 
allow us to deal with them quickly and process them.
    Coming out of those efforts have been, by our lights, 
anyway, a number of enhanced abilities to do two things: Let 
the good returns flow through quickly and pay appropriate 
attention to returns that deserve more scrutiny.
    Mr. Rangel, you made a comment, and I think inferred in 
your comment was we need to be careful about the language we 
use because people will, I think, sometimes talk about fraud 
and cheating and overclaim and lots of things in ways that do 
not actually distinguish the factual difference among returns.
    So today, I would like to be very careful in suggesting 
that most of the data that we put before you in the form of our 
report and our testimony is characterized as overclaim, not 
because we are trying to be clever or cute with words, but 
because below the numbers that represent overclaim amounts 
there are a number of fairly important nuances and distinctions 
that become very misleading if somebody jumps to a conclusion 
that the overclaim amounts all represent fraud or jumps to the 
conclusion, quite frankly, that it all represents just innocent 
mistakes.
    So there are some significant nuances below the level of 
the gross number of overclaims. Hopefully, our comments will 
elucidate and not obfuscate if we seem reticent to apply a 
label to the overclaims.
    I know the Committee is particularly interested in the 
report that the Chairman mentioned in his opening comments. I 
would like to provide some context, of which I think the 
Committee may be aware. That report, as was pointed out, is 
1994 tax year information. Those returns, for the most part, 
were filed between January and April 1995. There have been two 
filing seasons since then.
    It was also a report that was drawn in the midst of the 
filing season, and again, I think as Chairman Archer mentioned, 
in the midst of a filing season where we had taken fairly 
substantial efforts to correct, particularly, the issue of 
invalid Social Security numbers. That also was the year, as 
many of you might remember since you experienced some of the 
frustration that came with people contacting your offices, that 
was the year in which we used an all-out campaign to do two 
things. There were many, many people who, just because of 
passage of time and reluctance or forgetfulness, did not 
correct their Social Security numbers. There were people who 
were married, still in the system with their maiden name. So a 
tremendous number of Social Security numbers were corrected 
that year for people for whom there was no ill intention or 
action at all.
    Beyond that, there also were a number of people who, by our 
after-the-fact analysis, could have only intended to use a 
Social Security number incorrectly and a number of those cases 
have now disappeared in the wake of that 1994 campaign.
    Subsequently, the 1995 and 1996 tax years have also been 
processed. In each of those years, we have made incremental 
improvements that would not be reflected in the 1994 test. 
Probably the most substantial thing that has occurred in that 
timeframe is an area that the Chairman referenced and an area 
where we have to thank Congress, because the technique that we 
are using this year, called math error technique, which allows 
us to avoid the long and arduous deficiency process and gives 
us a much quicker tool to deal with Social Security numbers 
that appear on their face to be invalid.
    That is something we are using, for the first time this 
filing season. It is, at this preliminary stage, a tool that 
has been very useful in sorting out instances of erroneous use 
of Social Security numbers and in allowing us to deal with that 
much more quickly than under the old system.
    Mr. Chairman, I will close with a couple of other comments. 
Since the 1994 report, as I mentioned, a number of incremental 
changes have been made that affect the actual base experiences 
that we were reporting on in 1994. A similar study is being 
done on the tax year 1995.
    We are complementing that with a series of research efforts 
in five or six of our district offices. They are taking various 
subsets of our experience in this and other areas and looking 
for further refinements to our process to assure us that the 
claims going through are appropriate.
    In addition to the data that is in the report, you can also 
appreciate that there are other forms of analysis and there is 
other data that underlie the report. You, Mr. Chairman, make 
the point that you have asked the Joint Committee to look at 
that data. Clearly, like any report, there are cuts on that 
data that can be taken and have been taken in terms of systems 
changes in place. There are other cuts on that data that, quite 
frankly, if we were publicly to go into at any great lengths, 
would probably encourage those we want to discourage--that is, 
those who are out there who intend to scheme at the margins on 
this thing.
    So I think you will find as the Joint Committee receives 
and analyzes that data that there are a number of ways to look 
at the data developed in 1995. Again, I would make the point, 
that data in the 1994 report was designed to assist us in 
improving the systems. It makes no pretense about being an 
authoritative work on EITC, and in point of fact, it is a 
report that has already generated a fair number of changes in 
the way we do business.
    With that, I think that you will no doubt have some 
questions. My colleagues and I are quite prepared to respond, 
but maybe to get on with Karl's presentation and in the 
interest of the Committee's time, I would at this point close.
    [The prepared statement and attachment follow:]

Statement of Michael P. Dolan, Deputy Commissioner, Internal Revenue 
Service; accompanied by Ted F. Brown, Assistant Commissioner, Criminal 
Investigation, Internal Revenue Service, and John Dalrymple, Deputy 
Chief, Taxpayer Service, Internal Revenue Service

    Mr. Chairman and Distinguished Members of the Committee, I 
appreciate the opportunity to be here today to discuss the IRS' 
administration of the Earned Income Tax Credit (EITC). With me 
today are John Dalrymple, Deputy Chief Taxpayer Service, and 
Ted Brown, Assistant Commissioner for Criminal Investigation.
    Congress enacted the EITC in 1975 as a refundable credit 
available to eligible low and moderate income workers. The 
amount of the EITC to which a taxpayer is entitled depends upon 
the taxpayer's earned income and whether the claimant has 
``qualifying children.'' The EITC phases out above certain 
income levels.
    Since 1975, Congress has changed the EITC in several ways. 
These changes have included increasing the dollar amount of the 
EITC and the income levels at which EITC phases out. More 
recently, in the Omnibus Budget Reconciliation Act of 1993, 
Congress simplified the EITC by eliminating the two 
supplemental credits for health insurance coverage and for 
taxpayers with children under 1 year of age. The available EITC 
amounts were also increased and EITC was made available to 
individuals who do not have children, but otherwise qualify 
based solely on earned income.
    In 1994, Congress denied the EITC to nonresident aliens and 
prison inmates for any income received for services provided by 
the inmate while incarcerated. In addition, Congress required 
taxpayers to provide a social security number for each EITC 
qualifying child, regardless of the child's age. In the 
Personal Responsibility and Work Opportunity Reconciliation Act 
of 1996, Congress altered the income requirements for the EITC 
and denied the EITC to individuals who were issued taxpayer 
identification numbers solely for the purpose of receiving 
Federally funded benefits. Congress also authorized the IRS to 
treat a taxpayer's failure to provide a valid social security 
number as a mathematical error, which is a simpler and more 
efficient procedure than using the examination process.
    The Treasury Department and the IRS have worked with 
Congress to develop measures designed to ensure that only those 
taxpayers eligible for the EITC actually receive it. The IRS 
has used education and publicity in administering the EITC to 
assure that taxpayers receive the benefits to which they are 
entitled. At the same time, the IRS has also focused its 
efforts towards preventing taxpayers from receiving the EITC if 
they are not entitled to it.

                       A. Education and Publicity

    It has been estimated that between 80 percent and 86 
percent of all eligible families actually claimed the EITC in 
1990. Through our education and publicity efforts over the past 
several years, the IRS has made a concerted effort to reach an 
even larger percentage of eligible families. For example, the 
IRS currently issues post-filing notices to taxpayers who 
appear to qualify for the EITC, but do not claim it on their 
returns. These notices advise taxpayers of their potential 
eligibility for the credit, and invite taxpayers to apply for 
the credit by returning the notices, along with certain 
requested information. In 1996, the IRS sent out over 1.2 
million notices to taxpayers with a response rate of 38 
percent. Of those responding, 99.7 percent received the credit.
    Besides these notices, the Service also pursues other 
methods of educating taxpayers about EITC and their potential 
eligibility for the credit. The Service uses brochures, 
notices, press releases and direct mailings to publicize the 
EITC. Many of these products are available in Spanish, as well 
as English. Our publicity and educational efforts occur 
throughout the year, although we increase our outreach efforts 
during each filing season.
    We are also taking steps to educate the public about the 
availability of the Advance Earned Income Tax Credit (AEITC) 
and to encourage employees to consider it. Although the 
percentage of taxpayers availing themselves of the EITC is 
high, a much smaller number takes advantage of the AEITC, which 
is paid out to employees in each paycheck. The IRS sends 
publications to employers describing both EITC and AEITC, as 
well as publications for employers to distribute to employees.
    In addition, the IRS has sent Publication 1235, along with 
the necessary form to file with their employers, to employees 
who claimed EITC this year and would possibly benefit from the 
AEITC. This month, we will send out almost 4.7 million copies 
of Publication 1235. Additional mail-outs are planned for June 
and September.
    To assist taxpayers in properly claiming the credit, the 
IRS will compute the EITC for a taxpayer upon request. The 
taxpayer merely writes ``EIC'' on the appropriate line of the 
yearly tax return and submits the Schedule EIC with the 
appropriate supporting information. The IRS will then calculate 
the proper amount of the taxpayer's credit, based on that 
information.

                         B. Enforcement Efforts

    While we want to ensure that taxpayers receive the EITC if 
they are entitled to it under the law, we must also guard 
against ineligible taxpayers from receiving such benefits. To 
expand our understanding of EITC compliance, the IRS conducted 
a pilot study of the 1994 filing season of the electronically 
filed returns on which taxpayers had claimed the EITC. The 
study was designed to provide information needed to put 
controls in place quickly for the rest of the 1994 filing 
season so that the IRS could detect and prevent EITC compliance 
problems. The study, however, was not statistically valid for 
the entire EITC population and, therefore, the results were not 
representative of this filing population.
    As a result of the issues identified by the 1994 filing 
season study, the IRS undertook a second study of EITC, which 
involved a statistically valid random sample of EITC returns 
filed throughout the 1995 filing season. A detailed report on 
the 1995 study is a attached as an Appendix. The sample 
included 2,046 returns, of which 1,250 were paper and 796 were 
electronically filed between January 15 and April 21, 1995.
    Soon after the taxpayers filed their returns, agents from 
IRS Criminal Investigation Division made face-to-face contact 
with the taxpayers to validate their EITC claims. The agents 
also contacted other parties, such as employers, tax return 
preparers, family members and neighbors, if needed, to validate 
the EITC claims. The agents then made initial judgments about 
the legitimacy of the EITC claims, which were subject to review 
and to change, if the judgments were found to be in error.
    The study results showed that EITC claims filed during the 
1995 filing season contained errors that required adjustments, 
both upwards and downwards, in EITC. Of the total EITC dollars 
claimed in 1994, 25.8 percent of the EITC was overclaimed, 
while 1.7 percent of the EITC was underclaimed for both paper 
and electronically filed returns. The study further showed an 
overclaim rate of 26.1 percent for taxpayers claiming 
qualifying children and an overclaim rate of 15.7 percent for 
taxpayers not claiming qualifying children.\1\ Preliminary 
results from the study provided the IRS with a better 
understanding of EITC compliance prior to the 1997 filing 
season. The final study results provide a baseline from which 
to analyze further studies of the effectiveness of our EITC 
administration efforts.
---------------------------------------------------------------------------
    \1\ These overclaim rates include both paper and electronically 
filed returns.
---------------------------------------------------------------------------
    Beginning with the 1994 filing season and continuing 
through this year's filing season, the IRS has developed and 
implemented numerous initiatives directed towards identifying 
and preventing erroneous refund claims, including EITC claims. 
These initiatives include increasing verification of taxpayer 
social security numbers, screening and monitoring of electronic 
return originators, delaying refunds in order to allow the IRS 
additional time to verify EITC claims before issuing refunds 
and dedicating enforcement resources to identifying fraudulent 
schemes, as well as examining questionable claims.
    In FY 1995, IRS' Criminal Investigation Division identified 
more than 4,400 refund schemes involving almost 62,000 returns 
and prevented the issuance of $83 million in refunds. In 
addition, we initiated 491 criminal investigations involving 
refund schemes and return preparers. Prosecution 
recommendations were forwarded on 404 cases and we obtained 
indictments of 329 individuals and convictions in 300 cases.\2\ 
Also in FY 1995, through pre-refund examinations, we prevented 
the issuance of an additional $425 million in refunds. Thus, in 
FY 1995, direct compliance efforts prevented $508 million in 
improper refunds from being issued.
---------------------------------------------------------------------------
    \2\ These totals include cases initiated in the prior fiscal year.
---------------------------------------------------------------------------
    In FY 1996, we continued our vigorous compliance efforts to 
identify and stop fraudulent refund schemes and to pursue 
questionable claims through pre-refund examinations. In FY 
1996, we identified nearly 2,450 fraudulent refund schemes 
involving 24,000 returns and prevented the issuance of $46.8 
million in refunds. We initiated 313 criminal investigations 
involving refund schemes. Prosecution recommendations were 
forwarded on 279 cases and indictments were obtained on 290 
individuals and conviction in 304 cases.\3\ Through pre-refund 
examinations, we prevented the issuance of an additional $864 
million in refunds. Thus, last fiscal year, our direct 
enforcement efforts prevented $932 million in erroneous or 
fraudulent refunds from being issued.
---------------------------------------------------------------------------
    \3\ These totals include cases initiated in the prior fiscal year.
---------------------------------------------------------------------------
    In this time of declining resources, we must balance our 
use of enforcement resources to address a myriad of compliance 
issues, including EITC. However, I assure you that the IRS will 
continue its programs to detect, investigate and examine 
questionable EITC claims.
    This concludes my prepared remarks. Thank you for allowing 
us the opportunity to discuss our efforts to improve 
administration of the EITC. I assure you that the IRS will 
remain vigilant in its efforts to ensure that only those 
taxpayers who are earned the credit receive it. My colleagues 
will be happy to answer any questions you or other Committee 
Members may have.
      

                                

      
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    Chairman Archer. Thank you, Mr. Dolan.
    Mr. Scholz, would you like to give us your statement on 
behalf of the Treasury.

STATEMENT OF JOHN KARL SCHOLZ, DEPUTY ASSISTANT SECRETARY, TAX 
             ANALYSIS, U.S. DEPARTMENT OF TREASURY

    Mr. Scholz. I certainly would. Mr. Chairman and Members of 
the Committee, I am very pleased to have the opportunity to 
discuss the administration's proposals to improve the earned 
income tax credit.
    Since I have not testified before the Full Committee, let 
me tell you a little bit about my background. For the past 9 
years, I have been an economics professor at the University of 
Wisconsin-Madison and a Research Associate at the Institute for 
Research on Poverty. My academic research has, in part, focused 
on the effectiveness of the EITC and I look forward to working 
with the Committee on improving the credit.
    The administration is strongly committed to the goals of 
the EITC and will oppose any proposals that reduce the EITC and 
raise taxes on millions of working families who play by the 
rules. The credit provides a clear message that work pays----
    Chairman Archer. Mr. Scholz, if you will suspend for a 
moment, I would hope that we do not get into political rhetoric 
in this hearing today. We are here to determine why there is a 
fraud and error rate in the program, and I would hope that the 
witnesses and the Members of the Committee will not let this 
turn into a hearing that involves political rhetoric. You may 
continue.
    Mr. Scholz. Mr. Chairman, my testimony addresses important 
sources of noncompliance and I have worded my testimony very 
carefully to make sure that we do not want to raise taxes on 
working families who play by the rules.
    Mrs. Johnson. Will the gentleman yield?
    Chairman Archer. The gentlelady from Connecticut is 
recognized.
    Mrs. Johnson. No one here is interested in raising taxes on 
the working poor. No one is interested in undermining the EITC. 
We are interested in the fact that $5 billion is going out 
every year to people who are not qualified. So for you to start 
your testimony that way is to say that we have to defend this 
program against you. You do not. We are for this program, but 
we want it honest. We do not want to waste $5 billion and we do 
not want a 25-percent error rate. I think that is the point 
that we are trying to make to you, and if you will get to how 
you are going to reform this, that would be useful.
    Mr. Lewis. Mr. Chairman.
    Chairman Archer. Mr. Lewis.
    Mr. Lewis. If you invited the gentleman here to testify, to 
speak, he should be given that courtesy and not muzzled and not 
censored on what he has to say.
    Mr. Rangel. Mr. Chairman.
    Chairman Archer. I would simply reiterate what I said, 
which is not political. I do not want these hearings to fall 
into political rhetoric. I do not want these hearings to be 
involved in how are we going to increase people's taxes. I do 
not want these hearings to be involved in even how we are going 
to solve the problem. We want to know what the problem is and 
why it is what it is, as the gentleman from New York said in 
his opening statement, and I would encourage all the witnesses 
and the Members of the Committee to stick to the purpose of 
this hearing.
    You may proceed, Mr. Scholz.
    Mr. Rangel. Mr. Chairman? Mr. Chairman, may I be 
recognized?
    Chairman Archer. Mr. Rangel.
    Mr. Rangel. Might this not be the appropriate time for us 
to go vote and then come back?
    Chairman Archer. I think that is an excellent suggestion. 
The Committee will stand in recess while we vote, and let us 
return as quickly as we can.
    [Recess.]
    Chairman Archer. The Committee will come to order.
    Mr. Scholz, you may continue.
    Mr. Scholz. Thank you very much, Mr. Chairman.
    The EITC provides a clear message that work pays and so 
plays a critical role in public policies directed toward low-
wage labor markets. While the U.S. economy has become the envy 
of the world, labor markets for low-skilled workers in the 
United States have not performed well over the last 20 years. 
Between 1979 and 1992, the earnings of a male without a high 
school degree has declined by more than 23 percent in real 
terms. Among male workers with a high school degree, real 
earnings have declined by 17 percent over this period.
    The EITC helps the operation of low-wage labor markets by 
increasing the returns to work and, hence, labor force 
participation for low-skilled workers. In addition, it helps 
close the poverty gap by increasing disposable incomes of 
families. The Census Bureau reports that the EITC lifted 3.7 
million persons out of poverty during 1995. The EITC will play 
an increasingly important role over time in making welfare 
reform work.
    In the public dialog regarding the EITC, some have raised 
the question of whether the credit is a nontax function of the 
IRS. Let me be clear. The EITC belongs in the Internal Revenue 
Code. The credit was created and expanded to offset the overall 
tax burden of low- and moderate-income families. It continues 
to play this role as about 85 percent of EITC costs offset the 
combined Federal income, Federal excise, and Federal payroll 
tax burden of families receiving the credit.
    In addition, 95 percent of EITC recipients would still file 
an individual income tax return even if there were no EITC and 
the IRS would still have to verify much of the same information 
regarding their filing status, number of children, and income.
    Because most EITC claimants would file a tax return even if 
the credit did not exist, the costs both to the taxpayers and 
to the IRS of administering the EITC are very low compared to 
the corresponding administrative costs of other programs. For 
example, in 1995, the Food Stamp Program cost $3.7 billion to 
administer. The Aid to Families with Dependent Children, AFDC, 
Program cost $3.5 billion to administer. Even with these large 
administrative outlays, the overpayment rates of these programs 
were between 6 and 7 percent. These figures point to a clear 
tradeoff between administrative costs and noncompliance in the 
design of programs targeted to any specific group of taxpayers.
    Another advantage of administering the EITC through the tax 
system is that participation by taxpayers eligible for the 
credit is higher than participation in many other assistance 
programs targeted to low-income families. For the EITC to meet 
the role that Congress and the administration envision, the 
credit must reach those it is intended to serve. The EITC meets 
this standard.
    Today's hearing has been called in response to the recent 
release of new IRS data on EITC noncompliance. Deputy 
Commissioner Dolan has described the major findings of this 
study. Let me add a couple additional words.
    The results provide both good news and bad news. The good 
news is there has been a significant improvement since the last 
comparable compliance study, when the IRS found that the EITC 
error rate was 35.4 percent in 1988. The improvement in EITC 
compliance to 25.8 percent in 1994 represents the 
implementation of several sensible compliance initiatives.
    Taking into account only one of the steps that has been 
enacted since 1994, that is the use of the math error 
procedures Deputy Commissioner Dolan referred to for most 
children, the net error rate in 1994 would have been 20.7 
percent. Other compliance initiatives adopted since 1994 cannot 
be examined using the data from the study but would bring the 
noncompliance rate down still further.
    While the EITC error rate has fallen sharply over time, the 
bad news from the compliance study is clear. The EITC error 
rate is too high. The administration and Congress recognize 
that the EITC can best meet its goals of making work pay and 
lifting families out of poverty by ensuring that only those who 
are eligible receive the credit.
    To better understand the remaining sources of 
noncompliance, the Treasury Department has conducted its own 
analysis of the data. We have found the most common EITC error 
is caused by taxpayers claiming qualifying children who do not 
reside with them for over half the year.
    The second most common error is due to misreporting of 
filing status among married taxpayers.
    The third most common error results from complicated living 
arrangements, where at least two taxpayers are eligible to 
claim the child. In such cases, there is an adjusted gross 
income, AGI, tie-breaker--that is tax law esoterica--where the 
taxpayer with the higher income is supposed to claim the child. 
Mistakes in meeting the tie-breaker test result in errors.
    Given the insights that arise from the current compliance 
study, Treasury and the IRS have designed a set of proposals to 
provide the IRS with new tools to identify erroneous EITC 
claims while minimizing additional administrative costs to the 
Federal Government. Our eight-point plan consists of six 
legislative proposals and two administrative actions. These 
proposals will help reduce EITC errors by increasing error 
detection before EITC refunds are paid, by imposing new, more 
effective penalties on EITC claimants, and by reducing the risk 
of unintentional errors by well-meaning taxpayers. Very 
briefly, let me list these initiatives.
    To reduce EITC errors by increasing error detection before 
refunds are paid, we are proposing new due diligence 
requirements on paid tax preparers. We are asking taxpayers who 
have lost their EITC through a deficiency procedure to file an 
expanded schedule EITC to be recertified by the Service. We are 
proposing that four States be selected for demonstration 
projects to investigate alternative mechanisms for delivering 
the credit and determining the effect of those alternative 
mechanisms on compliance. And last, the IRS has committed 
resources, significant resources during the 1998 filing season 
to investigate EITC claims.
    We are increasing penalties for intentional noncompliance 
by imposing penalties for intentional and fraudulent errors 
that would result in a taxpayer not being able to receive the 
credit in subsequent years. We are proposing to institute a 
continuous levy, so a portion of unemployment compensation and 
certain means tested public assistance could be levied to bring 
back part of outstanding tax liabilities, including 
overpayments of the EITC. Last, to simplify the credit, we have 
proposed to simply foster child definitions and improve access 
to the Tax Volunteer Assistance Program.
    These eight steps build on our previous efforts that have 
thus far reduced the EITC error rate from 35.4 to 20.7 percent 
or less, and I want to emphasize previous efforts, not all from 
this administration. We ask for your support in enacting these 
six new legislative proposals which are necessary to further 
improve noncompliance.
    Mr. Chairman, thank you once again for providing me with 
the opportunity to testify and I will be happy to answer any 
questions that you or others on the Committee have.
    [The prepared statement follows:]

Statement of John Karl Scholz, Deputy Assistant Secretary, Tax 
Analysis, U.S. Department of Treasury

    I am pleased to have the opportunity to discuss the 
Administration's proposals to improve the earned income tax 
credit (EITC) and look forward to working with the Committee on 
this issue.
    The Administration is strongly committed to the goals of 
the EITC and will oppose any proposals which reduce the EITC 
and raise taxes on millions of working families who play by the 
rules. The goals of the EITC are to make work pay and to lift 
workers out of poverty in the most efficient and administrable 
manner possible. With its message of ``work pays,'' the EITC 
helps reduce dependency on welfare and increase reliance on 
jobs.

               Economic Conditions Among Low-Wage Workers

    To understand the role of the EITC, a couple of facts about 
the labor market for low-skilled workers in the United States 
are useful.
    There has been a striking drop in real wages for unskilled 
workers, beginning in the 1970s and accelerating over the 
1980s. Between 1979 and 1992, the earnings of full-time male 
workers who had not graduated from high school declined by more 
than 23 percent in real terms. Among full-time male workers 
with a high school diploma, real earnings fell by 17 percent 
over the same period.
    This decline in the real wage for many unskilled workers 
has serious implications. In the United States, it is still 
possible for a family, containing a worker, to live in poverty. 
According to the Census Department, there were 2.4 million 
persons, over the age of 16, who lived in poverty and had 
worked year-round at full-time jobs in 1995.

     Effectiveness of EITC in Making Work Pay and Reducing Poverty

    The ETC makes work pay in two ways. Unlike many assistance 
programs for low-income families, the EITC is limited to 
working families. Moreover, the credit amount initially 
increases--rather than decreases--for each additional dollar of 
earnings. As a consequence, the EITC is different from many 
low-income assistance programs that are characterized by a 
reduction in benefits for each additional dollar of earnings. 
In my work prior to coming to Treasury, I--together with Stacy 
Dickert-Conlin and Scott Houser--examined the net impact of the 
OBRA 1993 expansion of the EITC on labor supply. We found that 
the EITC has a modest, positive effect on labor supply by 
encouraging individuals to enter the workforce. The EITC also 
directly increases the disposable income of working families. 
According to the most recent Census data, the EITC lifted 3.7 
million persons out of poverty during 1995.
    By making work pay, the EITC increases the probability that 
some parents may enter the workforce and perhaps leave the 
welfare rolls. The EITC, then, plays a key role in our efforts 
to reform welfare.

             Administering the EITC through the Tax System

    The EITC achieves the goals of making work pay and 
relieving poverty by reducing the tax liabilities of low and 
moderate-income families. Thus, it is improper to characterize 
the EITC, as some have done recently, as a ``non-tax function'' 
of the IRS. The EITC was created and expanded to offset the 
overall tax burden of low and moderate-income families and 
should not simply be measured as an offset to income and SECA 
taxes. About 85 percent of EITC costs will offset the combined 
Federal tax burden of families receiving the credit in 1998.
    As these numbers suggest, EITC claimants are taxpayers. If 
the EITC did not exist, almost all EITC filers would still file 
an individual income tax return (in addition to paying payroll 
and excise taxes), and the IRS would still have to process 
their returns and verify much of the same information regarding 
their filing status, number of children, and income. In 1998, 
about 69 percent of EITC claimants will be required to file a 
tax return because they have an individual income tax liability 
(before the EITC), owe special taxes, have self-employment 
income in excess of $400, or their gross income will exceed the 
filing threshold. In addition, over 25 percent of EITC 
claimants will file a tax return in order to obtain a refund 
for overwithheld taxes paid throughout the year.
    Because most EITC claimants would be filing a tax return 
even if the credit did not exist, the direct budgetary costs of 
administering the EITC are significantly lower than if the 
credit were provided through another means. The IRS cannot 
easily disentangle the costs of administering one line on the 
Form 1040 from other lines on the tax return, and we thus do 
not have estimates of the costs of administering this 
particular tax provision through the tax system. We can safely 
say, however, that the costs are lower than those associated 
with certain government expenditure programs. For example, in 
FY 1995, the food stamp program cost $3.7 billion to 
administer, while AFDC administrative costs were an additional 
$3.5 billion--nearly 14 percent of the combined costs of these 
two programs. For these administrative costs, the AFDC program 
served, on average, about 4.9 million families in a given 
month, while over 10 million households received food stamps. 
By way of comparison, the entire IRS budget in FY 1995 was $7.6 
billion, and the IRS served over 116 million individual 
taxpayers and 15 million corporations.
    Taxpayers also benefit from obtaining the EITC through the 
tax system. Many low-income workers learn about the EITC when 
they file a tax return to obtain a refund. By claiming the 
credit on tax returns, EITC claimants do not have to take time 
off from work to apply for the credit at a government office.
    Not surprisingly, then, participation in the EITC tends to 
be higher than many other assistance programs targeted to low-
income families. In my research prior to joining Treasury, I 
found that 80 to 86 percent of those eligible received the 
credit in 1990. This high participation rate is striking when 
compared to the AFDC participation rate of 62 to 72 percent and 
the food stamp participation rate of 54 to 66 percent. 
International comparisons also confirm this finding. The United 
Kingdom has an EITC-like program called the Family Credit. It 
is administered through the transfer system and directed toward 
families with children. Official estimates place the 
participation rate of the Family Credit at around 50 percent. 
Thus, both compared to cash and in-kind transfers in the United 
States and comparable work-related benefits in the United 
Kingdom, the EITC is much better at reaching those who are 
eligible for the credit.
    Notwithstanding these benefits, there are costs associated 
with operating the EITC, as with other tax provisions, through 
the tax system. A system based largely on self-assessment will 
have lower administrative costs than a more bureaucratic 
approach, but it will also lead to higher noncompliance. Many 
of us were very concerned when EITC compliance data, from the 
1980's, first became available. The Taxpayer Compliance 
Measurement Program (TCMP), last conducted in 1988, showed that 
35.4 percent of the EITC claimed ($2 billion) exceeded the 
amounts to which taxpayers were eligible.
    But the same TCMP also places the problems of the EITC in 
perspective. Last April, the IRS released a study, based on the 
1988 TCMP, showing that the gross individual income tax gap in 
1992 was between $93.2 and $95.2 billion. The IRS estimated 
that the total ``true'' individual income tax liability was 
between $550.2 and $552.3 billion for tax year 1992. Over 40 
percent ($39.1 to $39.9 billion) of the gross tax gap for 1992 
was attributable to the underreporting of business income 
(including self-employment income, partnership income and rents 
and royalties). About 20 percent ($18.1 to $18.7 billion) of 
the gross tax gap was due to the underreporting of non-business 
income. Over 14 percent ($13.5 to $13.8 billion) of the gross 
tax gap was due to persons who failed to file tax returns. 
These problems exceed any noncompliance problems associated 
with the EITC.
    Nonetheless, the Administration and Congress have 
recognized that the EITC can best meets its goals--of making 
work pay and lifting families out of poverty--by ensuring that 
only those who are eligible and deserving receive the credit. 
Congress took a first step in this direction during the 
consideration of OBRA 1990, when data from the 1985 TCMP became 
available. The TCMP data suggested that EITC errors were linked 
to complicated and unverifiable support and household 
maintenance tests. OBRA 1990 replaced the support and household 
maintenance rules for EITC eligibility with simpler age, 
residency, and relationship tests, lowered the age requirement 
for reporting a taxpayer identification number for EITC 
qualifying children, and created a separate schedule to claim 
the EITC.
    This Administration, with the support of Congress, has 
taken 17 additional legislative and administrative actions to 
further improve the targeting and operations of the credit. 
First, Congress has enacted stricter reporting requirements 
proposed by the Clinton Administration, and the IRS has 
tightened enforcement of these requirements. Since 1995, the 
IRS has transcribed the social security numbers of all EITC 
qualifying children and most dependents, and it has intensified 
its examination of returns with missing social security 
numbers. The Personal Responsibility and Work Opportunity 
Reconciliation Act of 1996 (the welfare reform act) contains a 
Clinton Administration proposal which will enable the IRS to 
use the simpler and more cost-efficient mathematical error 
procedures to deny both the EITC and dependent exemptions to 
taxpayers who fail to provide valid social security numbers. As 
a consequence of the Uruguay Round Agreement Act of 1994, 
taxpayers will also be required to provide social security 
numbers for all dependents and EITC qualifying children without 
regard to their age on their 1997 tax returns.
    Other reporting requirements have also been strengthened. 
The Uruguay Round Agreement requires the Department of Defense 
to report to both the IRS and military personnel nontaxable 
earned income used in the computation of the EITC. The 1996 
welfare reform act also authorizes the IRS to treat the 
omission of self-employment taxes as a mathematical error, if 
the taxpayer claims eligibility for the EITC on the basis of 
self-employment income.
    The IRS, with the support of Congress, has also intensified 
scrutiny of ``questionable'' EITC claims and preparers. For the 
last several years, the IRS has conducted studies of EITC 
compliance and has used this information to better identify 
questionable returns. In addition, the IRS increased scrutiny 
of electronic return originators (EROs), instituted fingerprint 
and credit checks on certain new ERO applicants, and eliminated 
the direct deposit indicator.
    Finally, the Administration has consistently supported 
provisions that would simplify the EITC, opposed provisions 
that would add significant complexity to the EITC, and has 
striven to ensure that EITC reforms can be administered. In 
1993, the Administration proposed the repeal of two 
supplemental credits (for children under the age of one and for 
the purchase of health insurance for qualifying children), 
arguing that the IRS could not enforce the eligibility criteria 
for them, and these supplemental credits were subsequently 
repealed. In 1995, the Administration opposed, on 
administrative grounds, proposals to base EITC eligibility on 
child support payments and hours of work. The Administration's 
proposal to deny the EITC to undocumented workers, included in 
the welfare reform act, was also designed in a manner which 
could be administered by the IRS.

          Analysis of EITC Compliance Study for Tax Year 1994

    The combined effects of these efforts cannot be fully 
measured at this time, since several key steps did not take 
effect until the 1997 filing season and another step--the 
requirement that all children, regardless of their age, have a 
social security number--will not be fully implemented until the 
1998 filing season. Today's hearing, nonetheless, has been 
called in response to the recent release of new IRS data on 
EITC noncompliance for tax year 1994.
    The Criminal Investigation (CI) Division of the IRS 
conducted this study of compliance among 2,046 taxpayers who 
claimed the EITC on tax returns filed and accepted by the IRS 
between January 15 and April 21, 1995. CI Special Agents 
visited a random sample of EITC claimants, shortly after they 
filed their paper or electronic tax returns. Taxpayers (and 
often their employers, tax return preparers, family members, 
and neighbors) were interviewed at length and asked to produce 
verification that they met the EITC eligibility criteria. While 
the Special Agents made initial judgements about the legitimacy 
of the EITC claim, these judgements were reviewed--and 
sometimes changed--in subsequent review by Examination staff 
who had access to other sources of independent information 
(such as the Forms W-2 and 1099 sent by employers and other 
payers).
    The study found that of the $17.2 billion claimed in EITC 
between January and April 1995, $4.4 billion, or 25.8 percent 
of total EITC claimed, exceeded the amount to which taxpayers 
were eligible. The overclaim rate among EITC claimants was 
slightly higher among paper filers (26.1 percent) than for 
electronic returns accepted by the IRS (25.3 percent). 
Noncompliance was found to be much higher among filers who 
claim EITC qualifying children than for those EITC claimants 
without qualifying children. Among those who claimed EITC 
qualifying children, the overclaim rate was 26.1 percent, while 
the overclaim rate was 15.7 percent for those who did not 
reside with a qualifying child. IRS enforcement practices, in 
place during the 1995 filing season, reduced the estimated net 
overclaim rate from 25.8 percent to 23.5 percent. If the IRS 
had been able to treat a taxpayer's failure to provide valid 
social security numbers for EITC qualifying children over the 
age of one as a mathematical error on 1994 tax returns, the net 
overclaim rate would have been reduced further, to an estimated 
20.7 percent.
    While EITC noncompliance remains at unacceptably high 
levels, the study's results do show significant improvement 
since the late 1980s, the last time that the IRS examined a 
comparable group of taxpayers as part of the TCMP. The 
improvement in EITC compliance since 1988 reflects the 
implementation of many, but not all, of the steps described 
earlier.
    To better understand the remaining sources of 
noncompliance, we have conducted an analysis of the data. We 
have found that the most common EITC error is caused by 
taxpayers claiming qualifying children who do not reside with 
them for over half the year. Among taxpayers with children, 
such errors account for about 39 percent of overclaimed EITC 
amounts. Under current law, taxpayers are required to reside 
with their qualifying children for at least six months or a 
full year, depending on the relationship of the child. 
Taxpayers fail the residency test for many different types of 
reasons. For example, divorced parents who share the custody of 
their children might both claim the EITC because they both feel 
the child lived with them for over half the year. At the other 
extreme, a taxpayer may claim a child with whom he or she has 
never resided.
    A second common error is due to misreporting of filing 
status among married taxpayers. Filing status errors account 
for about 31 percent of overclaimed EITC amounts among 
taxpayers with children.\1\ Sometimes, separated couples do not 
understand that they must still file as married persons if they 
have not yet obtained a legal separation. In other cases, 
married couples, who are still living together, do not file 
either a joint return or a ``married filing separate'' return.
---------------------------------------------------------------------------
    \1\ Some taxpayers misreport their filing status and also claim 
children who did not reside with them. They are included in both error 
categories.
---------------------------------------------------------------------------
    The third most common error results from complicated living 
arrangements. In such situations, a child lives with more than 
one adult who appears qualified to claim him or her for EITC 
purposes. However, about 18 percent of overclaimed EITC amounts 
result when, in such households, the caregiver with the lower 
AGI claims the child. In some cases (although it is difficult 
to quantify), the other caregiver was, in fact, qualified to 
claim the EITC but did not. The study does not account for the 
offsetting errors which occur because the taxpayer's relative, 
with the higher AGI, did not claim the EITC when he or she was 
eligible.
    Even among EITC claimants without qualifying children, many 
errors are caused by the misreporting of family structure. 
Among these taxpayers, about 40 percent of overclaims are 
attributable to the misreporting of filing status among married 
taxpayers. However, most errors among EITC claimants without 
qualifying children are due to the misreporting of income.
    While we can identify the sources of EITC errors in this 
study, we do not know from the study the extent to which the 
EITC, itself, is the root cause of the noncompliance on the 
part of the taxpayers. By misreporting filing status, child 
dependents, and income, taxpayers may be able to reduce their 
tax liability through other provisions in addition to the EITC. 
Because this study focused only on EITC claimants, it does not 
isolate the effect of the EITC on noncompliance, or the extent 
to which higher income taxpayers are benefiting from 
misreporting their income or family circumstances.
    The study does provide evidence that the refundable nature 
of the credit does not induce ineligible individuals to enter 
the tax system simply to claim the credit. As I have discussed, 
95 percent of EITC claimants have a reason other than the EITC 
to file a return. The overclaim rate among those with a 
positive pre-EITC tax liability is nearly three times larger 
than the rate among those who did not have a tax liability. The 
data thus suggest that noncompliant EITC claimants do not enter 
the tax system merely to claim the credit.
    While the results of this study are not fully applicable to 
the current EITC, the study does point to the need for new 
approaches. Many types of EITC errors are difficult to detect 
with the current IRS enforcement tools, such as matching of 
information reports and Social Security Administration records 
to tax returns. Our proposals are designed to provide the IRS 
with new tools to identify erroneous EITC claims while 
minimizing additional administrative costs to the Federal 
government.

                Legislative and Administrative Proposals

    The Treasury Department's eight-point plan contains six 
legislative proposals and two administrative actions. These 
proposals will help reduce EITC errors by increasing IRS's 
ability to detect errors before EITC refunds are paid out, by 
imposing new, more effective penalties on EITC claimants, and 
by reducing the risk of unintentional errors by law-abiding 
taxpayers.

 Proposals to Improve the Flow of Information Prior to Release of EITC 
                                 Claims

    Due diligence requirements for preparers--About half of 
earned income tax credit (EITC) claimants use a paid preparer 
to complete their income tax returns. As a consequence, tax 
preparers can play a key role in helping working families file 
accurate tax returns. While there is little significant 
difference among returns prepared by the taxpayer and those 
prepared by a paid preparer, the error rate does differ 
depending on the type of preparer consulted by the taxpayer. 
Noncompliance was much lower among taxpayers who went to a 
preparer who was either a certified public accountant, lawyer, 
enrolled agent, or a representative of one of the large 
nationally-recognized organizations. It was higher among those 
who sought other types of preparers.
    Under our proposal, the responsibilities of paid preparers, 
with respect to potential EITC claimants, would be clarified. 
Preparers who do not fulfill certain due diligence requirements 
would be subject to cash penalties ranging from $50 to the full 
amount of an EITC overclaim. The proposed penalties would be in 
addition to the penalties imposed on preparers and taxpayers 
under current law. The proposal would be effective for taxable 
years beginning after December 31, 1997.
    Recertification--When questions arise about EITC claims, 
the IRS generally must follow deficiency procedures to 
determine the accuracy of the taxpayer's return. While 
deficiency procedures protect taxpayers' rights, they can be 
time-consuming and relatively expensive when compared to the 
amount of tax at issue.
    Under the proposal, a taxpayer who has been denied the EITC 
as a result of deficiency procedures would be ineligible to 
claim the credit in subsequent years unless he or she provides 
evidence of his or her eligibility for the credit. To 
demonstrate current eligibility, the taxpayer would be required 
to meet evidentiary requirements established by the Secretary 
of the Treasury. Failure to provide this information when 
claiming the EITC would be treated as a mathematical or 
clerical error. If a taxpayer is recertified as eligible for 
the credit, he or she would not be required to provide this 
information in the future unless the IRS again denies the EITC 
as a result of a deficiency procedure. Ineligibility for the 
EITC under the proposal would be subject to review by the 
courts. The proposal would be effective for taxable years 
beginning after December 31, 1997.
    Demonstration Projects--The Treasury Department is seeking 
legislation permitting it to select four states to experiment 
with alternative ways of providing the EITC throughout the 
year. Under the proposal, the four states could provide advance 
payments of the EITC to wage earners through state agencies 
rather than employers for a three year period. States would be 
required to verify eligibility for the EITC before paying out 
the credit. Effects on advance payment participation and 
compliance would be studied by Treasury. Applications would be 
submitted by the states to the Treasury Department during 1998 
for demonstration projects to begin in January, 1999.
    Earmarking of IRS Resources--Using information from the 
EITC compliance studies and other ongoing pilot projects, the 
IRS will continue to develop and use profiles of potentially 
erroneous EITC claimants. These profiles will be used to 
identify questionable EITC claims during the 1998 filing 
season. The IRS will expand the number of questionable EITC 
claims that it investigates during the 1998 filing season. 
Refunds associated with these claims will be delayed until the 
investigation is complete. Out of its current appropriations 
request, the IRS is earmarking 550 full time equivalent staff 
persons for this intensified effort during the 1998 filing 
season.

         Increasing the Penalties for Intentional Noncompliance

    New Penalties for Intentional and Fraudulent Errors--
Existing civil penalties have a limited deterrence effect 
against ineligible taxpayers repeatedly claiming the EITC. 
Denying subsequent eligibility to claim the EITC to taxpayers 
who have recklessly, intentionally, or fraudulently claimed the 
EITC in the past should help ensure that only those who are 
eligible for the credit receive it.
    Under the proposal, any person who fraudulently claims the 
EITC would be ineligible to claim the EITC for a subsequent 
period of ten years. In addition, any person who erroneously 
claims the credit and such error is due to the reckless or 
intentional disregard of rules or regulations would be denied 
eligibility for the EITC for two subsequent years. The sanction 
under the proposal would be in addition to civil and criminal 
penalties imposed under current law. In addition, the sanction 
would be subject to review by the courts. The proposal would be 
effective for taxable years beginning after December 31, 1997.
    Continuing Levy--The IRS does not generally find it cost-
effective to recoup overpayments of the earned income tax 
credit (EITC) or impose monetary penalties on noncompliant 
claimants. To some extent, these efforts are hindered by the 
exemption from levy of certain types of income prevalent among 
EITC claimants. By removing these exemptions, this proposal 
would make it more likely that the IRS would recapture 
overpayments.
    In our FY 1998 budget, the Administration proposed that 
certain exemptions be partially lifted from the levy. Under the 
budget proposal, Federal workers' compensation payments, 
annuity or pension payments under the Railroad Retirement Act, 
and benefits under the Railroad Unemployment Insurance Act 
would no longer be fully exempted from levy. The proposal would 
change the exempt amount of Federal wages, salaries, and other 
income to a flat 85 percent exemption. The proposal would 
provide for ``continuous'' levy on non-means tested, recurring 
Federal payments.
    Under the EITC initiative, unemployment benefits and means-
tested public assistance would no longer be fully exempted from 
levy for any purpose. Up to 15 percent of these benefits would 
be subject to levy. The proposal would also provide for the 
option of a ``continuous'' levy on these payments. Treasury 
would work with affected Departments and state agencies to 
design the mechanisms appropriate for each program. If 
necessary, conforming changes would be made to the laws and 
regulations governing public assistance to ensure that there 
would not be offsetting changes in these benefits to compensate 
for the levy. The proposal would apply to levies issued after 
December 31, 1997.
    As under current law, taxpayers would be allowed to apply 
for relief from a levy if they can demonstrate that they are 
suffering significant hardship as a consequence.

                      Reduce Unintentional Errors

    Simplification of Foster Child Rule--Under current law, a 
taxpayer is eligible to claim the earned income tax credit 
(EITC) if he or she resides with a son, daughter, or grandchild 
for over half the year. EITC qualifying children also include 
individuals who reside with taxpayers for a full year and for 
whom the taxpayers ``care for as the taxpayers' own children.'' 
All EITC qualifying children (including foster children) must 
either be under the age of 19 (24 if a full-time student) or 
permanently and totally disabled.
    The foster child'' rule is confusing to both taxpayers and 
the IRS. Clarifying the definition would eliminate 
unintentional errors by taxpayers and provide better guidance 
to the IRS. In addition, the definition of a foster child for 
EITC purposes would be conformed to the dependency exemption 
definition proposed as part of the Administration's 
simplification package.
    Under the proposal, a foster child would be defined as a 
child who (i) is under the age of 19 (24 if a full-time 
student), (ii) is cared for by the taxpayer as if he or she 
were the taxpayer's own child, and (iii) either is the 
taxpayer's niece, nephew, or sibling or was placed in the 
taxpayer's home by an agency of a state or one of its political 
subdivisions or a tax-exempt child placement agency licensed by 
a state. The proposal would be effective for taxable years 
beginning after December 31, 1997.
    Improve Access to Taxpayer Assistance--In 1996, 1.9 million 
low-income taxpayers receive assistance preparing their tax 
returns from over 47,000 volunteers in IRS-sponsored VITA 
(Volunteer Income Tax Assistance) facilities. The IRS provides 
training materials and tax forms to 8,300 sites. The IRS also 
provides software for electronic filing and lends computer 
hardware to selected sites. These VITA efforts will be 
continued and strengthened as part of the Administration's 
commitment to volunteerism. The Treasury Department is 
contacting businesses and tax professional organizations to 
make sure that they are aware of the need for VITA volunteers, 
computers, facility sites, and outreach assistance. By 
improving access to free taxpayer assistance and electronic 
filing, these efforts will help reduce the risk of 
unintentional errors.
    This concludes my remarks. We look forward to working with 
you toward the enactment of these provisions. Thank you once 
again for providing me with the opportunity to testify. I would 
be pleased to answer any question that the Committee may have.
      

                                

    Chairman Archer. Thank you, Mr. Scholz, and thank you, Mr. 
Dolan. Thank you for also being here, Mr. Dalrymple and Mr. 
Brown.
    Mr. Dolan, I would like to try to get a little better 
understanding of the parameters of your study. The study 
indicates that your sample was selected from returns that were 
actually accepted by the IRS. However, the IRS electronic 
screens are designed to automatically reject electronic returns 
with invalid or missing Social Security numbers or mismatches 
between the qualifying children's Social Security numbers and 
their dates of birth. Do you know what percentage of the 
returns were rejected during the time period that this study 
was conducted?
    Mr. Dolan. Mr. Chairman, I am going to ask Ted Brown to 
comment. But you are exactly right. There were a number of 
returns that would have been rejected electronically. We do not 
have a way to systematically follow each of those rejected 
returns to see when or if they came back in on paper.
    However, based on the parameters of the study, the fact 
that the study did, encompass returns filed through April 15, 
our assumption is that one of three things happened. Somebody 
corrected the Social Security number and it came back in 
electronically, they were bogus and did not come back in at 
all, or they attempted to come back in on paper. If they had 
come back in on paper, the statistical sample would have 
accounted for that population as a part of the group that was 
studied in 1994.
    As to your specific question on a percentage, I am not sure 
whether Ted has that or not.
    Mr. Brown. Mr. Chairman, we do not count the number of 
returns that are rejected, so I cannot give you a percentage, 
because returns can be resubmitted repeatedly. We count 
occurrences, how many times we have a reject. That would run 
about 14 to 15 percent of the attempts to file a return 
electronically during 1995.
    Chairman Archer. And you had no flag or tickler placed on 
the electronic rejections to determine whether they came back 
on paper filings, is that correct, or did you have such a 
thing?
    Mr. Brown. No, sir. We cannot track an electronic return 
that is rejected and comes back in on the paper side.
    Chairman Archer. And as I understand, Mr. Dolan, what you 
said preliminarily, if a return that had been rejected 
electronically did come back in writing on paper during the 
window of your sampling, you would have picked that up, is that 
correct?
    Mr. Dolan. It would have been part of the universe from 
which the sample was drawn, correct.
    Chairman Archer. But if it came back after that window 
closed, then you would not have any data on that?
    Mr. Dolan. That is an accurate statement. However, I think 
if we showed the demography of the return filing patterns, I 
think there is a reasonably good inference that most EIC refund 
claimants are going to come in on or before April 15.
    Chairman Archer. There were a rather significant number of 
electronic returns that were rejected and not taken into 
consideration in this study, are you confident that the results 
of the study capture the full level of potential errors in the 
EITC?
    Mr. Brown. Yes, sir, other than the group that might have 
decided not to refile and that is your only exposure to 
something that would not be included in the sample.
    Chairman Archer. But this 14 percent that you mentioned, 
would that not possibly have augmented the number of errors?
    Mr. Brown. The first issue, Mr. Chairman, is that that is 
an occurrence count. So, for example, the taxpayer submits a 
return and it is rejected for an error. They think they have 
corrected it. They try it again. It is rejected again. So we 
can have multiple occurrences from the same taxpayer, so that 
tends to make that number higher than it is in reality.
    Chairman Archer. Mr. Brown, I am going to move on to a 
little different approach. Can you elaborate on exactly what 
types of erroneous claims your study identified and can you 
give us a breakdown of the types of fraud and error that the 
IRS detected by their root cause?
    Mr. Brown. Mr. Chairman, we have a lot of different data 
about the makeup of this sample. Sometimes when you get down to 
very specific subcategories, the statistical validity of the 
sample falls away because the numbers get very small, so that 
is one caveat.
    Beyond that, we have tried to analyze the data to look at 
and determine if there are patterns based upon filing status, 
based upon income levels, based upon the number of children 
that were claimed, and based upon the types of income that were 
reported. We have used that data to attempt to redirect our 
enforcement efforts, our audit programs, as well as our 
screens.
    My concern is if I get too specific, I may disclose some of 
our capabilities as well as some of our vulnerabilities. For 
that reason, perhaps the Joint Committee, after they have 
analyzed the data, may have better answers than I could give 
you today. If that is not sufficient, I would be willing to 
come back in and give you some of the examples.
    Chairman Archer. Inasmuch as we have asked the Joint 
Committee to look at the raw data and to develop the kind of 
responses for us that my question solicits, it might be best 
not to do that here publicly today. However, I will say that it 
is my common sense opinion, not backed by any technical 
expertise, that if someone wants to commit fraud on this 
program, that there is an underground grapevine that most 
clearly permits them to understand how to do it without your 
giving them a road map. That has been the experience that we 
have seen in an awful lot of programs, but I will not push that 
any farther.
    Mr. Brown. Thank you.
    Chairman Archer. Mr. Brown, what are the qualifications of 
the special agents who conducted the investigation in this 
study?
    Mr. Brown. Most of our special agents, they are all college 
graduates. The majority of them are accountants by training, 
but we also have attorneys and former revenue agents, former 
law enforcement officers. After they are hired, they are sent 
through about 6 months of training at our Federal Law 
Enforcement Training Center in Brunswick, Georgia, where they 
get an introduction to law enforcement techniques as well as 
specialized training on our techniques to prove tax fraud and 
money laundering.
    The agents that were selected, my work force is very 
experienced. Most of them are very experienced agents around 
the country, so they are experienced investigators.
    Chairman Archer. So they are experienced in investigating 
fraud issues?
    Mr. Brown. Yes, sir. These are criminal investigators.
    Chairman Archer. Based on their training and experience, 
did the special agents who conducted this study and 
investigation reach a conclusion in each case in which 
erroneous payments were identified about whether the mistakes 
were simply errors due to the complexity of the Code or whether 
they were intentional fraud?
    Mr. Brown. We asked the agents during their field contacts 
to categorize each case and to make a subjective assessment as 
to their reaction to the facts as they identified them. The 
first and the simple one was that the return was correct, and 
at the other extreme was that they simply could not develop 
enough information, they could not locate the taxpayer, they 
could not locate appropriate witnesses to make a determination.
    In those cases in between, we asked them to classify that 
the error either was due to misunderstanding, error, or some 
mistake by the taxpayer or that, in their opinion, 
subjectively, that the error was due to an intentional 
nonadherence to the law.
    Chairman Archer. And based on your training and experience, 
what percentage of the overclaims were simply error and what 
percentage were intentional fraud?
    Mr. Brown. Again, as Mr. Dolan mentioned earlier, we did 
not use the term ``fraud'' during this study. We did use the 
term ``intentional,'' because as a criminal investigation----
    Chairman Archer. Let us take fraud out of it and say 
intentional.
    Mr. Brown. In the classification of the cases, it was about 
50 percent due to error and about 50 percent classified as 
intentional by the investigators.
    Chairman Archer. Thank you very much. I have one last 
question for Treasury and then I will yield to my colleague, 
Mr. Rangel.
    Mr. Scholz, in your new proposals, what you are suggesting 
is that they would help to reduce the amount of overpayment. If 
enacted, what level of error rate would this bring the 
noncompliance down to?
    Mr. Scholz. It would bring the noncompliance down a 
significant amount. It is a very difficult question to answer 
that you asked because we do not know what the current error 
rate is because of steps that have been adopted since the 1994 
has been taken. In particular, we have new math error 
procedures for primary and secondary taxpayers and the Social 
Security number requirement and math error procedures for 
children under one. So this makes it very difficult to know 
what the current noncompliance rate is.
    What adds to and compounds the difficulty is at least two 
of our significant noncompliance proposals are directed at tax 
preparers and are deterrence proposals for taxpayers and there 
is very little out there in existing academic or policy 
literatures that would allow us to base an estimate.
    We, Congress and the administration, do have a track 
record, though, when we say that these proposals will reduce 
the noncompliance rate significantly and the track record is 
bringing the noncompliance rate down from 35.4 percent to the 
current 20.7 percent that would be the noncompliance rate if 
the math error procedures that we could model were 
incorporated.
    Chairman Archer. So you believe that if your current 
proposals were adopted, that there would be an additional 
significant amount of reduction in the error rate, is that 
correct?
    Mr. Scholz. I do, Mr. Chairman.
    Chairman Archer. And how would you define significant? What 
percent would you put on the term ``significant''? What range 
of percent, if you cannot be totally accurate?
    Mr. Scholz. I can bound the effect. I can tell you that I 
have a strong feeling that it is going to be lower than 20.7 
percent, and beyond that, it would be inappropriate for me to 
hazard a guess for the reasons that I just said. We do not know 
what the existing noncompliance rate is. We do not have any 
objective basis upon evidence from the policy literature or the 
academic literature on the effects of these noncompliance 
rates. So it is very, very difficult. It would be, in fact, 
irresponsible for me to give you a point estimate of what I 
think the effect of these proposals would be.
    Chairman Archer. I assume that you have looked carefully at 
the study that has been done by Mr. Brown under Mr. Dolan's 
supervision----
    Mr. Scholz. Yes, sir, we surely have.
    Chairman Archer [continuing]. And that you have the benefit 
of all of that analysis.
    Mr. Scholz. That is correct.
    Chairman Archer. You, therefore, know probably more than we 
do at this time. Have you seen the raw data, also?
    Mr. Scholz. Yes, sir, we have.
    Chairman Archer. So you have even more information than the 
Members of this Congress have or that we will even have at the 
end of this hearing today but which will be turned over to the 
Joint Committee for their evaluation.
    Based on that information, which is not even available to 
us today, at this moment, you have no ability to determine what 
your proposals will do to reduce that error rate other than to 
say that it will be significant?
    Mr. Scholz. We certainly do, because we have designed the 
particular proposals with the knowledge that we have from 
extensive analysis of the data that underlies the IRS study. So 
we know, for example, that tax returns prepared by the large 
national tax preparation community have lower noncompliance 
rates. Our proposaal to require due diligence on EITC claims 
among professional tax preparer proposal was generated by this 
fact, and we are asking other tax preparers to take the same 
kinds of steps that the large national tax preparers take.
    Every single one of our six legislative proposals and two 
administrative proposals is generated by the knowledge that we 
have gained from looking at this noncompliance study. That is 
why I am confident when I sit here and tell you that there will 
be a significant reduction in the error rate as a consequence 
of adopting our proposals.
    Chairman Archer. After saying all that, I was hoping I 
could get you to draw a conclusion from that. Significant, 
then, might be one-half of 1 percent, is that correct?
    Mr. Scholz. Significant--that would not be significant, Mr. 
Chairman.
    Chairman Archer. That would not? What about 1 percent?
    Mr. Scholz. That probably would not be significant, either.
    Chairman Archer. What about 2 percent?
    Mr. Scholz. That would probably not be significant, either, 
Mr. Chairman.
    Chairman Archer. What about 3 percentage points?
    Mr. Scholz. It starts to get hard.
    [Laughter.]
    Chairman Archer. So that is beginning to enter the range of 
what you would consider significant, 3 percent. So we would be 
able to anticipate that if your proposals were enacted, that we 
would at least reduce the rate to 17.7 percent, at a minimum.
    Mr. Scholz. As you know, Mr. Chairman, the world does not 
stop when you adopt some proposals, so there are lots of other 
things happening in the economy. There are lots of other things 
happening with IRS enforcement efforts. The EITC is getting 
larger because of the steps that you and the administration 
took in 1993 and all of those things make it very, very 
difficult to make the statement that you have just made. We do 
not know what the noncompliance rate is right now. The credit 
has gotten somewhat larger. That would tend to possibly 
increase----
    Chairman Archer. No. I understand that it is not easy to do 
this, but you have an expertise that no Member of this 
Committee has, both from your academic background and the fact 
that you have done an intensive study of this investigation 
report. I am simply asking you to try to give us the benefit of 
that expertise and that study and tell the Committee what we 
might expect if these proposals are adopted.
    If we are only going to get 1 percentage point, we have not 
made a whole lot of progress. I am trying to understand what 
you mean by significant, and I think that the record will show 
now that you think significant is a minimum of a 3-percentage 
point reduction. I appreciate your giving us the benefit of 
that conclusion.
    Now, let me further ask you, and then I am going to yield 
to the gentleman from New York, what do you believe is a 
reasonable target for EITC compliance? What would you accept as 
a reasonable error rate?
    Mr. Scholz. Compliance initiatives----
    Chairman Archer. Please, just give me your opinion as to a 
number that you would accept. I know that you have all this 
background of knowledge, but I want to know what you would 
accept as a reasonable target for EITC compliance, where you 
could rest easy and say, now this program is one that we think 
has got an error rate that is acceptable.
    Mr. Scholz. Mr. Chairman, I, like you, have a goal of 
trying to reduce the EITC noncompliance rate as far as we 
possibly can with sensible, cost-effective steps.
    Chairman Archer. But where would you rest easy? What would 
your target be, where you would rest easy and say, now we have 
a program that is defensible and an error rate that is 
defensible and I am satisfied with it?
    Mr. Scholz. Just as with my professional career, I never 
rest easy, Mr. Chairman. I am always trying to improve, and 
compliance initiatives have to be the same.
    Chairman Archer. Mr. Scholz, you are not answering my 
question.
    Mr. Scholz. I am trying to, Mr. Chairman.
    Chairman Archer. You are saying that you want it to be as 
good as possible, and that is very vague, but with your 
background and your experience and your knowledge on this 
subject, what would you personally accept as a target for 
noncompliance that you believe would be defensible? Just give 
me a percentage figure.
    Mr. Scholz. It is a number that does not----
    Chairman Archer. If it is zero, say zero and we will keep 
working toward that goal, but----
    Mr. Scholz. We will always strive to zero, Mr. Chairman. 
There is no question about that.
    Chairman Archer. No. But what do you----
    Mr. Scholz. But it requires a careful balancing of the 
benefits of the program with the costs, and the costs are part 
of this noncompliance problem that we are all so frustrated 
about.
    Chairman Archer. Clearly, there is some point where you 
believe we need to get before you will be comfortable that we 
have an error rate that is acceptable.
    Mr. Scholz. To be honest, Mr. Chairman, I will never be 
comfortable when taxpayers are receiving dollars----
    Chairman Archer. We cannot get to zero. We know that.
    Mr. Scholz [continuing]. When taxpayers are receiving 
dollars that are inappropriate, and so noncompliance 
initiatives are an evolving thing. They are incremental. You 
always find problems and you go and attack them and you try to 
attack them in a sensible, cost-effective manner. That process 
will never stop. It has not stopped in any single area of the 
Tax Code. I am sure my colleagues from the IRS would assure you 
of that. There is not one single area----
    Chairman Archer. Let me see if I can just synthesize this. 
You would not be satisfied with the significant reduction that 
you say your proposals would give the country.
    Mr. Scholz. Those would be a major policy achievement and 
then there would be new compliance initiatives. We would 
continue to study the problem and we would continue to do it 
better.
    Chairman Archer. So you would not be satisfied with what 
your proposals will produce?
    Mr. Scholz. I would call it a major policy achievement and 
one that we should seek because the proposals are low cost and 
they promise to do a lot of good.
    Chairman Archer. I yield briefly to the gentleman from 
Florida.
    Mr. Shaw. Mr. Chairman, I just want to inject here that, 
you are trying to get an answer from an economist. Economists 
do not give answers.
    Chairman Archer. I thank the gentleman for his observation.
    Mr. Rangel.
    Mr. Rangel. Dr. Scholz, when you described your background, 
you indicated that you were new in testifying in front of 
Committees?
    Mr. Scholz. I have testified a couple of times, but never 
with so many Members present.
    Mr. Rangel. Most of your background has been academic?
    Mr. Scholz. That is correct.
    Mr. Rangel. As an economist, have you ever heard the 
expression, dynamic scoring?
    Mr. Scholz. I certainly have.
    Mr. Rangel. That is pretty creative, is it not?
    Mr. Scholz. Dynamic scoring?
    Mr. Rangel. Yes.
    Mr. Scholz. I suppose it depends on what context, Mr. 
Rangel.
    Mr. Rangel. But it is subjective. It allows economists to 
reach conclusions that we want to reach here. You are new, but 
we have to do better in our assumptions because they are based 
on things that are not in your control, are they?
    Mr. Scholz. The best and most capable scoring would be 
based on things that are objective and do come from, either the 
academic or policy literature.
    Mr. Rangel. Let us see, now, Mr. Dolan, you have been 
around a long time. Can we do better in our assumptions as to 
bringing this rate down more than 2 or 3 percent?
    Mr. Dolan. I liked it better when you were asking Mr. 
Scholz a question like that. [Laughter.]
    Is your question whether we think these proposals can bring 
it down or what it would take to bring it down?
    Mr. Rangel. Who is in charge of administering this program 
at the IRS?
    Mr. Dolan. The Commissioner and I are.
    Mr. Rangel. I mean, directly hands on, you are?
    Mr. Dolan. I am sorry?
    Mr. Rangel. Are you hands on, directly involved?
    Mr. Dolan. Well, I think the accountability clearly is with 
me, Mr. Rangel.
    Mr. Rangel. The accountability is with the President of the 
United States. I am trying to find out----
    Mr. Dolan. I am not trying to obfuscate.
    Mr. Rangel. No. No. I am just trying to find out. The 
recommendations have come from Treasury. You have evaluated 
them. I assume you agree. Both of you are reading from the same 
page as to what can be done to correct a situation that looks 
like a hemorrhaging of overclaims. You have targeted it. On 
your own, you figured something was wrong, so you had your 
study. You evaluated somehow whether it was fraud or mistakes 
and you created some way that you think you can close this gap 
in order to save what many of us believe is a very, very good 
program. Is that correct?
    Mr. Dolan. That is correct.
    Mr. Rangel. So with all of your creativity and all of the 
safeguards, are we suggesting that the best we can look forward 
to is bringing this down from 25 to 23?
    Mr. Scholz. May I answer that, Mr. Rangel? As I mentioned 
in my oral statement, with just the math error procedures that 
the Committee and Congress and the administration supported in 
last year's welfare reform law, the error rate would be 20.7 
percent. The error rate has come down from 35.4 percent in 1988 
to 20.7 percent with the 1994 data. More initiatives have 
already been adopted. We have proposed another set and we think 
those error rates will come down further, significantly.
    Mr. Rangel. Well, we have a problem with the word 
significantly, but what do you tolerate with other taxpayers' 
groups? Is there a group identified as individual self-employed 
proprietors that you categorize as having specific problems in 
overclaims? Mr. Dalrymple.
    Mr. Dalrymple. Mr. Rangel, I can answer that. We have a 17-
percent overall tax gap. That is the overall tax gap, roughly. 
Wage earners are basically in the 98-percent turnstile. They 
are 98-percent compliant. When you start talking about sole 
proprietors, which I think you asked the question about, it is 
in the range of 56- or 57-percent compliant. I hope that 
answers your question.
    Mr. Rangel. So the noncompliance is what is left?
    Mr. Dalrymple. The noncompliance would be about 42 percent.
    Mr. Rangel. Did you do a study on that?
    Mr. Dalrymple. We have done several TCMP studies around 
that.
    Mr. Rangel. Are you doing things to correct it?
    Mr. Dalrymple. We are doing all kinds of things to try to 
correct that.
    Mr. Rangel. Do you have any assumptions to what improvement 
is going to be made in that? Are you an economist?
    [Laughter.]
    Mr. Dalrymple. I do have a degree in economics, yes, sir. I 
am almost sorry to have said that, Mr. Rangel.
    [Laughter.]
    Mr. Rangel. Well, you never can be wrong with this 
Committee. Everyone needs their own economists and I thought 
they sent the wrong team here.
    Mr. Dalrymple. Part of the $405 million revenue initiative 
several years ago was to address specifically that particular 
market segment.
    Mr. Rangel. We are constantly trying to improve the system, 
and in order to have confidence in the system, people have to 
believe that they cannot beat it. It is very important that you 
try to evaluate this overclaim problem as to which people are 
deliberately cheating on the U.S. Government and which are not 
educated enough to understand the complexity in the 39-page 
information sheet that some people have to read in order to 
take advantage of it. We ought to find out how many people are 
so frightened of the darn thing that they do not even apply for 
it, as well.
    I think it would help us in our thinking if you could tell 
us the delivery of services or benefits to poor people. It is 
my understanding, since the delivery administration system is 
already locked in with these working people, that the overall 
cost of the program is dramatically lower than the delivery of 
food stamps and other benefits. If you find reason to be so 
tolerant of the 42 percent, then we ought to have the same type 
of understanding with the EITC. We have to constantly report to 
this Committee and the Congress and the American people what we 
are doing, how can the Congress assist you to make certain that 
programs and the tax collection system and a voluntary system 
works.
    I want to thank the IRS for initiating their own study to 
see how they could do better and I join with the Chairman and 
Mrs. Johnson in saying, the program is not in jeopardy. The 
program is good. But in order for the program, which costs a 
lot of money, to continue to succeed, it cannot carry the 
political burden of having people believe that either people 
are deliberately cheating or the IRS cannot do the job or come 
up with a solution.
    I gather that the complexity of the lives of hard working, 
low-income people, the taking the credit for children that may 
be living with grandmothers and other people, have caused a 
great problem. I, for one, think that we have to, if we cannot 
explain the complexity of the problems because the Tax Code is 
really something that is designed for lawyers and not 
taxpayers, that we should spell out in no uncertain terms that 
those people who intend to take advantage of this credit better 
know what they are doing under penalty and they had better have 
some pamphlets in the community.
    I do not have anything in my Congressional offices except 
the regular forms. We have to do a better outreach job. All of 
the Congressional offices, especially those with large numbers 
of poor people, should have special people assigned with 
literature to let our people know. We will attempt to help you 
prior to income tax day. We can help those people that are 
locked into the system. Please ask the Congress to help you to 
resolve this program and not allow it to fall victim to 
criticism, some deserved and a lot not deserved.
    Dr. Scholz, before you come back to the Committee, let us 
discuss some of the things earlier about how we make 
assumptions around this place. Thank you.
    Chairman Archer. Thank you, Mr. Rangel.
    Mr. Shaw.
    Mr. Shaw. Thank you, Mr. Chairman.
    I would like to go back to Dr. Scholz. He seems to be a 
favorite target this morning. I would like to ask you in the 
questions that I am going to ask you, as painful as it might 
be, if you could give me brief yes or no answers, as would be 
appropriate to the question.
    The first matter that I want to go into, according to the 
Congressional Budget Office, CBO's, latest figures, we expect 
the total cost of the credit to be $25.7 billion in 1997. Do 
you agree with that figure?
    Mr. Scholz. Yes, I do.
    Mr. Shaw. Second, the IRS study shows the 25 percent of the 
benefits paid by this program are wasted in the sense that they 
are paid either in fraud or in error. Now, this was the study, 
I believe, that Mr. Dolan referred to, is that correct? This is 
the 1994 study?
    Mr. Scholz. What year are you talking about?
    Mr. Shaw. I know you want to try to get this back to 20.7 
percent, but the only study that has been completed with fresh 
data is 25 percent, is that correct?
    Mr. Scholz. So you are talking about filing season 1994?
    Mr. Shaw. That is the latest study that has been completed.
    Mr. Scholz. Yes, sir.
    Mr. Shaw. I hope the error rate is less than that, and I am 
sure you do, too, but this is the latest study that we have.
    Mr. Scholz. Correct.
    Mr. Shaw. If we take the projections from the Congressional 
Budget Office on the EIC and calculated the total revenue and 
outlays scored for the 5-year period, according to CBO figures, 
the total EIC cost over the next 5 years would be $144.5 
billion. Do you have any reason to disagree with the 
Congressional Budget Office on that, $144.5 billion over the 
next 5 years?
    Mr. Scholz. That sounds reasonable.
    Mr. Shaw. Based upon the figures that we agree on, we know 
that we will waste over $36 billion in this program during a 
period when we are trying to balance the budget, and everyone 
is trying to balance the budget. We are working hard toward 
that goal. But let me repeat that figure, because this is quite 
dramatic. This is a waste of $36 billion on the income credit 
over the next 5 years.
    Thirty-six billion dollars would pay for Head Start for a 
decade. Thirty-six billion dollars would pay for the WIC 
Program, which we are currently debating, which provides 
nutrition for children, also for a decade. This is $36 billion, 
and under any system, whether you are an accountant or an 
economist, we can all agree, this is a lot of money and it is a 
lot of money that is being wasted at this time. I am sure you 
agree with that.
    Mr. Scholz. Mr. Shaw, $36 billion is clearly a lot of 
money. The calculations that you have made are not appropriate, 
though. The reason is that 25.8 percent cited in the IRS study 
is a percentage of overclaims and not overpayments. So 25.8 
percent was not paid out. The net overclaim rate after IRS 
enforcement efforts was around 23 percent. Then, as I said, 
this 20.7 figure that I have mentioned, that is not made up. 
That is the law that you passed as part of the Welfare Reform 
Act--that is the math error procedure that corrects a lot of 
overpayments.
    Mr. Shaw. Even using your figure, Dr. Scholz, we still have 
over $25 billion being wasted. We can sit here for the rest of 
the day and argue between $36 billion and $27 or $28 billion, 
but the bottom line is that we are wasting money that can be 
used for many worthwhile projects that help the poor.
    Mr. Scholz. Mr. Shaw, that is why we are all here today, to 
try to improve that noncompliance rate for this important 
program.
    Mr. Shaw. Mr. Chairman, I look at this and I look at what 
we are doing and how we are using the Internal Revenue Service 
and all of these things and I think that all of us agree. I 
think you have made the point, Mrs. Johnson made the point, and 
Mr. Rangel made the point that if you continue these programs 
with these high figures of wasted money, you are endangering 
the programs, and none of us wants to do that. We want to be 
sure these programs work.
    We want to be sure the money is getting to the people so 
that we are helping the people not be the working poor. We are 
helping the people that are working to put the extra money into 
their paychecks.
    The problem of the abuse in this program and the fraud and 
abuse and waste, however, is scandalous and I think that we 
need in a very bipartisan way and in cooperation with all 
involved to work together to try to see that this program is 
not used as a stepping stone for receiving all of this money 
that is taxpayer money being paid out. Eighty percent of it is 
being paid out. It is not a question of coming out of the 
taxes. It is a question of this money being paid out of the 
U.S. Treasury by the U.S. taxpayers to a group of people and 
the fraud and waste level is far too high. I think we all agree 
with that and I would hope we could work together.
    Chairman Archer. The gentleman's time is expired.
    Mrs. Johnson.
    Mrs. Johnson. Thank you, Mr. Chairman.
    I have two questions I want to ask, so I do not want to get 
bogged down on either one, but on this 42-percent 
noncompliance, let me just pursue that for a moment, if I may. 
That is, for the most part, underpayment, so it is people 
paying their taxes but not enough, and on audit, auditors going 
back and saying, according to the rules and regulations, we do 
not think you paid enough.
    When you look at how many of the audits are sustained when 
they are appealed, what is that rate, the sustention rate?
    Mr. Dalrymple. Mrs. Johnson, I do not have the sustention 
rate with me on sole proprietorships. I could have that 
document given to you.
    Mrs. Johnson. I am interested that you do not. I would be 
interested in that, because the sustension rate overall is 25 
percent. So if you apply that to the 40 percent, what you 
really have is an error rate of 10 percent, and I think that 
ought to be clear, because we are kind of comparing apples and 
orange here. In our welfare program, where we provide direct 
payments, the error rate is 6 percent in welfare and 8 percent 
in food stamps.
    This is a tax program that provides direct payments, and 
while we are unlikely to ever get down to that rate, frankly, 
because we do not put the money into the administrative 
superstructure that the direct payment programs do, 
nonetheless, the current error rate of the program is totally 
unsustainable. But to compare it to the error rate in the sole 
proprietorship area is really misleading because you are 
comparing it to audits, and only 20 percent of the audits are 
found to be accurate and payments needing to be made and that 
is 20 percent of 40 percent, so you have a 10-percent error 
rate.
    What I want to go to on----
    Mr. Dolan. Mrs. Johnson, not to prolong this at all or to 
be argumentative, the TCMP data that John referred to would 
have accounted for the results through appeal. So you are 
exactly right on the normal appeal for a particular strata. I 
would like to give you some more specific data so we do not 
mislead you on----
    Mrs. Johnson. I would be interested, because, of course, 
the TCMP audits, those auditors are not permitted to take into 
account judicial precedents or even the probability that the 
positions will be asserted in audit on appeal.
    Mr. Dolan. Like I said, I am not interested in being 
argumentative as much as not misleading you on that fact.
    Mrs. Johnson. OK, because I do not think we should leave 
that standing on the record that there is that great 
noncompliance among sole proprietorships, and especially when 
it is underpayment as opposed to nonpayment.
    I do want to, though, get to Mr. Scholz, and any one of 
you, Mr. Dolan, who wants to address this. You have made some 
proposals to bring down the error rate. Now, we know a lot 
about the source of this error rate. We know that 65 percent of 
the errors are the result of joint return filing, inappropriate 
return filing, married taxpayers improperly filing separate 
returns, claiming single or head of household status. That is 
30 percent of the EIC overclaim returns, $1.4 billion. We know 
that 2.3 million men file EIC benefits claiming head of 
household status and 59 percent of them were ineligible to file 
for $1.7 billion.
    So these are big groups where noncomplying in filing is a 
big issue. How are the recommendations that you are proposing 
going to get to these groups specifically? I know you are 
making these recommendations about the tax preparers, but you 
really are going to have to be able to tell whether people 
filing as single heads of households are filing accurately and 
whether men claiming deductions are doing it accurately and how 
are your screens going to determine that.
    Mr. Scholz. The largest source of taxpayers' mistakes is 
the failure to meet the residency test. That accounts for about 
39 percent of overclaims by our calculations. So this may be a 
case where a couple may have split up. Both taxpayers are 
spending time with the child, both think they are entitled to 
claim the child, and the noncustodial parent claims the child, 
and that is inappropriate.
    A second type of very common error are these so-called 
filing status errors. There can be two cases. One could be 
clearly intentional, where both a husband and wife go ahead and 
file as heads of households and claim the credit. Another might 
be that there is a married couple who have separated, and they 
are living in different places now. They are supposed to file 
as a married couple until they are legally separated, but they 
do not, and that would account for a filing status error.
    The third kind are these complicated intergenerational 
families, where grandma is living with mother and her daughter, 
and they make a mistake on the AGI tie-breaker rules.
    The proposal to modify the foster child definition gets at 
exactly that last kind of case, where you have an unmarried man 
and woman living together, both of whom think that they might 
be able to claim the child under the foster child provisions, 
but that definition is not clear because it talks about caring 
for a child as if it is your own, and that, of course, is an 
inherently subjective kind of thing.
    Mrs. Johnson. Then how are you addressing these?
    Mr. Scholz. We are having very definitive rules about what 
is a foster child. That is, it has to be appointed by a court 
or meet narrow relationship tests.
    Mrs. Johnson. What about the problem of an individual 
parent, in the case of the large number of men who claim 
inappropriately? How are you going at that problem?
    Mr. Scholz. Right. The men claiming inappropriately come up 
in the first two examples that I gave, where often, the 
noncustodial parent is a male claiming the credit 
inappropriately. The case where a married couple is both filing 
as head of household could both be a woman and a man filing in 
error.
    So what is going to happen in those cases is the due 
diligence requirement on tax preparers--as you know, at least 
half the EITC recipients are using professional tax preparers, 
and there will be a series of questions that are already being 
asked in many of the better tax preparation offices about 
living arrangements, a child that might qualify someone for an 
EITC.
    In addition, there is the checking that my colleagues at 
the Internal Revenue Service do on Social Security numbers. 
They are developing new ways of identifying duplicate children, 
children that are claimed by taxpayers twice, and the powers 
that we are proposing to grant the IRS in investigating those 
cases should help in that kind of problem. Both of those would 
directly lower the noncompliance associated with male heads of 
households, the problem that you spoke to.
    Mrs. Johnson. Thank you, Mr. Chairman. My time is expired.
    Chairman Archer. The gentlelady's time has expired.
    Mrs. Kennelly.
    Mrs. Kennelly. Thank you, Mr. Chairman.
    Mr. Scholz, at the beginning of your testimony, you said 
you were new to all of this and new to us. I am not new to Mr. 
Dolan. I was one of the original advocates of the earned income 
tax credit. I was there when nobody used it because they did 
not know about it. I was there when it was so complicated, 
nobody applied for it. And now I am here today at a hearing 
about waste and abuse, so I do not know what the IRS means by 
waste and abuse, I do not know the difference, but the good 
news is, people are using the earned income tax credit. The bad 
news is that we have this high error rate.
    Having been with the program from the very beginning, I 
would say we are on two tracks. The first track is, if, in 
fact, somebody has abused the credit, they should not get the 
credit. They should be prosecuted, and if not, at least their 
tax return should be checked or tagged that they have been 
abusive.
    Having said that, I want to thank the Chairman very much 
for saying today that the reform of EITC would not be used as 
political football in the whole budget situation. It relieved 
me greatly.
    Having said that, I want to join with the Chairman in 
reforming this program that I have put so much of my time into, 
but I cannot do it and this Committee cannot do it without the 
information from Treasury and without the cooperation of IRS. I 
have known from the very beginning of this program that IRS did 
not want to get into this, but unfortunately, they have had to.
    I read your report and I see a root cause of the 
noncompliance is the self-determination of eligibility by 
taxpayers with then limited ability by IRS to verify the 
taxpayers' eligibility before the check goes out. So I think 
that is where we are right now. We have got to figure out how, 
in fact, the check does not go out before the eligibility is 
verified, and if, in fact, that does happen, we are going to 
have to put a great deal of effort to make sure, that people do 
not think they can just get away with it.
    I think we need some new legislative approaches. One issue 
that I have looked at and I want to ask you gentlemen about, 
one I have looked at for the last couple of years is conforming 
the personal exemption and the EITC. I would like to know if 
you have any comments on that. Is that an avenue we should 
pursue, and if not that avenue, what other legislative avenue 
can we pursue to make a program that is intended to keep people 
out of poverty and off welfare work?
    It looks like it can work. It has a huge error rate that is 
unacceptable, but, my heavens, I just have to tell you, we need 
you to help us figure out what to do next and I would ask for 
your suggestions.
    Mr. Dolan. Mrs. Kennelly, let me, first of all, tell you 
that we have appreciated your support and your willingness to 
invite us into the equation. While it might have been your 
perception that we were not anxious to be in EIC when it was 
created, I think what we have tried to do is be as diligent as 
we know how to be in helping manage the program to produce the 
outcome Congress intends, the nonpartisan outcome Congress 
intends.
    You put your finger on a point that I think frequently is 
lost on others, that one of the underlying explanations for the 
complexity of the EIC is clearly not limited to earned income 
tax credit. The entire functioning of the Tax Code turns on 
filing status classifications--head of household, married 
filing jointly, married filing separately. Similarly, the same 
dependent that is at issue in an EITC claim is at issue in a 
tax return that is filed without any EITC claim.
     Neither of those lend themselves to some silver bullet 
classification. They are both highly personal, highly 
subjective, and no computer made is going to sort out all those 
personal relationships in an absolute pristine way in advance 
of an action.
    So, as a consequence, what we have tried to do in EIC is 
the same thing we do in other areas. We look for probabilities; 
we look for hallmarks that would cause us to question a 
particular return or a particular set of returns. I think our 
best hope of continuing on the path that Karl talked about of 
incrementally bringing this down is to continue to refine the 
way we look at the returns that have the greatest likelihood of 
question.
    I do not think there is a silver bullet, no more than there 
is a silver bullet to reduce a 17-percent overall noncompliance 
rate to zero. That 17 percent was worth $95 billion last year, 
and if we could find some tonic to wipe that out, I think we 
would all be happy.
    I will let Karl speak to any additional legislation. I 
think, in large part, the course we are on, which has 
demonstrated a continued step downward in the risk that that 
program represents, is probably the only practical way in the 
short run to improve it.
    Mrs. Johnson. Mr. Dolan, do we have a problem with personal 
exemption claims?
    Mr. Dolan. Certainly.
    Mrs. Johnson. We have been talking and we will continue to 
talk. Would you like to respond quickly?
    Mr. Scholz. The legislative and administrative steps that 
we have offered, are the most sensible next steps in this 
evolving fight against EITC noncompliance. We certainly share 
your concerns. We want to bring this error rate down.
    Mrs. Johnson. Thank you. Thank you, Mr. Chairman.
    Chairman Archer. The gentlelady's time has expired.
    Mr. Collins.
    Mr. Collins. No questions, Mr. Chairman.
    Chairman Archer. Mr. Portman.
    Mr. Portman. Thank you, Mr. Chairman, and thanks to the 
witnesses for all the good testimony.
    Mr. Scholz, you said you had not testified much. When you 
get down to this level, most of the big picture questions have 
been asked, so then you start to roll up your sleeves and get 
into more of the detail. It is not as much fun sometimes, but 
that is our role down here. I have a number of questions 
relating to the IRS role and a number of questions related to 
the program itself and to some of the data you have presented 
today in your testimony.
    First, Mr. Dolan, as you know, this Restructuring 
Commission that is due to report in about 1 month that I 
cochair and that Mr. Coyne is also a member of has done some 
pretty extensive surveying of IRS employees, and I am just 
following up on Mrs. Kennelly's questions as to the IRS support 
of this program, whether it makes sense to do this within our 
tax structure.
    We have interviewed 300 online IRS employees, and it is 
interesting what we found, which is that more than half of 
those employees have told the Commission--these are your 
people--that the EITC is the greatest source of difficulty in 
administering the tax law. I assume you have that data from 
your own internal communications with your employees and you 
understand that they are very frustrated by this program. Have 
you taken their views into account in putting together your 
advice to Treasury on Treasury's proposals?
    Mr. Dolan. Mr. Portman, the specific survey that the 
Restructuring Commission has overseen has not directly been a 
function in the advice and the consultation we have done with 
Treasury. I think the characterization that the Restructuring 
Commission would make of the attitudes of IRS employees is 
probably not wide of the mark. Those who have been directly 
involved in trying to improve the administration of EIC, I 
think have been frustrated by the continuing presence of 
overclaims, erroneous claims.
    I think it might be a leap, at least in my mind, and I will 
not speak for the half of the group of the IRS employees 
surveyed who told you what was in their minds, it might be a 
leap for me to call that the single biggest frustration or 
concern in the tax administration. I think there are clearly, 
as I think you probably well know, along that whole spectrum of 
compliance and noncompliance, I can think of some areas that 
probably would be at least as vexing, both as to the dollars 
involved and as to the basic structure of the tax system.
    Mr. Portman. It is interesting you mention that, because I 
think the data will speak for itself and I think that it will 
show that it is the greatest frustration, at least in an 
absolute sense, but as you say, the dollars involved might be 
very different.
    That is one of the reasons that we ask, based on what we 
have learned from your report and what we have learned from 
independent surveys, such as this one that the Restructuring 
Commission did, is it the appropriate role of the IRS to be 
increasing its compliance in this area? Is it something that 
your people are capable of doing?
    A lot of what Treasury is recommending involves some pretty 
difficult work in the trenches, and levying unemployment 
compensation and levying people's welfare benefits. Is this 
what you all want to do and can do effectively and efficiently? 
Is it appropriate?
    Mr. Dolan. Those are both tough questions--what we want to 
do and what we can do appropriately. I think what we want to do 
is certainly a whole lot more collegial and deliberate a 
process than just the IRS deciding what it wants to do. Part of 
what you, the Congress, I think, in consultation with the 
administration have to tell us is, is that the----
    Mr. Portman. But I think what has been missing in this 
debate in my 4 years here, which is a short period of time, I 
realize, is the IRS is not at the table, whether it is helping 
to direct Treasury in terms of policy or helping to direct this 
Committee in terms of tax administration and we need to hear 
from you. You are the ones who are supposed to administer this 
program.
    You did not answer my earlier question as to whether you 
are taking the views into account of those frustrated employees 
as to how to fix the program. But even as we are talking about 
this program and how it could work better, does it make sense 
to crank up the compliance side, as you said, on the relatively 
low dollar program?
    Mr. Dolan. It really is a mixed bag, just from my vantage 
point, because while we could both sit here and call it low 
dollar, if you look at the----
    Mr. Portman. The aggregate, as we have said earlier, is 
very, very high. We are talking about $5 billion, maybe $6 
billion a year. But when you are looking at the individual 
problems and the resources the IRS has and where the IRS should 
devote its resources, I am taking your side, really, Mr. Dolan, 
saying that this may not be the most efficient use of your 
resources.
    Mr. Dolan. It is an observation that is clearly fair for 
discussion and debate among people who have investment in the 
tax system. There are only 100 pounds of us and there are 200 
pounds of challenge out there, and I think at the end of the 
day, the issue is where is the best place to put that 100 
pounds. That is, I think, an issue that involves more than just 
the IRS for the ultimate determination.
    Mr. Portman. Mr. Chairman, I have some additional questions 
for Mr. Scholz. Maybe we can get to those later, if we have 
time.
    Chairman Archer. The gentleman may continue if Mr. Collins 
or Mr. English would like to yield him any time, and then we 
will go to questioning on the Minority side.
    Mr. English. Mr. Chairman, I would like to yield my time to 
Mr. Portman.
    Mr. Portman. Mr. Scholz, just briefly, your testimony, I 
have read some of it and certainly listened to all your oral 
testimony. You talked about the cost to administer the program 
being very low compared to other programs. What is the cost to 
administer the EITC, and maybe Mr. Dolan and Mr. Dalrymple or 
others can jump in here. What is the cost? I do not know what 
it is and we have been trying to find out through various 
means. It is very difficult.
    Mr. Scholz. I believe the entire IRS budget is on the order 
of $7 billion, slightly over $7 billion.
    Mr. Portman. Seven-point-six.
    Mr. Scholz. Seven-point-six billion, very good. They handle 
well over 100 million tax returns and the 15 million tax 
returns of the corporate----
    Mr. Portman. Two-hundred-million paper returns alone.
    Mr. Scholz. So the incremental costs of administering the 
quarter-page, three-quarters of a page schedule EIC and a line 
on the 1040, I would argue, are quite small.
    Mr. Portman. You would argue they are quite small but you 
do not know what the cost is. And I notice in your testimony 
you said you think it is probably around 1 percent, and then 
there was a footnote that said, this estimate is for return and 
refund processing only and does not include the cost of IRS 
enforcement.
    Mr. Scholz. Mr. Portman, that is the GAO testimony.
    Mr. Portman. Then you compare it in your testimony to AFDC 
and AFDC does include those noncompliance costs. I mean, Mr. 
Dolan, when he looks at the EITC, he has to look at not just 
that form, putting in that form, but the data collection and 
the enforcement, the fraud detection, and those numbers are not 
in your 1 percent, I guess, because your footnote says they are 
not, whereas in AFDC, you use the 3-percent figure, I guess----
    Mr. Scholz. Mr. Portman, you are not reading my testimony, 
sir. That is the GAO testimony that cites a 1 percent figure. 
That is not a figure that we understand how they came up with.
    Mr. Portman. So you do not know what the number is but you 
know that it is a lot lower than it is in other programs.
    Mr. Scholz. Yes.
    Mr. Portman. Based on----
    Mr. Scholz. The incremental costs of administering one line 
of form and a three-quarter page schedule has to be vastly 
lower----
    Mr. Portman. I guess my only point is, if we are going to--
--
    Mr. Scholz [continuing]. When the entire budget was $7.6 
billion in fiscal year 1995, as you said.
    Mr. Portman. Right. If we are going to solve this problem, 
whether it is within the tax system or whether it is without 
the tax system, we should certainly get a handle on what the 
problem is and what the costs are. For you to say from Treasury 
that the costs are very low compared to other programs, which 
was your oral testimony, $3.5 billion for AFDC, that is about 
12 percent of program costs. Food stamps is roughly the same, 
as I understand it.
    Mr. Scholz. That is right.
    Mr. Portman. Then on the error rate, we talked earlier 
about a 6- to 7-percent error rate in those programs. The error 
rate, as we know, here is somewhere between 20 and 25 percent. 
You said the EITC meets your standards of participation, that 
it is a much better participation rate. What is the 
participation rate on food stamps?
    Mr. Scholz. Around 54 to, say, 66 percent.
    Mr. Portman. AFDC?
    Mr. Scholz. Slightly higher by about 5 percentage points.
    Mr. Portman. What is the participation rate on EITC?
    Mr. Scholz. Between 80 and 86 percent, is the best 
evidence.
    Mr. Portman. What is that based on? How do you know that?
    Mr. Scholz. Scholarly work and the literature, some of 
which I have done.
    Mr. Portman. Because one of the things that we are hearing 
out there, and Mr. Rangel talked about it, is the lack of 
communication and marketing and evidence. You have this 
tremendous problem of error and there is some significant 
fraud, but then you also have a lot of participation that is 
probably not what it should be because people are not aware, 
and it is so darn complex to do it for many taxpayers.
    My only point is that I do not think we have the numbers 
yet on what it costs to administer, and I do not think we have 
analyzed the problem thoroughly. Your own report really does 
not give us any sense of the problem, which is why now the 
Joint Tax Committee has to go back and look at your raw data 
and try to figure out what the problem really is to be able to 
analyze whether your solutions make any sense.
    I just wish that the Treasury Department would be able to 
provide us with some more data to be able to properly analyze 
it and now simply say, this is a great program because the 
error rate is much better than it was 5 years ago and because 
participation is relatively high and because it does not cost 
much to administer. We need to know what the numbers are.
    Mr. Scholz. My testimony contains the numbers for the three 
most common errors, and in my oral responses, I have given you, 
sir, a flavor of what those errors are, as well. We certainly 
want to be forthcoming, Mr. Portman.
    Mr. Portman. Thank you, Mr. Scholz.
    Thank you, Mr. Chairman.
    Chairman Archer. Mr. Coyne.
    Mr. Coyne. Thank you, Mr. Chairman.
    Mr. Dolan, do you think that the EITC constitutes the 
largest compliance issue for your agency today?
    Mr. Dolan. No. I do not think I would characterize it that 
way.
    Mr. Coyne. How does the EITC compliance rate compare, then, 
with the error rate for individual and corporate taxpayers?
    Mr. Dolan. I think that was sort of the road we began down 
before, and maybe the best way to answer that is to suggest 
that the most recent tax gap would have spread, and I do not 
have it at my fingertips, but it spreads basically that $95 
billion, the annual significance of the tax gap, and basically, 
that amount that is not paid voluntarily, it spreads it----
    Mr. Coyne. I want to talk about percentages. We are talking 
about a 20- or a 25-percent rate here. How does that compare 
with individuals' error rates on other returns, individual 
returns and corporate returns?
    Mr. Dolan. I think, as Mr. Dalrymple said earlier, on one 
end of the spectrum is the individual taxpayer for whom all of 
his or her income is both withheld and reported on. That is a 
compliance rate that is very high, and it is, as John said, in 
the 98th percentile.
    You go to the other end of the spectrum where the person's 
income could be in any number of endeavors and it is not 
withheld and not reported on either in whole or in part. That 
is clearly the most chronic part And that is where you get into 
the 40-plus percentage range that John had talked about 
earlier.
    Mr. Coyne. So that is clearly a larger compliance problem 
for the IRS than the EITC program.
    Mr. Dolan. It is complex, because it is impossible to 
capture one root cause or one answer to it. So it is very 
complex, yes.
    Mr. Coyne. I would like to ask you, should the problem that 
exists here with EITC compliance, should it be an error rate 
problem or is it a fraud problem? What would you describe it 
as, error or fraud?
    Mr. Dolan. I think I would have to say it has some of both. 
In all----
    Mr. Coyne. It has some of both, but I would like for you to 
be able to distinguish, can you, how much of it is fraud and 
how much of it----
    Mr. Dolan. Ted, I think, took a crack at that initially, 
Mr. Coyne, and I think it is really hard to get much past the 
characterization he made. A group of special agents looked at a 
set of cases by a standard that is, by definition, subjective, 
and declared some of them to be intentional and some mistakes.
    To take it the next step, to put it through a rigor of 
deciding that some subset of the intentional are fraudulent is 
beyond any analysis that has actually been applied and really 
would be far more rigorous than the study set out to be. I am 
not trying to equivocate rather, I do not want to be sloppy 
about jumping from intentional to fraud.
    Mr. Coyne. You have been dealing with the figures, though.
    Mr. Dolan. Correct.
    Mr. Coyne. You have looked at it. You have looked at this 
study. What is your judgment? Is it a fraud problem or is it an 
error problem?
    Mr. Dolan. I do not know any other way than to say it has 
some of both in it. As we said at the outset, it has got 
everything from the most obvious error, that people made claims 
because they did not understand the rules----
    Mr. Coyne. Maybe Mr. Brown could answer that question. Is 
there anything you could add to that?
    Mr. Brown. No, sir. The study was not designed to answer 
that question and we do not have that kind of data in the 
study. The resource commitment and the requirement of proof to 
satisfy a special agent that he can prove fraud would be beyond 
a reasonable doubt and we certainly did not invest that kind of 
rigor into this test.
    Mr. Coyne. What about Mr. Scholz? Could you answer that? Do 
you have any thoughts on that?
    Mr. Scholz. A lot of the errors you see come up because of 
the complexity of family living situations and the like, and so 
surely there is some of both. Because it is impossible to be 
into the mind of the taxpayer, it is very, very difficult to 
say that x percentage was intentional or fraudulent.
    Mr. Coyne. Thank you.
    Chairman Archer. Mr. McDermott.
    Mr. McDermott. Thank you, Mr. Chairman.
    Before I ask you to comment on future tax proposals 
relevant to this hearing, I would first like to ask a couple of 
questions about present tax reporting. When an ordinary 
taxpayer, no matter where they are in the income scale, reports 
that they have a child, what verification is there that they 
have, in fact, got a child living with them? Is there any 
verification done at all on that issue?
    Mr. Dolan. The principal verification would be the Social 
Security number verification that indicates that the child and 
the Social Security number belong together. What is only 
susceptible to after-the-fact validation is the reality of 
where that child lived during the filing season, so----
    Mr. McDermott. On the average taxpayer making $100,000, is 
there anything where you check to see if that child is actually 
living with that person or not?
    Mr. Dolan. It would be checked only to the same extent it 
is in EIC, either through correspondence audit programs, 
through various compliance efforts that identify a set of 
returns and go in for that kind of validation.
    Mr. McDermott. Have you ever done a study on all taxpayers 
in terms of compliance about where kids actually live?
    Mr. Dolan. Not that I am aware of.
    Mr. McDermott. So this is just----
    Mr. Dolan. What I would like to do is give you for the 
record, a report that I am told that we did some years ago on 
what we call a deferred tax consequences study that would offer 
some insight into that area.
    Mr. McDermott. My point is that in this day when children 
live with a mother or father after a divorce and they live 5 
months with the mother one place and 7 months with the father, 
it is possible for people making $75,000, both parents to take 
credit for those kids and you would never know it, is it not?
    Mr. Dolan. I think you make both points. One is that 
complexity of living circumstances or personal circumstances 
are not confined to a particular strata on the income ladder--
--
    Mr. McDermott. So it is not only people making less than 
$15,000, where the kids might live with the father, the mother, 
or the grandmother, or an aunt?
    Mr. Dolan. I think you are exactly right.
    Mr. McDermott. That could happen at any level of society, 
but you made no check. You have nothing in place that checks 
that today.
    Mr. Dolan. Only with respect to what I mentioned before, 
that is, we do have ways in which we identify a return for 
further scrutiny and in that further scrutiny that issue, in 
some instances, would be examined.
    Mr. McDermott. Now, as we move forward to the future, there 
is a proposal on the table that we have a nonrefundable $500 
tax credit for children. You are aware of that, right?
    Mr. Dolan. I am.
    Mr. McDermott. There will be no verification, except sort 
of in the general way. We could have the fraud go all the way 
up to $200,000 under that proposal because there is no way you 
are going to know whether the kid is living with the father or 
the mother or the aunt or the uncle or the grandpa.
    Mr. Dolan. In that case, the one governor that you would 
have, I think, Mr. McDermott, that would be helpful to you is 
an ability to ensure that the child only appears one place. We 
do not have an ability to----
    Mr. McDermott. How would you know that if you cannot 
computer check?
    Mr. Dolan. Well, we can----
    Mr. McDermott. My number is ``x,'' and if my name is put 
down by my mother and my father, one living in Kansas City and 
one living in New Hampshire, how would anybody ever know that 
my name was put down twice and I was claimed twice?
    Mr. Dolan. We can check that.
    Mr. McDermott. You cannot check that?
    Mr. Dolan. We can.
    Mr. McDermott. You can?
    Mr. Dolan. We can, and we do.
    Mr. McDermott. You can electronically, or you do on paper?
    Mr. Dolan. We can get--irrespective of whether the return 
was electronic or paper, the data is either captured 
electronically or transcribed manually. It is in the system. We 
do the check and we can satisfy ourselves that the dependent 
was only claimed once, or if it was claimed twice, we can work 
the contention between the duplicate claims.
    Mr. Shaw. Would the gentleman yield?
    Mr. McDermott. I will yield in just a second. If you can do 
that for me at my income level, why can you not do it for 
people down at the lower level?
    Mr. Dolan. We can. We can and we do. What that does not 
answer, though, is the question that you posited in the first 
instance. I can ascertain whether the child showed up in one or 
two places----
    Mr. McDermott. So you can get the duplicates.
    Mr. Dolan. Correct.
    Mr. McDermott. But what you cannot get is the one who is 
claiming it who did not actually have it, is that correct?
    Mr. Dolan. As between the two, the one may have been 
entitled and the other may have claimed on----
    Mr. McDermott. But if you have a divorce decree that says 
that the child can be claimed by the father although the child 
lives with the mother, how do you know that one?
    Mr. Dolan. At the moment, and you are probably taking me as 
deep or deeper than I would like to be in a public setting, but 
what we have, in that particular instance, we have right now 
under exploration with the Social Security Administration the 
use of a data base. They are still trying to determine whether 
it is legally acceptable for us to take and routinely use some 
of that information that would, at least in some of those 
factors, help sort out who is the legal custodial parent and be 
able to use that.
    Mr. McDermott. I would yield to my colleague from Florida.
    Mr. Shaw. If the Chairman would indulge me just for another 
second, because you are on an interesting line of questioning. 
You said you can catch whether the same Social Security number 
is used twice on two returns for the same child. The question 
is, would that automatically pop up or is it something that you 
can do but do not routinely do?
    Mr. Dolan. No. We can do and do routinely do.
    Mr. Shaw. So if the mother and father separated and use, or 
if anybody uses the same Social Security number for a dependent 
on the return, the chances of picking it up is almost certain, 
is that correct?
    Mr. Dolan. The answer to that is yes. I guess what I would 
really like to do with maybe Mr. Shaw's and the Chairman's 
permission is we are at a point now where to go much more into 
what exactly is done and how it is done, while I would like to 
meet your information needs, I would sure like to take it in a 
closed session.
    Mr. Shaw. That would be of interest to the Committee, Mr. 
Chairman.
    Chairman Archer. The gentleman's time has expired and we 
would very much like to pursue that with you. We do not want to 
hinder your ability to enforce as a result of these hearings--
--
    Mr. Dolan. I appreciate that.
    Chairman Archer [continuing]. But we do want to get as much 
information as we can out so that we have an understanding of 
the root cause of the fraud and mistakes which will put us in a 
position to evaluate this program as we move on. I do not want 
to cross that line, to get into information that would be 
adverse to our desired goals, but I do want to ask you a couple 
of additional questions to followup on, an excellent line of 
questioning from the gentleman from the State of Washington.
    Do you have access to all Federal information that would be 
helpful to you in doing your enforcement job?
    Mr. Dolan. That is a good question. The only reason I 
hesitate to say yes is I am not sure I know what I do not know. 
What we have----
    Chairman Archer. I know that is a very broad question, but 
it seems to me that that is one of the things that we should 
consider, is that you should be able to have access to whatever 
information is held by other Federal agencies in order to be 
able to do your job of enforcement.
    Mr. Dolan. I would say, Mr. Chairman, in the main, that has 
not been a problem. As you know, we do the prisoner matches and 
we do a fairly wide range of other information matches, and I 
mentioned to Mr. McDermott the issue is now between the IRS and 
Social Security on using this custodial parent database. So 
there may be another source of information out there----
    Chairman Archer. Because the Treasury, to my knowledge, has 
made no recommendation in that regard and it seems to me that 
you should look at that.
    Let me ask you about the individual without children who 
now qualifies for the EITC. I would like to ask Mr. Brown, is 
the error rate the same there as it is generally for the entire 
cohort?
    Mr. Brown. No. It is lower.
    Chairman Archer. What would the error rate be in that 
category?
    Mr. Brown. About 15 percent.
    Chairman Archer. That is not the amount that is due to 
fraud. That is the total error rate----
    Mr. Brown. That is the total overclaim.
    Chairman Archer [continuing]. Including fraud and mistakes?
    Mr. Brown. The total overclaim rate, right.
    Chairman Archer. What is the root cause of that? You do not 
have to match any Social Security numbers for children and you 
do not have the complexities that Mr. McDermott spoke of in his 
line of questioning.
    Mr. Brown. It is usually an income adjustment. Somebody has 
either not reported all of their income, moving them down in 
the higher ranges of the earned income tax credit, or they have 
created income to move themselves into higher credit payoffs.
    Mr. Scholz. A lot of it, Mr. Chairman, as well, is filing 
status mistakes, where a married couple are both filing 
separate returns and one of them who is filing as a single 
person would have an income low enough to get the EITC. So it 
is a combination of some of the filing status errors and income 
errors.
    Chairman Archer. Thank you for that input, because that is 
another aspect of this that is going to be awfully difficult to 
come to grips with. If it has not been asked, where you have 
two taxpayers married filing separately and they have two 
children, is there any way that you can prescreen or know 
whether or not they are entitled to get this credit because 
each one of them applies with one of the children? Is there any 
way at all that you can enforce that?
    Mr. Brown. If they file married, filing separate, disclose 
the other taxpayer on the form properly and follow the 
instructions properly, there would not be a problem. The 
problematic area is when they both claim to be heads of 
household. That is the area that is problematic for us.
    Chairman Archer. But if they do not claim to be heads of 
household and the one files claiming one child and the other 
claiming the other child, that is not a problem?
    Mr. Brown. We would be able to identify that.
    Chairman Archer. Do you identify it today? You would be 
able to, but do you?
    Mr. Brown. It has not been an area of high emphasis in our 
screens, no, currently.
    Chairman Archer. Maybe that is something that you ought to 
try to put in place administratively. I know that your 
resources are limited in trying to do the massive job that this 
very arcane, complex, counterproductive Tax Code puts upon you, 
but I will leave that for another time, to talk about what we 
ought to do to rectify the overall Tax Code.
    Let me ask you, Mr. Dolan, and see if I can get a little 
better answer from you than I got from Dr. Scholz, and I 
apologize for calling you Mr. Scholz, but that is what is on 
your nameplate in front of your desk there. What would you 
accept as a tolerable target for an error rate in this program 
and feel like you have done your job?
    Mr. Dolan. If I change my nameplate, would you ask me an 
easier question? [Laughter.]
    Mr. Chairman, I think the way I would try to think about 
that is in the context of, again, this discussion we were 
having about what does the spectrum look like of tax compliance 
in general and where might most of the EIC claimants fit on 
that spectrum. Then what I guess I would like to say is to the 
extent they fit on the end of the spectrum that is largely a 
wage-earner population, I would hope that, ultimately, the 
characteristics of wage-earner returns that have an EIC claim 
would fit into that kind of a compliance pattern, which would 
take us down into the low noncompliance----
    Chairman Archer. So you think, depending upon the nature of 
the law and the job that is assigned to you, that it might not 
be possible to have a target that is much below 18 percent? 
Would that be----
    Mr. Dolan. No. No. The 18 percent, 17 or 18 percent is when 
you comb it across the whole spectrum. I am trying not to give 
you a number because I do not know how to select a number with 
accuracy. But I would say there is a spectrum that up here is 
40 and 50 percent and down here is under 10 percent, and what I 
guess I would like to do over time is see us moving it down 
here because these are the returns and the compliance patterns 
of wage earning, wages withheld, wages reported Americans, 
which for the largest part of the EIC population would be their 
demographics as well. So that is why I say, I would try to push 
it into that range of compliance with the incremental security 
improvements.
    Mr. Portman. Mr. Chairman, would you be willing to yield on 
that answer? I do not want to interrupt you, but are you moving 
on? Could I ask one followup on that question?
    Chairman Archer. I yield to the gentleman from Ohio.
    Mr. Portman. Thank you, Mr. Chairman.
    Mr. Dolan, to put them in that part of the spectrum does 
not take into account the fact that the externals of this 
program are entirely different. How can you say that the wage 
earner who is paying taxes should be compared in terms of the 
ultimate error rate to an EITC recipient, because you are 
talking about a withholding program that essentially the 
private sector does for you.
    You are talking about whether people are going to be paying 
the appropriate amount of taxes, and you talked about the 
concern, as an example, with the single individual without 
children having this 15-percent error rate, that it is income 
often that is overreported rather than underreported. It is a 
whole different phenomenon. Plus, you have a refundable credit. 
It is a refundable credit.
    So I do not know how in your analysis you are thinking 
about it. I know you have been at this a long time and you know 
the different taxpayer groups that might have various error 
rates, but how could you lump those two groups together? Is it 
not a very different kind of a scenario with regard to 
compliance?
    Mr. Dolan. Mr. Portman, you make a series of very good 
points. I guess what I was trying to do is rise to the 
Chairman's question of what would I accept. I was trying, 
without giving you anything precise, I was trying to tell you 
that where my thinking would take me is, because----
    Mr. Portman. But how would your thinking take you there, 
because the answer to the Chairman's question I think you gave 
him is it should be in the 10 percent or under range because 
that is where it is with the wage earners, but this is a 
different program.
    Mr. Dolan. Let me go on.
    Mr. Scholz. There is no evidence that taxpayers are 
overreporting income to maximize their EITC claims in the data 
in our study.
    Mr. Portman. Say that again?
    Mr. Scholz. There is not evidence----
    Mr. Portman. There is no evidence that any taxpayers are 
overreporting income----
    Mr. Scholz. That that is a major----
    Mr. Portman [continuing]. To claim the EITC?
    Mr. Scholz. That that is a major problem among taxpayers 
claiming the EITC.
    Mr. Portman. There is no evidence? The Treasury Department 
makes that statement?
    Mr. Scholz. That that is a major----
    Mr. Portman. That is amazing to me.
    Mr. Scholz. Please.
    Mr. Portman. I yield back, Mr. Chairman.
    Mr. Scholz. The statement is that there is no evidence that 
that is a major problem in the IRS compliance data.
    Mr. Portman. Mr. Brown just said it was.
    Mr. Scholz. He was talking about for childless taxpayers. 
He was saying----
    Mr. Portman. Right, overreporting income to claim the EITC.
    Mr. Scholz. Some portion of----
    Mr. Portman. And you just said there is no evidence of it. 
There is either evidence of it or there is not.
    Mr. Scholz. I said there was no----
    Mr. Portman. You said there was no evidence----
    Mr. Scholz. I said there was not----
    Chairman Archer. I believe we understand.
    Mrs. Thurman. The Chairman's time has expired. Mrs. 
Thurman.
    Mrs. Thurman. Hello. It has been fun already, has it not? 
Maybe we can let people answer questions now for a little bit.
    Let me ask, first of all, have any of you seen the 
Certified Public Accountant, CPA, testimony that was put before 
this Committee to be put into the record on this issue?
    Mr. Dolan. I have not.
    Mrs. Thurman. Let me ask a couple of questions, because I 
think it is kind of pertinent to particularly where there has 
been some consideration on the paid preparers who have actually 
suggested that about one-half of theirs have had problems. They 
suggest--let me see where it is--that part of this problem, and 
again, I always think that we always hit the agencies and, 
quite frankly, we make the laws, that part of the problem has 
been because the credit has been changed 12 times and in that 
12 times, actually, starting from 1976, 1977, 1978, 1979, 1984, 
1986, 1988, 1990, 1993, 1994, 1995, and 1996.
    Within that, the computation of that credit currently 
requires the taxpayer to consider, now you need to tell me if 
these are true, nine eligibility requirements; the number of 
qualifying kids, taking into account relationship, residency, 
and age tests; the taxpayer's earned income, taxable and 
nontaxable; the taxpayer's adjusted gross income; the 
taxpayer's modified adjusted gross income, AGI; threshold 
amounts; phase-out rates; and varying credit rates. Are all 
those part of compliance, where they would have to fill this 
all out? How much time does that take them to do? What does 
that require from this taxpayer?
    Mr. Dolan. I do not know that we can give you today the 
time implications. Your point, Mrs. Thurman, though, is an 
accurate one. Clearly, between some of the changes and then at 
the end of the day the actual calculations a taxpayer has to 
make, they are significant.
    Mrs. Thurman. But if I were claiming this, and I am sure 
that we have changed Tax Codes all the time, so these are not 
the only people that are being confused, but could this be a 
part of the problem for compliance? I mean, if the people that 
are being paid to make these claims and then the person who 
might do it on their own, to take all of this information that 
is required and then change the procedure almost every year 
since 1976, I mean, is that a part of our problem with 
compliance?
    Mr. Dolan. I would say it certainly is a part of it but it 
is a story that is not totally bleak. I think that the Congress 
and a series of administrations have tried to counter that 
complexity. When I first entered this picture back in, I guess 
it would have been 1993, I actually appeared before a body on 
the other side that was concerned that we were going to ask 
taxpayers to use a schedule to try to figure out their EITC and 
people were just kind of reading directions and putting on the 
face of the return.
    I think what Congress has done with a series of 
administrations is try hard to take things out of the mix that 
do not make sense and get schedules that make sense and----
    Mrs. Thurman. So you are thinking that it makes it a little 
bit easier?
    Mr. Dolan. I think it has been everybody's objective to try 
to rationalize something that is supposed to be----
    Mrs. Thurman. With that, then, in mind, we have talked in 
the Subcommittee a couple of times about what kind of 
information we give to taxpayers in being able to fill these 
out. What are we doing with that today? I can tell you, 2 years 
ago, I did a television show that I sent out to my cable 
television programs specifically on the earned income tax 
person so that they could understand how they could apply for 
this, what the qualifications were to try to help give them 
some good information. What are you doing in that area to help 
these folks?
    Mr. Dolan. We have a series of initiatives, some of which 
take advantage of exactly the kind of generosity that you have 
extended in terms of using Congressional outreaches. We work 
with an awful lot of churches and civic groups. We also--
somebody made the point, and I forget which of the Members made 
the point earlier on, at the end of a filing season, we 
actually go through the filings looking on the face of the 
return for filing patterns that look like the person would have 
otherwise been eligible. I think it was Congressman Portman 
that made the point that there are people out there that do not 
know about it and are not claiming it.
    I am doing this from memory, but I think in the last one of 
those cycles we sent out about 1.2 million of those notices and 
something like 38, 40 percent of the people came back and said, 
gee, having gotten your notice, here is my factual 
circumstance, and then a high percentage of those people 
actually qualified. So that was a way we got people in.
    We are now also trying to use, as I said, the advanced 
earned income publicity and we are going with a new wave of 
that to bring people in.
    Mrs. Thurman. I have just one quick question. In some cases 
where there are two adults, an example would be a grandma and a 
mom, in the household and the wrong person claims the credit, 
the rule is, as I understand it, that the one with the higher 
AGI should claim the EITC, but we understand that the entire 
erroneous payment is counted by the IRS as an error, even when 
the mom in this case would have legitimately have gotten the 
EITC. Does that then overstate the issue of error?
    Mr. Brown. I guess it does not hurt. I do not know what 
percentage of the sample----
    Mrs. Thurman. But there is that out there, and that does 
get counted twice, then, so an error----
    Mr. Brown. No, it would not be counted twice, because in 
our study, it is unlikely we picked up both the daughter and 
the mother in that example.
    Mrs. Thurman. So one.
    Mr. Brown. If our random sample had picked one or the 
other, then that would be the party. Then in the sample, we 
would have adjusted that person's return. We would not show a 
corresponding change to say there was another person that was 
entitled to the credit.
    Mr. Shaw [presiding]. The time of the gentlelady has 
expired.
    Mrs. Thurman. Thank you.
    Mr. Shaw. We have two more Members that have not had a 
chance to inquire, Mr. Jefferson and Mr. Levin. Mr. McDermott 
has stated that he has another question. We will recess long 
enough for the Committee to vote and we will be back and finish 
up. Thank you.
    [Recess.]
    Mr. Shaw. If we could resume. The Chair now recognizes Mr. 
Jefferson, the gentleman from Louisiana.
    Mr. Jefferson. Thank you, Mr. Chairman, and good afternoon.
    I want to follow up a little bit on what Congresswoman 
Thurman was asking, to talk about the issues of complexity and 
the solution for that, which is some simplification. Why is it 
that you made some recommendations, some of you have in your 
testimonies, I think Dr. Scholz has for sure, why do we not in 
this program define earned income as taxable wages and self-
employment income from line 12 of the 1040 form instead of all 
of these myriad ways we define it here, which are terms which 
are not commonly used in that same context and some of them 
actually include some idea of non-taxable earnings. They do not 
include taxable income for most of it, so we are using it in a 
very different way.
    Why do we not just take the earned income definition on the 
tax form and use that one? Would that not simplify this process 
tremendously and cut down on the errors?
    Mr. Dolan. We are very anxious to take steps to further 
simplify the EITC or other areas of the Tax Code to reduce 
differences between tax treatment of some income items and 
family status of the EITC and elsewhere in the Tax Code. For 
instance, we have a simplification proposal that would move the 
definition of dependent a lot closer to the EITC definition.
    Your suggestion sounds like one that ought to be taken very 
seriously, and I can certainly say from the Office of Tax 
Policy at Treasury, we would be interested in speaking further 
with you about these things and seeing whether there are 
constructive steps that can be taken to make the credit work 
better.
    Mr. Jefferson. The other point is, not only in this area 
but in every other area where you have references in Tax Code 
about thresholds that provide definitions, they ought not be 
different in the EITC area because it just adds to the 
complications of it----
    Mr. Dolan. Right.
    Mr. Jefferson [continuing]. Which is why the preparers, the 
paid preparers, have a difficult time keeping up with it as 
well as the folks who work on it themselves.
    Mr. Dolan. We agree, and that is why our simplification 
initiative is so important, to try to conform the definitions 
or more closely conform the definition of dependent with the 
qualifying child and the EITC.
    Mr. Jefferson. I would urge that in addition to the 
recommendations we have talked about already, just simply tie 
these things into current Tax Code provisions so everybody can 
understand it. It would be a whole lot simpler and we could get 
this form down to a few pages that ordinary people can have a 
chance to work with. You compare this to the short form of the 
Internal Revenue Service reporting form and it is no 
comparison. You have got a short form to report your regular 
taxes and you have this huge thing to do the EITC calculation. 
It is just almost impossible to do it and to not make a mistake 
on it, really.
    But in any event, that is my editorial comment on it, and I 
think a great reason for the problems we are having is it is 
just too complex.
    This whole issue of----
    Mr. Scholz. Mr. Jefferson, would it be inappropriate? Could 
I add one more thing to what you have just said?
    Mr. Jefferson. Yes.
    Mr. Scholz. That is, for millions of taxpayers who have 
wage and salary income, have standard living situations, the 
EITC really is not complex. It is not horribly complex and 
millions of taxpayers are easily able to comply with the 
credit. The particular form is about three quarters of a page 
and it is very simple and the Congress and the administration 
have worked very hard to make that form simple.
    It is when you get these unusual living situations, the 
three-generation family, the couple that has split up, and that 
kind of thing, or have unusual sources of income, that the 
credit gets very complex. But for the vast majority of EITC 
recipients, the credit really is not overly complex.
    Mr. Jefferson. For the vast majority? What percentage is 
that?
    Mr. Scholz. Oh, no. I got into this again.
    [Laughter.]
    Mr. Jefferson. I am just asking. Is it----
    Mr. Scholz. Around 18 million taxpayers claim the EITC and, 
let us say 13 million, 12 million of them have very common 
standard living arrangements.
    Mr. Jefferson. And so 5 million have these other 
complicated things?
    Mr. Scholz. This is just a wild guess, at the encouragement 
of Mr. Rangel.
    Mr. Jefferson. It falls in the range of the errors and 
problems that you have, is what I am talking about. I am sure 
everyone does not have a problem and most folks get it right. 
Twenty percent of them do not and those are the ones we are 
talking about and those are the ones who, I think, have fallen 
victim to some of the problems here, who have these complicated 
issues. So that is the same point.
    My time is quickly passing, and already gone, but I wanted 
to deal with this other issue that I did not understand from, 
and I am glad she is back, Congresswoman Johnson's question 
earlier today when she reduced the 42-percent noncompliance 
rate with self-employed folks down to 10 percent. Now, that is 
not the way I read it and it did not seem to me to be correct, 
so I want you to clarify that for me just so I will be sure 
that either she is right or the reading of this thing is right.
    When you talk about the 42-percent compliance, this is 
after the TCMP has been completed and that is how you come out. 
So you have taken everything into account that you should have 
taken into account in that examination and you come out with a 
42-percent noncompliance rate. Is that right, or is it 10 
percent, as she was suggesting this morning?
    Mr. Dalrymple. No, you are right. It takes into account the 
entire process, so the 42-percent noncompliance rate would be 
applicable. The sustension rate that is described is the 
sustension rate across all tax returns. Sole proprietors, 
especially at the lower level, have a much higher sustension 
rate in our appeals process, also. So there are a number of 
different factors there.
    Mr. Jefferson. So it takes into account underpayment and 
nonpayment and every other consideration that creates this gap 
that we are talking about.
    Mr. Dalrymple. That is right.
    Mrs. Johnson. Would the gentleman yield on that?
    Mr. Jefferson. Sure, if I have any time.
    Mr. Shaw. Go ahead with this, and then we will move on.
    Mrs. Johnson. The gentleman from Louisiana asked you, does 
the TCMP rate take everything into account. It is my 
understanding that TCMP audits are not permitted to take into 
account judicial precedents or even the probability that the 
positions that they are asserting in the audit level would be 
upheld by litigation, is that not true?
    Mr. Dalrymple. Yes, that is true.
    Mrs. Johnson. Then in this audit category across the 
agency, only 25 percent of the audits are sustained, correct?
    Mr. Dalrymple. The sustension rate varies for different----
    Mrs. Johnson. But across the agency, is it not 25 percent?
    Mr. Dalrymple. I really do not have that number with me, 
Mrs. Johnson, but----
    Mrs. Johnson. That is what we were told----
    Mr. Jefferson. But reclaiming my time----
    Mrs. Johnson [continuing]. But in sole proprietors, the 
sustension rate is even higher, is my understanding, in this 
audit business.
    Mr. Dalrymple. It is much higher than 25 percent.
    Mrs. Johnson. Right, the sustension, the rate at which 
people are sustained that they were right and the agency was 
wrong.
    Mr. Dalrymple. No. No. That the IRS was sustained and that 
the--it is just the reverse, Mrs. Johnson.
    Mrs. Johnson. OK. Sorry. So 25 percent, the IRS is 
sustained that the IRS is right. Seventy-five percent of the 
time, they are wrong?
    Mr. Dalrymple. In certain categories, that is true.
    Mrs. Johnson. Right. Overall, the agency----
    Mr. Jefferson. Let me reclaim my time.
    Mrs. Johnson. I just want to get this----
    Mr. Jefferson. It is going to get more and more confusing.
    Mr. Shaw. I am about ready to say the time has expired.
    Mrs. Johnson. I will give you back time.
    Mr. Jefferson. Across the board sustensions, and I am 
dealing just in the context of sustensions kind of across the 
board. It is very hard to isolate that into this area, if you 
want to kind of use a gross percentage figure. But in any 
event, Mr. Chairman, we will never finish this conversation in 
the time that I have.
    Mr. Shaw. The time of the gentleman has definitely expired.
    Mr. Levin.
    Mr. Levin. Thank you, Mr. Chairman.
    Some of the discussion related to targets, and I believe 
that most everybody, and I think, really, yourselves believe 
that the target for noncompliance should be zero, that we 
should aim for everybody complying, because that is surely my 
position. I want to pick up what Mr. Rangel raised and has now 
just been discussed between several other colleagues and 
yourselves. You mentioned the sole proprietor noncompliance. Do 
you have figures on noncompliance in any other area?
    Mr. Dalrymple. Yes, Congressman Levin, we do. In fact, we 
discussed them earlier. The overall tax gap is at about 17 
percent----
    Mr. Levin. OK, but how about other specific areas.
    Mr. Dalrymple. I was just going to break that down for you. 
In the people who are normal wage earners who have----
    Mr. Levin. You covered that earlier.
    Mr. Dalrymple [continuing]. About 98 percent, and when you 
get down to our least compliant area would be in sole 
proprietors and that compliance rate is around 58 percent.
    Mr. Levin. How about some other area in between? Are there 
any other categories?
    Mr. Dalrymple. I did not bring breakdowns with me but we do 
have those and I can certainly supply them to you.
    Mr. Levin. Would there be any other area besides sole 
proprietors that would be as high as the noncompliance for EITC 
filers?
    Mr. Dalrymple. Like I said, Mr. Levin, I would have to get 
that data for you. I did not bring it with me.
    Mr. Levin. You do not remember? Do you happen to have that 
information available?
    Mr. Scholz. It looks like the answer is no, Mr. Levin, not 
right now. We would be happy to provide it to you. We would be 
happy to try to provide it to you.
    Mr. Levin. I take it, though, if the average is 17 percent, 
that there probably are other categories where the 
noncompliance rate would be over 20 percent besides sole 
proprietors. That is logical, is it not, likely?
    Mr. Dalrymple. That is a fair statement, Mr. Levin.
    Mr. Levin. I would hope, Mr. Chairman, that our Committee 
would look into these other areas of noncompliance. We have 
focused on EITC. The record there is not acceptable, though it 
has been an improvement, and I think the word ``substantial'' 
has been used, a substantial improvement since 1988. By the 
way, were any of you involved in enforcement in 1988?
    Mr. Dalrymple. No, sir.
    Mr. Levin. It was a different cast of characters? But 
anyway, there has been some substantial progress since then, 
but we still have a considerable ways to go. Go ahead. Somebody 
was saying something.
    Mr. Scholz. We actually do have results from the IRS tax 
gap study, Mr. Levin, that business income in general is the 
area with the largest net misreported percentage, and then 
there are several categories within business income.
    Mr. Levin. What is the overall for business income?
    Mr. Scholz. It ranges overall between 29 and 30 percent.
    Mr. Levin. Twenty-nine what?
    Mr. Scholz. And 30 percent.
    Mr. Levin. Thirty percent? You mentioned sole proprietors. 
What are some of the other categories?
    Mr. Scholz. These would be separated into nonfarm 
proprietors----
    Mr. Levin. And what is that figure?
    Mr. Scholz. Between 31 and 32 percent.
    Mr. Levin. Keep going.
    Mr. Scholz. Informal supplier income, around 81 percent.
    Mr. Levin. Eighty-one percent what?
    Mr. Scholz. Is misreported. These are informal suppliers.
    Mr. Levin. Informal suppliers, 81 percent noncompliance?
    Mr. Scholz. The underground economy, Mr. Levin.
    Mr. Levin. And what else?
    Mr. Scholz. Farm income.
    Mr. Levin. And what is that?
    Mr. Scholz. Thirty-one, 32 percent.
    Mr. Levin. Thirty-one to 32 percent. Give me a few others, 
if you would.
    Mr. Scholz. Capital gains would be between 6 and 7 percent.
    Mr. Levin. Mr. Chairman, I would hope that this Committee, 
trying to further our efforts to crack down on noncompliance, 
would hold some hearings in these other areas.
    Mr. Shaw. I think we should, but I would be very quick to 
point out to the gentleman that this is taxpayers' money. 
Eighty to 85 percent of it is taxpayers' money that is being 
paid to people as part of a welfare program. If you compare it 
with some of the other welfare programs, according to the green 
book, AFDC only has an error rate of 6 percent. Food stamps 
only has an error rate of 7 percent. I think it is always 
important in all of these areas to get compliance, but this is 
a question of Federal money being paid out. It is not a 
question of income being reported.
    Mr. Levin. But, Mr. Chairman, all of this is taxpayers' 
money, all of it. Noncompliance----
    Mr. Shaw. No, but this is a welfare----
    Mr. Levin. I understand. I do not think EITC is a welfare 
program, but----
    Mr. Shaw. So I think when you are----
    Mr. Levin. No, let me just----
    Mr. Shaw. No, wait a minute. I have the floor. I think when 
it is a question of what you compare this to, I think it is 
important that we look and see how are we doing in other 
welfare programs. This is a welfare program and I think it is a 
question of--now, I am not trying in any way to diminish the 
statistical data for noncompliance in the payment of income 
tax. I think that is also very important and I agree with you. 
I think we, as a Committee, have a constant obligation to look 
at this.
    But I think to compare a welfare program with a question of 
reporting of income is not entirely fair, and particularly when 
you are talking about in the cases of the percentages. We are 
talking about the dollars and how they are reflected in the 
compliance.
    Mr. Levin. Let me just finish by saying, I do not think 
EITC is a welfare program, but noncompliance, no matter where 
it is, needs to be examined, and there are Federal subsidies in 
some of these areas. For example, the farm area has 
considerable Federal subsidy. So I think we need to be strict 
and stringent about compliance in every single area and I think 
the testimony today has indicated that there is a shortfall in 
a number of these areas that we had better look into.
    Mr. Shaw. I do not think there is any question about that.
    Mr. Becerra is recognized.
    Mrs. Johnson. Mr. Chairman, would you just yield on that 
for 1 minute?
    Mr. Shaw. Yes, I will yield to you.
    Mrs. Johnson. I think one of the problems here is that the 
percentages that were named are a percentage of data that GAO 
has told us has not been adjusted for appeals, so it is just 
the amount of money that IRS thinks is owed. When you adjust 
that for appeals, 25 percent is what they really get paid out 
of the whole amount.
    So apparently there is some dispute between IRS and GAO as 
to whether this is adjusted for appeals or not, and so we 
should come back to that subject, but that is certainly--I am 
taking my comments from GAO testimony.
    Mr. Levin. Twenty-five percent is a huge amount.
    Mr. Scholz. Mrs. Johnson, the same point would apply with 
the EITC compliance study, as well. Some of the noncompliance 
that we are talking about in this study today might be 
overturned on appeal, as well.
    Mrs. Johnson. That is true, but it was not a TCMP audit 
kind of study. It was a different kind of study with screens 
and rather more focused on just EITC actions.
    Mr. Scholz. It was not an entire TCMP----
    Mr. Shaw. Mr. Becerra is recognized.
    Mr. Becerra. Thank you, Mr. Chairman.
    Let me ask a question. I know we have been talking 
generally in the Committee about the issue of noncompliance, 
and, of course, the focus today is on the EITC. I believe the 
child tax credit that is being proposed by both the President 
and the Congressional leaders in both the Senate and the House 
would give us a tax credit of somewhere, I think it is about 
$40 billion. Can you comment, and perhaps, Mr. Dolan, we could 
start with you, whether you believe that the $500 child tax 
credit will result in any noncompliance?
    Mr. Dolan. It is hard to make a categorical estimate of 
that. I suspect we will see the typical gamut of everything 
from needing to appropriately inform and educate and make sure 
that instructions and the forms all coincide to what it is the 
taxpayers are trying to do. I have no doubt that when you 
introduce a new provision, there will be some of that. I have 
no reason to expect any kind of runaway problem with it.
    Mr. Becerra. So it is unclear at this stage what type of 
noncompliance there may be, but certainly, as you just 
mentioned, when you add any new component to the tax structure, 
there is a good chance that you will have some form of 
noncompliance, whether it is intentional or not.
    Mr. Dolan. I think, as the Congress has often said, when 
there is the volatility that there is in the Tax Code, the 
process of absorbing the change is substantial year to year, 
whether I am an individual filer or a practitioner.
    Mr. Becerra. Do you have any way of gauging of what type of 
noncompliance we have out there, whether it is by business or 
individuals, whether it is on a credit or some other matter, is 
there some way to try to get a sense of how much noncompliance 
there is out there?
    Mr. Dolan. Part of what was just going on with Mrs. Johnson 
is that we have data that we put together in something that we 
publish as a tax gap estimate and that would probably at this 
point be our best calibration of that, and I would be happy to 
be sure that we furnished you those materials. That is probably 
the best product we have today that would attempt to break down 
some of those. That is actually the document from which Dr. 
Scholz was reading, as well.
    Mr. Becerra. You or Dr. Scholz, do you happen to remember 
offhand what some of those estimates might have indicated in 
terms of noncompliance?
    Mr. Dolan. I think probably what will meet your needs best 
is maybe to give you the document and walk you through it. We 
talked about an overall average of 17. The wage-earner end of 
the spectrum is 2 or 3 percent; the other end of the spectrum 
is up in the 40-plus percent, a lot of it depending on 
characteristics of the income and whether the income is 
reported upon and withheld. I think that the document we will 
show you breaks that down to unreported income, unfiled 
returns, returns that are filed and reported correctly but 
unpaid at the point, so it is calibrated in a number of 
different ways.
    Mr. Becerra. Dr. Scholz, do you have anything?
    Mr. Scholz. I think the overall tax gap for 1992 was 
estimated to be around $90-some-odd billion, about $39 billion 
accounted for by business kinds of incomes, which would be the 
largest source of the tax gap.
    Mr. Becerra. Mr. Dolan, do you have any other studies or 
examinations underway with regard to noncompliance beyond what 
you did here with the EITC?
    Mr. Dolan. We have a fairly wide range. I mentioned, 
perhaps before you came in, we have an actual research 
capacity, both in our National office and in our district 
office, where we are constantly looking at various pieces of 
the compliance gap and trying to through those studies identify 
both sort of wholesale prescriptions that could influence 
compliance as well as looking for ways to influence where we 
spend our compliance resources.
    Mr. Becerra. Can you give us a sense of what types of 
studies you are doing at this time on compliance?
    Mr. Dalrymple. I guess, specifically, I would address a 
couple that we have going on that we are looking at around 
EITC, because that is the subject of the hearing.
    Mr. Becerra. But beyond EITC, because, obviously, we know--
--
    Mr. Dalrymple. Beyond EITC, we have looked at tip 
reporting, we have looked at advance payment agreements, we 
have----
    Mr. Becerra. Not what you have done, I am asking what you 
have underway, any other examinations you have underway.
    Mr. Dalrymple. Actually, I have a number, and I could get 
you a list back, would be the best thing to do. But we have a 
number of studies underway.
    Mr. Becerra. It sounds from your response that you have too 
many to articulate.
    Mr. Dalrymple. That is right.
    Mr. Becerra. Maybe, then, if you could provide the 
Committee with those various projects that you have underway.
    Mr. Dalrymple. Sure.
    Mr. Becerra. I appreciate that.
    [The following was subsequently received:]

List of Research Projects Dealing with Taxpayer Compliance:

    Construction Industry
    Duplicate Use of Social Security Numbers
    Fishing Industry
    Schedule C Unallowable Expenses
    Use of Accounting Methods
    Automotive Industry
    Form 2119 Compliance (Sale of Residence)
    Tax Effect of Income Verification by Mortgage Companies 
using IRS data
    Earned Income Credit Compliance
    Research on Nonfilers
    Self Employment Tax Compliance
    Passive Activity Losses
    Government nonfilers of Form 1099
    Capital Gain Basis
    Wholesale and Retail Industry
    US Source Income/1042 Credits
    Health Care Industry Compliance
    Tax Protesters
    Tax Return Preparer Compliance
    Alternative Ways of Filing
    Profiles of Accounts Receivable Taxpayers
    Form 1040 Filing Characteristics

Also:

    As part of our modernization efforts, IRS is in the later 
stages of development of a research database (Compliance 
Research Information System-CRIS) which allows a researcher to 
answer questions about individual return compliance or filing 
characteristics. This database currently contains 1600 data 
elements and will be expanded to 2600 elements in October 1997. 
No individual identifiers are accessible through the system.
      

                                

    Mr. Becerra. Thank you, Mr. Chairman. Thank you very much.
    Mr. Shaw. Mr. Portman, do you seek recognition?
    Mr. Portman. Just very briefly, Mr. Chairman. Thank you for 
your patience here among our witnesses.
    Just quickly, with regard to Mr. Becerra's comments, I 
think he makes a very good point. When you look at the current 
situation, and Mr. Dolan, I guess I would ask you, you have the 
personal exemption, we have the deduction for dependents, we 
have the standard deduction. We now will have a tax credit, 
which obviously will create, as you indicate, more problems for 
you in enforcement, in not just communicating it but in 
enforcing that, because there is more of an incentive for 
people to claim a child and claim a credit.
    Are you looking at some ways to simplify that from an 
enforcement point of view, or an administration point of view 
collapsing those or coming up with ways that would make it 
easier, that would relate to EITC but also to the other 
exemptions, deductions and credits?
    Mr. Dolan. I can tell you, in the arena of credits per se, 
Mr. Portman, that we have a compliance strategy underway. We 
are anticipating and watching quite carefully where the 
proposed legislation might take us, so that, when given the 
opportunity, we would offer our opinion as to what will or will 
not work--both from the point of view of simplicity for the 
taxpayer and from the point of view of our being--to followup 
and corroborate.
    Mr. Portman. My only point is, I think what your data 
apparently shows, we do not have the raw data yet but when we 
get it and look at it, is that this is one of the major 
problems in terms of current EITC but also future problems with 
compliance.
    Let me just back up to where Mr. Shaw was. I think he is 
right. We are talking about apples and oranges here. We are 
talking about a program that is a cash benefit. Eighty to 85 
percent of it, whether you call it welfare or not, is a 
nonrefundable credit and that is a cash benefit program. You 
all keep talking about the tax gap. This is not part of the tax 
gap, folks. This is not taxes that are not being collected or 
paid. This is whether we are paying out too much or not. It is 
an entirely different parameter.
    Second, this TCMP analysis that the IRS keeps bringing up 
today, I mean, it is not the same study. What Mrs. Johnson is 
trying to say is that the auditors put their estimation on the 
table and that is what TCMP is based on. That is what they are 
putting on the table and there is only a 25-percent rate of 
sustaining overall in the system. Let us at least compare 
apples to apples, and maybe that is something Treasury can give 
us so that we can answer some of the questions Mr. Becerra and 
Mr. Jefferson and others have as to the compliance, because we 
are not comparing the same numbers here.
    Finally, I just have to make the comment that when you are 
talking about comparing, again, this program, EITC, with our 
other noncompliance problems, we cannot collect taxes from sole 
proprietors any other way than through a tax collection system, 
can we? Is there another program out there that enables us to 
collect revenue from people?
    Mr. Dolan. No. I think your point is----
    Mr. Portman. Whereas with EITC, we have lots of other 
programs. We have a Food Stamp Program. We have public 
subsidies in the housing area. We are talking about it on the 
floor right now. We have the AFDC Program. We just sent block 
grants to the States. We have welfare-to-work programs.
    There are some inherent flaws in a voluntary tax system 
that are going to lead to noncompliance, whether it is sole 
proprietors, or elsewhere. This is not the fault of the IRS. It 
is not the fault, frankly, of the public at large. It is just a 
function of human nature and the tax collection system. We do 
not have any choice on sole proprietors, but we do with regard 
to providing appropriate subsidies to get people from welfare 
to work and to keep them there.
    Thank you, Mr. Chairman.
    Mr. Shaw. Thank you, and I know this panel will be very 
glad to wish us a nice weekend, as we certainly wish you a nice 
weekend. Thank you for being with us. I think we received a lot 
of information.
    Mr. Rangel. We thank them. Let me thank you, too. I hope 
that you reach out to this Congress and feel comfortable in 
reaching out to Members to let us know what you need to support 
this program, because the statistical data could cause us 
political problems and because it is so expensive when you are 
trying to balance a budget, some people may target it for the 
wrong reason. So I enjoyed your testimony and want you to know 
that you have to reach out a little more because I did not know 
you were having these kind of problems until you did your 
survey. Thank you.
    Mr. Shaw. Thank you. The next panel will be Lynda Willis, 
Director of Tax Policy and Administration Issues, General 
Government Division of the U.S. General Accounting Office.
    There is a series of votes on the floor now and I have 
checked with Ms. Willis and I understand that she would be 
willing to try to get her testimony behind her before we go to 
vote, so we do have a few minutes.
    Ms. Willis? Ms. Willis, we are in receipt of your testimony 
and it will be placed in the record. Proceed as you wish.

    STATEMENT OF LYNDA D. WILLIS, DIRECTOR, TAX POLICY AND 
  ADMINISTRATION ISSUES, GENERAL GOVERNMENT DIVISION,  U.S.  
                  GENERAL  ACCOUNTING  OFFICE

    Ms. Willis. Thank you, Mr. Chairman.
    In the interest of time, I will not even summarize my 
written statement. I recognize that most of the Members here 
have had an opportunity to read what we had to say. There are 
just a couple of points that I would like to emphasize in our 
statement that I think are cogent to the discussion that has 
gone on here.
    One is that a great deal of the difficulty with the credit 
and noncompliance with the credit is the conflict between how 
the credit is designed and IRS' ability to administer it, and 
that gets back to the quote that someone made of IRS having to 
determine eligibility before the refund goes out, and that is 
very, very difficult for IRS to do.
    The second point that I would emphasize is that we have 
some concerns about the proposals put forth by Treasury. There 
are a number of issues that need to be pursued, not the least 
of which is if we put additional resources into administering 
the earned income credit, where we are going to take those 
resources from.
    IRS, like most Federal agencies, is facing declining or 
stagnant budgets between now and 2002 and if we move resources 
into the EIC enforcement program, we have to move them out from 
somewhere else and those sorts of tradeoffs need to be very 
carefully considered and evaluated, particularly in light of 
the difficulty in enforcing this credit and in light of the 
other topics of noncompliance that we have discussed here 
today.
    Having said that, I would be happy to answer any questions.
    [The prepared statement follows:]

Statement of Lynda D. Willis, Director Tax Policy and Administration 
Issues, General Government Division, U.S. General Accounting Office

    Mr. Chairman and Members of the Committee
    We are pleased to be here today to participate in the 
Committee's inquiry into noncompliance surrounding the Earned 
Income Credit (EIC)--a refundable tax credit available to low-
income, working taxpayers. As used in connection with the EIC, 
``noncompliance'' occurs when persons either claim credits to 
which they are not entitled or claim credits in excess of the 
amount to which they are entitled. This statement is based on 
our past work on the EIC,\1\ a review of limited data on the 
results of IRS' study of EIC filers for tax year 1994,\2\ and a 
review of various Department of the Treasury proposals to 
reduce EIC errors.
---------------------------------------------------------------------------
    \1\ A list of related GAO products is at the end of this testimony.
    \2\ We did not assess IRS' study methodology or the reliability of 
its reported results.
---------------------------------------------------------------------------
    Our statement makes the following points:
     EIC noncompliance has been a concern for a number 
of years and is a major factor underlying our designation of 
filing fraud as one of the federal program areas at high risk 
because of vulnerability to waste, fraud, abuse, and 
mismanagement.\3\ Through design changes and administrative 
actions, noncompliance (expressed as a percentage of total EIC 
dollars paid out) has been reduced since 1988 but, because of 
increases in the number of claimants and changes in credit 
amounts over the past few years, the amount of dollars 
erroneously paid out has increased dramatically. A root cause 
of EIC noncompliance is the self-determination of eligibility 
by taxpayers combined with IRS' limited ability to verify 
eligibility before the refund is issued.
---------------------------------------------------------------------------
    \3\ High-Risk Series: IRS Management (GAO/HR-97-8, Feb. 1997).
---------------------------------------------------------------------------
     IRS has undertaken, with some success, a variety 
of efforts to reduce EIC noncompliance in recent years. While 
the impact of IRS' efforts cannot be precisely quantified, it 
is reasonable to expect that recent declines in the 
noncompliance rate were in part the result of IRS' efforts. How 
much further it can be reduced with available resources is 
uncertain.
     It will not be easy to significantly reduce EIC 
noncompliance because of the nature of the credit and the 
design of IRS' systems. Treasury has announced eight proposals, 
six of which would involve legislation, to reduce EIC 
noncompliance. Those proposals provide a starting point for 
deliberations on what can reasonably be done to address this 
difficult problem. Various questions need to be answered in 
assessing those proposals, the most significant being whether 
they get at the real causes of noncompliance.

                               Background

    Congress established the EIC in 1975 to (1) offset the 
impact of Social Security taxes on low-income families and (2) 
encourage low-income families to seek employment rather than 
welfare.
    EIC eligibility depends on taxpayers' amount of earned 
income \4\ or, in some cases, adjusted gross income (AGI).\5\ 
Credit amounts depend on the number of qualifying children who 
meet age, relationship, and residency tests. The credit 
gradually increases with increasing income (the phase-in 
range), plateaus at a maximum amount (the plateau range), and 
then gradually decreases until it reaches zero (the phase-out 
range). Taxpayers with earned income or AGI exceeding the 
maximum qualifying income level are not eligible for the 
credit. Taxpayers with AGI falling in the credit's phase-out 
range receive the lesser amount resulting from using their 
earned income or AGI in calculating the credit.
---------------------------------------------------------------------------
    \4\ Earned income for calculating the EIC includes both taxable and 
nontaxable earned income. For the EIC, taxable earned income includes 
(1) wages, salaries, and tips; (2) union strike benefits; (3) long-term 
disability benefits received prior to minimum retirement age; and (4) 
net earnings from self-employment. Nontaxable earned income includes 
(1) voluntary salary deferral such as 401(k) plans or the federal 
thrift savings plan, (2) pay earned in a combat zone, (3) basic quarter 
and subsistence allowances from the U.S. military, (4) housing 
allowances or rental value of a parsonage for the clergy, and (5) 
excludable dependent care benefits.
    \5\ In addition to taxpayers' taxable earned income, AGI includes 
their taxable income from other sources such as investments, alimony, 
and unemployment compensation. Beginning in tax year 1996, taxpayers 
are to use a newly defined ``modified AGI'' that excludes certain 
losses to determine EIC eligibility and to calculate the credit.
---------------------------------------------------------------------------
    EIC coverage and benefit rules have been modified several 
times since 1990. In the Omnibus Budget Reconciliation Act 
(OBRA) of 1990, Congress made two major changes to the EIC that 
took effect in tax year 1991. These changes (1) adjusted the 
credit structure to grant different credit amounts to taxpayers 
with one qualifying child and taxpayers with two or more 
qualifying children and (2) added two supplemental credits--one 
for taxpayers with a child under 1 year of age and another for 
taxpayers who paid health insurance premiums on policies 
covering their children. OBRA 1990 also allowed taxpayers with 
a filing status of single to claim the credit, as long as they 
had a qualifying child, and specified a general increase in 
credit rates that was to be phased-in over 4 years (the planned 
increase for 1994, however, was superseded by 1993 
legislation).
    OBRA 1993 made two changes in the credit's structure that 
went into effect in tax year 1994. First, to simplify EIC 
filing, the act repealed the supplemental young child and 
health insurance credits. Second, the act expanded EIC 
eligibility to include certain taxpayers without qualifying 
children or ``childless adults.'' \6\ OBRA 1993 also increased, 
over a 3-year period beginning in tax year 1994, the maximum 
credit for families with children.
---------------------------------------------------------------------------
    \6\ Although referred to as ``childless adults,'' these taxpayers 
may be noncustodial parents or may live with a child who, for some 
reason, cannot be claimed as an EIC qualifying child.
---------------------------------------------------------------------------
    The maximum basic credit amount for EIC families with two 
or more children was $953 in tax year 1990, $1,511 in tax year 
1993 (reflecting OBRA 1990), and $3,556 in tax year 1996 
(reflecting OBRA 1993). The maximum credit for childless adults 
in tax year 1996 was $323.
    The Personal Responsibility and Work Opportunity 
Reconciliation Act of 1996 made three additional changes to the 
EIC. First, beginning with tax year 1996 returns, the act made 
taxpayers with certain investment income greater than $2,200 
ineligible for the EIC, regardless of their earned income or 
AGI. Second, the act created a ``modified AGI'' to be used in 
calculating the credit. Modified AGI disregards certain losses 
from investments and businesses. And third, the act denied the 
EIC to filers without valid Social Security Numbers (SSN).\7\ 
Taxpayers were already required to provide valid SSNs for 
qualifying children.
---------------------------------------------------------------------------
    \7\ A valid SSN is one that matches Social Security Administration 
records.
---------------------------------------------------------------------------
    As shown in figure 1, both the number of taxpayers claiming 
the credit and EIC program costs (in 1996 dollars) increased 
steadily from tax years 1990 through 1994. In large part, this 
growth reflects the impact of either eligibility or benefit 
expansions implemented in tax years 1991 and 1994, as discussed 
earlier.


            EIC Noncompliance and IRS' Efforts to Control it

    Despite efforts over time to change design and 
administration of the EIC, it is still a major source of 
noncompliance. That continuing noncompliance is one reason why 
refund fraud remains on our list of high-risk federal program 
areas.
    IRS' study of tax year 1994 EIC filers showed that of $17.2 
billion in EIC claimed, 25.8 percent ($4.4 billion) was 
overclaimed. While that percentage of noncompliance is an 
improvement over the level identified in the 1988 Taxpayer 
Compliance Measurement Program (TCMP), the dollars involved 
have increased significantly.\8\ The 1988 TCMP showed that 
about $1.9 billion, or 34 percent of the total EIC paid out, 
was awarded erroneously.
---------------------------------------------------------------------------
    \8\ Before IRS' study of tax year 1994 EIC filers, the 1988 TCMP 
provided the most current comprehensive data on EIC noncompliance. IRS 
did a study of tax year 1993 EIC filers, but that study only covered 
returns filed electronically during the last 2 weeks of January 1994.
---------------------------------------------------------------------------
    The lower rate of noncompliance since 1988 may be due, at 
least in part, to legislative changes since the 1988 TCMP. In 
that regard, IRS data indicated that taxpayers who claimed the 
wrong filing status were the most frequent source of EIC error 
in the 1988 TCMP. Legislative action in 1990 simplified the 
rules for qualifying for the credit by eliminating different 
eligibility rules for different filing statuses. Even with that 
change, eligibility-related compliance issues remain. For 
claimants of the credit for families with children, eligibility 
for the credit is still self-determined by the taxpayer using a 
three-part test based on the relationship of the child to the 
taxpayer, the length of time the child lived with the taxpayer, 
and the child's age.
    Congress has long been concerned about the high level of 
EIC noncompliance. However, reducing it to more acceptable 
levels will be difficult. Many of the noncompliance problems 
identified by IRS are the result of a process whereby taxpayers 
self-determine their eligibility for the credit and/or the 
amount of credit they are due. These erroneous claims 
frequently related to qualifying children or choosing the wrong 
filing status.\9\ In both instances, IRS faces difficulty in 
verifying the information on the return without using field 
resources to determine taxpayer eligibility in a fashion 
similar to that used by organizations administering welfare 
programs.
---------------------------------------------------------------------------
    \9\ A change in filing status, per se, will not necessarily 
disqualify a taxpayer from claiming the EIC. Only taxpayers who use the 
married-filing-separately status are ineligible for the credit. 
However, reporting an incorrect filing status has implications for 
correctly reporting income. For example, taxpayers who file as a head 
of household when they should have filed as married may underreport 
income, by excluding their spouse's income, and thus overclaim, in 
whole or in part, the EIC.
---------------------------------------------------------------------------
    The reported level of EIC noncompliance is much higher than 
the reported level of noncompliance in some other federal 
outlay programs but those other programs also have much higher 
administrative costs. For example, according to the Committee 
on Ways and Means 1996 Green Book, about 6.1 percent of the 
dollars paid out under the Aid to Families With Dependent 
Children (AFDC) program was overpaid in fiscal year 1993 and 
7.3 percent of the dollars paid out in the Food Stamp program 
was overpaid in fiscal year 1995. As we noted in June 1995 
testimony before the Senate Finance Committee, those programs 
not only have lower noncompliance rates than the EIC program 
but also have administrative costs that likely are many times 
higher than those of the EIC program.\10\ Data available at 
that time showed AFDC and Food Stamp administrative costs of 
about 12 percent of total program expenditures in 1993. In 
comparison, we estimated EIC administrative costs to be about 1 
percent of EIC program costs.\11\
---------------------------------------------------------------------------
    \10\ Earned Income Credit: Noncompliance and Potential Eligibility 
Revisions (GAO/T-GGD-95-179, June 8, 1995).
    \11\ This estimate is for return and refund processing costs only 
and does not include the cost of IRS enforcement efforts related to EIC 
noncompliance.
---------------------------------------------------------------------------

                      Causes of EIC Noncompliance

    Before deciding on how to reduce EIC noncompliance, it is 
important to know the major causes of that noncompliance. Data 
IRS made available on the results of its study shed little 
light on that question. According to an analysis of IRS' study 
by Treasury's Office of Tax Analysis, however, the three most 
common causes were (1) taxpayers claiming qualifying children 
who did not reside with them for over half the year, (2) 
taxpayers claiming the wrong filing status, and (3) complicated 
living arrangements involving more than one custodial 
caregiver.
    It seems clear that a major share of the problem can be 
traced back to the nature of the credit, as explained by an IRS 
consultant in 1993. According to the consultant, the EIC, and 
other tax credits, have historically caused problems for IRS 
because IRS' systems were designed and, for the most part, are 
operated with the overriding objective of enabling anyone who 
wants to pay their taxes to do it. The distribution of EIC is 
philosophically different from the issuance of traditional 
refunds, where the government returns the taxpayer's own money 
after excess withholding. The consultant noted that payment of 
the EIC has much more in common with government distribution of 
welfare benefits through other agencies but that the standards 
of proof required to prove eligibility for EIC are not 
comparable to the standards of proof required for receipt of 
welfare benefits. As he pointed out, establishing eligibility 
for benefits delivered through other agencies normally requires 
the claimant to deal with government employees face to face; to 
produce proof of identification; and to prove the existence of, 
and relationship with, any relevant dependents. These types of 
controls are foreign to traditional IRS modes of operation.
    A Treasury Task Force on Tax Refund Fraud made similar 
observations in 1994. According to the Task Force, (1) every 
refundable credit provides some incentive for the filing of 
problematic returns, and the incentive rises as the amount of 
the refundable credit rises and (2) the incentive to file 
problematic returns is likely to increase as IRS' capability to 
verify information on the return decreases. With the EIC, there 
are various important pieces of information, such as filing 
status and the existence of qualifying children, that IRS 
cannot easily verify. The relationship between verifiable 
information and compliance is not unique to the EIC. Throughout 
the tax system, noncompliance tends to be higher whenever there 
is an absence of easily verifiable data.

                IRS Efforts to Control EIC Noncompliance

    IRS took several steps in the past few years to combat EIC 
noncompliance, with some success. Although the impact of IRS' 
efforts cannot be precisely quantified, it is reasonable to 
assume that those efforts contributed to the recent decline in 
the rate of EIC noncompliance.
    Improved verification of SSNs was a key objective of IRS' 
recent efforts. For electronic returns, IRS increased the 
number of automated filters that are designed to identify and 
reject submissions that involve missing, invalid, or duplicate 
SSNs. Through those filters, IRS identified 4.1 million SSN 
problems on tax year 1994 returns, 1.3 million of which 
involved the EIC. This year, as of April 24, the filters 
identified about 3.2 million SSN problems, of which 1.1 million 
involved the EIC.
    IRS also emphasized SSN verification on paper returns. For 
tax year 1994, it identified 3.3 million paper returns with 
missing or invalid SSNs (how many involved EIC returns is 
unknown) and followed up on 1 million of those cases (it did 
not have sufficient resources to follow up on all 3.3 million). 
IRS continued that effort, but at a reduced level, for tax year 
1995 paper returns. According to IRS, these verification 
efforts resulted in recommended changes to taxpayers' refunds 
or tax liabilities of about $900 million in fiscal year 1996. 
Starting with tax year 1996 returns filed this year, IRS was 
authorized to treat missing or invalid SSNs on filed returns as 
math errors. As such, IRS can automatically reduce or deny the 
taxpayer's EIC claim, if there is any.
    Also for tax year 1994, IRS (1) improved the Questionable 
Refund Program, (2) strengthened the process for checking the 
suitability of persons applying to participate in the 
electronic filing program as return preparers or transmitters, 
and (3) eliminated the direct deposit indicator.\12\
---------------------------------------------------------------------------
    \12\ The direct deposit indicator gave return preparers a quick 
signal from IRS that a taxpayer was going to receive a refund check and 
was relied on by providers of Refund Anticipation Loans. IRS' objective 
in eliminating the indicator was to give providers of Refund 
Anticipation Loans greater incentive to check the eligibility of EIC 
claimants before approving the loans.
---------------------------------------------------------------------------
    Despite the various changes discussed above, IRS' study of 
tax year 1994 EIC filers indicates that much more needs to be 
done. For example, even with the many electronic filing 
filters, which are intended to keep erroneous returns from 
being submitted electronically, the percent of tax year 1994 
electronic returns with EIC overclaims, according to IRS' data, 
was almost as high as the percent of paper returns (25.3 
compared with 26.1). Also, IRS determined that even if its 
study results were adjusted to reflect the impact of its 
enforcement efforts in 1995 and the new math-error procedure 
being used this year, the overall noncompliance rate would 
still be about 21 percent.
    It is also interesting to note, as shown in table 1, that 
the number of fraudulent returns detected by the Questionable 
Refund Program has declined since 1994, with a dramatic 
decrease in 1996.

                         Table 1: Questionable Refund Program Data for 1993 Through 1996                        
----------------------------------------------------------------------------------------------------------------
                                                                  Amount of fraudulent    Percent of fraudulent 
            Calendar year                Number of fraudulent    dollars detected  (in    returns that involved 
                                           returns detected            millions)                 the EIC        
----------------------------------------------------------------------------------------------------------------
1993.................................                   77,840                   $136.8                       98
1994.................................                   77,781                    160.5                       91
1995.................................                   62,309                    131.7                       73
1996.................................                   24,919                     82.5                       72
----------------------------------------------------------------------------------------------------------------
 Source: IRS data.                                                                                              

    According to program officials, a major reason for the 
decline in fraudulent returns and dollars detected in 1996 was 
a staffing reduction from 553 full-time equivalent staff in 
1995 to 379 full-time equivalent staff in 1996.

                         What More Can Be Done?

    It will not be easy to significantly reduce EIC 
noncompliance without somehow addressing the basic underlying 
problem--the self-determination of eligibility by taxpayers and 
IRS' limited ability to verify that eligibility before issuing 
the refunds. On April 23, 1997, Treasury announced eight 
proposals, six of which would require legislation, that it 
believes will help reduce noncompliance.
    The six proposals requiring legislation would (1) deny 
future EIC claims from persons who are found to have claimed 
the EIC fraudulently or through reckless or intentional 
disregard of the rules and regulations; (2) require taxpayers 
who have had an EIC claim denied after an audit to prove their 
eligibility to IRS before being allowed future credits; (3) 
allow IRS to place liens and execute levies on a portion of 
unemployment compensation, welfare benefits, and other types of 
assistance in order to recapture EIC claims that were found to 
be erroneous after IRS had paid them; (4) penalize preparers 
who did not meet certain due diligence requirements; (5) 
clarify the definition of a foster child; and (6) conduct state 
tests of new ways to provide the EIC and to verify eligibility. 
The other two proposals would (1) increase IRS' enforcement 
efforts and (2) expand access to volunteer return preparation 
services.
    There are not enough details in IRS' study and Treasury's 
announcement to identify the major causes of EIC noncompliance 
or to assess the costs, benefits, and administrability of 
Treasury's proposals. However, based on available information 
as well as our past work on the EIC specifically and tax 
administration in general, we have identified several issues 
that Congress needs to consider in deliberating on those 
proposals.
    The most important issue is whether the various proposals 
get at the real causes of noncompliance. According to IRS' 
data, for example, a disproportionate segment of the 
noncompliant returns involved incorrect filing status. However, 
IRS' report provides no information that helps explain what it 
is about those claims that made them noncompliant, and none of 
Treasury's proposals directly addresses that issue.
    On the other hand, three Treasury proposals address issues 
that do not seem, on their face, to be major causes of 
noncompliance. Those proposals call for (1) clarifying the 
definition of a foster child; (2) testing alternate ways to 
provide advance EIC payments and, at the same time, to verify 
the eligibility of persons receiving the advance payments; and 
(3) increasing the availability of volunteer return preparation 
assistance. Although each of those actions probably has some 
merit, IRS' report and Treasury's proposals provide no evidence 
that the benefits, in terms of reducing EIC noncompliance, 
would be of any consequence.
    Specifically,
     IRS' report provides no information on the extent 
to which noncompliance can be traced back to confusion over the 
definition of a foster child or even how many EIC claims 
involve foster children,
     only about 1 percent of all EIC recipients have 
historically used the advance payment option, and
     IRS has provided no data comparing the 
noncompliance rate for returns done without the help of a 
preparer and those done by preparers, much less volunteer 
preparers.
    A second issue relates to administrability. Much more 
information is needed on the proposals and how they will be 
implemented in order to determine if they can be easily 
administered. The proposals that most need attention in this 
regard, because they would apparently involve major operating 
changes, are the ones that would (1) automatically deny the EIC 
for several years to anyone who is found to have claimed the 
credit fraudulently or due to reckless or intentional disregard 
of the rules and regulations, (2) require taxpayers who had an 
EIC claim denied after an audit to prove their eligibility for 
future credits, and (3) penalize preparers who did not meet 
certain due diligence requirements.
    To assess the administrability of the preparer penalty 
proposal, for example, we would want to know what preparers 
would have to do to demonstrate due diligence and what IRS 
would have to do enforce those requirements. Our interest in 
this proposal is heightened by the results of our past work on 
preparer penalties. In a 1991 report, we said that IRS' 
examiners and supervisors were reluctant to pursue return 
preparer penalties because of the low dollar amounts of the 
penalties.\13\ We wonder whether the new penalties proposed by 
Treasury would be viewed similarly.
---------------------------------------------------------------------------
    \13\ Tax Administration: Effectiveness of IRS' Return Preparer 
Penalty Program Is Questionable (GAO/GGD-91-12, Jan. 7, 1991).
---------------------------------------------------------------------------
    In assessing administrability, it is also important that 
Congress consider whether the action being proposed is the most 
appropriate given the facts. In explaining its proposal that 
certain EIC claims be automatically denied, for example, 
Treasury says that ``existing civil penalties do not appear to 
be an effective deterrent against ineligible taxpayers 
repeatedly claiming the [EIC].'' We saw nothing from IRS' study 
related to the effectiveness of penalties. Nor have we seen any 
information on the extent to which IRS, in the past, has 
asserted available civil and criminal sanctions for fraudulent 
or reckless EIC claims and the extent to which penalized 
parties have submitted fraudulent claims afterwards. Such 
information would help determine if the answer lies in better 
administering existing procedures or establishing new 
procedures.
    A third issue surrounding Treasury's proposals involves the 
need to ensure that any legislative or administrative change 
include adequate controls to protect taxpayer rights. For 
example, Treasury is proposing that IRS be allowed to place 
liens and execute levies on a portion of unemployment 
compensation, welfare benefits, and other types of assistance 
in order to recapture EIC claims that were found to be 
erroneous after IRS had paid them. Those types of income are 
now exempt from levy. It is for Congress to decide whether 
there is now sufficient reason to revise those exemptions. But, 
it is important in doing so that any such change include 
adequate controls to protect taxpayers' rights.
    A final issue involves tradeoffs. It is important that 
concern about EIC noncompliance not become so encompassing that 
other areas of noncompliance are neglected. In that regard, one 
of Treasury's proposals calls for aggressive IRS action to 
prevent the payment of erroneous EIC claims. While we support 
the first part of that proposal--the development of new 
profiles to help IRS better target its enforcement efforts--we 
cannot support the second part--earmarking substantial 
resources for an intensified EIC compliance effort--without 
knowing the tradeoffs. IRS, like most of the federal 
government, is facing stagnant or declining resources through 
2002. Consequently, knowing where the resources will come from 
is critical. Equity and financial concerns have already been 
raised about IRS reducing its audit coverage of high income 
individuals in order to target EIC returns.
    To assess tradeoffs, it is important to know what the 
return on investment is for EIC-related enforcement efforts 
compared with other programs. In fiscal year 1995, for example, 
all examinations done by tax auditors (those IRS staff who 
would normally do EIC-related audits) resulted in average 
additional recommended taxes of about $3,500 per return, 
compared to the average EIC refund that year of less than 
$1,500.
    Finally, as IRS becomes more and more involved in 
determining whether taxpayers are eligible to receive the EIC, 
the benefits of delivering income assistance to low income 
taxpayers through the tax code may erode. Specifically, 
administrative costs will increase and participation rates may 
fall. In addition, IRS employees will be faced with new job 
responsibilities traditionally more related to welfare programs 
than tax administration.
    In conclusion, Mr. Chairman, many questions remain about 
EIC noncompliance and the most effective ways to reduce it. IRS 
efforts have reduced the level of noncompliance but it still 
remains above 20 percent, with several billion dollars in 
overclaimed credits annually. How much further it can be 
reduced with available resources is uncertain.
    As I noted earlier, it will not be easy to significantly 
reduce EIC noncompliance without somehow addressing the basic 
underlying problem--the self-determination of eligibility by 
taxpayers and IRS' limited ability to verify that eligibility.
    Treasury's proposals provide a starting point for 
deliberations on what can reasonably be done to address this 
difficult problem. Much more information is needed on the 
proposals and IRS' study findings before any overall judgment 
can be made on how much the proposals will contribute to 
reducing noncompliance.
    It is important, in further deliberations on Treasury's 
proposals or those made by others, that Congress and the 
administration consider whether (1) the actions being proposed 
are feasible; (2) potential benefits justify expected costs, 
especially in light of tighter budgets and other compliance 
problems facing IRS; and (3) adequate procedures are built in 
to protect taxpayers' rights.
    That concludes my statement. We welcome any questions that 
you may have.

                 Past GAO Products Relating to the EIC

    Earned Income Credit: IRS' 1995 Controls Stopped Some 
Noncompliance, But Not Without Problems (GAO/GGD-96-172, Sept. 18, 
1996)
    Earned Income Credit: Profile of Tax Year 1994 Credit Recipients 
(GAO/GGD-96-122BR, June 13, 1996).
    Earned Income Credit: Noncompliance And Potential Eligibility 
Revisions (GAO/T-GGD-95-179, June 8, 1995)
    Earned Income Credit: Targeting to the Working Poor (GAO/T-GGD-95-
136, Apr. 4, 1995).
    Earned Income Credit: Targeting to the Working Poor (GAO/GGD-95-
122BR, Mar. 31, 1995)
    Tax Administration: Earned Income Credit--Data on Noncompliance and 
Illegal Alien Recipients (GAO/GGD-95-27, Oct. 25, 1994).
    Tax Policy: Earned Income Tax Credit: Design and Administration 
Could Be Improved (GAO/GGD-93-145, Sept. 24, 1993).
    Earned Income Tax Credit: Advance Payment Option Is Not Widely 
Known or Understood by the Public (GAO/GGD-92-26, Feb. 19, 1992).
    The New Earned Income Credit Form Is Complex and May Not Be Needed 
(GAO/T-GGD-91-68, Sept. 17, 1991).
      

                                

    Mr. Shaw. Mr. Rangel, do you have any questions of the 
witness?
    Mr. Rangel. Does your report have any specific 
recommendations as how we can cut down the error rate?
    Ms. Willis. Our testimony today does not make any specific 
recommendations regarding the proposals made by Treasury beyond 
their being more fully analyzed and evaluated. We do have on 
the books a recommendation similar to the administration's 
regarding the qualifying child and the exemption, making those 
more similar.
    Mr. Rangel. You testified that the Treasury 
recommendations, in your opinion, are inadequate, so that means 
you evaluated it and you probably had some thoughts of what 
should be done to make them adequate.
    Ms. Willis. I think I testified that they deserve more 
scrutiny and that we have concerns about them. One where there 
is definitely more information needed that has potential is in 
the development of profiles of taxpayers who are noncompliant, 
but until we have more data and we know more about who these 
people are and how they are noncompliant, it is going to be 
hard to design programs to identify them.
    Mr. Rangel. Can you get that data so that you could really 
come up with some positive recommendations that you think are 
better than what Treasury has come up with?
    Ms. Willis. We will be looking at the data, the study, and 
everything that IRS has done for this Committee with exactly 
that in mind.
    Mr. Rangel. Throughout my political career, when I have had 
to deal with complex legislation and people ask me questions, 
one answer fit it all. I said, it is good in concept but it 
just did not go far enough, and I kind of think that that is 
the response you are giving the Treasury recommendations.
    Ms. Willis. They did not go far enough in terms of being 
developed with the details. A number of the other proposals 
that Treasury has on the board we think are not particularly 
well targeted to the noncompliance. It is hard to argue with 
additional assistance to taxpayers. But, I do not know how much 
noncompliance you are going to eradicate with additional 
assistance to taxpayers.
    Mr. Rangel. Who were you working with in Treasury as 
relates to this?
    Ms. Willis. We will be working with the people who were 
here at the witness table today as well as with IRS. We----
    Mr. Rangel. Before you made your report, who were you 
working with? Did you assist them in putting together their 
recommendations?
    Ms. Willis. No, we did not.
    Mr. Rangel. Does that violate the General Accounting Office 
rules? I mean, it is all one government.
    Ms. Willis. We were never approached in terms of working 
with Treasury on any of the recommendations. We have done quite 
a large body of work related to the earned income credit and 
noncompliance that----
    Mr. Rangel. I am just asking, would it violate any 
principles if you say, we have studied this problem as well as 
you and these are the recommendations we would make.
    Ms. Willis. No.
    Mr. Rangel. Did you do it?
    Ms. Willis. No, we have not.
    Mr. Rangel. Will you do it?
    Ms. Willis. Yes, we will.
    Mr. Rangel. You are a great body. I depend on you a lot 
because you do good work, but good work, unless we can put the 
results into action, is just an academic experience. I will ask 
you, and maybe I have to do it in writing, to try to get 
together with the Treasury people because they are looking for 
answers and you may have some that they need and then we can 
come together and hope that we can reduce the underclaim or 
whatever it is. Thank you so much.
    Ms. Willis. Thank you.
    Mr. Shaw. Mr. Becerra.
    Mr. Becerra. Thank you, Mr. Chairman. I will just ask one 
or two quick questions.
    I note that in the report, which, again, I want to 
emphasize what Mr. Rangel says, we appreciate the good work 
that is done by the GAO, in the report, you mention that 
throughout the tax system, noncompliance tends to be higher 
whenever there is an absence of easily verifiable data.
    Ms. Willis. Yes.
    Mr. Becerra. Is the data that you need for the purpose of 
certifying an EITC claim by a filer, a tax filer, easy to come 
by?
    Ms. Willis. No.
    Mr. Becerra. What makes it difficult to come by that data?
    Ms. Willis. Because the data are not filed in any central 
location that you can match to, in essence, determine whether 
someone is eligible or has eligible children under the EIC. You 
have to go through many of the same procedures that a welfare 
agency would have to go through, and that is face-to-face 
contact where you are being provided documentation that the 
children are eligible and that you have some way of documenting 
that they do, indeed, reside with you.
    Mr. Becerra. So it seems it is an issue for the IRS of 
access to that data. You have to go track it down somehow.
    Ms. Willis. You have to do field enforcement.
    Mr. Becerra. Is there another level of nonverifiability in 
that the data may never really exist except as produced by that 
filer? In other words, I may tell you I generated $100,000 in 
income but you have really no way to verify that short of 
looking through every receipt and expense that I have, which 
makes it perhaps more difficult than finding out if someone has 
a child or not.
    Ms. Willis. Yes.
    Mr. Becerra. So in your comment that noncompliance tends to 
be higher whenever there is an absence of easily verifiable 
data, on that spectrum, it would seem that if we could come up 
with some mechanisms of enforcement, you are more likely to 
improve your compliance within the EITC than you might ever be 
able to get, say, within the business field because you know if 
he is entitled or not.
    Mr. Shaw. If the gentleman would suspend. If you do want to 
continue this line of questioning, we are going to have to come 
back. There is a series of votes and we are going to be lucky 
to make this first vote.
    Mr. Becerra. We are at less than 5 minutes now, Mr. 
Chairman?
    Mr. Shaw. Yes.
    Mr. Becerra. Then let me just pose that question and maybe 
later on we can get the response. I do not wish to hold the 
witness up just for that.
    Thank you, Mr. Chairman.
    Mr. Shaw. We are adjourned. There is one thing. I think the 
point has been made that this is a program that is somewhat out 
of control. The taxpayers are getting ripped off. We are losing 
billions and billions of dollars. It has been a valuable 
program, one that we want to preserve but one that we have got 
to bring under control. Despite all the spin that both sides 
have tried to put on it today, it is a big problem that we need 
to work together to solve and I thank you.
    I would like to place into the record a document prepared 
by the staff of the Joint Committee on Taxation with respect to 
the EITC.
    [The prepared statement follows:]

Statement of Joint Committee on Taxation

                              Introduction

    The House Committee on Ways and Means has scheduled a 
public hearing on May 8, 1997, on the Administration's 
proposals relating to the earned income credit. On April 23, 
1997, the Department of Treasury released eight proposals to 
reduce errors on tax returns with respect to the earned income 
credit (``EIC'').\1\
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    \1\ The Administration proposals also include two administrative 
actions to be undertaken relating to EIC compliance. These actions are 
continued IRS efforts to improve: (1) compliance by providing 
additional IRS personnel to work on EIC issues and, (2) awareness of, 
access to, and resources for volunteers in the IRS-sponsored Volunteer 
Income Tax Assistance (``VITA'') program.
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    This document,\2\ prepared by the staff of the Joint 
Committee on Taxation in connection with the May 8 Committee 
hearing, provides a description of present-law earned income 
credit provisions (Part I), a brief legislative background 
(Part II), a summary description of the April 1997 IRS 
compliance study (Part III), and a description of the 
Administration's legislative proposals (Part IV).
---------------------------------------------------------------------------
    \2\ This document may be cited as follows: Joint Committee on 
Taxation, Description of the Administration's Proposals Relating to the 
Earned Income Credit (JCX-14-97), May 7, 1997.
---------------------------------------------------------------------------

     I. Description of Present-Law Earned Income Credit Provisions

In general

    Certain eligible low-income workers are entitled to claim a 
refundable earned income credit (EIC) (sec. 32 of the Internal 
Revenue Code of 1986 (``Code'')). A refundable credit is a 
credit that not only reduces an individual's tax liability but 
allows refunds to the individual in excess of income tax 
liability. The amount of the credit an eligible individual may 
claim depends upon whether the individual has one, more than 
one, or no qualifying children, and is determined by 
multiplying the credit rate by the individual's earned income 
\3\ up to an earned income amount. The maximum amount of the 
credit is the product of the credit rate and the earned income 
amount. The credit is reduced by the amount of alternative 
minimum tax (``AMT'') the taxpayer owes for the year. The EIC 
is phased out above certain income levels. For individuals with 
earned income or modified adjusted gross income (``modified 
AGI''), in excess of the beginning of the phaseout range, the 
maximum credit amount is reduced by the phaseout rate 
multiplied by the amount of earned income (or modified AGI, if 
greater) in excess of the beginning of the phaseout range. For 
individuals with earned income (or modified AGI, if greater) in 
excess of the end of the phaseout range, no credit is allowed. 
Modified AGI means AGI, but for this purpose does not include 
the following amounts: (1) net capital losses (if greater than 
zero); (2) net losses from trusts and estates; (3) net losses 
from nonbusiness rents and royalties; and (4) 50 percent of the 
net losses from business, computed separately with respect to 
sole proprietorships (other than in farming), sole 
proprietorships in farming, and other businesses. Amounts 
attributable to a business that consists of the performance of 
services by the taxpayer as an employee are not taken into 
account for purposes of (4).
---------------------------------------------------------------------------
    \3\ In the case of a married individual who files a joint return 
with his or her spouse, the income for purposes of these tests is the 
combined income of the couple.
---------------------------------------------------------------------------
    The parameters for the EIC for 1997 are given in the 
following table:

                                     Earned Income Credit Parameters (1997)                                     
----------------------------------------------------------------------------------------------------------------
                                                            Two or more                                         
                                                             qualifying       One qualifying     No qualifying  
                                                              children            child             children    
----------------------------------------------------------------------------------------------------------------
Credit rate (percent)..................................              40.00              34.00               7.65
Earned income amount...................................             $9,140             $6,500             $4,340
Maximum credit.........................................             $3,656             $2,210               $332
Phaseout begins........................................            $11,930            $11,930             $5,430
Phaseout rate (percent)................................              21.06              15.98               7.65
Phaseout ends..........................................            $29,290            $25,760             $9,770
----------------------------------------------------------------------------------------------------------------


    Under present law, an individual is not eligible for the 
earned income credit if the aggregate amount of ``disqualified 
income'' of the taxpayer for the taxable year exceeds $2,250. 
Disqualified income is the sum of: (1) interest (taxable and 
tax-exempt); (2) dividends; (3) net rent and royalty income (if 
greater than zero); (4) capital gain net income; and (5) net 
passive income (if greater than zero) that is not self-
employment income. The $2,250 threshold is indexed for 
inflation.
    The earned income amount and the phaseout amount are 
indexed for inflation.

Earned income

    Under present law, earned income means the sum of (1) 
wages, salaries, tips, and other employee compensation, and (2) 
the amount of the taxpayer's net earnings from self employment 
for the taxable year, determined without regard to the 
deduction for one-half of the taxpayer's self-employment taxes 
(Code sec. 164(f)). For purposes of this definition, earned 
income is computed without regard to any community property 
laws, pension and annuity payments are not treated as earned 
income, certain amounts relating to nonresident aliens are 
disregarded, and no amount received by inmates for services in 
penal institutions is treated as earned income.

Eligible individual

    Under present law, an individual is an eligible individual 
entitled to claim the EIC for a year if
    (1) the individual has a qualifying child for the taxable 
year, or
    (2) the individual does not have a qualifying child, but 
satisfies the following requirements:
    (i) the individual's principal place of abode is in the 
United States for more than \1/2\ of the year,
    (ii) the individual (or, if the individual is married, 
either the individual or the individual's spouse) has attained 
age 25, but has not attained age 65 before the close of the 
year, and
    (iii) the individual is not a dependent for whom a 
dependency exemption is allowed on another taxpayer's return 
for a taxable year beginning in the same calendar year as the 
taxable year of the individual.
    An individual is not an eligible individual for the year if 
the individual (1) is a qualifying child of another taxpayer, 
(2) claims any exclusion from income under Code section 911 for 
citizens or residents living abroad, (3) is a nonresident alien 
individual for any portion of the year unless the individual is 
treated as a U.S. resident for the year under Code section 
6013, or (4) does not include the individual's taxpayer 
identification number (``TIN'') or the individual's spouse's 
TIN on the tax return.

Qualifying child

    A qualifying child must meet a relationship test, an age 
test, an identification test, and a residence test. Under the 
relationship and age tests, an individual is eligible for the 
EIC with respect to another person only if that other person: 
(1) is a son, daughter, or adopted child (or a descendent of a 
son, daughter, or adopted child); a stepson or stepdaughter; or 
a foster child of the taxpayer (a foster child is defined as a 
person whom the individual cares for as the individual's child; 
it is not necessary to have a placement through a foster care 
agency); and (2) is under the age of 19 at the close of the 
taxable year (or is under the age of 24 at the end of the 
taxable year and was a full-time student during the taxable 
year), or is permanently and totally disabled. Also, if the 
qualifying child is married at the close of the year, the 
individual may claim the EIC for that child only if the 
individual may also claim that child as a dependent.
    To satisfy the identification test, an individual must 
include on their tax return the name, age, and TIN of each 
qualifying child.
    The residence test requires that a qualifying child must 
have the same principal place of abode as the taxpayer for more 
than one-half of the taxable year (for the entire taxable year 
in the case of a foster child), and that this principal place 
of abode must be located in the United States. For purposes of 
determining whether a qualifying child meets the residence 
test, the principal place of abode shall be treated as in the 
United States for any period during which a member of the Armed 
Forces is stationed outside the United States while serving on 
extended active duty.

Advance payment

    An individual with qualifying children may elect to receive 
the credit on an advance basis by furnishing an advance payment 
certificate to his or her employer. For such an individual, the 
employer makes an advance payment of the credit at the time 
wages are paid. The amount of advance payment allowable in a 
taxable year is limited to 60 percent of the maximum credit 
available to an individual with one qualifying child.

TIN requirement

    Under present law, for purposes of determining who is an 
eligible individual and who is a qualifying child, a TIN means 
a social security number issued to an individual by the Social 
Security Administration other than a social security number 
issued pursuant to clause (II) (or that portion of clause (III) 
that relates to clause (II)) of section 205(c)(2)(B)(i) of the 
Social Security Act relating to the issuance of a Social 
Security number to an individual applying for or receiving 
Federally funded benefits.

Mathematical or clerical errors

    The IRS may summarily assess additional tax due as a result 
of a mathematical or clerical error without sending the 
taxpayer a notice of deficiency and giving the taxpayer an 
opportunity to petition the Tax Court. If an individual fails 
to provide a correct TIN, such omission is treated as a 
mathematical or clerical error. Also, if an individual who 
claims the EIC with respect to net earnings from self 
employment fails to pay the proper amount of self-employment 
tax on such net earnings, the failure is treated as a 
mathematical or clerical error for purposes of the amount of 
EIC claimed. Where the IRS uses the summary assessment 
procedure for mathematical or clerical errors, the taxpayer 
must be given an explanation of the asserted error and a period 
of 60 days to request that the IRS abate its assessment. The 
IRS may not proceed to collect the amount of the assessment 
until the taxpayer has agreed to it or has allowed the 60-day 
period for objecting to expire. If the taxpayer files a request 
for abatement of the assessment specified in the notice, the 
IRS must abate the assessment. Any reassessment of the abated 
amount is subject to the ordinary deficiency procedures. The 
request for abatement of the assessment is the only procedure a 
taxpayer may use prior to paying the assessed amount in order 
to contest an assessment arising out of a mathematical or 
clerical error. Once the assessment is satisfied, however, the 
taxpayer may file a claim for refund if he or she believes the 
assessment was made in error.

                       II. Legislative Background

    The EIC was enacted in 1975 as a means of targeting tax 
relief to working low-income taxpayers with children, providing 
relief from the Social Security payroll tax for these 
taxpayers, and improving incentives to work. As originally 
enacted, the credit equaled 10 percent of the first $4,000 of 
earned income (i.e., a maximum credit of $400). The credit 
began to be phased out for taxpayers with earned income (or 
AGI, if greater) above $4,000, and was entirely phased out for 
taxpayers with income of $8,000.
    The Revenue Act of 1978 increased the maximum credit to 
$500 (10 percent of the first $5,000 of earned income). Also, 
the income level at which the phaseout began was raised to 
$6,000, with a complete phaseout not occurring until an income 
level of $10,000. The Deficit Reduction Act of 1984 increased 
the maximum credit to $550 (11 percent of the first $5,000 of 
earned income) and the credit was phased out beginning at 
$6,500 of income and ending at $11,000.
    The Tax Reform Act of 1986 increased the maximum credit to 
$800 (14 percent of the first $5,714 of earned income), 
beginning in 1987. The maximum credit was reduced by 10 cents 
for each dollar of earned income (or AGI, if greater) in excess 
of $9,000 ($6,500 in 1987). These $5,714 and $9,000 amounts 
(stated above in 1985 dollars) were indexed for inflation.
    The Omnibus Budget Reconciliation Act of 1990 (``OBRA 
1990'') substantially increased the maximum amount of the basic 
credit and added an adjustment to reflect family size. OBRA 
1990 also created two additional credits as part of the EIC: 
the supplemental young child credit and the supplemental health 
insurance credit. Both of these supplemental credits used the 
same base as the basic EIC.
    OBRA 1990 also modified the definition of taxpayers 
eligible for the EIC. Under prior law, taxpayers were required 
to file a joint return or file as a head of household or 
surviving spouse in order to be eligible for the EIC. OBRA 1990 
generally broadened the set of eligible taxpayers and set out 
uniform requirements for qualifying children. The definition of 
``qualifying child'' enacted in OBRA 1990 is described in the 
present-law section.
    The Omnibus Budget Reconciliation Act of 1993 (``OBRA 
1993'') expanded the EIC in several ways. For taxpayers with 
one qualifying child, the EIC was increased to 26.3 percent of 
the first $7,750 of earned income in 1994. For 1995 and 
thereafter, the credit rate was increased to 34 percent. In 
1995, the maximum amount of earned income on which the credit 
could be claimed is $6,160 (this is a $6,000 base in 1994, 
adjusted for inflation). The phaseout rate for 1994 and 
thereafter is 15.98 percent.
    For taxpayers with two or more qualifying children, the EIC 
was increased to 30 percent of the first $8,425 of earned 
income in 1994. The maximum credit for 1994 was $2,527 and was 
reduced by 17.68 percent of earned income (or AGI, if greater) 
in excess of $11,000. The credit rate increases over time and 
equals 36 percent for 1995 and 40 percent for 1996 and 
thereafter. The phaseout rate is 20.22 percent for 1995 and 
21.06 percent for 1996 and thereafter.
    OBRA 1993 also extended the EIC to taxpayers with no 
qualifying children. This credit for taxpayers with no 
qualifying children is available to taxpayers over age 24 and 
below age 65. Finally, OBRA 1993 repealed the supplemental 
young child credit and the supplemental health insurance 
credit.
    The implementing legislation for the General Agreements on 
Tariffs and Trade, enacted in 1994, made a number of 
modifications to the EIC. First, it denied the EIC to inmates 
for any amount received for services provided by the inmate in 
a penal institution. Second, it generally made nonresident 
aliens ineligible to claim the EIC. Third, it deemed that a 
member of the Armed Forces stationed outside the United States 
while serving on extended active duty would satisfy the test 
that the principal place of abode be within the United States. 
Fourth, it required that members of the Armed Forces receive 
annual reports from the Department of Defense of earned income 
(which includes nontaxable earned income such as amounts 
received as basic allowances for housing and subsistence). 
Fifth, it required a TIN for each qualifying child regardless 
of the dependent's age. Prior to the legislation, taxpayers had 
to provide a TIN only for qualifying children who attained the 
age of one before the close of the taxpayer's taxable year.
    Under the Self-Employed Person's Health Care Reduction 
Extension Act of 1995, effective for taxable years beginning 
after December 31, 1995, a taxpayer is not eligible for the EIC 
if the aggregate amount of disqualified income (i.e., taxable 
and tax-exempt interest, dividends, and (if greater than zero) 
net rent and royalty income) of the taxpayer for the taxable 
year exceeds $2,350 (``the disqualified income test'').
    The Personal Responsibility and Work Opportunity 
Reconciliation Act of 1996 included several changes to the EIC. 
First, it modified the disqualified income test by adding 
capital gain net income and net passive income (if greater than 
zero) that is not self-employment income to the definition of 
disqualified income, and by reducing the threshold above which 
an individual is not eligible for the EIC from $2,350 to $2,200 
(indexed for inflation). Second, it modified the definition of 
AGI used for phasing out the earned income credit by 
disregarding certain losses. The losses disregarded are: (1) 
net capital losses (if grater than zero); (2) net loses from 
trusts and estates; (3) net losses from nonbusiness rents and 
royalties; and (4) 50 percent of the net losses from 
businesses, computed separately with respect to sole 
proprietorships (other than in farming), sole proprietorships 
in farming, and other businesses. Third, it applied 
mathematical and clerical error treatment to the failure to 
provide a correct Social Security Number (SSN) or to pay the 
proper amount of self-employment tax on net self-employment 
earnings on which an EIC is claimed. Finally, it denied the EIC 
to individuals whose SSNs were issued solely for purposes of 
the individual applying for or receiving Federally funded 
benefits.

             III. Internal Revenue Service Compliance Study

    In April 1997, the Internal Revenue Service (``IRS'') 
released a study of EIC filers for tax year 1994. This study 
based on a final sample of 2046 tax returns examined both paper 
and electronic returns that were accepted by the IRS through 
April 21, 1995; this represents about 80 percent of the EIC 
filing population for that tax year 1994. The study found that 
the total amount of erroneously overclaimed and accepted EIC 
amounts for tax year 1994 amounted to $4.44 billion (25.8 
percent of the total EIC claimed and accepted for that tax year 
1994). The study determined that the overclaim rate should be 
adjusted down to $4.05 billion (23.5 percent of the total EIC 
claimed and accepted for tax year), to reflect the full effects 
of IRS enforcement activities which were in effect during the 
next tax year 1995, Also, certain EIC legislation enacted after 
tax year 1994, (i.e., mathematical and clerical error treatment 
for the failure to provide valid TINs for qualifying children), 
was estimated to reduce the overclaimed amount by an additional 
$489 million down to $3.56 billion. This would have lowered the 
overclaim rate to 20.7 percent for tax year 1994 had the 
mathematical and clerical error rule been in place for the 
year.

               IV. Description of Administration Propsals

A. Deny EIC Eligibility for Prior Acts of Recklessness or Fraud

    Present Law.--The accuracy-related penalty, which is 
imposed at a rate of 20 percent, applies to the portion of any 
underpayment that is attributable to (1) negligence, (2) any 
substantial understatement of income tax, (3) any substantial 
valuation overstatement, (4) any substantial overstatement of 
pension liabilities, or (5) any substantial estate or gift tax 
valuation understatement (sec. 6662). Negligence includes any 
careless, reckless, or intentional disregard of rules or 
regulations, as well as any failure to make a reasonable 
attempt to comply with the provisions of the Code.
    The fraud penalty, which is imposed at a rate of 75 
percent, applies to the portion of any underpayment that is 
attributable to fraud (sec. 6663).
    Neither the accuracy-related penalty nor the fraud penalty 
is imposed with respect to any portion of an underpayment if it 
is shown that there was a reasonable cause for that portion and 
that the taxpayer acted in good faith with respect to that 
portion.
    Description of Proposal.--A taxpayer who fraudulently 
claims the EIC would be ineligible to claim the EIC for a 
subsequent period of 10 years. In addition, a taxpayer who 
erroneously claims the EIC due to reckless or intentional 
disregard of rules or regulations would be ineligible to claim 
the EIC for a subsequent period of two years. These sanctions 
would be in addition to any other penalty imposed under present 
law. The determination of fraud or of reckless or intentional 
disregard of rules or regulations would be made in a deficiency 
proceeding (which would provide for judicial review).
    Effective Date.--The proposal would be effective for 
taxable years beginning after December 31, 1997.

B. Recertification Required When Taxpayer Found to be 
Ineligible for EIC in Past

    Present law.--If an individual fails to provide a correct 
TIN and claims the EIC, such omission is treated as a 
mathematical or clerical error. Also, if an individual who 
claims the EIC with respect to net earnings from self 
employment fails to pay the proper amount of self-employment 
tax on such net earnings, the failure is treated as a 
mathematical or clerical error for purposes of the amount of 
EIC claimed. Generally, taxpayers have 60 days in which they 
can either provide a correct TIN or request that the IRS follow 
the current-law deficiency procedures. If a taxpayer fails to 
respond within this period, he or she must file an amended 
return with a correct TIN or clarify that any self-employment 
tax has been paid in order to obtain the EIC originally 
claimed.
    The IRS must follow deficiency procedures when 
investigating other types of questionable EIC claims. Under 
these procedures, contact letters are first sent to the 
taxpayer. If the necessary information is not provided by the 
taxpayer, a statutory notice of deficiency is sent by certified 
mail, notifying the taxpayer that the adjustment will be 
assessed unless the taxpayer files a petition in Tax Court 
within 90 days. If a petition is not filed within that time and 
there is no other response to the statutory notice, the 
assessment is made and the EIC is denied.
    Description of Proposal.--A taxpayer who has been denied 
the EIC as a result of deficiency procedures would be 
ineligible to claim the EIC in subsequent years unless evidence 
of eligibility for the credit is provided by the taxpayer. To 
demonstrate current eligibility, the taxpayer would be required 
to meet evidentiary requirements established by the Secretary 
of the Treasury. The evidentiary requirements have not yet been 
specified. Failure to provide this information when claiming 
the EIC would be treated as a mathematical or clerical error. 
If a taxpayer is recertified as eligible for the credit, the 
taxpayer would not be required to provide this information in 
the future unless the IRS again denies the EIC as a result of a 
deficiency procedure. Ineligibility for the EIC under the 
proposal would be subject to review by the courts.
    Effective Date.--The proposal would be effective for 
taxable years beginning after December 31, 1997.

C. Establish IRS Continuous Levy and Improve Debt Collection

1. Continuous levy.
    Present Law.--If any person is liable for any internal 
revenue tax and does not pay it within 10 days after notice and 
demand \4\ by the IRS, the IRS may then collect the tax by levy 
upon all property and rights to property belonging to the 
person,\5\ unless there is an explicit statutory restriction on 
doing so. A levy is the seizure of the person's property or 
rights to property. Property that is not cash is sold pursuant 
to statutory requirements.\6\
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    \4\ Notice and demand is the notice given to a person liable for 
tax stating that the tax has been assessed and demanding that payment 
be made. The notice and demand must be mailed to the person's last 
known address or left at the person's dwelling or usual place of 
business (sec. 6303).
    \5\ Sec. 6331.
    \6\ Secs. 6335-6343.
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    In general, a levy does not apply to property acquired 
after the date of the levy,\7\ regardless of whether the 
property is held by the taxpayer or by a third party (such as a 
bank) on behalf of a taxpayer. Successive seizures may be 
necessary if the initial seizure is insufficient to satisfy the 
liability.\8\ The only exception to this rule is for salary and 
wages.\9\ A levy on salary and wages is continuous from the 
date it is first made until the date it is fully paid or 
becomes unenforceable.
---------------------------------------------------------------------------
    \7\ Sec. 6331(b).
    \8\ Sec. 6331(c).
    \9\ Sec. 6331(e).
---------------------------------------------------------------------------
    A minimum exemption is provided for salary and wages.\10\ 
It is computed on a weekly basis by adding the value of the 
standard deduction plus the aggregate value of personal 
exemptions to which the taxpayer is entitled, divided by 
52.\11\ For a family of four for taxable year 1996, the weekly 
minimum exemption is $325.\12\
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    \10\ Sec. 6334(a)(9).
    \11\ Sec. 6334(d).
    \12\ Standard deduction of $6,700 plus four personal exemptions at 
$2,550 each equals $16,900, which when divided by 52 equals $325.
---------------------------------------------------------------------------
    Description of Proposal.--The Administration's budget 
proposal would amend the Code to provide that a continuous levy 
is also applicable to non-means tested recurring Federal 
payments. This is defined as a Federal payment for which 
eligibility is not based on the income and/or assets of a 
payee. For example, Social Security payments, which are subject 
to levy under present law, would become subject to continuous 
levy.
    In addition, the Administration's budget proposal would 
provide that this levy would attach up to 15 percent of any 
salary or pension payment due the taxpayer. This rule would 
explicitly replace the other specifically enumerated exemptions 
from levy in the Code. Under the Administration's budget 
proposal, the continuous levy could apply to the entire amount 
of a Federal payment that is not salary or a pension payment. 
Under the Administration's EIC proposal, a continuous levy of 
up to 15 percent could also apply to unemployment benefits and 
means-tested public assistance.
    Effective Date.--The Administration's budget proposal would 
be effective for levies issued after the date of enactment. The 
Administration's EIC proposal would be effective for levies 
issued after December 31, 1997.

2. Modifications of levy exemptions.
    Present Law.--The Code exempts from levy workmen's 
compensation payments,\13\ annuity or pension payments under 
the Railroad Retirement Act and benefits under the Railroad 
Unemployment Insurance Act \14\ described above, unemployment 
benefits \15\ and means-tested public assistance.\16\
---------------------------------------------------------------------------
    \13\ Sec. 6334(a)(7).
    \14\ Sec. 6334(a)(6).
    \15\ Sec. 6334(a)(4).
    \16\ Sec. 6334(a)(11).
---------------------------------------------------------------------------
    Description of Proposal.--The Administration's budget 
proposal would provide that the following property is not 
exempt from levy if the Secretary of the Treasury (or his 
delegate) approves the levy of such property:
    (1) workmen's compensation payments,\17\ and
---------------------------------------------------------------------------
    \17\ Many workmen's compensation payments are made by States. The 
heading of the new subsection of the Code (but not the text of the 
subsection itself) refers to ``Federal'' payments. A clarification of 
this matter may be desirable.
---------------------------------------------------------------------------
    (2) annuity or pension payments under the Railroad 
Retirement Act and benefits under the Railroad Unemployment 
Insurance Act.
    The Administration's EIC proposal would provide that the 
following property is not exempt from levy if the Secretary of 
the Treasury (or his delegate) approves the levy of such 
property:
    (1) unemployment benefits, and
    (2) means-tested public assistance.
    Effective Date.--The Administration's budget proposal would 
apply to levies issued after the date of enactment. The 
Administration's EIC proposal would apply to levies issued 
after December 31, 1997.

D. Due Diligence Requirements for Paid Preparers

    Present Law.--There are several penalties that apply in the 
case of an understatement of tax that is caused by an income 
tax return preparer. First, if any part of an understatement of 
tax on a return or claim for refund is attributable to a 
position for which there was not a realistic possibility of 
being sustained on its merits and if any person who is an 
income tax return preparer with respect to such return or claim 
for refund knew (or reasonably should have known) of such 
position and such position was not disclosed or was frivolous, 
then that return preparer is subject to a penalty of $250 with 
respect to that return or claim (sec. 6694(a)). The penalty is 
not imposed if there is reasonable cause for the understatement 
and the return preparer acted in good faith.
    In addition, if any part of an understatement of tax on a 
return or claim for refund is attributable to a willful attempt 
by an income tax return preparer to understate the tax 
liability of another person or to any reckless or intentional 
disregard of rules or regulations by an income tax return 
preparer, then the income tax return preparer is subject to a 
penalty of $1,000 with respect to that return or claim (sec. 
6694(b)).
    Also, a penalty for aiding and abetting the understatement 
of tax liability is imposed in cases where any person aids, 
assists in, procures, or advises with respect to the 
preparation or presentation of any portion of a return or other 
document if (1) the person knows or has reason to believe that 
the return or other document will be used in connection with 
any material matter arising under the tax laws, and (2) the 
person knows that if the portion of the return or other 
document were so used, an understatement of the tax liability 
of another person would result (sec. 6701).
    Additional penalties are imposed on return preparers with 
respect to each failure to (1) furnish a copy of a return or 
claim for refund to the taxpayer, (2) sign the return or claim 
for refund, (3) furnish his or her identifying number, (4) 
retain a copy or list of the returns prepared, and (5) file a 
correct information return (sec. 6695). The penalty is $50 for 
each failure and the total penalties imposed for any single 
type of failure for any calendar year are limited to $25,000.
    Description of Proposal.--Return preparers would be 
required to fulfill certain due diligence requirements with 
respect to returns they prepare claiming the EIC. The due 
diligence requirements have not yet been specified. The penalty 
for failure to meet these requirements would range from $50 to 
the full amount of the EIC overclaimed. This penalty would be 
in addition to any other penalty imposed under present law.
    Effective Date.--The proposal would be effective for 
taxable years beginning after December 31, 1997.

E. Simplification of Foster Child Definition

    Present law.--For purposes of the EIC, qualifying children 
may include foster children who reside with the taxpayer for a 
full year, if the taxpayer ``cares for the foster children as 
the taxpayer's own children.'' (Code sec. 32(c)(3)(B)(iii)(I)). 
All EIC qualifying children (including foster children) must 
either be under the age of 19 (24 if a full-time student) or 
permanently and totally disabled. There is no requirement that 
the foster child either be: (1) placed in the household by a 
foster care agency or (2) a relative of the taxpayer.
    Description of Proposal.--A foster child would be defined 
as a child who (1) is under the age of 19 (24 if a full-time 
student), (2) is cared for by the taxpayer as if he or she were 
the taxpayer's own child, and (3) either is the taxpayer's 
niece, nephew, or sibling or was placed in the taxpayer's home 
by an agency of a State or one of its political subdivisions or 
by a tax-exempt child placement agency licensed by a State.
    Effective Date.--The proposal would be effective for 
taxable years beginning after December 31, 1997.

F. Advance Payment Demonstration Projects

    Present law.--Qualifying individuals can claim the EIC when 
filing their tax returns at the end of the year. Alternatively, 
qualifying individuals with children have the choice of 
obtaining a portion of the EIC in advance through their 
employers, and claiming the balance of the EIC upon filing 
their income tax returns at the end of the year. The annual 
advanced EIC payment cannot exceed 60 percent of the maximum 
full-year EIC for a family with one child ($1,326 for 1997).
    Description of Proposal.--The Secretary of the Treasury 
could select four States to provide advance payments of the EIC 
to wage earners through State agencies rather than employers 
for a three-year period. The four States would be selected from 
those States applying for participation in the demonstration 
project. States would be required to verify eligibility for the 
EIC before paying out the credit. Effects on advance payment 
participation and compliance would be studied by the Treasury 
Department.
    Effective Date.--Applications would be submitted by the 
States to the Treasury Department during 1998 for demonstration 
projects to begin in January 1999.
      

                                

    Mr. Shaw. I would also like to include in the record a 
written statement from the American Institute of Certified 
Public Accountants.
    [The prepared statement follows:]

Statement of the American Institute of Certified Public Accountants

                              Introduction

    The American Institute of Certified Public Accountants 
(AICPA) is the national professional organization of CPAs, with 
more than 320,000 members. Many of our members are tax 
practitioners who, collectively, prepare income tax returns for 
millions of Americans.
    The AICPA urges that simplification of the tax system be 
made a legislative priority. In particular, the earned income 
tax credit (EITC) is an area in critical need of 
simplification.
    We strongly urge the Committee and Congress to re-write the 
EITC rules to be understandable and usable by the taxpayers 
that this provision is intended to benefit--low-income wage 
earners. This group of taxpayers generally lacks the ability to 
deal with complex tax laws and is unable to pay for tax 
preparation assistance. The AICPA welcomes proposed changes to 
make the credit more effective and offers several suggestions.

                         Background on the EITC

    The refundable EITC was enacted in 1975 with the policy 
goals of providing relief to low-income families from the 
regressive effect of Social Security taxes, and improving work 
incentives among this group. According to the IRS, EITC rules 
affect almost 15 million individual taxpayers.
    Over the last few years, the number one individual tax 
return error discovered by the IRS during return processing has 
been the EITC, including the failure of eligible taxpayers to 
claim the EITC, and the use of the wrong income figures when 
computing the EITC. The frequent changes made to the EITC over 
the past twenty years contribute greatly to the credit's high 
error and noncompliance rates. In fact, the credit has been 
changed 12 times (1976, 1977, 1978,1979, 1984,1986, 1988 ,1990, 
1993, 1994, 1995, and 1996). The credit now is a nightmare of 
eligibility tests, requiring a maze of worksheets. Computation 
of the credit currently requires the taxpayer to consider:
     9 eligibility requirements;
     the number of qualifying children--taking into 
account relationship, residency, and age tests;
     the taxpayer's earned income--taxable and non-
taxable;
     the taxpayer's adjusted gross income (AGI);
     the taxpayer's modified AGI;
     threshold amounts;
     phase out rates; and
     varying credit rates.
    As part of the Self-Employed Health Insurance Act of 1995, 
a new factor was added for determining eligibility--the amount 
of interest (taxable and tax-exempt), dividends, and net rental 
and royalty income (if greater than zero) received by a 
taxpayer, even if total income is low enough to otherwise 
warrant eligibility for the EITC. A threshold of this type of 
disqualified income was set at $2,350 in 1995, but was then 
altered as part of the Personal Responsibility and Work 
Opportunity Reconciliation Act of 1996 to be $2,200. In 
addition, in 1996, capital gain net income and net passive 
income (if greater than zero) that is not self-employment 
income were added to this disqualified income test.
    In 1996, the credit computation became even more 
complicated, with the introduction of a modified AGI definition 
for phasing out the credit, wherein certain types of nontaxable 
income need to be considered and certain losses are 
disregarded. Specifically, nontaxable items to be included are: 
tax-exempt interest, and nontaxable distributions from 
pensions, annuities, and individual retirement arrangements 
(but only if rolled over into similar vehicles during the 
applicable rollover period). The losses that are to be 
disregarded are:
     net capital losses (if greater than zero);
     net losses from trusts and estates;
     net losses from nonbusiness rents and royalties; 
and
     50 percent of net losses from businesses, computed 
separately with respect to sole proprietorships (other than in 
farming), sole proprietorships in farming, and other 
businesses--but amounts attributable to businesses that consist 
of the performance of services by an individual as an employee 
are not taken into account.
    In addition to the prior requirement that a taxpayer 
identification number (TIN) be supplied for each qualifying 
child, starting in 1996, the taxpayer must be authorized to be 
employed in the U.S. in order to claim the credit, and failure 
to provide a correct TIN is now treated as a mathematical or 
clerical error.
    To claim the credit, the taxpayer may need to complete:
     a checklist (containing 8 complicated questions),
     a worksheet (which has 9 steps),
     another worksheet (if there is self-employment 
income),
     a schedule with 6 lines and 2 columns (if 
qualifying children are claimed); and
     Usually, the normal Form 1040 (rather than Form 
1040A or Form 1040EZ).
    For guidance, the taxpayer may refer to 7 pages of 
instructions (and 39 pages of IRS Publication 596). The credit 
is determined by multiplying the relevant credit rate by the 
taxpayer's earned income up to an earned income threshold. The 
credit is reduced by a phaseout rate multiplied by the amount 
of earned income (or AGI, if less) in excess of the phaseout 
threshold.
    While Congress and the IRS may expect that the AICPA and 
its members can comprehend the many pages of instructions and 
worksheets, it is unreasonable to expect those individuals 
entitled to the credit (who will almost certainly NOT be expert 
in tax matters) to deal with this complexity. Even our members, 
who tend to calculate the credit for taxpayers as part of their 
volunteer work, find this area to be extremely challenging. In 
fact, we have found that the EITC process can be a lot more 
demanding than completing the Schedule A--Itemized Deductions, 
which many of our members complete on a regular basis for their 
clients.
    Our analysis suggests that most of the EITC complexity 
arises from the definitional distinctions in this area. While 
each departure from definitions used elsewhere in the Code can 
be understood in a context of accomplishing a specific 
legislative purpose, the sum of all the definitional variances 
causes this Code section to be unmanageable by taxpayers and 
even the IRS. We recognize that many of the additions and 
restrictions to the credit over the years were for laudable 
purposes. However, the rules are so complex that the group of 
taxpayers to be benefited find them incomprehensible and are 
not effectively able to claim the credit to which they are 
entitled.

               Summary of Our Legislative Recommendations

    We recommend that Congress adopt the following changes to 
the EITC:
    1. Simplify definitions and the calculation. (See Appendix 
for specific administrative proposals that we intend to pursue 
with the IRS).
    2. Define ``earned income'' as taxable wages (Form 1040, 
line 7) and self employment income (Form 1040, line 12).
    3. Modify the ``qualifying child'' rules.
    A. Replace the ``qualifying child'' definition with the 
already existing dependent child definition.
    B. Increase the incremental amount of credit provided for 
two children versus one child.
    C. Use the dependency exemption rather than the EITC to 
provide benefits for children.
    4. Combine and expand the denial provisions.
    A. Deny the credit for taxpayers with: foreign earned 
income, alternative minimum tax liability, and AGI that exceeds 
earned income by $2,350 or more.
    5. Modify the EIC Table or provide a percentage rate 
instead of the table.

                  Specific Legislative Recommendations

1. Simplify definitions and the calculation.

    The current rules for the EITC, as previously noted, 
provide different rules depending upon the number of qualifying 
children the taxpayer claims. The many rates, thresholds, 
limitations, and classifications regarding this credit are 
confusing. For the 1994 tax year, the parameters are as 
follows:

                                                                                                                
----------------------------------------------------------------------------------------------------------------
                                                                                2 or more                       
                                                              1 Child            Children         No Children   
----------------------------------------------------------------------------------------------------------------
Credit rate (%)........................................              26.30              30.00               7.65
Phaseout rate (%)......................................              15.80              17.68               7.65
Earned income threshold................................             $7,750             $8,425             $4,000
Phaseout threshold.....................................             11,000             11,000              5,000
Phaseout limit.........................................             23,755             25,296              9,000
Maximum credit.........................................              2,038              2,528                306
----------------------------------------------------------------------------------------------------------------


Recommendation:
    Congress should simplify the definitions and the 
calculation of the credit. Specifically, as detailed below, we 
suggest the definitions of qualifying child and earned income 
be modified. The many rates, thresholds, limitations, and 
classifications regarding this credit should be referenced to 
other similar thresholds and classifications throughout the 
Code. These changes, and the changes listed below, would reduce 
the number of pages needed for the worksheets, Schedule EIC, 
EIC Table, and instructions. (See Appendix for specific 
administrative proposals that we intend to pursue with the IRS 
to simplify the definitions and calculation.)

2. Define ``earned income'' as taxable wages (Form 1040, line 
7) and self-employment income (Form 1040, line 12).

    The current EITC definition of ``earned income'' needs to 
be simplified. Currently, to calculate the credit, the taxpayer 
must take into account all earned income, including amounts not 
otherwise reported on the tax return or not taxed. This is one 
area where numerous errors are made. As GAO states in its 
September 1993 report GAO/GGD-93-145, Tax Policy: Earned Income 
Tax Credit: Design and Administration Could Be Improved, 
``determining the amount of income that should be included in 
calculating the credit poses a problem for taxpayers and IRS.''
    Currently, potentially eligible recipients must take into 
account:
     Taxable earned income (wages, salaries, and tips; 
union strike benefits; long-term disability benefits received 
prior to minimum retirement age; and net earnings from self-
employment), PLUS
     Nontaxable earned income (defined in the 
instructions as: contributions to a 401(k) plan and military 
housing and subsistence, excludable dependent care benefits, 
pay earned in a combat zone, the value of meals or lodging 
provided by an employer for the convenience of the employer, 
housing allowance or rental value of a parsonage for clergy, 
voluntary salary reductions such as under a cafeteria plan, and 
``anything of value that is not taxable which you received from 
your employer for your work'').
    Furthermore, because taxable scholarships and fellowship 
grants are reported on Form 1040 line 7, taxpayers are 
instructed to subtract taxable scholarships or fellowship 
grants not reported on the Form W-2. This one exception 
complicates the calculation and is not verifiable, as it is not 
on the Form W-2.
    In addition, as discussed in our administrative 
recommendations in the Appendix, the earned income calculation 
does NOT include various other forms of income not on line 7 of 
the Form 1040 (i.e., welfare benefits, workers' compensation 
benefits, alimony, child support, unemployment compensation, 
social security and railroad retirement benefits, pension and 
annuities, interest and dividends, and variable housing 
allowances for the military). The exclusion of these items is 
mentioned in IRS Publication 596, but is not mentioned in the 
worksheet or instructions. Since these items are taxable, but 
are not wage income (line 7 of the Form 1040), taxpayers may 
inadvertently include these items as ``earned income.''
    Currently, the calculation of ``earned income'' involves a 
detailed knowledge of tax terminology, such as: ``excludable,'' 
``taxable,'' ``for the convenience of the employer,'' and 
``voluntary salary reductions.'' The definition of taxable 
income includes many items not commonly thought of as earnings. 
In addition, the definition of ``nontaxable earnings'' is 
unique to the EITC and is defined in different ways in the 
instructions and IRS Publication 596 (as addressed in our 
administrative recommendations in the Appendix). Most people 
think that ``earned income'' is wages. Omissions are likely to 
happen when uncommon terms are used to cover many items that 
normally are not treated as earnings.

Recommendation:
    Congress should define earned income as wages appearing on 
line 7 of Form 1040, plus self-employment income from line 12 
of the Form 1040.
    Earned income should only include taxable income, as the 
statute originally provided when it was created in 1975. As the 
GAO points out, much of ``this (nontaxable) income is not 
reported to recipients or to IRS,'' and IRS has no way right 
now of verifying the nontaxable amounts. GAO states, ``we do 
not see a need to provide space on the tax return for 
nontaxable earned income since less than 3 percent of eligible 
taxpayers claim (report) this type of income.'' Therefore, 
nontaxable income should be removed from the EITC definition of 
``earned income'' to make the process simpler for the majority 
of taxpayers who need to complete this worksheet.
    We also believe that there should be no exceptions to this 
taxable earned income definition. If Congress wants to treat 
taxable scholarships and fellowships different from taxable 
wages, taxable scholarships and wages should not be reported on 
in line 7 of the Form 1040. Alternatively, if taxable 
scholarships are to be treated as taxable wages (line 7 of Form 
1040), the current EITC subtraction for scholarships and 
fellowship grants should not be allowed.

3. Modify the ``qualifying child'' rules.

    According to a GAO analysis, most EITC errors have been 
linked to issues involving filing status and qualifying 
children. The qualifying child test is complex. Taxpayers are 
confused by the ``qualifying child'' definition and the 
different definition for a dependent. The definition of 
``eligible child'' complicates the EITC instructions for 
determining eligibility. The IRS attempts to communicate that a 
``qualifying child'' usually does not have to be a dependent. 
However, there are a few exceptions that confuse taxpayers. For 
example, if one divorced parent has custody of the child, but 
the other parent claims the child as a dependent, the parent 
with custody can claim the child as a ``qualifying child'' for 
the EITC, but can not claim the child as a dependent. Also, if 
a child is married, the child must be a dependent (i.e., over 
half of the child's support is provided by the taxpayer) to 
claim the child as a ``qualifying child'' for the EITC. This 
married child exception confuses taxpayers.
    Additionally, the different EITC treatment for different 
taxpayers--depending on the number of children--seems 
unnecessarily complex, especially for the minor additional 
benefit derived. The maximum additional credit for more than 
one child is only $490. The minor additional benefit is 
illustrated by an eligible taxpayer with $4,000 of earned 
income receiving a credit for one child of $1,059, while for 
two or more children, the taxpayer's credit is $1,208, a 
difference of only $149. What is this differential meant to 
reflect? Clearly, the difference cannot be cost. In addition, 
there is no EITC difference between taxpayers with two children 
and taxpayers with three or more children.
    Also, taxpayers with and without children are treated 
differently with regard to their eligibility for the advance 
EITC. The advance EITC is available only to taxpayers with 
qualifying children. There does not appear to be any reason for 
this difference. The EITC should focus on one goal--earned 
income.

Recommendation:
    The rules throughout the Code, and especially in this area, 
could be simplified if just one definition was used 
consistently. Congress should eliminate the distinction between 
``qualifying child'' and ``dependent child.'' Section 
32(c)(1)(A)(I), which currently allows the EITC to certain 
taxpayers with non-dependent children, should be changed. If 
the term ``eligible children'' is restricted to dependent 
children, section 32(c)(1)(A)(I) could be cross referenced to 
section 151. This definition would provide an easy reference to 
information already on the Form 1040, line 6, and would 
eliminate the need for the additional information currently 
required on the Schedule EIC. We also suggest that the married 
dependent child test, which is rarely applied, be removed. 
Alternatively, if Congress deems that the ``qualified child'' 
is a better definition than ``dependent child,'' then the 
``qualified child'' test should be used for the dependency 
exemption as well. Either way, there should be just one 
definition of child in the Code.

Recommendation:
    The spread in the amount of credit for one child and two 
children should be made more significant than under the current 
EIC Table. The difference between one and two children in the 
current table is so small that it could not possibly reflect a 
cost differential and it is too incomprehensible for it to be a 
motivating factor in individual conduct.

Recommendation:
    Even greater simplification would result if there was no 
EITC differential based on the number of children. The current 
three classes of EITC recipients and three considerations at 
each point in the process are cumbersome. If just one class of 
EITC recipient existed, the ``qualifying child'' versus 
dependent child confusion would be eliminated, making the 
credit process much easier. In addition, if this recommendation 
is adopted, all EITC recipients would be able to claim the 
advance EITC.
    As stated previously, an objective of the credit is to 
remove the regressivity of the Social Security tax for lower-
income individuals. This objective applies to all lower income 
taxpayers, regardless of the number of children in the home. 
Thus, eliminating the incremental amount of the credit based on 
the number of children would not detract from the stated 
objectives of this provision. The calculation and the EIC Table 
would be simplified, and the additional information on age and 
social security numbers of children (currently required on a 
separate Schedule EIC) would not be needed for the EITC.

Recommendation:
    Congress should coordinate all of the Code's tax provisions 
related to children. These child-based tax provisions include: 
the incremental child EITC, the child tax credit, the 
dependency exemption deduction, and the proposed family tax 
credit in H.R. 1215. All of these child tax benefits should be 
provided through one mechanism--the dependency exemption. The 
dependency exemption takes into account the total number of 
children in the household, versus the EITC, which only accounts 
for up to two children in a household.
    However, since the current dependency exemption is a 
deduction rather than a credit, the result is regressive (that 
is, the higher the tax bracket, the greater the tax benefit) at 
the income levels that the EITC can be claimed. Therefore, if 
the dependency exemption is to take part of the place of the 
EITC, one point Congress might consider would be replacing the 
dependency exemption with a refundable credit, not a deduction. 
The credit could be refundable and set at a fixed dollar amount 
per dependent child. This credit could be available in advance 
from the taxpayer's employer, as is the advance EITC. The per 
child credit amount could be a round number that is easy to 
multiply.
    The proposed child credit could be phased-out above some 
threshold AGI that is simple and consistent with other phase-
out rules. We suggest that the phase-outs for itemized 
deductions, personal exemptions, and this proposed child credit 
all start at the same threshold and that threshold should be a 
number that is easy to apply--e.g., $100,000 of AGI. The phase-
out mechanism for all tax provisions in the Code should be the 
same.

4. Combine and expand the denial provisions.

    IRS and GAO have stated that many people receiving the 
credit are not considered ``low-income'' individuals. As these 
individuals are identified, greater restrictions are placed on 
eligibility for the credit, and the computation is made more 
complex for all EITC recipients. As mentioned earlier, Congress 
recently agreed to deny the credit to individuals with interest 
and dividends, tax-exempt interest, and net rental and royalty 
income in excess of $2,350. Additionally, the credit currently 
is not available if the taxpayer: excludes from gross income 
any income earned in foreign countries, or claims a tax benefit 
for foreign housing amounts. An individual who owes alternative 
minimum tax (Form 1040, line 48) is allowed a credit, but the 
EITC is reduced by any alternative minimum tax. The taxpayer's 
AGI is used as a limitation for the credit and greatly 
complicates the computation for most taxpayers.

Recommendation:
    We support Congress limiting the credit to those taxpayers 
originally intended to benefit from the EITC. However, we 
suggest that this limitation only occur through the denial 
rules, not the computation rules. We recommend that all the 
denial provisions be included in one place. The eligibility/
denial rules should include the current denial for taxpayers 
with foreign earned income. We suggest adding to the denial 
rule all taxpayers subject to AMT. This would delete the 
computational exception for AMT taxpayers.
    Congress also should include in the denial provision 
taxpayers with AGI that exceeds earned income by $2,350 or 
more. H.R. 831's denial for taxpayers with $2,350 of interest 
or dividends should be replaced (and essentially combined) with 
this denial for taxpayers with AGI that exceeds earned income 
by $2,350 or more. This exclusion based on AGI would deny the 
credit to taxpayers with all forms of unearned income (i.e., 
capital gains, income from partnerships and'S corporations, 
etc.), not just taxpayers with interest and dividends of $2,350 
or more. As the H.R. 831 proposed EITC restriction stands now, 
these ``wealthy'' individuals affected by the legislation 
(i.e., with this type and amount of non-earned income) could 
change their investments to earn partnership investment income, 
capital gains, or pay off their home mortgage and still claim 
an EITC. If H.R. 831 is enacted as currently drafted, when 
additional abuses occur, Congress will have to add more 
restrictions to the EITC statute. However, if our proposed 
broader AGI denial is used, fewer, or no, additional 
limitations will be needed. This denial of credit for 
individuals with higher incomes seems to be the intent of the 
unearned income restrictions.
    An important result of moving the AGI calculation 
restriction to the eligibility rules is that the calculation 
would be much simpler. The calculation would no longer require 
a worksheet.
    Specifically, in order to implement this change, we suggest 
that section 32(h), which currently requires a reduction of the 
EITC for taxpayers subject to the alternative minimum tax, be 
modified. On the basis of simplicity, this provision should be 
combined with section 32(c)(1)(D), denying the EITC to anyone 
claiming a foreign earned income exclusion. Section 32(c)(1)(D) 
should also include taxpayers with AGI that exceeds earned 
income by $2,350. Section 32(a)(2) should also be modified to 
remove AGI from the computation. All the restrictions based on 
income should be contained in one paragraph or subsection, 
rather than throughout this Code provision.

5. Modify the EIC Table or provide a percentage rate instead of 
the table.

    Although the IRS EIC Table takes into account all the 
phaseouts, the table can still be a mystery to many taxpayers. 
Many taxpayers are confused between the EIC Table and the Tax 
Table.

Recommendation:
    Section 32(f) currently requires that the EIC Table have 
income brackets not greater than $50 each. Form 1040 
instructions currently include two pages of the EIC Table with 
$50 brackets, resulting in earned income credit intervals of 
$3-$8. Congress should amend section 32(f) to allow wider 
brackets which result in greater than $3 earned income credit 
intervals. This will reduce the EIC Table to half a page and 
will minimize the overwhelming nature of the table, and, 
hopefully, facilitate ease of use.

Recommendation:
    We suggest an even bolder alternative--eliminate the EIC 
Table completely, and instead provide a credit equal to a 
certain percent (i.e., 10 percent) of earned income. This 
option could be modified to provide for a few percentage levels 
(i.e., 30% if earning less than $8,000, 25% if earning between 
$8,000 and $16,000, and 20% if earning between $16,000 and 
$24,000). This would approximate the average credit currently 
allowed--$900 if earning $3,000 (with 2 qualifying children), 
$2,500 if earning $10,000 (with 2 qualifying children), and 
$2,000 if earning $20,000 (with 2 qualifying children), and 
would be much easier to calculate. This would be much simpler 
and would save space in the instruction booklets and ease much 
of the confusion. The rates could be written directly onto the 
EITC line of the Form 1040. This, combined with a changes in 
the ``earned income'' definition and AGI limitation should make 
the worksheets, checklists, and tables a thing of the past.

                      Other Reforms to the System

    Lastly, in reviewing comprehensive reform of benefits and 
tax reform, in general, Congress should consider the problems 
and complexities for low-earning Americans illustrated above. 
Some of the reforms listed below have been suggested as a 
potential solution to the EITC problems.
     Use the EITC to eliminate the regressivity of the 
social security tax, by setting the refundable credit at the 
current social security tax rate (7.65 percent). The FICA tax 
regressivity results because the first dollar earned is taxed 
for FICA purposes, while income (for 1994) generally up to: 
$11,250--married filing jointly, $8,050--head of household, 
$6,250--single, and $2,450--married filing separately is exempt 
from the progressive income tax. This option would permit all 
taxpayers with ``earned income'' to claim this credit 
regardless of their age, filing status or dependency status.
     Limit the EITC benefit to no more than 15.3 
percent (the current self-employment rate) of any self 
employment income reported. This would address the fraud and 
overreporting problems involved with self-employment income.
     Exempt the first $X of taxable earned income from 
the employee's share of social security tax and from + of the 
self-employment tax. (This tax could be administered by 
adjusting social security withholding and by amending Schedule 
SE). Exempting low-income individuals from FICA (social 
security and Medicare) taxes would directly address (with no 
paperwork) what the EITC was intended to do--mitigate the 
regressivity of the FICA taxes.

                               Conclusion

    In conclusion, we have identified quite a few areas that 
need simplification and proposed various means to achieve it. 
We support measures to eliminate the current EITC problems so 
that those who legally qualify for the EITC receive it and can 
claim the benefits in a simplified and easy process.

 Appendix--Suggested Administrative (IRS) Changes to the EITC Claiming 
                                Process

1. EITC Line of Form 1040 Should be in the Credits Section of 
the Form.
    Even if the taxpayer is not allowed to claim the credit, 
the taxpayer must go through many procedures to find out if he/
she is ineligible, and then write ``NO'' on line 56. Line 56 is 
not even in the section of the Form 1040 dealing with credits; 
it is in the section of the Form 1040 dealing with payments. 
The current placement of the EITC line on the tax return could 
be confusing to taxpayers (although it is in bold). Therefore, 
we suggest the EITC line be moved to the credit section of the 
Form 1040.

2. The IRS Calculation Option Should be Presented at the 
Beginning of the Checklist and Instructions.

    IRS currently offers to calculate the EITC for taxpayers, 
but it mentions the option rather late in the process and 
requires the taxpayer to supply additional information on a 
separate schedule. The IRS calculation option is mentioned on 
the last line of the checklist, which reads ``If you want the 
IRS to figure it for you, enter 'EIC''' on the appropriate line 
on the appropriate type of Form 1040. IRS should encourage more 
taxpayers to use this option and should consider mentioning 
this option at the top of the checklist and instructions.

3. All Information Required for the Credit Should be on the 
Form 1040--Schedule EIC and the Dependency Exemption 
Information Should be Combined on the Form 1040.

    The Form 1040 should provide sufficient information for the 
IRS to determine if a taxpayer legitimately qualifies for the 
EITC. The IRS should inform legitimate eligible taxpayers of 
the correct credit amount. The taxpayer should not have to take 
the currently required additional steps of reading the 
instructions and completing the checklist, worksheet, and 
Schedule EIC.
    We agree with GAO's Sept. 1993 report, Tax Policy: Earned 
Income Tax Credit: Design and Administration Could Be Improved, 
that stated,''most of the necessary information could be 
included on the tax return itself. With minor modifications to 
the dependency and filing status sections of the Form 1040 or 
1040A, all the requisite information (the already required 
child's name, social security number, relationship to taxpayer, 
and number of months lived with taxpayer, as well as the age 
and student/disability status of the child) would be available 
to determine whether a child qualified * * * . We believe 
taxpayer simplification can be better achieved by the 
elimination of the separate EIC Schedule; the separate two-page 
schedule is an additional obstacle for very low-income tax 
filers.'' We, therefore, support elimination of the current 
separate Schedule EIC that merely covers repetitive 
information, and suggest the necessary information be combined 
into the existing Form 1040 exemption section, as shown on page 
64 of the GAO report. This issue would disappear if a 
legislative change is made (as we proposed) so that the 
distinction in number of children is pursued through the 
dependency exemption.
    We also suggest an even easier modification to the Form 
1040. The only additional pieces of information (not currently 
required on the Form 1040) that are requested on the Schedule 
EIC are: (1) if the child was older than 18--whether the child 
was a student under age 24 or permanently/totally disabled, and 
(2) the child's year of birth. The year of birth could easily 
take the place of column 2 on line 6c, where the IRS currently 
asks the taxpayer to check if under age 1. The information in 
(1) could also be included and coded on line 6c (i.e., next to 
the age, put an'S if a student and/or D if disabled). If the 
legislative change we proposed concerning the definition of 
``eligible child'' and dependent is not made, the taxpayer also 
could put an ``E'' on line 6c to indicate that the child is an 
``eligible child'' for the EITC. The Form 1040 would then 
include all the information currently requested on the Schedule 
EIC.

4. All Responses on the Checklist Should Consistently Direct 
the Taxpayer.

    The current locations and responses are confusing to 
taxpayers and should be switched. Checklist question number 5 
should be worded in such a way that a YES response is positive 
and a NO response results in the taxpayer not qualifying for 
the credit (similar to all the other seven questions on the 
checklist). Accordingly, the YES and NO box locations to 
question number 5 should be switched too.

5. The Worksheet Should be Incorporated in the Schedule EIC.

    If the credit remains as complex as it is right now, 
instead of a worksheet calculation, the EITC should be 
calculated on an IRS designed schedule which is attached to the 
tax return. The Schedule EIC could be modified for this purpose 
to include the actual computations rather than mere taxpayer 
identification information. The IRS also could better monitor 
the credit amounts and if fraud or abuse is involved. It does 
not make sense for the taxpayer to first complete a checklist, 
then be directed to the worksheet, then complete the 
informational Schedule EIC, and then enter the credit from the 
worksheet onto the tax return. The IRS never sees the worksheet 
and, therefore, cannot see where the taxpayer made a mistake in 
the calculation and if it was intentional or not.

6. The Description of Items Subtracted from ``Earned Income'' 
Should be Stated Similarly in All IRS Publications.

    All IRS publications should clearly state the same 
definition and explanation of earned income. Specifically, IRS 
Publication 596 currently includes a detailed list of items to 
subtract from earned income, while the worksheet and 
instructions do not contain this list. The worksheet and 
instructions should include this list. Taxpayers may 
inadvertently include these items as ``earned income.'' 
Specifically, according to Publication 596, the various forms 
of income that are not included in the earned income 
calculation (and are not subtracted on the worksheet) are not 
included in line 7 of the Form 1040 (i.e., welfare benefits, 
workers' compensation benefits, alimony, child support, 
unemployment compensation, social security and railroad 
retirement benefits, pension and annuities, interest and 
dividends, and variable housing allowances for the military). 
Our legislative recommendation to define ``earned income'' as 
taxable wages (line 7 of the Form 1040) and self-employment 
income (line 12 of Form 1040) would greatly simplify this 
problem.

7. The Taxpayer Should be Directed to the EIC Table Only Once.

    Rather than sending the taxpayer to the EIC Table twice 
(once for earned income and another time for AGI), the 
worksheet should direct the taxpayer to enter the smaller of 
the net earned income or the taxpayer's AGI, and then look up 
that smaller number in the table. The repetitive reference 
procedure is not necessary if the AGI is less than the 
beginning of the phase-out threshold. However, if that is the 
case, the taxpayer should be told to stop once the first credit 
amount is found in the table, before entering AGI and 
completing the rest of the worksheet meaninglessly.
      

                                

    Mr. Shaw. The hearing is now adjourned.
    [Whereupon, at 1:04 p.m., the hearing was adjourned.]
    [Submissions for the record follow:]


                                     Center For Law and    
                                             Human Services
                                                       May 23, 1997

A.L. Singleton
Chief of Staff
Ways and Means Committee
U.S. House of Representatives
1102 Longworth H.O.B.
Washington, D.C. 20515-6348

Re: 5/8/97 Hearing on IRS Study of Earned Income Tax Credit 
        Noncompliance

    Dear A.L. Singleton:

    I am writing on behalf of the Center for Law and Human Services, 
Inc. (CLHS) to offer comments and recommendations on the IRS Study of 
Earned Income Tax Credit Noncompliance and the Treasury Department 
legislative initiative.
    CLHS is a non-profit organization devoted to improving 
effectiveness of human service programs through legal research, 
training, technical assistance and advocacy. CLHS has a long history of 
involvement in tax issues affecting the working poor. In 1991 CLHS 
developed the Nation's only training package on tax benefits for foster 
and adoptive parents; since 1995 the organization has sponsored the Tax 
Counseling Project (TCP), one of the country's largest VITA projects. 
During the '97 filing season, TCP fielded 220 volunteers at ten sites 
across Illinois, and assisted more than 4,400 low income taxpayers.
    The Earned Income Tax Credit is a critical source of financial 
support for low income workers, and its importance is growing during 
implementation of welfare reform. The IRS study on noncompliance is an 
obvious source of concern for all taxpayers. Maintaining the continued 
integrity of EITC requires effective remedies that will reduce 
noncompliance to more reasonable levels while assuring eligible persons 
are able to claim the credit. Unfortunately, certain legislative 
remedies offered by the Department of Treasury will not achieve this 
result. The following are comments on Treasury Department proposals:
    Civil Sanctions. The recommendation that anyone fraudulently 
claiming EITC be ineligible for 10 years is a classic case of overkill. 
This sanction represents a civil penalty that could exceed $36,000 (A 
taxpayer who fraudulently claimed the maximum EITC benefit in the '97 
tax year, $3,648, would be subject to potential loss exceeding $36,000 
over 10 years, if the taxpayer qualified for maximum benefits in those 
years). While no one can argue that a fraudulent EITC claim should go 
unpunished, no documentation has been offered that the current civil 
and criminal sanctions are inadequate. Current law authorizes a civil 
penalty for fraud of 75% of the amount received. Therefore an 
individual who fraudulently claimed the maximum EITC benefit for the 
'97 tax year, $3,648, would be subject to an penalty of $2,736.
    The proposed sanction, two years ineligibility, for ``negligently'' 
claiming EITC represents a potential civil penalty of more than $7,200. 
Comparison to current civil penalties also raises troubling concerns 
about fairness. A taxpayer who ``negligently'' claimed an EITC refund 
of $3,648 for '97 tax year would be subject to a civil penalty of 20%, 
or $730. The proposed sanction potentially increases by penalty by a 
factor of 10. Moreover, to be effective, these penalties would have to 
be widely publicized. The resulting chilling effect will reduce the 
participation rate for taxpayers who are eligible for EITC.
    Verification. The most effective strategy involves prevention of 
EITCpayments to ineligible persons. The Treasury Department proposal 
regarding prior verification of claims is a step in the right 
direction, but it does not go far enough. This measure should not be 
limited to persons who have erroneously received EITC payments in a 
prior year. The IRS should utilize compliance data and verification of 
SSN's to flag categories of taxpayers with high risk of ineligibility, 
and require documentation for qualifying children and filing status 
prior to releasing refunds to these individuals. Careful attention 
needs to be given to assuring adequate procedural safeguards for 
taxpayers. The emphasis on ``mathematical errors'' as a basis for 
limiting safeguards is a cause for alarm if in fact the IRS makes a 
substantive decision on whether a taxpayer has adequately documented 
residence for a qualifying child.
    VITA. Expansion of Volunteer Income Tax Assistance programs is 
indeed part of the solution to the EITC noncompliance problem. However, 
the Treasury recommendations fail to address three major weaknesses in 
the current VITA structure. First, there is a complete absence of 
funding at the federal level to support VITA programs. Staff time is 
essential to recruit and screen volunteers; to establish, market and 
manage sites; and to supervise work of volunteers.
    A second limitation of the VITA programs is the narrow range of tax 
issues that they typically address. Almost all VITA programs decline to 
prepare prior year returns. Because the Tax Counseling Project in 
Illinois recruits accounting and tax professionals, that project has 
emphasized prior year returns, and about 15% of all federal returns we 
have completed are for prior years. Generally, VITA programs also 
decline to handle moderately complex returns, such as those involving 
self employment income. According to a SOI report for the '94 tax year, 
15% of EIC claimants had self employment income. Many cannot afford the 
$150 or more that a competent, professional preparer would charge for 
such a return.
    A third limitation of VITA programs is their seasonal nature. 
Virtually all operate only during the regular tax season. Given the 
likelihood of increasing correspondence between the IRS and EITC 
claimants, there is an additional need for year round VITA projects. 
The Tax Counseling Project, with support from area foundations, 
corporations, and the Illinois Department of Public Aid, maintains 
extended hours at four sites through June 30th, and we have two staff, 
an accountant and an attorney, available to assist taxpayers in 
responding to IRS correspondence throughout the year.
    A small (about $3 million) appropriation currently exists to 
support Tax Counseling for the Elderly, with most of that funding 
allocated to the American Association of Retired Persons. A similar 
appropriation should be made to support grass roots efforts directed at 
creating and expanding VITA programs. These funds could be tied to a 
condition that matching grants be obtained by local sponsors. It is 
worth noting that IRS officials have not welcomed this suggestion in 
prior years, on the ground that the Service is not a grant making 
institution, and no administrative funds were expected to be available. 
The IRS is not necessarily the only federal agency that could 
administer this funding stream. HHS could manage the funds, or a set 
aside in Community Development Block Grant might be an option.
    Levy on Welfare Benefits. The proposal to collect EITC over-
payments from welfare benefits is not a productive solution. In 
Illinois a mother with two children receives $377 per month in cash 
assistance and $315 in food stamp benefits. The total monthly income of 
$692 represents 62% of the federal poverty level. Reducing that family 
to 50% or less of the federal poverty level increases risk of harm to 
the children in the family, as well as risk of greater costs for child 
welfare and other services for the family.
    Foster Children. The proposed changes in the definition of foster 
children have not been directly tied to any compliance data. Currently 
a foster child is anyone that the taxpayer care for as if he/she were 
the taxpayer's own child and the child lives in the taxpayer's home for 
the entire year. The proposal to create a new relationship test is a 
substantial change that raises some concerns. It appears that many 
caretakers of extended family arrangements that are common in low 
income communities could lose EITC eligibility. For example, great 
grandchildren, great nieces and great nephews and cousins appear to 
lose qualifying child status. Also, the description is unclear about 
implications for disabled adults who are presently qualifying children.
    Finally, I want to make an urgent plea for more detailed 
information regarding the Noncompliance findings. I was pleased to read 
that Chairman Archer has requested that the Joint Committee on Taxation 
obtain underlying data and findings. I would urge that the Committee 
share with the public as much of this as is consistent with 
confidentiality protections.
    Thank you for the opportunity to make these comments and 
recommendations known to the members and staff of the Ways and Means 
Committee. I am looking forward to reviewing and commenting on any 
specific legislative language that may be introduced.

            Sincerely,
                                        Michael A. O'Connor
                                                 Executive Director

Enc.
    P.S. For your general information, and not necessarily for 
inclusion in the record of this hearing, I am forwarding copies of the 
most recent annual report for the Tax Counseling Project, as well as 
copies of a handbook on tax benefits for foster and adoptive parents 
produced by CLHS.
    [Attachments are being held in the Committee's files.]
      

                                

Statement of Community Tax Aid, Inc.

    These comments were prepared by Jeffrey S. Gold, JD, CPA, 
based on 28 years of volunteer work with low-income taxpayers. 
He is the founder and past chairman of Community Tax Aid, Inc. 
in New York City, the oldest public service group in 
accounting, which began in 1969, and co-founder and chairman of 
Community Tax Aid, Inc. in Washington, DC, which began in 1987. 
Both groups are all-volunteer and have never had paid staff. 
Mr. Gold served two years on IRS Commissioner Donald C. 
Alexander's advisory group and has testified before several 
Congressional committees on matters affecting low-income 
taxpayers.
    We are concerned that, while the Earned Income Credit (EIC) 
is being abused to the substantial tune of billions of dollars, 
several of the proposed remedies are overdone to the point of 
being draconian. With the 1993 expansion of the maximum credit 
the current abuses were all but predictable--it's almost as 
though the credit would be killed by kindness.
    From its start, the intent of the EIC was to provide relief 
to families with children. Yet, some of the proposals, if 
enacted, would harm these same children. The following 
discussion addresses each proposal separately.

                      1. Denying EIC Eligibility.

    In describing intentional abuses--as distinguished from 
errors (a 50-50 split according to Assistant Commissioner Ted 
Brown at the hearing)--nothing was said about the percentage 
attributed to tax-return preparers.
    The majority of low-income taxpayers--those eligible for 
the credit--have little education and below-average literacy 
skills. According to the United States Depart-ment of 
Education, in studies spanning almost 20 years, nearly half of 
the adults over age 17 in our country are either illiterate or 
functionally illiterate. This, say the studies, means that, for 
example, people have difficulty reading bus schedules or 
following recipes.
    Do we really expect them to understand tax-form 
instructions despite the best efforts of the very able people 
at the IRS forms and publications department to translate the 
tax laws passed by Congress into readable, usable forms and 
instructions? Even one half of the 300 IRS employees 
interviewed, noted a Ways and Means Committee member at the 
hearing, say that the EIC is a complex area.
    Most low-income individuals rely on help to have their tax 
returns prepared. They simply cannot stand or understand our 
system and when they err, no matter how innocently, they 
certainly cannot withstand IRS enforcement. When a preparer 
gives them a completed form, they sign it. They want a refund, 
often as a way to pay off Christmas bills or other consumer 
debt. Preparers know this and many take advantage.
    The commercial preparer system also works against the 
taxpayer much as the initial drop of a taxi meter. The hourly 
rate for getting in the paid preparer system, like the taxicab, 
is far higher than the rate for additional work beyond the 
basic form. Turnover is the key. Even well-intentioned 
preparers may not take all the time needed to get all the 
details needed to cope with the complex rules.
    When proposing a denial of the credit, whether for two 
years or ten, the Office of Tax Analysis (OTA) options of April 
21, do not indicate whether preparer error or fraud will be 
attributed to the taxpayer who signs the tax return. After all, 
the taxpayer ultimately is responsible for everything on it. 
The proposals also do not indicate who will determine what is 
``reckless or intentional disregard of rules or regulations'' 
and what standards will apply. This could well vary from IRS 
district to IRS district as well as from agent to agent.
    When due to fraud, denial of the credit for ten years would 
affect the child for about half of the time he or she would be 
a qualifying child. It would deny the substantial benefits to a 
family likely already at or below the poverty line. Sub-
sistence would have to come from another pocket, whether 
government or charitable, and would likely harm the child.
    If draconian measures must be invoked, let the burden fall 
on those who take advantage of both the taxpayer and the tax 
system. To suggest, as do the OTA proposals, that the severe 
taxpayer penalties would be ``subject to review by the 
courts,'' ignores the reality that ``most of them [the American 
poor] have been poor so long and have such a feeling of 
hopelessness about the enterprise of life that it is not in 
character for them to be aggressive, to assert claims, or to 
find ways to solve their problems within the framework of 
society's laws.''--Monrad G. Paulsen in The Expanding Horizons 
of Legal Services.
    The proposed severe penalties also ignore the prohibitive 
cost--in dollars and in time-- of seeking relief through the 
courts. This ``remedy'' would not be a remedy at all.

   2. Recertification Required for Taxpayers Ineligible for the EIC.

    This proposal seems reasonable. But it does transfer a 
substantial part of the cost of not being able to understand 
the complex system from the government that enacted it, and the 
agency that administers it, to the low-income people affected 
by it--those least able to afford it. Nowhere in the proposal 
is the estimated cost to the IRS of recertification.
    As costly as the deficiency procedures are to the IRS, 
allowing taxpayers only 60 days to respond is demanding. As 
noted earlier, the vast majority of the people affected have 
low literacy skills. Too often they are coping with day-to-day 
existence and even a letter from the IRS, as feared as the 
agency might be viewed, might not be opened when a more 
pressing matter exists.
    Compare this with taxpayers who have access to, and can 
afford, lawyers, accountants and lobbyists to argue their case. 
From the May 14, 1997 Wall Street Journal Tax Column:
    ``Pressure grows on the IRS to waive penalties for some 
businesses [about the new law requiring electronic deposits of 
federal payroll taxes as of July 1] * * * . Lobbyists fear the 
electronic federal-tax payment system won't be running smoothly 
enough by then--and that unsuspecting companies may get hit 
with stiff IRS penalties.''
    Compare this also with the user fees--in addition to 
interest and penalties--imposed on taxpayers applying for 
installment agreements. This fee was imposed two years ago to 
make up a budget shortfall first imposed on the IRS by Congress 
although it was rather clear to the IRS that the amounts owed 
by about 95 percent of the delinquents applied to unsuspecting 
individuals--people improperly treated as independent 
contractors, recipients of unemployment compensation [a 
withholding option has been in place since 1/1/97], and working 
couples who did not understand withholding and both parents 
claimed their children.
    Only three people testified at the IRS hearings against 
this penalty and a few IRS employees were brave enough to go on 
the record against it. The $43 fee, wrote one, may be the cost 
of lunch in Washington but to us it's real money. To someone 
earning $6 an hour--more than 25 percent higher than the 
current $4.75 minimum hourly wage--the $43 is about a full 
day's net income after social security taxes. For future 
action, the IRS needs to be funded so it can end this fee.

       3. Improve Debt Collection and Extend IRS Continuous Levy.

    This is another proposal that seems draconian. The 
resources that would be levied typically are those of families 
already on the edge, or below the edge, of poverty. The penalty 
ultimately would be paid by the children.

           4. Due Diligence Requirements for Paid Preparers.

    This proposal is sound. The statement that about half of 
EIC claimants use a paid preparer to complete their income tax 
returns apparently includes only those who sign the returns. 
Consider also that many preparers do not sign returns and that 
many returns are prepared by unpaid relatives or friends who 
cannot cope with the complexities of the law. The proposals do 
not affect these unpaid preparers, apparently preferring 
instead to ``motivate'' the taxpayer by seeking out a paid 
preparer--regardless of the reality that a preparation fee is 
not in the taxpayer's budget.

             5. Simplification of Foster Child Definition.

    This may be simplification for the IRS but the severe 
restriction in the definition denies the reality of caring, 
extended families. We have seen enough great nieces, great 
nephews and cousins fit within the ``qualifying child'' 
definition after their parents or grandparents were unable to 
care for them. In passing, it is worth noting that in the early 
1980s grandchildren were not deemed eligible for the EIC by the 
IRS until CTA pointed out that the statute and the committee 
reports both supported this construction. Needless to say, what 
low-income taxpayer could have afforded the services of a tax 
professional to challenge the original IRS interpretation?

               6. Advance Payment Demonstration Projects.

    As noted in item (1), many EIC recipients use the sizable 
credit to help pay their debts, which is one likely reason why 
the advance payment system has not succeeded after several 
years of trying. Another is fear and mistrust of the IRS and 
``the system'' in general.
    Despite the billions of dollars of fraud in claiming the 
EIC, the vast majority of recipients are honest and need this 
financial boost. Consider that if the taxpayer were later found 
ineligible for a credit already received--and spent--where 
would the money come from to repay the amount, plus interest, 
plus penalties to the IRS?
    We agree that it would be more prudent to manage a large 
amount of money by receiving it throughout the year. But nearly 
all EIC recipients do not have even rudimentary money 
management skills and do not agree. For a Congress that has 
made much of letting the market decide, why are we continuing 
to spend more money on this? It would seem better to allocate 
the money to other projects.

          7. Continue Aggressive Action to Prevent EIC Errors.

    In pursuing EIC errors it is regrettable that as many as 
550 full-time equivalent positions are needed. The proposal, 
however, does not indicate how many of these are additional 
resources. Nor does it account for needless pursuit of 
taxpayers who have proved eligibility for themselves or their 
qualifying child(ren) in the past.
    For example, one CTA client, a single parent, had two 
qualifying children for 1994. One had a social security number 
(SSN) but the other did not and it was taking their lawyer 
longer than expected to secure it. This was before SSNs were 
required for the EIC. Not only did the Philadelphia Service 
Center hold the portion of the credit that applied to the child 
without the SSN, it held the entire credit and the amount of 
over withheld income tax and issued a deficiency notice.
    We mailed the information the Service Center asked for, 
including copies of school records with the child's address so 
it was clearly the same as the parent's. Only a few days before 
the 90-day letter expired and as we were about to file a 
protective claim with the Tax Court, the refund arrived.
    For 1995, it was surprising to have the IRS tackle the same 
issue the same way. The refund did not arrive and our volunteer 
attorney did file a claim with the Tax Court. After a meeting 
with District Counsel, the matter was stipulated in the 
client's favor. But it took many months for the more-than-
$2,000 refund check to be issued-- truly a hardship for a 
three-person family with an income of less than $14,000.

               8. Improve Access to Taxpayer Assistance.

    CTA began in the same year as VITA and maintains contact 
with VITA although we are not a VITA program since our CPA and 
attorney volunteers represent clients at audits and, in a few 
cases, at Tax Court. As long as a client's income is within our 
limits--$18,000 for individuals and $25,000 for families for 
1996--we also handle such situations as prior-year returns, 
Schedule C (self-employed) and nonresident aliens, including 
those that require reference to tax treaties.
    VITA--and taxpayer service--does need to be encouraged with 
more resources, particularly within the IRS budget. But, VITA 
is, at best, a band-aid solution to an increasingly complex 
problem.
    The most important suggestion to improve compliance is to 
slow down the frequency of tax law changes. Give people a 
chance to become familiar with the forms, the instruc-tions and 
the law. With twelve changes in the EIC alone since it was 
enacted in 1975, the burden on those it is intended to benefit 
is too great.
    [Attachments are being held in the Committee's files.]
      

                                

Statement of Nina E. Olson, Executive Director, Community Tax Law 
Project

    Thank you, Mr. Chairman and members of the Committee, for 
providing the opportunity for comment upon the matter of Earned 
Income Tax Credit compliance. I am writing as the Executive 
Director of The Community Tax Law Project (CTLP), a 501(c)(3) 
organization providing pro bono legal representation to low 
income Virginia residents in tax disputes. CTLP provides this 
representation through a panel of volunteer attorneys (and 
accountants) and an in-house staff attorney.
    The Community Tax Law Project receives referrals form local 
social service agencies, legal aid societies, homeless 
shelters, churches, agencies on aging and other community 
service organizations throughout Virginia. In January, 1996, 
CTLP entered into an agreement with the United States Tax Court 
whereby letters advising pro se petitioners about our services 
are included in trial notices for the Richmond and Roanoke Tax 
Court calendars.
    As CTLP's executive director and staff attorney, I have 
gained some insight into the difficulties experienced by 
taxpayers claiming the Earned Income Tax Credit (EITC), head-
of-household status and dependency exemptions. While I do not 
deny that there is an element of fraud among EITC claims, based 
on my professional experience, I believe that the majority of 
EITC errors are not attributable to fraud or neglect but simply 
to a reasonable misunderstanding of a very complex statute as 
well as to that statute's counter-intuitive interaction with 
other provisions such as the dependency exemption rules.
    In this statement today, I will limit my remarks to the 
procedural and administrative implications of the IRS 1994 EITC 
Compliance Study. At the outset, it is interesting to note that 
the study itself does not identify what percentage of 
overclaims are attributable to fraud (as opposed to error) nor 
does it identify what category of household is responsible for 
the most overclaims. We are not told of the reasons for the 
errors. For example, did many people claim children in multi-
generational households, where the person with the highest 
income is the only taxpayer entitled to claim the credit? This 
rule is an obscure, complicated requirement and conducive to 
honest mistakes. With over 50% of EITC returns prepared by tax 
return preparers, shouldn't we know how many of the errors 
occurred on such returns? Without this information, the 
Administration's proposals for 10-year and 2-year EITC 
restrictions appear heavy-handed. The Internal Revenue Code 
contains ample provisions for prosecuting taxpayer fraud; any 
``automatic'' fraud penalties will lead to greater taxpayer 
alienation and noncompliance. Further inquiry may confirm that 
compliance efforts should focus on preparers rather than on the 
taxpayers themselves.
    During the last two weeks of this year's tax filing system, 
my organization received five calls from taxpayers who were 
denied electronic refunds because someone else claimed their 
children as dependents and as qualifying children for EITC 
purposes. Based on these interviews, CTLP determined that these 
callers were in fact entitled to the EITC, but that the 
noncustodial parent of the children managed to file 
electronically and claim the children first. The taxpayers were 
advised to send their return to the Service by mail with 
supporting documentation and a cover letter explaining the 
circumstances. We all know this issue will take months to 
resolve during which the eligible household will not receive 
the intended benefit of the EITC. Further, it highly likely 
that the government will never recover the EITC erroneously 
paid to first filer.
    Of the last year's United States Tax Court dockets in 
Richmond and Roanoke, Virginia, I personally entered an 
appearance in or otherwise directly counselled five cases in 
which the EITC was at issue. Each of these cases were resolved 
in favor of the taxpayer. Somehow they made it through all IRS 
administrative review levels without an accurate ruling on 
their eligibility. On the collection side I see numerous pre-
1994 cases of people who are denied the EITC. Some are 
eligible, some are ineligible. All of the ineligible cases are 
the result of inadvertent error or reasonable mistake. As the 
Treasury report shows, approximately 88% of 1994 EITC 
recipients had adjusted gross income of under $20,000. The 
ineligible taxpayers will most likely be placed in ``currently 
not collectible'' collection status; their credit will be 
permanently damaged as a result of the filing of a federal tax 
lien. Surely this is not the intended result of this benefit 
program.
    There are many sources of taxpayer confusion, but one 
stands out above the rest. With increased child support 
enforcement measures, many non-custodial parents in this income 
category are now paying support for their children. Because of 
the confusion between the dependency exemption ``support'' 
requirement and the EITC ``residence/maintaining household'' 
requirements, it is understandable (and predictable) that 
errors occur. A major source of the problem rests with return 
preparers who fail to adequately question their clients as to 
the circumstances surrounding the dependent/EITC claims. Many 
preparers receive referrals from taxpayers who receive large 
refunds and thus have an incentive to not question clients too 
closely. A few preparers are downright unscrupulous and 
criminal; we should remember that while the government is 
injured by these people, it is the taxpayer/client who is the 
true victim here.
    Imagine a preparer dialogue with a client who is a 
noncustodial parent paying child support.
    Preparer: Do you have children?
    Taxpayer: Yes.
    Preparer: Do you support your children?
    Taxpayer: Yes.
    Neither of these answers are false statements. If the 
preparer fills out a tax return claiming dependency exemptions 
and the EITC, where is the taxpayer fraud in this return? The 
taxpayer is relying on a paid professional to correctly prepare 
his return. And yet, the taxpayer is the one who will have the 
full weight of the IRS collections efforts thrown upon him.
    Last week, I received a phone call from an attorney on the 
Eastern Shore of Virginia. This attorney's client is a legal 
resident alien who supports his children living in Mexico. He 
is entitled to a dependency exemption for these children. The 
client had his return prepared by someone who set up shop in 
the community of migrant workers. The client told the preparer 
about his children and also told the preparer that he had heard 
from fellow workers that he could not claim the EITC because 
his children lived in Mexico. The preparer told him ``not to 
worry, it was all right'' to claim the EITC and prepared the 
return accordingly. The client filed the return as prepared but 
became worried and contacted the attorney. The preparer had not 
signed the return as required.
    The manner in which the Service attempts to determine the 
legitimacy of dependent and EITC claims is also fraught with 
problems. Although the notices requesting additional 
information list a few examples of documentation which can 
support the deduction, there is no clear, easy-to-read 
explanation of the support requirement for dependents or the 
``maintaining a household'' requirement for qualifying child 
included in the notice. Since so many returns are 
professionally prepared, the IRS letter may be the first 
occasion the taxpayer has actually learned the legal 
requirements for the dependency exemption or the EITC. It is 
unreasonable to expect a surprised, upset, and intimidated 
taxpayer to adequately represent him-or herself before 
overworked and hurried Service employees, especially where the 
taxpayer has no idea of what he or she needs to prove.
    Today I received a call from a woman who claimed her 
deceased sister's children as dependents and qualifying 
children. They were living with her during the tax years under 
audit. The children each received social security as minor 
dependent children. During the office audit, the agent never 
explained to the taxpayer that she had to prove that she 
contributed more than the social security received by the 
children. When the taxpayer offered evidence of her purchase of 
a car for her 16-year old nephew, the agent called her a 
``liar'' and told the taxpayer that with her income no bank 
would ever loan her money. (This despite the loan documents and 
payment book offered as proof.) This same agent asked the 
taxpayer how much her niece spent on sanitary napkins. The 
taxpayer told me that she never imagined she would have to 
justify to her government the cost of feminine hygiene. Such 
taxpayer contacts are not conducive to taxpayer compliance. Nor 
do they help discover the truth about the entitlement to 
deductions and credits. They only make the taxpayer defensive. 
Needless to say, we are appealing the revenue agent's report.
    It is highly likely that EITC and dependency exemption 
errors occur most frequently in divided households. We must 
remember that among the lower middle class and the working 
poor, many do not have the benefit of counsel at the time of 
separation or divorce. Divided families in the middle and upper 
classes often work out such issues as dependency and custody 
during a separation or property settlement agreement and are 
instructed by counsel as to the rules for claiming the 
dependent care credit, head of household status and the like. 
Because the dependency exemption is a bargaining chip in many 
divorce/separation proceedings, people are more aware of the 
rules and the parties reach an informed agreement. These 
taxpayers are not relying on IRS brochures for their tax 
information--they rely on their counsel or their tax advisors. 
In effect, the Treasury's proposed EITC compliance measures 
would punish people because they cannot afford counsel or other 
professional advice.
    As stated earlier, I believe that the Code today contains 
sufficient penalties to punish fraud. My concern is that with 
the compliance measures suggested by Treasury we will rope in 
people who have not committed fraud or negligence but who 
simply cannot represent themselves adequately before the 
Internal Revenue Service. We will lose people to the 
underground cash economy and further alienate people from their 
government. These measures will undermine the increased 
compliance efforts that my organization and others like it are 
trying so hard to accomplish.
    How can we solve these problems? How can we get at the 
cause of error in EITC reporting and the related problems with 
multiple claiming of dependents and household status? Certainly 
the Administration's proposals to make the dependent and 
qualifying child tests more congruent will reduce inadvertent 
mistakes. Better publicity and readable explanations of current 
law will also help. (CTLP targets all of its materials to a 
second grade and fifth grade reading level.) The following 
suggestions will also have a positive impact on the error rate 
as well as targeting unscrupulous preparers.
     When the Service sends a taxpayer a request for 
additional information about his/her entitlement to the 
dependency exemption or EITC, it should include a graphically 
attractive, easy-to-read, simple brochure describing the 
dependent/EITC requirements and listing examples of 
documentation that might prove these requirements. A computer-
generated letter just doesn't cut it. The information form 
should be designed with input from nonprofit tax groups who 
actually serve the target taxpayer population, including groups 
working with newcomers to the United States.
     Even the most honest and careful return preparer 
will forget on occasion to ask if a taxpayer has custody of his 
children or provides the majority support for the child. 
Certain unscrupulous preparers enhance their business by 
purposely failing to ask these questions. A professionally 
prepared return should include a certification by the preparer 
and the taxpayer, under penalties of perjury, that the preparer 
has asked a series of questions, listed on the form, designed 
to avoid the most common errors. Failure to include this 
certification in the return will result in a penalty against 
the preparer (unless the preparer can show that he gave the 
form to the taxpayer and the taxpayer did not include it with 
the return).
    This form will not only deter certain ``preparers'' from 
committing fraud but it will also help honest taxpayers 
accurately prepare returns. The minor inconvenience of handling 
another form is outweighed by the increased accuracy of returns 
and decrease in erroneous refund payments.
     As a matter of course, the Service should delay 
sending EITC refunds to taxpayers until June 1 of each year. 
Prior to June 1, the Service can match all social security 
numbers for dependent/EITC duplicates. If any matches arise, 
the Service should send a notice to both taxpayers listing the 
social security number. This notice will request information 
and include the graphic brochure outlining the law and 
providing examples of documentation. Proof should be required 
from any taxpayer claiming a duplicate SSN/qualifying child, 
regardless of who files first.
    While this delay may have a negative impact on the 
electronic filing rate, it is my perception that electronic 
filing enables much of the EITC compliance problem (i.e., first 
come, first served, even if fraudulent). After the first year's 
shock at the delay, there will be no economic disadvantage to 
taxpayers--they will receive their EITC refund the same time 
each subsequent year.
     Where the ``delayed refund'' procedure flags 
returns and taxpayers do not respond, the Service can deny the 
EITC and flag the taxpayer's account. A legible notice should 
be sent to the taxpayer explaining the refund procedures for 
claiming the denied EITC. (Again, this notice should be 
designed with advice from taxpayer service groups.) If the 
taxpayer claims the EITC in a subsequent year, the claim can be 
checked by the customary questionnaire; if it is determined 
that the taxpayer has acted negligently or in reckless 
disregard of the tax laws in the subsequent year, the civil 
fraud penalty (where applicable) or a new fine could be levied, 
designed to cover the administrative cost of compliance 
checking.
     The Service should ``promote'' qualified nonprofit 
taxpayer assistance groups which provide taxpayers with pro 
bono representation. Taxpayers represented by trained 
professionals always fare better than pro se taxpayers. These 
organizations have greater credibility with taxpayers than does 
the Service and they can often place the taxpayer on the road 
to continued compliance. Inserts like those utilized in Tax 
Court trial notices and posters at IRS walk-in offices are 
simple promotional devices that do not require IRS personnel to 
unnecessarily inquire into a taxpayer's financial 
circumstances.
    Although all of these methods put some burden on the 
Service to accomplish some fact-finding, it is the least we can 
offer our lower income taxpayers. Our first goal should be 
continued compliance. Punishment is necessary only in the 
egregious cases.
    Ultimately, the manner in which Congress and the Service 
addresses EITC fraud is a taxpayer fairness and access to 
justice issue. If we decide to deal harshly and automatically 
with underrepresented taxpayers, let no one be surprised at the 
lack of compliance in other tax responsibilities or of respect 
for government's functions. Low income taxpayers, i.e., the 
EITC population, must be granted respect and due process within 
the tax system. The EITC program can be altered to provide law-
abiding low income taxpayers with information and assistance, 
under the assumption that they intend to comply with the law. 
Until Congress and the Service do a better job at simplifying 
these complex provisions of law, taxpayers should not be 
faulted or unduly punished for being confused.
    The Earned Income Tax Credit is a valuable work incentive 
that is directly delivered to taxpayers without government 
intervention. Given the complexity of its requirements, 
additional error checking devices should be established. These 
measures must be designed with the characteristics of the EITC 
population in mind--they should not be unduly harsh but instead 
distinguish between reasonable error on the one hand and fraud 
and negligence on the other.
    Thank you for your interest and attention to these matters 
impacting low income taxpayers. I would be happy to answer 
questions you might have about EITC compliance and proposed 
reforms.
      

                                

Statement of Judy VandeZandschulp, EA, President, Iowa Society of 
Enrolled Agents on behalf of the National Association of Enrolled 
Agents

    Mr. Chairman and members of the Ways & Means Committee, my 
name is Judy VandeZandschulp, EA. I am an Enrolled Agent in 
private practice in Sioux City, Iowa. I am submitting these 
written comment on behalf of the more than 9,500 members of the 
National Association of Enrolled Agents.
    As you know, Enrolled Agents are licensed by the Treasury 
to represent taxpayers before the Internal Revenue Service. 
Enrolled Agents were created by legislation signed into law by 
President Chester Arthur in 1884 to remedy problems arising 
from claims brought to the Treasury after the Civil War. We 
represent taxpayers at all administrative levels of the IRS. 
Since we collectively work with millions of taxpayers and small 
businesses each year, Enrolled Agents are truly at the front 
lines of tax administration.

               Problems with the Earned Income Tax Credit

    I would like to make three points with respect to the 
Earned Income Tax Credit.
    First and foremost, the concept and theory behind the EITC 
is essentially sound. The idea, that we as a nation wish to 
help low-income individuals who have children living with them 
and who are working, is definitely worthwhile and deserving of 
our support. By providing the Earned Income Tax Credit, which 
offsets part of the cost of Social Security taxes, we are 
aiding those families by supplementing their income. Often it 
makes the difference in whether those families need welfare 
assistance.
    Second, the Earned Income Tax Credit, as it is written and 
administered today, is unfair in how it is calculated. Let me 
provide you with some very typical examples: Take two single 
women, each with one child. Both women earn $12,000 in wages 
from their jobs. One woman receives $1,000 a month in tax-free 
child support, and the other woman receives none, yet they both 
receive the same amount of earned income credit. A similar 
situation takes place with respect to Aid to Families with 
Dependent Children (AFDC) and Supplemental Security Income 
(SSI) payments which are also not considered when computing the 
Earned Income Tax Credit. All untaxed income, including child 
support, AFDC, or SSI payments, should be considered in 
arriving at the Earned Income Tax Credit. Another problem 
occurs when couples live together or any other adult earning 
incomes lives with the candidate for the EITC. Consider the 
situation where parents allow their unmarried daughter with 
children to live with them and then claim they charge her rent 
in an effort to make their daughter eligible for head of 
household status and the EITC.
    Third, we are undermining marriage and family formation 
with our tax policy. If I may provide you with another very 
typical example: A single woman with one child makes $15,000 
per year and lives with her boyfriend who also makes $15,000 
per year. Together, their income exceeds the threshold for the 
EITC. However, as long as the woman can claim that she is 
paying the costs of the household, she is eligible for the EITC 
(based on her income alone). If she and her boyfriend marry, 
their dual income exceeds the threshold for the EITC. She will 
lose her head of household status and the EITC, and they will 
pay substantially more in income taxes. I have attached a 
spreadsheet to demonstrate precisely this situation. My 
colleagues and I see many taxpayers coming in with this sort of 
living arrangement. Many couples do not marry rather than lose 
their tax benefits. Our system actually encourages them to live 
together rather than marry.

                            Recommendations

    We would like to offer several suggestions for ways in 
which the Earned Income Tax Credit can be reworked and 
improved. We would note that there is always tension between 
simplicity and fairness. Often, to achieve fairness, some 
amount of complexity must be accepted. In this instance, we 
believe a little more complexity is needed so that fairness may 
be achieved.
    1. The Earned Income Tax Credit should not be received with 
the income tax refund. It should be calculated and handled much 
like the way Minnesota used to do its property tax credit. An 
additional form, much like the 1040X (amended tax return), 
needs to be created. The form needs to be totally separate from 
the tax return and needs to be signed by the taxpayer. On the 
original tax return, taxpayers would only be able to receive 
their overwithholding of federal income taxes as a tax refund.
    2. The EITC form should be filed at the same time as the 
tax return, but the credit should not be paid out until after 
the filing season has passed. Congress could select a date--
perhaps August 31--at which time all EITC refunds would be 
mailed out.
    3. The EITC form should be revised to include a thorough 
determination of the taxpayer's eligibility. The definition of 
head of household should be clarified, or eliminated, to 
equalize the single and married statuses. Two single people in 
the same household should equal a married household status, a 
dependency exemption could only be used on one return, just as 
it is now.
    The EITC form should contain a series of questions to 
determine eligibility for the credit. The form could ask 
questions such as:
    (A) How long have you resided at your current address?
    (B) Do your children reside with you all year, part of the 
year?
    (C) If your children did not reside with you all year, 
please provide names, addresses and social security numbers of 
any other parties they lived with.
    (D) Do you receive child support, Aid to Families with 
Dependent Children (AFDC), Supplemental Security Income (SSI)? 
How much do you receive from each?
    (E) Are you responsible for all the costs of the household 
in which you and your children live?
    (F) Do any other adults reside at your address at any part 
of the year? If so, please provide their names, social security 
numbers, and any other addresses they may have had this year. 
Also, please provide income information on the other adults who 
have resided with you for any part of the year.
    The list of questions should be long enough and detailed 
enough to address the real issues surrounding EITC eligibility. 
If done correctly, the individual who is answering these 
questions will come to understand the basis for this 
eligibility and will be less likely to enter a false claim for 
the EITC.
    4. Slow down the refund and do not make it part of 
electronic filing. The abuse is so significant in part because 
of how fast and easy it is to receive the money and in part 
because of how simple the current EITC form is to add to the 
tax return.
    5. Mailing the refunds after tax season would allow the IRS 
the opportunity to verify the information.
    6. Finally, IRS would need to educate the public on the 
changes and why they are necessary.

                      Penalties for Tax Preparers

    The U.S. Department of the Treasury has recently proposed 
initiatives to curb abuses of the EITC. One proposal would levy 
stiff penalties on preparers who do not use ``due diligence.'' 
We would comment that policing the Earned Income Tax Credit 
should not be solely the responsibility of the practitioners. 
Most practitioners strive to provide accurate tax returns. If 
we see the same clients each year, we know their circumstances 
with a fair degree of certainty. However, in the case of new 
clients, we often must take their word for their situation. We 
would therefore suggest that IRS provide some definition of 
``due diligence'' with perhaps a checklist or guidelines and 
that taxpayers be held accountable for the information they 
provide to the preparer, perhaps through the revised EITC form 
as suggested above, which the taxpayer would sign. These steps 
would go a long way toward helping both taxpayers and 
practitioners in understanding and achieving accuracy in 
determination of EITC eligibility.

                               Conclusion

    As Enrolled Agents who are actively participating in 
administering our nation's tax laws, we are very pleased to 
have this opportunity to share our views with the Committee. We 
hope that our recommendations will be seriously studied in 
order to assure the continuation of the Earned Income Tax 
Credit and the confidence of the American taxpayer in the 
fairness of our tax system.