[House Hearing, 110 Congress]
[From the U.S. Government Publishing Office]


 
                          IRS AND THE TAX GAP 

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

                                HEARING

                               before the

                        COMMITTEE ON THE BUDGET
                        HOUSE OF REPRESENTATIVES

                       ONE HUNDRED TENTH CONGRESS

                             FIRST SESSION

                               __________

           HEARING HELD IN WASHINGTON, DC, FEBRUARY 16, 2007

                               __________

                            Serial No. 110-9

                               __________

           Printed for the use of the Committee on the Budget


                       Available on the Internet:
       http://www.gpoaccess.gov/congress/house/budget/index.html

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                        COMMITTEE ON THE BUDGET

             JOHN M. SPRATT, Jr., South Carolina, Chairman
ROSA L. DeLAURO, Connecticut,        PAUL RYAN, Wisconsin,
CHET EDWARDS, Texas                    Ranking Minority Member
JIM COOPER, Tennessee                J. GRESHAM BARRETT, South Carolina
THOMAS H. ALLEN, Maine               JO BONNER, Alabama
ALLYSON Y. SCHWARTZ, Pennsylvania    SCOTT GARRETT, New Jersey
MARCY KAPTUR, Ohio                   THADDEUS G. McCOTTER, Michigan
XAVIER BECERRA, California           MARIO DIAZ-BALART, Florida
LLOYD DOGGETT, Texas                 JEB HENSARLING, Texas
EARL BLUMENAUER, Oregon              DANIEL E. LUNGREN, California
MARION BERRY, Arkansas               MICHAEL K. SIMPSON, Idaho
ALLEN BOYD, Florida                  PATRICK T. McHENRY, North Carolina
JAMES P. McGOVERN, Massachusetts     CONNIE MACK, Florida
BETTY SUTTON, Ohio                   K. MICHAEL CONAWAY, Texas
ROBERT E. ANDREWS, New Jersey        JOHN CAMPBELL, California
ROBERT C. ``BOBBY'' SCOTT, Virginia  PATRICK J. TIBERI, Ohio
BOB ETHERIDGE, North Carolina        JON C. PORTER, Nevada
DARLENE HOOLEY, Oregon               RODNEY ALEXANDER, Louisiana
BRIAN BAIRD, Washington              ADRIAN SMITH, Nebraska
DENNIS MOORE, Kansas
TIMOTHY H. BISHOP, New York
[Vacancy]

                           Professional Staff

            Thomas S. Kahn, Staff Director and Chief Counsel
                James T. Bates, Minority Chief of Staff
















                            C O N T E N T S

                                                                   Page
Hearing held in Washington, DC, February 16, 2007................     1
Statement of:
    Hon. John M. Spratt, Jr., Chairman, House Committee on the 
      Budget.....................................................     1
    Hon. Paul Ryan, a Representative in Congress from the State 
      of Wisconsin...............................................     2
    Mark Everson, Commissioner, Internal Revenue Service.........     4
        Prepared statement of....................................     5
        Response to question posed by Mr. Ryan...................    23
        Response to question posed by Mr. Andrews................    40
    Hon. J. Russell George, Inspector General for Tax 
      Administration, U.S. Department of the Treasury............    49
        Prepared statement of....................................    51
    Nina E. Olson, National Taxpayer Advocate, Internal Revenue 
      Service....................................................    65
        Prepared statement of....................................    66
    Michael Brostek, Director, Tax Issues, Strategic Issues Team, 
      U.S. Government Accountability Office......................    83
        Prepared statement of....................................    85
    Chris Edwards, director of tax policy studies, Cato Institute   109
        Prepared statement of....................................   111


                          IRS AND THE TAX GAP

                              ----------                              


                       FRIDAY, FEBRUARY 16, 2007

                          House of Representatives,
                                   Committee on the Budget,
                                                    Washington, DC.
    The committee met, pursuant to call, at 10:05 a.m. in room 
210, Cannon House Office Building, Hon. John Spratt [chairman 
of the committee] presiding.
    Present: Representatives Spratt, Cooper, Schwartz, Kaptur, 
Becerra, Doggett, Blumenauer, Berry, Boyd, McGovern, Sutton, 
Andrews, Scott, Etheridge, Hooley, Moore, Bishop, Ryan, 
Barrett, Garrett, Hensarling, Conaway, Campbell, Tiberi, 
Porter, Alexander, and Smith.
    Chairman Spratt. Good morning. I will call this hearing to 
order. I am pleased to open today's hearing on the IRS and tax 
gap.
    I welcome our panel of witnesses: Mark Everson, 
Commissioner of the Internal Revenue Service; Treasury 
Inspector General for the Tax Administration, Russell George; 
GAO's Director for Tax Issues, Michael Brostek; the National 
Taxpayer Advocate, Nina Olson; and the Director of Tax Policy 
Studies at the Cato Institute, Chris Edwards.
    We will first hear from the Commissioner of the Internal 
Revenue Service Mr. Everson, and then we will turn to the other 
witnesses for a second panel after questions of Mr. Everson.
    Given our committee's jurisdiction and our commitment to 
getting the country's fiscal house back in order, our focus 
today will be on the so-called ``tax gap.'' the tax gap is the 
difference between taxes legally owed and taxes actually 
collected. The Internal Revenue Service has developed a recent 
estimate of the size of our tax gap, the most recent being 
2001, which was $345 billion, a sizable sum, and that was 6 
years ago. The gap has, in all likelihood, grown even larger by 
now, but even that tax gap from 6 years ago is $1 billion more 
than last year's unified budget deficit, which was $248 
billion.
    This suggests that, if we can only do a better job of 
collecting taxes that are already current policy, already in 
the current Tax Code, our fiscal situation could be 
substantially better. The persistence of the tax gap means that 
we have larger deficits than we would otherwise rack up and a 
growing legacy of debt for our children and grandchildren. 
Saddling future generations with this huge mountain of debt is 
not just a budgetary problem, but it raises fundamental issues 
of moral fairness.
    There is another issue of fairness at work here as well. 
The tax gap is unfair to the scrupulous taxpayers, the vast 
majority who end up having to pay more in taxes because of 
those who do not pay what they obviously owe in taxes. So, as 
we try to get the budget back on the right track, for the sake 
of both fairness and practicality, a good place to look and 
look carefully is the tax gap and what we can do to collect 
better what is already owed the United States Government. That 
is why we have assembled this group of witnesses today to help 
us understand more about how we can narrow this tax gap and 
reap the benefits.
    I look forward to the witnesses' testimony. As I said, we 
will first hear from IRS Commissioner Everson and then 
entertain questions for him, and once those questions are 
completed, we will call up our second panel. But before turning 
to the Commissioner, let me turn to our Ranking Member Mr. Ryan 
for his opening statement.
    Mr. Ryan. I thank the Chairman, and I am excited that we 
are having this hearing today because this is an issue that we 
are going to be talking about quite a bit in the days to come 
as we assemble our budget. We are talking about this over on 
the Ways and Means Committee as well, and as you can see, 
Commissioner, there is a lot of Member interest here.
    First, I think it is important to note that the pro-growth 
tax policy and the tax relief that we have passed have helped 
to significantly increase the revenues that are now coming into 
the Federal Government. In fact, we have seen double-digit 
revenue growth for 2 consecutive years, the first time that 
this has happened since the 1980s, and again, through the first 
4 months of fiscal year 2007, revenues are coming in at a rate 
of 9.8 percent over last year. So right along with our economy, 
revenues are continuing to grow at a robust rate.
    Clearly our budget challenges are on the spending side 
rather than on the revenue side, but I understand that we are 
here to talk today about how we might close the so-called ``tax 
gap'' or the difference between the amount of taxes owed and 
the amount actually collected to get even more revenue. This 
tax gap has proven extremely difficult to define. I have spent 
the last 6 years on the Ways and Means Committee looking at 
this issue, and it is tougher than it first seems. We are never 
really sure how big it is, and we really do not know whether 
closing it would actually bring in much additional revenue, but 
beyond that, we have got to ask ourselves whether or not it is 
worth it to significantly increase enforcement and to try and 
get after what we are calling the ``tax gap'' because this 
could come with considerable costs.
    Back in the mid-1990s, you remember the hearings that were 
occurring here at the time. Congress saw a parade of taxpayers 
complaining about how IRS enforcement tactics were violating 
their rights. To relieve this, Congress passed the IRS 
Restructuring and Reform Act. The IRS has come a long way since 
that time, and IRS Commissioner Everson is really to be 
commended for that progress. They have done a great job of 
developing a very respectful relationship with the American 
people, and clearly that is something I would imagine Members 
on both sides of the aisle would want to preserve and see 
continue. So I think we need to be extremely careful that we do 
not reverse that progress and force the IRS back into the time 
when the American taxpayers consider compliant enforcement 
methods an actual threat.
    Furthermore, I think there is great danger that if we 
significantly increase enforcement and paperwork requirements 
to try and close this gap, we could be placing a larger burden 
on those who can afford it least, on the individuals in our 
small businesses who are struggling to compete in the global 
marketplace.
    Finally, I think it is also important to note that, while 
we have very limited data on the so-called ``tax gap,'' we do 
know that more than 80 percent of the tax gap is thought to be 
a result of simple individual taxpayer error. So what we are 
really talking about is well-meaning Americans who 
misunderstand one or more portions of the Federal Government's 
17,000-page Tax Code and 66,000 pages of accompanying 
regulations.
    As the Treasury Department concluded in its 2006 
Comprehensive Strategy for Reducing the Tax Gap report, the 
fact is that most Americans simply do not understand how to 
calculate their taxes because our Tax Code is too complex. 
Trying to comply with the current Tax Code is also tremendously 
difficult and costly for small-business owners. According to 
the Tax Foundation, the cost of Tax Code compliance has more 
than doubled in the past 10 years and was at $265 billion in 
2005, placing a large drain on our economy.
    So, clearly, the key to get after all of these taxpayer 
errors is to first reform the IRS Tax Code. This would provide 
significant improvement in taxpayer compliance rates and get us 
as close as we will ever be to closing the tax gap, while 
avoiding adding immense new taxpayer burdens and returning to a 
free reform-style IRS. I think if we really want to get at 
this, which we clearly do--we want people to pay the taxes that 
they owe, end of story--that is what the fair thing to do is, 
but the question is do we do it with an army of IRS agents and 
more complexity to the Tax Code and make it more burdensome for 
those who can least afford it, like individuals and small 
businesses, especially when we have a challenge of global 
competition, or do we clean the whole code up, reform the IRS 
Code and make it much easier for people to willingly and easily 
comply with the Tax Code?
    That seems to be, to me, the crux of this debate, and I 
hope we can flesh that out as this hearing and others like it 
continue on.
    Thank you, Mr. Chairman. I yield back the balance of my 
time.
    Chairman Spratt. Just to follow up on one thing that Mr. 
Ryan mentioned, you say that we do not have a revenue problem, 
that we have a spending problem. We do have a revenue problem, 
I think you will agree, with the alternative minimum tax. If we 
cannot stop it from applying to middle-income taxpayers, who 
are well in this target range right now, we are going to see 
millions of middle-income taxpayers paying the alternative 
minimum tax, and it was never meant to be imposed upon them. 
But to repeal it, to change it, to revise it, we have to come 
up with a substantial portion of revenues to make up for the 
revenues that will be lost due to the repeal or to the revision 
of the alternative minimum tax, and this is one source I think 
we should look to first. Let us see what we can squeeze without 
bearing down overmuch on the taxpayers out of the tax gap.
    So, for that reason, among others, we welcome you today, 
Mr. Commissioner. We are glad to have you.
    Before turning to you, let me ask for unanimous consent 
that all Members who wish may be able to submit an opening 
statement for the record at this point.
    Chairman Spratt. And I would like to say, if you have a 
statement, you can submit it for the record, and we will make 
it part of the record so that you can summarize it as you see 
fit. The floor is yours, Mr. Commissioner, and thank you again 
for coming.

   STATEMENT OF MARK EVERSON, COMMISSIONER, INTERNAL REVENUE 
                            SERVICE

    Mr. Everson. Thank you, Mr. Chairman, Ranking Member Ryan 
and members of the House Budget Committee.
    I am pleased to be with you this morning to discuss the 
President's fiscal year 2008 budget proposals that cover this 
subject of tax compliance. I am glad that the committee has an 
interest in this subject of tax administration. This is my 
first appearance before the committee.
    Before I start, I would like to introduce my daughter Emma. 
If you could stand up, Emma. She is here today because Fairfax 
County has decided to close the schools for the third day, and 
we did not let her sleep late. She came down for a civics 
lesson, and if I get any particularly tough questions, she is 
quite good, and I am going to ask her to answer them, so--but 
thank you.
    I have been in this job almost 4 years now, and during this 
period, we have worked hard to rebuild IRS enforcement 
capabilities. We have made real progress. Over the last several 
years, I would suggest we have restored respect for tax 
enforcement and the need to comply with the law, but I would 
add that we have not done so at the expense of service to 
taxpayers. At the IRS our working equation remains service plus 
enforcement equals compliance. That is not service or 
enforcement. You have to do both. I think we have a pretty good 
balance right now and are making strides in both areas.
    Turning to the President's 2008 budget request for the IRS, 
I want you to know that I am pleased with the submission which 
provides almost a 5 percent increase from the 2007 funding 
level. Most significantly, the request not only augments our 
enforcement activities, but also devotes monies to rebuild our 
system's infrastructure and increase our research capabilities. 
I feel that the request reflects Secretary Paulson's and 
Director Portman's confidence that the IRS will use these 
monies wisely and generate a real return for the Government.
    I know that a subject of keen interest to the members of 
the committee and to many others in Congress is the tax gap. By 
the ``tax gap,'' I mean the difference between taxes owed the 
government and those actually paid on a timely basis. Before 
taking your questions, I would like to make several 
observations about the tax gap.
    First, while the most recent National Research Program 
study did a good job of updating our numbers and sizing the 
gap, we need more research to better identify the sources of 
noncompliance. We need to conduct this research on a timely and 
continuing basis.
    Second, we cannot audit our way out of the tax gap, and 
while simplification of our tax laws will surely help the vast 
majority of Americans who already voluntarily comply with those 
laws, I would note that we will actually have to complicate the 
tax laws to change the behavior of noncompliant taxpayers, as 
an example, by requiring more information reporting.
    Third, in recent years we have made considerable progress 
in improving compliance, as indicated by the steady growth in 
enforcement revenues. Those are the direct monies that we 
receive from our audit-collection and document-matching 
programs.
    Fourth, to quickly and dramatically reduce the tax gap 
would take Draconian steps that would fundamentally alter the 
relationship between taxpayers and their government, require an 
unacceptably high commitment of enforcement resources and risk 
imposing unacceptable burdens on compliant taxpayers.
    That having been said, there are reasonable steps that can 
be taken to improve compliance. We have made 16 such proposals. 
In order to further improve tax administration, I ask the 
Congress to both fully support the President's 2008 budget 
request for the IRS and to enact the 16 accompanying 
legislative proposals into law.
    Before closing, since this is my first appearance before 
this committee, I would like to explain the nature of my duties 
and how they impact my ability to answer some of the questions 
you may wish to pose. As Commissioner of Internal Revenue, I 
oversee our Nation's tax administration system. I do not, 
however, develop tax policy proposals or take a position on 
them as a part of the legislative process. Questions on tax 
policy issues are better addressed to Treasury Secretary 
Paulson or Assistant Secretary Solomon.
    Beyond the fact that policy questions are outside of my 
lane, there are very practical reasons for the IRS not to be 
drawn into policy conversations. If, for example, a 
Commissioner were to take a position against a piece of pending 
legislation on policy grounds, and then the Congress were to 
actually pass it into law, the public might be skeptical 
concerning IRS implementation of the statute because of the 
Commissioner's previously stated opposition to the legislative 
proposal. In the tax policy area, the IRS' role is limited to 
advising on the potential compliance impact of legislative 
proposals.
    Having offered that clarification, Mr. Chairman, I am happy 
to take your questions. Thank you.
    Chairman Spratt. Thank you very much.
    [The prepared statement of Mark Everson follows:]

  Prepared Statement of Mark Everson, Commissioner of Internal Revenue

    Good morning Chairman Spratt, Ranking Member Ryan and Members of 
the Committee on the Budget. I am pleased to be here this morning to 
discuss the President's FY 2008 Budget request, and the IRS' efforts to 
improve compliance with our nation's tax laws.
                a commitment to service and enforcement
    In FY 2006, we continued making improvements in both our service 
and enforcement programs. This is not just our assessment, but also 
that of the IRS Oversight Board in its most recent annual report. 
According to the Board, the IRS has made steady progress towards 
``transforming itself into a modern institution that provides efficient 
and effective tax administration services to America's taxpayers.''
                       improving taxpayer service
    According to a survey commissioned by the Board in 2006, taxpayers 
increasingly recognize that the IRS provides good quality service 
through a variety of channels, such as its Web site, toll-free 
telephone lines and Taxpayer Assistance Centers. This is supported by 
the metrics that we use to measure the effectiveness of our taxpayer 
service efforts. In category after category we continue to see 
improvement in the numbers in our telephone services, electronic 
filing, and our IRS.gov access. This is demonstrated by the following:
     Electronic filing by individuals continued to increase, up 
6 percent from TY 2005 (3 percentage points) to 54 percent of all 
individual returns.
     The level of service for toll-free assistance was 82 
percent, about the same level of 2005 and up substantially from 2001. 
The level of customer satisfaction with the toll-free line remains 94 
percent, the same as last year.
     The tax law accuracy of toll-free response improved to 91 
percent from 89 percent in the prior year.
     Taxpayers continued to find IRS.gov a useful source of 
information about the tax system and how to comply with their tax 
obligations. Visits to the IRS Web site jumped nearly 10 percent in 
2006 to more than 193 million visits.
     More taxpayers used the online refund status tool 
``Where's My Refund.'' In 2006, there were 24.7 million status checks, 
up nearly 12 percent from 2005.
    Clearly, more work needs to be done by the IRS to improve services. 
But we are making progress, and these numbers underscore that point.
    Another development in our taxpayer service program is the Taxpayer 
Assistance Blueprint (TAB). This collaborative effort of the IRS, the 
IRS Oversight Board, and the National Taxpayer Advocate began in July, 
2005 through a Congressional mandate. We sent Phase 1 of the Blueprint 
to Congress in April, 2006. Phase 1 identified and reported the 
following five strategic service improvement themes for increasing 
taxpayer, partner, and government value:
     Improve and expand education and awareness activities: 
This theme addresses the critical need for making taxpayers and 
practitioners aware of the most effective and efficient IRS service 
options and delivery channels for meeting their tax obligations and 
receiving benefits they are due.
     Optimize the use of partner services: This theme 
emphasizes the critical role of third parties in the delivery of 
taxpayer services, and calls for improving the level of support and 
direction provided to partners to ensure consistent and accurate 
administration of the tax law.
     Enhance self-service options to meet taxpayer 
expectations: This theme focuses on providing clear, standard, and 
easily customized automated content to deliver accurate, consistent, 
and understandable self-assistance service options--particularly for 
transactional tasks.
     Improve and expand training and support tools to enhance 
assisted services: This theme highlights the need for ensuring accurate 
information across all channels by improving and expanding training, 
technology infrastructure, and support for employees, partners, and 
taxpayers.
     Develop short-term performance and long-term outcome goals 
and metrics: This theme provides for the development of a comprehensive 
set of performance goals and metrics to evaluate how effectively the 
IRS is meeting taxpayer expectations, and how efficiently it is 
delivering services.
    Phase 2 of the Blueprint will be sent to Congress soon. Throughout 
this project, extensive research allowed us to refine our understanding 
of taxpayer and partner needs, preferences, and behaviors and to 
identify current planning documents, decision processes, and existing 
commitments affecting IRS service delivery. Certain recurring findings 
emerged from the wealth of data analyzed. These findings, combined with 
agency-wide considerations and priorities, led to the development of 
the five-year Strategic Plan for taxpayer service.
    The Strategic Plan includes a suite of service improvement 
initiatives across all delivery channels, a portfolio of performance 
metrics, and an implementation strategy, which recommends numerous 
future research studies. The Strategic Plan outlines a decision-making 
process for prioritizing service improvement initiatives based on 
taxpayer, partner, and government value and ensuring continued 
stakeholder, partner, and employee engagement. This process is designed 
to help the IRS to balance quality service with effective enforcement 
to maximize compliance. More details on TAB Phase 2 will be available 
when the report is delivered to Congress.
    While TAB remains a work in progress, the FY 2008 budget request 
includes the funding necessary to implement some of the telephone 
service and Web site enhancements recommended by the Blueprint. 
Enhancing telephone service will contribute to the goal of increasing 
taxpayer, partner, and government value. Improving IRS.gov will help us 
to make the Web site the first choice of individual taxpayers and their 
preparers when they need to contact the IRS for help.
    The Blueprint also recommends a suite of multi-year research 
studies to continue to refine and improve our understanding of optimal 
service delivery. In addition to funding for research regarding non-
compliance, the FY 2008 budget includes funding for research to 
understand better the effect of service on compliance.
                     expanding enforcement efforts
    Another reason for the Oversight Board's positive assessment of our 
work in FY 2006 is that IRS enforcement efforts have increased in 
virtually every area. According to the Board, ``As demonstrated by a 
variety of measures, the IRS' performance on enforcement has improved 
considerably, and real progress has been achieved over the past six 
years.''
    One of the most obvious measures is the increase in enforcement 
revenue, which has risen from $34 billion in FY 2002 to almost $49 
billion in FY 2006, an increase of 44 percent. Since 2003, Federal 
government receipts have also increased by $600 billion. In FY 2006, 
the Federal government collected over $2.4 trillion in total receipts. 
This is an historic level, with annual receipts up 12 percent over FY 
2005 alone. In the past two years the U.S. has seen the highest year-
to-year revenue growth in 25 years. Revenue growth has been the 
greatest for corporate taxes and high income individual taxes--both 
areas where we have substantially increased our enforcement presence in 
recent years.
    In FY 2006, both the levels of individual returns examined and 
coverage rates have risen substantially. We conducted nearly 1.3 
million examinations of individual tax returns. This is almost 77 
percent more than were conducted in FY 2001, and reflects a steady and 
sustained increase since that time. Similarly, the audit coverage rate 
has risen from 0.58 percent in FY 2001 to 0.98 percent in FY 2006.
    While the growth in examinations of individual returns is visible 
in all income categories, it is most visible in examinations of 
individuals with incomes over $1 million. The number of examinations in 
the category rose by almost 80,000 as compared to FY 2004, the first 
year the IRS began tracking audits of individuals with income over $1 
million. The coverage rate has risen from 5.03 percent in FY 2004 to 
6.30 percent in FY 2006.
    Growth in audit totals and coverage rates extend to other taxpayer 
categories. Preliminary estimates show that the IRS examined over 
52,000 business returns in FY 2006, an increase of nearly 12,000 over 
FY 2001. The coverage rate over the same period rose from 0.55 percent 
to 0.60 percent. For corporations with assets over $10 million, 
examinations rose from 8,718 in FY 2001 to 10,591 in FY 2006, an 
increase in the coverage rate from 15.1 percent to 18.6 percent. For 
the largest corporations, those with assets over $250 million, 
examinations have increased by nearly 30 percent growing from 3,305 in 
FY 2001 to 4,289 in FY 2006.
    Finally, examinations of tax exempt organizations have also risen. 
In FY 2001 5,342 tax exempt examinations were closed. This has risen to 
7,079 in preliminary FY 2006 numbers.
               the president's fy 2008 irs budget request
    The first step in continuing the progress we have made to improve 
service and voluntary compliance is approval of the President's FY 2008 
budget request for the IRS. That request is for $11.1 billion in 
appropriated resources and represents a 4.7 percent increase over the 
FY 2007 House-passed Joint Resolution (JR) level of $10.6 billion.
    The request includes $3.6 billion in appropriated resources for 
taxpayer service and $7.2 billion for enforcement, an increase of 0.9 
and 5.8 percent, respectively, over the FY 2007 JR level. This increase 
includes $56 million in initiatives supporting taxpayer service and 
$291 million is initiatives supporting enforcement. As in FY 2006 and 
FY 2007, the Administration proposes to include IRS enforcement 
increases as a Budget Enforcement Act program integrity cap adjustment. 
The Budget also requests $282 million for Business Systems 
Modernization. This is a $69 million and 33 percent increase over the 
level in the House passed Joint Resolution.
    If approved, we project that these investments will increase annual 
enforcement revenue by $699 million dollars a year, once the new hires 
reach full potential in FY 2010. This does not include the indirect 
benefits of these investments, which as I will discuss later in my 
testimony, could be several times the direct return on investment. In 
addition, we estimate that the legislative proposals for improving 
compliance that are in the Budget, which I discuss later, will generate 
$29.5 billion over the next ten years.
    In addition to the broad goals of continuing the improvement of 
service and enforcement, the President's Budget request for the IRS 
will support a number of initiatives.
                       enhancing taxpayer service
    Taxpayer service is especially important to help taxpayers avoid 
making unintentional errors. The IRS provides year-round assistance to 
millions of taxpayers through many sources, including outreach and 
education programs, tax forms and publications, rulings and 
regulations, toll-free call centers, the Internet, Taxpayer Assistance 
Centers (TACs), and Volunteer Income Tax Assistance (VITA) and Tax 
Counseling for the Elderly (TCE) sites.
    Assisting taxpayers with their tax questions before they file their 
returns reduces burdensome post-filing notices and other correspondence 
from the IRS and reduces overall inadvertent noncompliance.
    The FY 2008 Budget contains two significant taxpayer service 
initiatives. First, we are requesting $5 million to expand volunteer 
income tax assistance. This taxpayer service initiative will help 
expand the IRS' volunteer return preparation, outreach and education, 
and asset building services to low-income, elderly, Limited English 
Proficient (LEP), and disabled taxpayers.
    Second, the budget contains a $10 million request to begin 
implementation of the TAB. As part of the TAB effort, we conducted a 
comprehensive review of our current portfolio of services to individual 
taxpayers to determine which services should be provided and improved. 
Based on the findings of the Blueprint, the funding for this initiative 
will implement the following telephone service and Web site interaction 
enhancements:
     Contact Analytics provide a tool for evaluating contact 
center recordings for the purpose of improving understanding of service 
levels for potential enhancements.
     Estimated Wait Time provides a real-time message that 
informs taxpayers about their expected wait time in queue, allowing 
them to make more informed decisions based on the status of their call 
and thus reducing taxpayer burden and increasing customer satisfaction.
     Expanded Portfolio of Tax Law Decision Support Tools 
enables taxpayers to conduct key word and natural language queries to 
get answers to tax law questions through the Frequently Asked Questions 
database accessed on IRS.gov, thereby steadily increasing customer 
satisfaction and operational savings.
     Spanish ``Where's My Refund?'' adds the ability to check 
refund status to the Spanish Web page on IRS.gov, enabling the Spanish-
speaking community to receive the same level of customer service on the 
web as available to the English Web page.
    Continued technological advancements offer significant 
opportunities for the IRS to improve the efficiency and effectiveness 
of call center services. Website enhancements are designed to maximize 
the value of IRS.gov, making the site taxpayers' first choice for 
obtaining the information and services required to comply with their 
tax obligations.
                    improving compliance activities
    The IRS is continuing to improve efficiency and productivity 
through process changes, investments in technology, and streamlined 
business practices. We will continue to reengineer our examination and 
collection procedures to reduce cycle time, increase yield, and expand 
coverage. As part of its regular examination program, the IRS is 
expanding the use of cost-efficient audit techniques first pioneered in 
the National Research Program (NRP).
    The IRS is also expanding its efforts to shift to agency-wide 
strategies, which maximize efficiency by better aligning problems (such 
as nonfilers and other areas of noncompliance) and their solutions 
within the organization. The IRS is committed to improving the 
efficiency of its audit process, measured by audit change rates and 
other appropriate benchmarks.
    There are six specific initiatives proposed in the FY 2008 Budget 
aimed at improving compliance. These include:
     Providing $73.2 million to improve compliance among small 
business and self-employed taxpayers in the elements of reporting, 
filing, and payment compliance. This funding will be allocated for 
increasing audits of high-risk tax returns, collecting unpaid taxes 
from filed and unfiled tax returns, and investigating for possible 
criminal referral, persons who have evaded taxes. It is estimated that 
this request will produce $144 million in additional annual enforcement 
revenue per year, once new hires reach full potential in FY 2010.
     Providing $26.2 million for increasing compliance for 
large, multinational businesses. This enforcement initiative will 
increase examination coverage for large, complex business returns; 
foreign residents; and smaller corporations with significant 
international activity. It addresses risks arising from the rapid 
increase in globalization, and the related increase in foreign business 
activity and multi-national transactions where the potential for 
noncompliance is significant in the reporting of transactions that 
occur across differing tax jurisdictions. With this funding, we 
estimate that coverage for large corporate and flow-through returns 
will increase from 7.9 to 8.2 percent in FY 2008, and produce over $74 
million in additional annual enforcement revenue, once the new hires 
reach full potential in FY 2010.
     Providing $28 million for expanded document matching in 
existing sites. This enforcement initiative will increase coverage 
within the Automated Underreporter (AUR) program by minimizing revenue 
loss through increased document matching of individual taxpayer account 
information. We believe the additional resources will result in an 
increase in AUR closures from 2.05 million in FY 2007 to 2.64 million 
in FY 2010. We expect $208 million of additional enforcement revenue 
per year, once the new hires reach full potential in FY 2010. In 
addition, the budget requests $23.5 million to establish a new document 
matching program at our Kansas City campus. This enforcement initiative 
will fund a new AUR site within the existing IRS space in Kansas City 
to address the misreporting of income by individual taxpayers. 
Establishing this new AUR site should result in over $183 million in 
additional enforcement revenue per year once the new hires reach full 
potential in FY 2010.
     Providing $6.5 million to increase individual filing 
compliance. This enforcement initiative will help address voluntary 
compliance. The Automated Substitute for Return Refund Hold Program 
minimizes revenue loss by holding the current-year refunds of taxpayers 
who are delinquent in filing individual income tax returns and are 
expected to owe additional taxes. We estimate that this initiative will 
result in securing more than 90,000 delinquent returns in FY 2008 and 
produce $82 million of additional enforcement revenue per year, once 
the new hires reach full potential in FY 2010.
     Approving $15 million to increase tax-exempt entity 
compliance. This enforcement initiative will deter abuse within tax-
exempt and governmental entities (TEGE) and misuse of such entities by 
third parties for tax avoidance or other unintended purposes. The 
funding will aid in increasing the number of TEGE compliance contacts 
by 1,700 (6 percent) and employee plan/exempt organization 
determinations closures by over 9,000 (8 percent) by FY 2010.
     Appropriating $10 million for increased criminal tax 
investigations. This will help us to aggressively attack abusive tax 
schemes, corporate fraud, nonfilers, and employment tax fraud. It will 
also address other tax and financial crimes identified through Bank 
Secrecy Act related examinations and case development efforts, which 
includes an emphasis on the fraud referral program. Our robust pursuit 
of tax violators and the resulting publicity, foster deterrence and 
enhance voluntary compliance.
    In addition to these initiatives, I should stress to you the 
importance of allowing us to continue with the private debt collection 
program. The use of private collection agents (PCAs) was authorized by 
the American Jobs Creation Act of 2004. As we continue to debate the 
efficacy of this program, I want to take this opportunity to make a 
couple of points for purposes of our ongoing discussions.
    One issue that has been debated is the relative efficiency of using 
PCAs versus using IRS employees to collect the taxes owed. The most 
important question is not whether IRS employees or PCAs can do the job 
more efficiently, but rather whether PCAs collect money that would 
otherwise go uncollected. The IRS lacks the resources to pursue the 
relatively simple, geographically dispersed cases that are now being 
assigned to PCAs. It is not realistic to expect that the Congress is 
going to give the IRS an unlimited budget for enforcement, and if 
Congress provided the IRS additional enforcement resources, I believe 
those resources would be applied best by allocating them to more 
complex, higher priority cases that are not appropriate for PCAs.
    The IRS continues to work with PCAs to ensure that the program is 
fair to taxpayers and respects taxpayer rights. We currently estimate 
that between now and FY 2017, our partnership with PCAs will result in 
approximately 2.9 million delinquent cases receiving treatment that 
would otherwise have gone unworked. This partnership will help reduce 
the backlog in outstanding tax liabilities, which has grown by 118 
percent over the last 12 years. From September 7, 2006, when cases were 
first assigned to PCAs, through December 31, 2006, PCAs collected more 
than $11 million in net revenue. We estimate that cases worked by PCAs 
will generate estimated gross revenue of between $1.4. billion through 
FY 2017.
    Another reason to continue to use this tool is to evaluate whether 
we in the public sector can learn anything from these PCAs that will 
enable us to do our jobs better. Particularly over the last 20 years, 
government agencies at all levels have adopted many practices and ways 
of doing business that have been pioneered in the private sector. One 
need look no further than the vastly expanded use by the government of 
the Internet in providing services to the public as an example of a 
practice that was pioneered in the private sector but adopted quickly 
and effectively by the government. We should not remove PCAs as a tool 
for addressing the problem before we have an opportunity to evaluate 
PCAs' potential to help improve compliance and perhaps even to show the 
government how to be more effective in its own efforts.
                   reducing opportunities for evasion
    The IRS is already aggressively pursuing enforcement initiatives 
designed to improve compliance and reduce opportunities for evasion. As 
pointed out earlier, these efforts have produced a steady climb in 
enforcement revenues since 2001, as well as an increase in both the 
number of examinations and the coverage rate in virtually every major 
category.
    In the budget request, the Administration proposes to expand 
information reporting, improve compliance by businesses, strengthen tax 
administration, and expand penalties in the following ways:
     Expand information reporting--Specific information 
reporting proposals would:
    1. Require information reporting on payments to corporations;
    2. Require basis reporting on sales of securities;
    3. Expand broker information reporting;
    4. Require information reporting on merchant payment card 
reimbursements;
    5. Require a certified taxpayer identification number (TIN) from 
non-employee service providers;
    6. Require increased information reporting for certain government 
payments for property and services; and
    7. Increase information return penalties.
     Improve compliance by businesses--Improving compliance by 
businesses of all sizes is important. Specific proposals to improve 
compliance by businesses would:
    1. Require electronic filing by certain large businesses;
    2. Implement standards clarifying when employee leasing companies 
can be held liable for their clients' Federal employment taxes; and
    3. Amend collection due process procedures applicable to employment 
tax liabilities.
     Strengthen tax administration--The IRS has taken a number 
of steps under existing law to improve compliance. These efforts would 
be enhanced by specific tax administration proposals that would:
    1. Expand IRS access to information in the National Directory of 
New Hires database;
    2. Permit the IRS to disclose to prison officials return 
information about tax violations; and
    3. Make repeated failure to file a tax return a felony.
     Expand penalties--Penalties play an important role in 
discouraging intentional non-compliance. Specific proposals to expand 
penalties would:
    1. Expand preparer penalties;
    2. Impose a penalty on failure to comply with electronic filing 
requirements; and
    3. Create an erroneous refund claim penalty.
    The Administration also has four proposals relating to IRS 
administrative reforms.
    The first proposal modifies employee infractions subject to 
mandatory termination and permits a broader range of available 
penalties. It strengthens taxpayer privacy while reducing employee 
anxiety resulting from unduly harsh discipline or unfounded 
allegations.
    The second proposal allows the IRS to terminate installment 
agreements when taxpayers fail to make timely tax deposits and file tax 
returns on current liabilities.
    The third proposal eliminates the requirement that the IRS Chief 
Counsel provide an opinion for any accepted offer-in-compromise of 
unpaid tax (including interest and penalties) equal to or exceeding 
$50,000. This proposal requires that the Secretary of the Treasury 
establish standards to determine when an opinion is appropriate.
    The fourth proposal modifies the way that Financial Management 
Services (FMS) recovers its transaction fees for processing IRS levies 
by permitting FMS to add the fee to the liability being recovered, 
thereby shifting the cost of collection to the delinquent taxpayer. The 
offset amount would be included as part of the 15-percent limit on 
continuous levies against income.
    The proposed budget provides $23 million to implement these 
initiatives. This will fund the purchase of software and the 
modifications to IRS information technology systems necessary to 
implement these legislative proposals.
                           enhancing research
    Research enables the IRS to develop strategies to combat specific 
areas of noncompliance, improve voluntary compliance, and allocate 
resources more effectively.
    Historically, our estimates of reporting compliance were based on 
the Taxpayer Compliance Measurement Program (TCMP), which consisted of 
line-by-line audits of random samples of returns. This provided us with 
information on compliance trends and allowed us to update audit 
selection formulas.
    However, this method of data gathering was extremely burdensome on 
the taxpayers who were forced to participate. One former IRS 
Commissioner noted that the TCMP audits were akin to having an autopsy 
without benefit of death. As a result of concerns raised by taxpayers, 
Congress, and other stakeholders, the last TCMP audits were done in 
1988.
    We conducted several much narrower studies since then, but nothing 
that would give us a comprehensive perspective on the overall tax gap. 
As a result, until the recent NRP data, all of our subsequent estimates 
of the tax gap were rough projections that basically assumed no change 
in compliance rates among the major tax gap components; the magnitude 
of these projections reflected growth in tax receipts in these major 
categories.
    The National Research Program, which we have used to estimate our 
most recent tax gap updates, provides us a better focus on critical tax 
compliance issues in a manner that is far less intrusive than previous 
means of measuring tax compliance. We used a focused, statistical 
selection process that resulted in the selection of approximately 
46,000 individual returns for Tax Year (TY) 2001. This was less than 
previous compliance studies, even though the population of individual 
tax returns had grown over time.
    Like the compliance studies of the past, the NRP was designed to 
allow us to meet certain objectives: to estimate the overall extent of 
reporting compliance among individual income tax filers and to update 
our audit selection formulas. It also introduced several innovations 
designed to reduce the burden imposed on taxpayers whose returns were 
selected for the study.
    Almost as important as understanding what the NRP research provides 
is to understand its limitations. The focus of the first NRP reporting 
compliance study was on individual income tax returns. It did not 
provide estimates for noncompliance with other taxes, such as the 
corporate income tax or the estate tax. Our estimates of compliance 
with taxes other than the individual income tax are still based on 
projections that assume constant compliance behavior among the major 
tax gap components since the most recent compliance data were compiled 
(i.e., 1988 or earlier).
    The NRP provided accurate data for determining the sources of 
noncompliance and for measuring changes in compliance rates over time. 
The IRS also uses the NRP findings to better target examinations and 
other compliance activities, thus increasing the dollar-per-case yield 
and reducing ``no change'' audits of compliant taxpayers. Innovations 
in audit techniques to reduce taxpayer burden, pioneered during the 
2001 NRP, have been adopted in regular operational audits.
    Recurring and timely compliance research is needed to ensure that 
the IRS can efficiently target its resources and effectively provide 
the best service possible and respond to new sources of noncompliance 
as they emerge. Compliant taxpayers benefit when the IRS uses the most 
up-to-date research to improve workload selection formulas, as this 
reduces the burden of unnecessary taxpayer contacts. Research is also 
critical in helping the IRS to establish benchmarks against which to 
measure progress in improving compliance.
    The FY 2008 Budget would fund two significant research initiatives. 
First, the budget requests $41 million to improve compliance estimates, 
measures, and detection of noncompliance. This will fund research 
studies of compliance data for new segments of taxpayers needed to 
update existing estimates of reporting compliance.
    Unlike the past, the IRS will conduct an annual study of compliance 
among 1040 filers based on a smaller sample size than the 2001 NRP 
study. This will provide fresh compliance data each year, and by 
combining samples over several years will provide a regular update to 
the larger sample size needed to keep the IRS' targeting systems and 
compliance estimates up to date.
    The second research program funded by the request is to research 
the effect of service on taxpayer compliance. The budget requests $5 
million for this project, which will undertake new research on the 
needs, preferences, and behaviors of taxpayers. The research will focus 
on four areas:
     Meeting taxpayer needs by providing the right channel of 
communication;
     Better understanding taxpayer burden;
     Understanding taxpayer needs through the errors they make; 
and
     Researching the impact of service on overall levels of 
voluntary compliance.
           continuing improvements in information technology
    Tax administration in the twenty-first century requires improved 
IRS information technology (IT). We are committed to continuing to make 
improvements in technology and the FY 2008 Budget reflects that 
commitment. The FY 2008 Budget requests $81 million to improve the IRS' 
information technology infrastructure. Sixty million dollars of this 
amount is requested to upgrade critical IT infrastructure. This 
infrastructure initiative will provide funding to upgrade the backlog 
of IRS equipment that has exceeded its life cycle. Failure to replace 
the IT infrastructure will lead to increased maintenance costs and will 
increase the risk of disrupting business operations. Planned 
expenditures in FY 2008 include procuring and replacing desktop 
computers; automated call distributor hardware; mission critical 
servers; and Wide Area Network/Local Area Network routers and switches.
    The other $21 million will be used to enhance the Computer Security 
Incident Response Center (CSIRC) and the network infrastructure 
security. This infrastructure initiative will provide $13.1 million to 
fund enhancements to the CSIRC necessary to keep pace with the ever-
changing security threat environment through enhanced detection and 
analysis capability, improved forensics, and the capacity to identify 
and respond to potential intrusions before they occur. The remaining 
$7.9 million will fund enhancements to the IRS' network infrastructure 
security. It will provide the capability to perform continuous 
monitoring of the security of operational systems using security tools, 
tactics, techniques, and procedures to perform network security 
compliance monitoring of all IT assets on the network.
    Finally, the FY 2008 Budget requests a total of $282.1 million to 
continue the development and deployment of the IRS' Business Systems 
Modernization program in line with the recommendations identified in 
the IRS' Modernization, Vision, and Strategy. This funding will allow 
the IRS to continue progress on modernization projects, such as the 
Customer Account Data Engine (CADE), Account Management Services (AMS), 
Modernized e-File (MeF), and Common Services Projects (CSP).
    The development of the CADE (Customer Account Data Engine) and AMS 
(Account Management Services) systems is the heart of the IT 
modernization of the IRS. The combination of these two systems working 
together will enable the IRS to process tax returns and deal with 
taxpayer issues in a near real-time manner. In fact, our objective is 
that IRS operate similarly to what one expects from one's bank; account 
transactions occurring during the business day will be posted and 
available by the next business day. In addition, AMS will enable the 
IRS representatives who work with taxpayers to have access to all the 
information regarding that taxpayer, including electronic access to tax 
return data, and electronic copies of correspondence. Armed with such 
comprehensive and up-to-date information, our representatives will be 
in a much better position to help taxpayers resolve their issues.
    MeF is the future of electronic filing. It provides a standard data 
format for all electronic tax returns, which will reduce the cost and 
time to add and maintain additional tax form types. MeF is a flexible 
real-time system that streamlines the processing of e-filed tax returns 
resulting in a quicker acknowledgement of the filing to the taxpayer or 
their representative. In FY 2007, the IRS will start development and 
implementation of the 1040 on the MeF platform, which is expected to 
take two years.
    CSP will provide funding for new portals, which are technology 
platforms that meet many IRS business needs through Web-based front-
ends and provide secure access to data, applications, and services. The 
portals are mission-critical components of the enterprise 
infrastructure required to support key business processes and 
compliance initiatives.
    The benefits accruing from the delivery and implementation of BSM 
projects not only provide value to taxpayers, the business community, 
and government, but also contribute to operational improvements and 
efficiencies within the IRS.
                      implications for the tax gap
    On September 27, 2006, the Office of Tax Policy in the Department 
of Treasury forwarded to Congress the outline of a comprehensive 
strategy to reduce the tax gap. It detailed a seven-prong approach 
needed to implement a multi-year strategy to reduce the tax gap. Many 
of the specific elements in our FY 2008 Budget request support this 
approach.
    Put simply, the tax gap is the difference between the amount of tax 
imposed on taxpayers for a given year and the amount that is paid 
voluntarily and timely. The tax gap represents, in dollar terms, the 
annual amount of noncompliance with our tax laws. While no tax system 
can ever achieve 100 percent compliance, the IRS is committed to 
finding ways to increase compliance and reduce the tax gap, while 
minimizing the burden on the vast majority of taxpayers who pay their 
taxes accurately and on time.
    It is important to understand, however, that the complexity of our 
current tax system is a significant reason for the tax gap and that 
fundamental reform and simplification of the tax law is necessary in 
order to achieve significant reductions.
            distinguishing the tax gap from related concepts
    The tax gap is not the same as the so-called ``underground 
economy,'' although there is some overlap (particularly in the legal-
sector cash economy). The tax gap numbers do not reflect taxes owed on 
income generated from illegal activities. This makes up a significant 
portion of the underground economy. However, what we think of as the 
underground economy does not include various forms of tax 
noncompliance, such as overstated deductions or claiming an improper 
filing status or the wrong number of exemptions. These are all included 
in our calculations of the tax gap.
    Equally important, the tax gap does not arise solely from tax 
evasion or cheating. It includes a significant amount of noncompliance 
due to the complexity of the tax laws that results in errors of 
ignorance, confusion, and carelessness. This distinction is important, 
even though we do not have the ability to distinguish clearly the 
amount of non-compliance that arises from willfulness from the amount 
that arises from unintentional mistakes. We expect future research to 
improve our understanding in this area.
    If all reporting errors were unintentional, we would expect to see 
a relatively even balance between over reporting and under reporting. 
However, since taxpayer overstatements of tax appear to be much smaller 
than understatements of tax, one can reasonably infer that much of the 
gap is the result of intentional behavior.
                       the most recent estimates
    The results of the NRP individual income tax reporting compliance 
study were combined with earlier estimates concerning other taxpayer 
segments such as corporate taxpayers resulting in an estimate of the 
overall gross tax gap for Tax Year 2001 of approximately $345 billion. 
The net tax gap, or what will remain after enforcement and other late 
payments, is estimated to be about $290 billion, corresponding to 13.7 
percent of estimated total liabilities.
    Noncompliance takes three forms: not filing required returns on 
time (nonfiling); not reporting one's full tax liability when the 
return is filed on time (underreporting); and not paying by the due 
date the full amount of tax reported on a timely return (underpayment). 
We have separate estimates for each of these three types of 
noncompliance.
    Underreporting constitutes over 82 percent of the gross tax gap, up 
slightly from our earlier estimates. Nonfiling constitutes almost 8 
percent and underpayment nearly 10 percent of the gross tax gap.
    The individual income tax accounted for about half of all tax 
receipts in 2001. However, as shown on the chart below, individual 
income tax underreporting was approximately $197 billion or about 57 
percent of the overall tax gap. The NRP data suggest that well over 
half ($109 billion) of the individual underreporting gap came from 
understated net business income (unreported receipts and overstated 
expenses). Approximately 28 percent ($56 billion) of the underreporting 
gap came from underreported non-business income, such as wages, tips, 
interest, dividends, and capital gains. The remaining $32 billion came 
from overstated subtractions from income (i.e., statutory adjustments, 
non-business deductions, and exemptions) and from overstated tax 
credits.

             FEDERAL GROSS TAX GAP ESTIMATES, TAX YEAR 2001
------------------------------------------------------------------------
                                                Gross Tax
              Tax Gap Component                  Gap ($       Share of
                                                billions)     Total Gap
------------------------------------------------------------------------
Individual income tax underreporting gap....          197           57%
    Understated non-business income.........           56           16%
    Understated net business income.........          109           31%
    Overstated adjustments, deductions,                32            9%
     exemptions and credits.................
Self-Employment tax underreporting gap......           39           11%
Corporate and Other Underreporting..........           49           15%
Non-Filers..................................           27            8%
Underpayment................................           33           10%
Total Gross Tax Gap.........................          345          100%
------------------------------------------------------------------------
Note: Detail does not add due to rounding

    The corresponding estimate of the self-employment tax 
underreporting gap is $39 billion, which accounts for about 11 percent 
of the overall tax gap. Self-employment tax is underreported primarily 
because self-employment income is underreported for income tax 
purposes. Taking individual income tax and self-employment tax 
together, we see that individual underreporting constitutes 
approximately two-thirds of the overall tax gap.
    The amounts least likely to be misreported on tax returns are 
subject to both third party information reporting and withholding, and 
are, therefore, the most ``visible'' (e.g., wages and salaries). The 
net misreporting percentage for wages and salaries is only 1.2 percent.
    Amounts subject to third-party information reporting, but not to 
withholding (such as interest and dividend income), exhibit a somewhat 
higher misreporting percentage than wages. For example, there is about 
a 4.5 percent misreporting rate for interest and dividends.
    Amounts subject to partial reporting by third parties (e.g., 
capital gains) have a still higher misreporting percentage of 8.6 
percent. As expected, amounts generally not subject to withholding or 
third party information reporting (e.g., sole proprietor income and the 
``other income'' line on form 1040) are the least ``visible'' and, 
therefore, are most likely to be misreported. The net misreporting 
percentage for this group of line items is 53.9 percent.
                      observations on the tax gap
    In the context of the President's Budget request, I would like to 
make several observations about the tax gap.
    First, while the most recent NRP study did a good job of updating 
our numbers, we need more research to better identify the sources of 
non-compliance on a timely and continuing basis.
    Second, I think it is well understood that we will never be able to 
audit our way out of the tax gap. And, while simplification of our tax 
laws will surely help the vast majority of Americans who already 
voluntarily comply with those laws, we will actually have to complicate 
the tax laws to go after the non-compliant taxpayers (e.g., by 
requiring more information reporting).
    Third, we have already made considerable progress in improving 
compliance as indicated by the steady growth in enforcement revenues in 
recent years.
    Fourth, to reduce the tax gap dramatically will take some draconian 
steps, ones that will fundamentally change the relationship between 
taxpayers and the IRS, require an unacceptably high commitment of 
enforcement resources, and risk imposing unacceptable burdens on 
compliant taxpayers. Nevertheless, there are reasonable steps, which I 
have outlined in this statement that can be taken to improve 
compliance.
                                summary
    The FY 2008 Budget request includes significant increases for IRS 
enforcement efforts. Fully funding that request will help us make 
progress in greatly improving compliance.
    Based on our analysis covering the most recent 11 years of 
collection experience, we estimate that every dollar we have spent on 
enforcement has generated a direct return of an average of four dollars 
in increased revenue to the Federal Treasury. This return can be 
expected to occur when the full productive benefit of the investment is 
realized.
    This 4:1 return on investment does not consider the indirect effect 
of increased enforcement activities in deterring taxpayers who are 
considering engaging in non-compliant behavior. Econometric estimates 
of the indirect effects indicate a significant impact from increased 
enforcement activities. Stated another way, taxpayers who see us 
enforcing the law against their friends, neighbors or competitors are 
more likely to comply voluntarily and not risk the chance that we might 
audit them. We have no means to measure this indirect impact, but 
research suggests it is at least three times as large as the direct 
impact on revenue.
    Our role is not unlike that of a highway patrolman. He will never 
be able to ticket every speeder, but he attempts to position himself in 
areas where he knows that his time is more likely to be spent 
productively. He also knows that every time he pulls a speeder over, 
other motorists see that and slow down as well.
    We also believe that dollars spent on taxpayer service have a 
positive impact on voluntary compliance. The complexity of complying 
with the nation's current tax system is a significant contributor to 
the tax gap, and even sophisticated taxpayers make honest mistakes on 
their tax returns. Accordingly, helping taxpayers understand their 
obligations under the tax law is a critical part of improving voluntary 
compliance. To this end, the IRS remains committed to a balanced 
program assisting taxpayers in both understanding the tax law and 
remitting the proper amount of tax.
    In addition, the President's FY 2008 Budget contains a number of 
legislative proposals that provide additional tools for the IRS to 
enforce the existing tax law. Perhaps the most critical of these tools 
is greater third party reporting.
    An analysis of the data from the National Research Program of TY 
2001individual income tax returns leads to one very obvious conclusion. 
Compliance is much higher in those areas where there is third party 
reporting. For example, only 1.2 percent of wages reported on Forms W-2 
are underreported. This compares to a 53.9 percent underreporting rate 
for income subject to little or no third party reporting.
    The FY 2008 Budget request asks Congress to expand information 
reporting to include additional sources of income and make other 
statutory changes to improve compliance. These legislative proposals 
are intended to improve tax compliance with minimum taxpayer burden. 
When implemented, it is estimated that these proposals will generate 
$29.5 billion over ten years.
    I anticipate that some of this year's Budget proposals will be 
criticized, perhaps because of concerns about their potential impact on 
small businesses. Our proposals are part of an effort to help small 
businesses and all other taxpayers pay less by collecting more of the 
taxes that are owed. In addition, while the information reporting 
proposals will inevitably impose some burden on compliant taxpayers, 
they are designed to minimize that burden and to help the IRS better 
target its audit resources, thereby reducing the number of burdensome 
audits that result in little or no change to compliant taxpayers' 
reported liability. The challenges that a small business faces are 
difficult enough without having to compete directly with noncompliant 
competitors. We have an obligation to support those compliant small 
businesses by ensuring that their competitors are also paying their 
fair share. This is not only a matter of fairness, but also a way of 
supporting compliant small businesses in their efforts to remain 
compliant.
    Finally, full funding of the budget request will enable the IRS to 
improve its research with respect to the tax gap. Despite all of our 
progress, there is still much we do not know about the tax gap. 
Although the updated estimates provided by the NRP study are more 
accurate than our previous estimates, and more accurate than the 
estimates made at various times by others using more indirect methods, 
they have many limitations.
    Tax gap estimates are useful for understanding the general areas 
and levels of noncompliance and the scope of the problem, but they are 
far from exact measurements. With the exception of the individual 
income tax gap, the estimates do not adjust for noncompliance that goes 
undetected during examination, and estimates are not even available for 
certain (minor) components of the tax gap.
    It is also important to understand that the NRP study looked only 
at TY 2001 individual income tax returns. The study provided no new 
information on anything other than the reporting behavior of individual 
income taxpayers. The data used to estimate corporate compliance and 
other tax gap components are much older. The estimates are based on 
data such as the Taxpayer Compliance Measurement Program (TCMP), which 
we ceased doing in 1988.
    To collect more data, we are currently doing an NRP study of 
reporting compliance of businesses filing Form 1120S (Subchapter S) 
returns. This involves approximately 5,000 Form 1120S returns from Tax 
Years 2003 and 2004, taken from a nationwide random sample. This is the 
first time the IRS has conducted a reporting compliance study across 
tax years, and it will require that we knit the data together to 
provide a comprehensive picture. We expect the study to continue 
through 2007.
    Beginning in October 2007, the IRS will begin ongoing annual 
research activities that will ensure we have the most up to date 
compliance data possible to measure portions of the tax gap, focus our 
resources, and improve our audit selection criteria.
    While I am confident we have made a significant dent in the tax 
gap, the lack of current data makes it difficult to quantify exactly 
how big of a dent has actually been made.
    I appreciate the opportunity to testify this morning, and I will be 
happy to respond to any questions that Members of the Committee may 
have.

    Chairman Spratt. Would you take a stab at what the size of 
the so-called ``tax gap'' is today?
    Mr. Everson. Well, let us put up the tax gap map.
    As you indicated, our research on this was conducted in 
2001. What happened was the last time we had really updated 
this previous to that was in 1988, and then we stood down in 
our research programs for a period of years, largely at the 
behest of the Congress, this feeling that the audits that you 
did to get the numbers were intrusive, and it was a pretty 
tough climb, as was indicated back in the 1990s.
    What we did in 2001--you can see the areas on this map that 
are sort of the underreporting. The gap has three components. 
There is an underreporting component, and that is the biggest 
piece of it, over 80 percent; then there is a nonfiling 
component, which is about 8 percent of it; and then there is an 
underpayment component. That is where somebody files a return, 
but then they just do not full pay, or they do not pay at all. 
So those are the three pieces of it.
    What we did in 2001 was we conducted 46,000 audits of 
individuals. We did not look at corporations. We looked at 
individuals. And so these blue lines or blue cones there--
boxes--under the underreporting, talk about the numbers that we 
estimated for individuals, and of the total gross tax gap in 
2001, which we estimated at $345 billion, the underreporting 
piece was $285 billion, and the individual income tax piece of 
that was almost $200 billion, and if you look over here, we 
draw these two together. That is a self-employment tax. This 
gap is really derivative of this piece, the underreported 
business income from individuals. So, if you link all of those 
together, some two-thirds of the tax gap, we would estimate, is 
tied to the individual income tax reporting.
    I readily concede that this $30 billion on corporation 
income tax was probably understated. What we did here was we 
simply took our old research, and then we updated it for 
changes and sizes of the economy.
    The point I always make, though, Mr. Chairman, is that, 
when you look at that, I would not have reallocated or I do not 
think any Commissioner would have reallocated our resources, 
because we were already doing quite a bit on the corporations 
with much higher audit rates.
    To get to the question about where is it today, there are a 
couple different things. Obviously, if the noncompliance rate, 
which here was estimated at 16 percent, remains steady, and the 
economy grows, the tax gap grows, but there are other things 
that happen. There are mixed changes in the revenue streams. 
There are rate reductions in capital gains and other areas, so 
that all impacts the gap as well.
    The other thing I would say is, if we go down to the 
enforcement revenue chart, the other thing that has happened 
is, in the 1990s, we drew down our enforcement resources by 
over 25 percent. We stepped back from really doing all that we 
could in enforcement. We, very clearly, had to improve 
services, but we did so at the expense of our enforcement 
activities. We have now brought the enforcement back, as I 
indicated.
    What this chart does is--the blue lines are the monies that 
we get in on our collection activities. The yellow strip is the 
money that we get in from our document-matching activities, and 
the green lines up top are the monies that come in from our 
audit, our exam activities, and you can see that between 2001 
when those monies totaled about $34 billion--and now this past 
fiscal year they came up to $49 billion--that is an increase of 
some $15 billion because of our enforcement activities. But the 
other point about this is that, when we audit you, Mr. 
Chairman, even if you are as clean as a whistle, if one of your 
colleagues is a little more aggressive and might be inclined to 
overstate the deductions, they hear about that audit--people 
talk--and there is an indirect impact, and those individuals--
because of the experience that you have had, they are less 
likely to overstate or to cheat, whatever you want to call it. 
It is not unlike the State trooper under the bridge who does 
not just pull over the guy doing 80. Everybody who sees that 
State trooper slows down and does a better job of obeying the 
law.
    What this chart does is it takes a look at and makes an 
assumption, which we think is pretty conservative, about the 
indirect effects that I am talking about. Very simply it says, 
if there is a 3-to-1 indirect effect, then what you would get 
is--on that $15 billion of extra enforcement effort since 2001, 
maybe you have clawed back something like $60 billion. So that 
is the other thing that is happening in here that I would draw 
your attention to in terms of if you are trying to say, ``What 
will we do? Where are we now?'' you would look at a variety of 
different factors, and I think you would also look at some 
improvement.
    The last thing I would say, and I am sorry I have gone on 
so long here, is that one of the problems, as I indicated, is 
getting research. The President's budget requests $41 million 
of incremental funding for the IRS, which we will put into the 
base so that now, instead of just having a 2001 update and then 
waiting a whole bunch of years, we will start to work on this 
on a regular basis, and that is--the real key is to get regular 
recurring research on all of the different facets of this and 
to be able to have a more timely conversation.
    Chairman Spratt. Using the factor you used, that 16 
percent, can you give us an updated current dollar estimate of 
what the tax gap is in 2006-2007?
    Mr. Everson. I would decline to do that, sir, just because 
there are so many moving parts.
    What we are going to do now is we are going to start to--we 
are working on updating the research right now on 1120S 
corporations, which we have not done any research on that in a 
long time, and we are going to restart doing the individuals 
shortly, but I think it would really be very difficult because 
of all of the factors I have outlined.
    Chairman Spratt. Well, you indicated, I believe, that the 
factor in deriving the $345 billion figure represented 16 
percent of the GDP.
    Mr. Everson. No. No, sir. What I said is it is about a 16.3 
percent noncompliance rate as what we estimated, yes, sir.
    Chairman Spratt. Do you have any back-of-the-envelope 
calculation for how much additional agents or additional 
audits, how much marginal income and incremental effort brings 
in?
    Mr. Everson. Yes. What we have said, sir, is with the 
monies we have requested in the President's budget, which, as I 
again indicated, would be about--do you want to bring up the 
budget chart--5 percent, you can see, as I indicated, the first 
thing we are doing is we are asking for money for 
infrastructure. Improving the infrastructure to us is critical 
because it supports not just the enforcement, but also the 
service side, the processing of the returns, the ability to 
communicate with the taxpayers, which is very important. But we 
have a big enforcement increment there, as you can see, almost 
$250 million.
    What we have done is--we can show a direct impact, we 
believe, or a correlation on things like adding auditors. There 
are some areas where we do not show a number. It would be like 
adding criminal investigators. We do not draw a direct point, 
but what happens here with this basket of proposals is we 
anticipate that after you hire the workforce and then you train 
them, which takes, of course, a couple of years, that you would 
get to a point where on this basket you would get something 
like $700 million of direct incremental revenues.
    The President's budget, as I mentioned, has 16 legislative 
proposals that run from the reporting of gross receipts for 
small businesses--from credit card issuers--that does get after 
this issue on small businesses that cuts both ways, as Mr. Ryan 
was talking about it. If you look at all of those 16 proposals, 
they have been scored by the Treasury economists as adding 
after, by 2010, about $3.5 billion, and there is no direct 
impact necessarily on that, and the way they have calculated 
it, I think their calculations are pretty conservative.
    If you think also about the normal growth in productivity 
that the IRS would have and just say that that is 2 percent a 
year, over a 3- or 4-year period that would get you another $4 
billion, let us say, of these enforcement revenues that I am 
talking about.
    I do not know if everybody can follow that, but, in a 
business, you would expect us to get more productive; and I am 
saying, if you steady state our funding, I would expect the 
organization to do something along that line. If you take that 
productivity increase and you take the incremental enforcement 
increase of $700 million, you would probably get a total of 
about $5 billion of direct impact. Then you could add an 
indirect impact on that.
    So, all things considered, when I testified Wednesday 
before the Senate, your counterpart committee in the Senate, it 
was that if you compare 2006 and 2010 and if you do all of 
these things--if you fund us at the increment and you adopt the 
legislative proposals--I believe it is fair to say that you 
would probably get another $20 billion pop or more from where 
we are now. But that does not score. I mean, one of the issues 
here, as you know, is that does not score.
    The only things that you folks score are the legislative 
proposals, none of the impact. We are just a drag. We had $500 
million. That is a $2.5 billion drag on the budget even though 
we make money, which is kind of hard to understand.
    Chairman Spratt. A couple more questions, and then others 
will have similar questions, I am sure.
    You have not mentioned havens and shelters; and there are 
certain havens that, to most of us, look like blatant devices 
for evasion, the Cayman Islands with one building having 12,000 
firms domiciled there. Can you tell me what the IRS is doing in 
that regard and what you need to have done legislatively to go 
after some of these cases of blatant evasion?
    Mr. Everson. Yes, sir. You are addressing what is a very 
important issue and what is a real compliance challenge for the 
IRS, and I would suggest to you that our estimates do not 
include either illegal activity here in the country or--I do 
not think that they have a particularly good--we do not have as 
good an idea as we ought to have about what is going on in some 
of these countries that you are talking about because the whole 
idea is that they are trying to obscure information from us.
    Now what we have done is we have significantly stepped up 
what we are doing in the corporate arena and in the high-income 
individual arena, and when we do see indications that there may 
be some abuse we will follow that as best we can, including 
criminal. There are criminal matters that we have brought.
    This is a bigger issue in the international community. The 
OECD established a group of tax administrators some 4 years ago 
in about three dozen countries, and it is sort of unusual to 
have an American-run OECD group, but I actually chair that 
group of tax administrators now. We met in Seoul in September, 
and the statement that we issued talks about tax avoidance as a 
growing international problem. We are looking at it across 
borders.
    We have commissioned a study of the role of intermediaries, 
because a lot of this is put together by investment banks, 
accounting firms and law firms; and the other thing we have 
done here is the IRS led an effort. We formed a Joint 
International Tax Shelter Information Center here in Washington 
where we have counterparts from the U.K., Canada and Australia, 
and we meet. They work side by side and share information, all 
of them treaty obligations or standards, to try to get some of 
this.
    But as to what you have just raised, the tax havens are 
amongst the most challenging areas for us to get after.
    Chairman Spratt. One final question, some years ago, there 
was a move on the part of the IRS to improve and to make a lot 
more rigorous information reporting. For example, there was a 
proposal to require contractors who make payments to vendors, 
suppliers and subcontractors above a certain amount to file 
what amounted to a 1099 or a W-2 or something like that so that 
these could be correlated to that payee's account as gross 
income.
    I chaired the subcommittee at that time with Chris Cox, and 
we held a hearing on all of these subjects, and the small 
business folks came and testified that, number one, it would be 
unduly onerous, but number two, even if the IRS got that 
information, it would not know what to do with it because it 
did not have anywhere near the equipment--the computers and 
scanners and everything else--that they needed to keep track of 
these payments on a volume basis.
    Do you have the wherewithal today to have that necessary 
complement to that kind of enforcement effort?
    Mr. Everson. This gets at the infrastructure question, and 
we do have monies in the budget to address the proposal we have 
made. If you will allow me for just one minute, I do want to 
get to the core of this point.
    Chairman Spratt. Sure.
    Mr. Everson. If we go to the tax gap map again just for a 
second, Lenny, if you look at that individual income tax number 
that has the 197 and you drop down there, the biggest piece of 
this is the underreported business income, $109 billion.
    Let us go to the visibility chart now.
    As we look across these 46,000 returns, there are some very 
clear conclusions, and these are not going to really surprise 
anybody. Out at the left here, where you have the spreading of 
some of these amounts that we are talking about, that is your 
wage income where you have substantial information reporting 
and withholding. That is to say that, if there is a police 
officer in your district, Mr. Chairman, that individual is not 
cheating on their salary. The noncompliance rate on their 
salary is 1 percent. That is de minimus. That is because we get 
the information.
    Chairman Spratt. Withholding. How is that?
    Mr. Everson. The information of withholding.
    If we have the information reporting, you get to a 4.5-
percent noncompliance rate. All the way out here at the right, 
though, it indicates that the noncompliance rate is about 50 
percent where there is no reporting.
    So what we have done is we made some proposals last year to 
try and get after this, and we have added some proposals this 
year, but the centerpiece and the proposal I would particularly 
draw to your attention is we would like to get the reporting of 
the gross receipts by credit card issuers to us, and we want to 
do this. We think that this would--this is not the collection 
of new information that each one of us gets a bill from the 
credit card company issuer. They know how much they have 
reported, and the business gets a summary of what they get as 
well. So you are not capturing new information. What you are 
doing is you are sending the information to the IRS, and it is 
not a small business that has to send that information to the 
IRS. It is a pretty big business. The credit card issuers are 
pretty big.
    What this would do is, if you had a dry cleaning business, 
for example--and let us assume that the typical breakdown of 
that revenue is 50-percent credit and 50-percent cash--and if 
you were reporting to us $1 million in revenues and then we got 
a notice from a series of credit card issuers that there was 
actually $1 million of credit card revenues from that business, 
that would raise a real red flag and might prompt an audit. It 
would certainly prompt the communication. The other thing it 
would do is it would change behaviors.
    Let me just draw one simple example about the impact of 
reporting. The last time that Congress really went after the 
Tax Code was in 1986, as you will recall. After 1986, on the 
face of the 1040, taxpayers put down the Social Security 
numbers of their dependents. The next year, even though the IRS 
had not phased in any matching capability yet--it did not have 
the infrastructure to do that--it had to work on this, which 
gets to your question--the next year, 5 million dependents 
vanished, 5 million. So what you really have here is you have 
an interaction in the change in behavior. So you need to do two 
things.
    You need to build the infrastructure, which we will do. We 
need the money to do that, and we have got some in the request 
to do that, but you will change the behaviors if you do some of 
the third-party reporting.
    Chairman Spratt. This is clearly an area where we need to 
be working in tandem.
    We very much appreciate your testimony, and others now have 
questions, Mr. Ryan to begin with.
    Mr. Ryan. Thank you, Mr. Chairman.
    I guess I will just pick up where we were leaving off. Let 
me go back to the estimate you just gave us in answering the 
chairman's question. Because, you know, for the Budget 
Committee purposes, we have got to find out how much is this 
and how much is recoverable, then to the question of how do you 
score this stuff.
    You are telling us that you think, with about $5 billion in 
direct and then maybe another $15 billion indirect, you know, 
having the trooper under the bridge, that it is about $20 
billion additional revenue that can be recovered without 
resorting to sort of draconian things. But that banks all of 
those 16 legislative changes you would make, the additional 
people at the agency? That is about $20 billion you are saying?
    Mr. Everson. That is by 2010. That is the delta between 
2006 and 2010. That is right. I think that is in the ballpark. 
And, again, this is an area where it is very hard to be precise 
because these things have a--I think they have a reinforcing 
effect throughout the system. If you just do the IRS stuff, the 
budget stuff, but you do not change the Code, that does not get 
to the powerful force that everything is happening.
    Mr. Ryan. So it will take years to phase in these reforms 
to get to that $20 billion number?
    Mr. Everson. Absolutely. Let me give you one very clear 
example on this.
    One of the proposals is basis reporting for securities. The 
way that would work is that you would not put that in going 
back for----
    Mr. Ryan. You would go prospective.
    Mr. Everson. You would go prospective.
    So that would roll in over a period of years, starting with 
purchases down the road; and then each year you would get more 
purchases and you would be capturing more information.
    Mr. Ryan. Okay. Now on to this credit card idea, because I 
am trying to get a better handle on this. That seems to be sort 
of one of the bigger pieces of your legislative package.
    Last year, when the administration first proposed requiring 
banks to provide annual information reports to the IRS on total 
payment of credit card reimbursements to merchants, the 
Treasury's estimate was that this would raise $225 million over 
10 years. This year, it seems like the proposal is a little 
narrower than last year's proposal, but Treasury is estimating 
that this will raise $11 billion over that period. What is the 
basis for this tremendous increase in your revenue estimate?
    Mr. Everson. You will have to, honestly speaking, refer 
that to them, because I do not make those estimates. Those are 
estimates made within tax policy by the economists.
    Mr. Ryan. Well, give me an idea of last year's proposal 
versus this year's proposal.
    Mr. Everson. I do not think we are making a substantially 
different proposal. We want the information reporting of gross 
receipts by a credit card issuer to a business, and that is the 
long and the short of the proposal. I actually do think--as a 
whole, I would say I think that the Treasury estimates are on 
the conservative side. Now there is a reason why they do that, 
and it gets back to the chairman's last question.
    The experience has been that you will put in something new 
and then it will not always be administered effectively by the 
service, so that gets in there, but I think that is a number, I 
believe, that is reasonably conservative, sir.
    Mr. Ryan. Okay. So I guess that is sort of puzzling to me. 
You know, we do a lot of scoring around here. How you see a 
score go from $225 million to $11 million is interesting.
    You are talking about not the credit card companies' 
reporting their information to the IRS. You are talking about 
banks' reporting the information to the IRS on behalf of their 
clients, right?
    Mr. Everson. Yes. There is a difference between, as I 
understand it, the banks and the issuer. It is the issuer of 
the credit card that has all of the information.
    Mr. Ryan. It is not Visa, MasterCard, Discover. It is every 
bank in America that has a merchant as a customer is reporting 
their merchant data----
    Mr. Everson. If they are in the credit card business, yes, 
sir.
    Mr. Ryan. Right. So, if a bank issues a credit card, which 
I think most do, they are the ones who are supposed to report 
this.
    Now how is this data square with, you know, your typical 
AGI measurement? How do credit card receipts square with 
measuring the profit and, therefore, the taxable income of a 
merchant?
    Mr. Everson. Well, the merchant--and where a lot of this 
problem is is in the Schedule C filers. That is the biggest 
number that is a part of what I indicated where you are not 
incorporated. You are doing the business, and if you are 
showing your receipts, you have to report your receipts to the 
IRS. You have got a number there. We are going to have a 
different number or we are going to have information reporting 
that is coming in that says what you got in the credit card 
receipts from--it would probably be from a series of issuers 
for just the reason that you indicated. It would not be just--
people do not just accept the American Express.
    Mr. Ryan. You will have 1,000 customers in a given year at 
a dry cleaner's. I do not know. I cannot even think of the 
number. But let us say you have 10,000 people who come to your 
dry cleaner's in a given year with all of their different 
credit cards. So for you to audit that dry cleaner, you are 
going to have to have the banks of each of those 10,000 
customers report to you the credit card receipts that go from 
that bank to that dry cleaner, and then you are going to look 
at that data. Is that basically what you would do?
    Mr. Everson. Well, that would all be electronically 
communicated to us or transmitted to us; and I do not think, as 
I have had conversations with systems people, that this is that 
heavy a lift. If you do something--this is not like we get 
suspicious activity reports----
    Mr. Ryan. I am just trying to understand the proposal.
    Mr. Everson. Yes, yes. No, they capture that data. They 
know how much they did over the course of the year with you if 
you are the merchant. They are just giving us that data. They 
have that data. That is different from, say, asking, which we 
do--we have suspicious activity reports you are familiar with 
when you have large cash transactions. That takes the creation 
of a different business process within a bank, say, to look at 
that and then do a special report. Here you are talking about 
the rolling up of the information which they already roll up by 
customer and then give it to us.
    Mr. Ryan. Okay, and then you are just going to look and see 
if there is something that stands out?
    Mr. Everson. Yes. And, again, I think this would 
potentially have even a bigger impact than it is scored for, 
because a lot of the indirect, some of that is in there, but 
this would make a big change.
    Mr. Ryan. One quick last one.
    Your budget also proposes that all contractors who receive 
payments of $600 or more in a calendar year from a particular 
business would be required to furnish the business with the 
contractor-certified TIN, the Taxpayer Identification Number. 
The business would then be required to verify the contractor's 
TIN with the IRS. If a contractor fails to furnish an accurate 
TIN, the business would be required to withhold the flat 
percentage of gross payments and do withholding.
    How does this work in practice? I mean, there have got to 
be tens of millions of contractors who would be subject to this 
requirement, and do you have the capability of, on a real-time 
basis, furnishing this TIN to people who call up and request 
it?
    If you want to give that to me in writing, that would be 
great.
    Mr. Everson. I will certainly do that, sir.
    Mr. Ryan. My time is getting short. Thanks.
    [The information follows:]

    Since October 2003, payers of certain income reported on Forms 1099 
B, DIV, INT, MISC, OID and PATR have had the ability to match their 
payee name and taxpayer identification number with the information 
contained in IRS tax records for that payee. This service is provided 
to payors in an attempt to assist them with perfecting the Form 1099 
prior to filing an information return with the IRS. As the law 
requires, the IRS may impose a penalty to payors who fail to obtain an 
accurate TIN from the payees with whom they conduct business.
    Current IRS operations provide an on-line interface for registered 
users to submit the name and TIN (Taxpayer Identification Number) of a 
payee to the TIN Matching program and receive a response regarding the 
status of the match request. This process may be accomplished via an 
interactive on-line input, whereby the user receives an on-screen 
instantaneous response or, via a bulk file submission which is 
transmitted to the IRS by a secure mailbox assigned to the user by the 
IRS. The processed file is returned to the requestor anywhere between 
2-24 hours and accommodates requests of up to 100,000 TIN/name 
combinations per file.
    The budget proposal would increase the overall TIN perfection rate 
for all payors of non-employee compensation reported on Form 1099-MISC, 
not just the payors who voluntarily utilize the TIN Matching program. 
If this proposal were enacted, the expansion of this voluntary program 
to mandatory usage for TIN verification of contractors (1099-MISC non-
employee service providers) may result in a substantial amount of user 
traffic for both the interactive and bulk features. Any staffing or 
other resource issues related to increased volumes would be addressed 
as part of implementation.

    Chairman Spratt. Mr. Cooper.
    Mr. Cooper. Thank you, Mr. Chairman; and thank you, Mr. 
Everson, for appearing before us.
    You noted that this is your first appearance before the 
committee, and you have been on the job for 4 years. I do not 
think it should go unnoticed that this is the Budget Committee. 
I have been on it for 4 years, and it is a shocking dereliction 
of our duty that we did not have the IRS Commissioner here 
before.
    If we look at the government as an enterprise, to ignore 
the revenue side of the income statement is truly an amazing 
oversight. So I would like to congratulate the current 
management of the committee for conducting things in a 
businesslike fashion. We should have regular visits.
    We can discuss exactly how big the tax gap is. I think it 
is important to remember the many flaws in our Code, I think, 
going all the way back to Jimmy Carter. I think he called it an 
abomination. So what we are discussing is a gap in complying 
with an abomination. It is our job as lawmakers to try to 
improve that abomination, to make it easier to comply with and 
to cut out some of the loopholes. I worry sometimes that there 
is barely enough law left to hold the loopholes together.
    We have seen an astonishing increase in so-called ``tax 
expenditures.'' with 17,000 lobbyists in Washington who lobby 
the Ways and Means Committee alone, most of them are seeking 
tax expenditures; and that, of course, does not create a tax 
gap. That creates someone who does not have to pay taxes 
because they were able to be successful in persuading Congress 
that he did not need to pay taxes.
    According to the GAO testimony that is coming out following 
you, the number of tax expenditures is up to $847 billion a 
year. That is a lot of money, and I am sure many of these are 
quite legitimate, but perhaps some of them are less legitimate, 
and the analytical question I want to focus on is this--and 
this was presented to this committee before by Pam Olson, a 
former Treasury official.
    She pointed out that, as bad as entitlement programs are--
and they are burgeoning beyond our ability to pay for them--
that tax expenditures are even worse because, as she put it, 
these are unmeasured and immeasurable losses in revenue, 
unverified and unverifiable losses in revenue.
    So while we can conduct estimates of what a tax expenditure 
costs, we do not really know. There is not the methodology in 
place to be accurate in giving us an estimate of foregone 
revenue.
    So I would suggest that our colleagues on Ways and Means 
need to be particularly careful, now that we are under new and 
improved management, in handing out these things because they 
are so difficult to measure and to verify.
    Of course, if you cannot succeed in persuading Congress to 
get a tax break, well, then the next best thing is to hope that 
the IRS will be slow in noticing there is a problem; and I 
wonder about your efforts in coordinating--and, of course, you 
do not want to invade client privacy--with the big four or big 
five accounting firms to find out their experience.
    Because, as a former investment banker and businessman, I 
have worked with probably several hundred small businesses, and 
I have noticed that when they were forced to adopt real 
accounting standards it was amazing how many hunting dogs were 
found on the payroll, how many minor children were hired as 
janitors to take out the garbage and other worse abuses, 
sometimes including an entire industry that had adopted overly 
lenient accounting standards. A lot of these are practices 
known to our brethren in the big four/big five accounting 
firms, and I would suggest that your employees would learn a 
lot if they talked more frequently with those folks.
    It seems to me that we are in a situation right now where 
the government needs more revenue. We need to arrive at it 
legitimately, and no one wants a tax increase. So I would hope 
that we could encourage more of our taxpayers to remember the 
proper basis for their stocks. I thought when we filled out 
those forms we were supposed to tell the truth, that if you 
bought Intel or GE at XYZ price--and it is pretty easy to look 
up--that that should be reported honestly on the return.
    As you point out, the large majority of noncompliance is 
underreporting of business income, and I hope our friends in 
the business community would help encourage their members to 
report honestly their true revenues and to be fair about 
claiming these new tax breaks because, as the GAO again will 
point out following you, there is a $32 billion noncompliance 
problem. Because we give someone a tax break and that is not 
good enough, then they exaggerate the tax break; and to have a 
$32 billion problem grow on top of $847 billion in tax 
expenditures is truly an amazing situation.
    So I appreciate your good work. We look forward to seeing 
more of you before this committee.
    Mr. Everson. Thank you. I appreciate your comments.
    If I could just respond very briefly, one of the challenges 
in the system is about visibility. You will write a law, and it 
could take 10 or 20 years before anybody really knows what the 
impact of that is because it takes us sometimes a year or 2 to 
write the regulations that interpret the law.
    Then in the corporate area, where there is a lot of 
complexity, we may not be auditing those companies for years; 
and then you get into challenges that go into our appeals, our 
administrative system or, ultimately, in the courts. So your 
visibility can be 10 or 20 years down the road before this gets 
resolved. That is not in anybody's interest.
    Simplifying the Code is clearly something that is very 
important that we have got to get after, but I have to say 
there is a tension there between that and a representative 
democracy because you are paid by your constituents to get the 
best deal for the industries or for the people in your 
districts. That means a different deal all too often. So 
simplification is a very tough thing to get after, but it would 
help a great deal, and we do meet regularly with the accounting 
firms, and we can do more of that.
    Chairman Spratt. Mr. Garrett.
    Mr. Garrett. Thank you, Mr. Chairman.
    Thank you, Mr. Commissioner.
    Before I begin, I am a little shocked about the 5 million 
dependents who have vanished in 1 year. I am hoping that the 
IRS is looking into it so we can track down those people and 
bring them home.
    Mr. Everson. That is right.
    Mr. Garrett. Yes. I appreciate your speaking with us today. 
I am sure members of both sides of the aisle believe that it is 
the obligation of all of us--I am sure we all do--to pay our 
appropriate tax to sustain the country, but when we discuss tax 
avoidance and tax schemes, you know, I thought of the words of 
Judge Learned Hand. He had a comment on this.
    He said that anyone who may arrange the failures so that 
his taxes shall be as low as possible is not bound to choose a 
pattern which best pays the Treasury. It is not even a 
patriotic duty to increase one's taxes over and over again. The 
courts have said that there is nothing sinister in so arranging 
failures as to keep taxes as low as possible. Everyone does it, 
rich and poor alike, and all do it right for everyone, and no 
one owes any public duty to pay more than the law demands.
    So here we are just trying to find out those who are paying 
less than what the law demands.
    Mr. Everson. That is entirely correct, sir.
    Mr. Garrett. Right. Part of the question goes to the issue 
of the complexity of the Tax Code. The ranking member pointed 
out there are 17,000 pages, 60-some-odd thousand, I guess, 
pages of rules. I would be curious how many members around here 
actually still do their own taxes. I stopped doing my taxes a 
number of years ago because of that complexity; and, as it gets 
more and more complex, I assume that puts a burden on both the 
taxpayer and the IRS and that is, in part, what adds to the tax 
gap--isn't it--the basic complexity of the Code.
    Mr. Everson. What I say, sir, is that complexity obscures 
understanding.
    What that means is that the taxpayer who seeks to be 
compliant has difficulty doing so and can ultimately throw up 
his hands and say, ``Why bother?'' Then, on the other hand, the 
taxpayer who seeks to be noncompliant counts on the complexity 
and uses the complexity to obscure things and to avoid 
detection by the IRS. So simplification is something that I 
strongly favor.
    Mr. Garrett. Yes, and if I go back to my constituents back 
home tomorrow or the next day and I ask them about the idea of 
greater enforcement, the first question or comment that most 
people would say is, ``Well, I pay my legitimate share. I am 
paying what I am supposed to be paying. It is too much,'' they 
will all say, ``but I pay my fair share.''
    Their first gut reaction is, yes, if there somebody out 
there who is not paying, then the IRS and the government should 
do everything they can do to track them down. But the flip side 
argument of that is, if I explain to them, ``Well, in order for 
us to do that, there may be added complications or added burden 
on you, the honest taxpayer, in additional requirements or in 
additional intrusions by the IRS and forms in addition to what 
you are talking about here as far as the administration's 
recommendations,'' then their response might be a little bit 
different.
    Mr. Everson. I agree with both of those observations. We 
say that we want--our service obligation is to help taxpayers 
understand their obligation and facilitate their participation 
in the system but that enforcing the law is important because 
average citizens do pay their taxes, and they have every right 
to expect that neighbors and competitors are doing the same.
    Some have criticized our 16 proposals, legislative 
proposals, as meager, but both the Secretary and I are acutely 
conscious of this second issue you are talking about. We feel 
what we try to do is craft things that are minimally burdensome 
that do not get to be too much, and each extra step you are 
going to take in this arena will get more resistance just for 
the reasons you are getting at, sir. They will touch more 
compliant people, and they will be more burdensome.
    So what we would like to do is get what we have got here 
now, and then if there is stomach for more, we will continue to 
talk, but we do not want to go too far on this.
    Mr. Garrett. And I hope either side of the aisle would as 
well, because it does put a burden on the legitimate taxpayer 
as to what the dishonest crook out there is doing. This may be 
beyond your area of comment, but I am just curious.
    Is there anything either in the proposals that you are 
making here, considering today, as far as the administration's 
proposals or other proposals that have been out there to try to 
get at this tax gap that look at the overall impact that it 
would have on the competitive nature of our whole new global 
economy that you will place on small businesses and mid-sized 
businesses as well?
    Mr. Everson. Again, I think that we are sensitive to that. 
As I think you know, the Secretary has particularly been clear 
on looking at this whole question of the regulatory 
environment. I think that we are comfortable that what we have 
put in here thus far does not really get to where it is too 
burdensome.
    Mr. Garrett. Okay. Thank you. I appreciate it.
    Chairman Spratt. Mr. Becerra of California.
    Mr. Becerra. Mr. Commissioner, thank you very much for 
being here, and I look forward to working with you on some of 
these matters. I know that when you have been before us in Ways 
and Means we have talked about this, and I know we have tried 
to figure out ways to tackle this in a more efficient way.
    Give me a quick sense. I know that the IRS underwent an 
automation of its computer systems and so forth and it did not 
work too well at first, but, overall, how much did that cost 
and is it completed yet?
    Mr. Everson. What happened was there were several sort of 
false starts that took place on this, one in, I guess, the 
early 1990s and then----
    Mr. Becerra. And I am just trying to find out how much have 
you spent.
    Mr. Everson. I would have to get you a figure, but we have 
each year now a separate appropriation that, for the last 
couple of years, has been running between $200 million and $400 
million a year. We actually brought it down, and now we are 
bringing it back up.
    Mr. Becerra. Okay. My point here is that, if we could help 
you get automated in ways that are modern and comprehensive so 
that your system is compatible with systems with other agencies 
and so forth or with other private sector entities, then it is 
probably going to be easier to move towards compliance through 
the Internet system, through the new wireless systems that we 
have in place today around the world.
    Mr. Everson. You are entirely correct.
    If you go back to that budget chart, the most important 
number in there for me is this $146 million increment--or, 
pardon me, it is $143 million on the infrastructure 
modernization side. In fact, if you asked our operating people 
right now, somebody running the unit, we can give you $5 
million or we could spend $5 million on getting better systems 
to support your people, they would, to a person, take the 
systems money and the infrastructure money. So you are right.
    Mr. Becerra. So if you have a $345 billion gap and you know 
that a major portion of that is coming from those who are in 
the small business arena who are not filing all of their 
information and, for example, the proposal that you have in 
your budget that would try to get us towards using the credit 
card of a business or of an enterprise to try to--or credit 
cards that are used to make purchases with that commercial 
enterprise, you could do a better job of tracking what is going 
on. If you could find a system, an IT system, that could help 
make it easier for the banks and commercial enterprises that 
have to report all of that information on credit cards, you 
could then probably do a pretty decent job of collecting far 
more than the cost of that IT system that you acquire to try to 
do a better job of collecting.
    Mr. Everson. They are collecting this information.
    What we would have to do is--any time we do new document 
matching, we have to adjust our system and then we have to work 
with them. This last year--at the end of 2004, we mandated 
electronic filing for large corporations. That had never been 
done before, and that information started to come in this past 
year, 2006 for 2005. That required new software and real 
changes for us and for the companies. So systems is important.
    Mr. Becerra. Is it fair to say that efficient investment in 
IT infrastructure pays off for you?
    Mr. Everson. It is essential, and it does pay off.
    Mr. Becerra. Okay. Could you use more than what you have in 
your current budget?
    Mr. Everson. Now that is dangerous territory here.
    Mr. Becerra. I did not say ``did you want'' or I am not 
asking----
    Mr. Everson. No. No. Well, I am going to be very clear 
here, as I was in the Senate.
    I am asking for every penny of this request but not a penny 
more, and what I said is we have to be extremely careful in 
this area because what happens----
    Mr. Becerra. You need not go into it, because I am going to 
run out of time, and I know what you are going to have to say. 
Let me move to another question.
    Given your testimony and the charts that you showed us, if 
I were a wage earner, if I got a check and I had deductions--
and, by the way, I guess all of us as Members of Congress do. 
We are wage earners, we get a paycheck, and out of that 
paycheck every month is deducted--or every 2 weeks or however 
often you get paid--is deducted the income taxes that we are 
supposed to pay along with the FICA taxes and Social Security 
and so forth. Whereas, if you are an independent 
businessperson, you independently file the paperwork to the IRS 
to document what taxes you should pay.
    Given your testimony, if I am a wage earner, I think I am 
the knucklehead in this process. Because if I own a business, I 
get to report what I want, but if I work for that business, it 
gets reported automatically, and the charts show it, that wage 
earners are the ones who pay. The honest folks are the folks 
who probably make the least amount of money. The folks who are 
not paying are the folks who can most afford to pay their 
taxes.
    I hope what we can do is work with you to make sure that we 
get rid of that tax gap of $345 billion when we have a budget 
that exceeds $200 billion and that we do more to make sure that 
the wage earner is not having to compensate for the folks who 
are not paying their taxes by paying more out of their 
paychecks every month or every week and that we do a little 
more. I hope we can work with you because I think it is 
extremely unfair, and it seems to me it is ripe for a revolt by 
those who are getting taxes deducted every month.
    Mr. Everson. Two points if I could respond briefly.
    First of all, there is disparate treatment between wage 
earners and others.
    The second thing I would say is I also view it as a matter 
of fairness in the small business community because--probably 
most of you are homeowners, but we have all been given two 
different quotes for a job at our house, one by somebody who is 
playing all by the rules and another that is a better quote by 
somebody who is not. The person who is not paying the taxes on 
his or her business has an unfair competitive advantage. That 
should be a concern to all of us, too.
    Chairman Spratt. Mr. Hensarling.
    Mr. Hensarling. Thank you, Mr. Chairman.
    Commissioner, welcome, and thank you for your service to 
your Nation. You have a thankless job. You may be the only man 
in America less popular than we are. We thank you for that.
    Commissioner, according to GAO, apparently since 1970 the 
compliance rate for taxes has been at 86 percent. So through 
roughly 15-20 Congresses--Republican and Democrat--through 
roughly six or seven presidents--Republican and Democrat--
through I do not know how many different IRS Commissioners, 
apparently this tax gap has remained fairly constant. So I 
think all of us on this committee would certainly share the 
goal of ensuring that every American pays their fair share of 
taxes, not a penny less, not a penny more. I know that we are 
always searching for that elusive pot of free money out there, 
the easy fix, but why should I not be skeptical? If it is such 
an easy fix, why hasn't it been done before now?
    Mr. Everson. I think that your observations in the broadest 
sense are quite fair, and there are some who say, let us just 
get rid of the tax gap, and then we have taken care of our 
fiscal issues here. It is not that easy, and it is not that 
easy for a variety of reasons.
    One is it gets into this issue of how much of a presence 
you would want to have for the IRS. The other gets into the 
very real issue we are talking about of burden and adding more 
reporting.
    So what I think we have done is we believe there is 
opportunity here, sir, and what we have made is what I would 
consider some pretty significant proposals, but it does not say 
you are going to eliminate or hugely reduce that gap just 
because of the difficulty and the many complicated things you 
get into if you try to do it.
    Mr. Hensarling. Also, Commissioner, is it possible that the 
cure could be worse than the ill?
    Let me just state the ridiculous. You could corner an IRS 
agent in every small business and home in America. Do you know 
what I mean?
    Mr. Everson. Yes. Let me say this, and I have not said 
this. We enjoy the best system in the world. Let us all be 
clear on that. Our system is the envy of other countries. I 
meet with a fair number of international counterparts, and we 
have got a great system here, so we want to make it better, but 
we could make some real mistakes here if we overreach.
    Mr. Hensarling. Well, in speaking of possibly the cure 
being worse than the ill, according to the Tax Foundation, the 
compliance cost has doubled over the last 10 years, and now 
there is a $265 billion drain on our economy. I mean, that is a 
huge figure, a huge transaction cost.
    Theoretically, might we raise more Fed revenue, say at 90 
percent compliance instead of a hundred? In other words, if we 
could somehow figure out how to take part of that $265 billion 
being devoted to compliance, instead turn it more into economic 
growth, capitalizing more small businesses, increasing revenue 
bases, isn't it at least theoretically possible that we don't 
want a hundred percent compliance because that would create 
less revenue than, say, 90 percent compliance.
    Mr. Everson. I think what you are saying is common sense, 
that to get after every last nickel here, that causes a whole 
series of costs to get in there, and burden is important. We 
have an Office of Burden Restriction, and we are constantly 
seeking ways to reduce burden and simplify it within our 
purview.
    Mr. Hensarling. Speaking of simplification, and I know at 
the outset of your testimony you said you weren't here to 
promote a favorable and predictable tax policy over another, 
but would you be in a position to offer an opinion that if our 
sole goal--if our sole goal was to close that tax gap, have you 
run models on either the flat tax or the fair tax and what the 
tax gap might be under one of those two policies? Would we have 
a smaller tax gap if Congress adopted one or the other?
    Mr. Everson. I have not run those models. People at the 
Treasury may look at this.
    What I say about legislative proposals of VAT or a flat tax 
is that my observation is that you can't compare a perfect 
theoretical system with an imperfect actual system. So you need 
to make sure you look at these things fairly.
    As an example, I know from discussions of my colleagues in 
the U.K. There are real compliance issues with the VAT. You 
need to bear that in mind when you have those conversations.
    Chairman Spratt. Mr. Doggett.
    Mr. Doggett. Thank you for your service, Commissioner, and 
your testimony. It is a measure of the new direction in which 
this Congress is moving that you are here today.
    Several of my colleagues have used the term ``shock''; and 
I have to say, frankly and sincerely, that I view your 
responses as shocking. As I understand your testimony as the 
Internal Revenue Service Commissioner, you are unable to tell 
us or the American people--to give us an estimate that you 
believe is reliable, that you can feel comfortable with, of 
what the gap is between taxes owed and taxes collected in 
America today.
    Mr. Everson. I think that is correct, sir, because we don't 
have the precise numbers.
    Mr. Doggett. If you put your tax gap map back up, we can 
get a better understanding. Because your tax gap map--as you 
pointed out, the last time that you did any study of this 
matter was tax year 2001, right?
    Mr. Everson. And it takes several years to complete a 
study.
    Mr. Doggett. That is a tax year that ends on December 31st 
of 2001, the end of the first year of the Bush administration. 
And in tax year 2002, tax year 2003, tax year 2004, tax year 
2005, you didn't do a study, you said, because you were told to 
stand down at the request----
    Mr. Everson. No, no, no, sir. What I said was that we had 
done--the last time before 2001 was in 1988 and then nothing 
was done in the intervening years because, during the 1990s, 
the Service was told to stand down.
    Mr. Doggett. To stand down, and you also had a 25 percent 
reduction in your enforcement resources.
    Mr. Everson. At the end of the 1990s, in 1996 through about 
2002, and so----
    Mr. Doggett. And the study that you did in 2001, as I 
understand it, you said there is a $3 billion figure there for 
corporations. You didn't really study that in 2001. You used 
old data. So that has not been studied.
    Mr. Everson. That has not, and I believe that is 
understated.
    Mr. Doggett. You indicated that one of the areas that you 
have found most of the greatest challenges is on the tax 
havens, and the biggest chunk you believe from your chart is 
business income. I realize much of that is not related to tax 
savings, but I was concerned that in your legislative 
recommendations you don't really seem to have much of anything 
to deal with that other than the 163(j) provision on related 
party interest deductions which the Ways and Means Committee 
should put a stop to and change but instead asked you to do a 
study. Is the study complete?
    Mr. Everson. I don't have an answer for that. That is a 
Treasury issue. What you are getting to is more legislative 
policy proposals, sir.
    Mr. Doggett. And you have input on those, but these are 
really Treasury's recommendations?
    Mr. Everson. Again, what I am talking about here is more 
tax compliance.
    Mr. Doggett. Let me turn to an area that is within your 
jurisdiction. I wrote you about this 3 weeks ago, and I know 
that some other colleagues wrote you about it. That was the 
report in the New York Times on January 12th saying that the 
IRS, when it came to large and mid-size business audits, 
basically had a catch-and-release program, that you limit the 
time of your auditors. That if your auditors find other tax 
avoidance schemes, they are only there to go for the tax 
avoidance scheme that they were sent to.
    Employees were interviewed, auditors were interviewed, 
retired auditors were interviewed in a number of States 
indicating that, though there had been an increase in 
collections, that they said that could be explained by the fact 
there are so many more tax avoidance schemes out there and that 
the IRS limited the access of the auditors to information. You 
set up a way that they would be rewarded on the faster they 
closed the case, not based on how effective they were.
    I asked you for a report about what I thought were very 
disturbing practices as reported in the Times, as editorialized 
in the times. Are you near----
    Mr. Everson. I am happy to respond to that, sir.
    Mr. Doggett. Will you have a more complete report?
    Mr. Everson. If we haven't responded, I sent a letter 
earlier this week on that issue to, I think, one that came in 
before yours, and I will send you a complete response.
    But I am glad you raised this because I spoke to this the 
other day in the Senate. If you could go to--yes.
    First, let me say this: Currency is important. It is 
shameful that things take years and years to get resolved. That 
serves neither the corporation's interest nor the government's 
interest. The compliant taxpayers need to get issues resolved 
because there is a real cost of certainty and the government 
needs to move quicker. In any given examination, decisions are 
going to be taken, and there will be a tension between the 
employee conducting that examination and the manager.
    I think we get things, by and large, correct; and if 
somebody thinks that something is being left behind and they 
think it is being done intentionally, they may object because 
they could get more. But the manager has to make the decision 
as to whether at a certain point they can be more productively 
used elsewhere. That is a basic question.
    I wouldn't say to you, sir, that we get it right each and 
every time. But when I look at the big picture--and, yes, we 
are trying to drive down a cycle time--I am reassured by the 
statistics.
    If I could just show you these. It is a little hard to 
read, but this takes the Es/Ex class of 10 to $250 million per 
corporation and this takes the Es/Ex class of over $250 
million. It says that in 2003 the number of audits that we did 
on the smaller class had declined over a 30-year period, until 
I got here, to 3,800 audits; and I had said for the bigger 
companies, they declined to 3,300 and that the amount of money 
set up was less than a billion here and the amount of money was 
just over $12 billion. Now that has increased in 2006 to 4,300 
audits. We didn't have much coverage here. We want to increase 
it. And the amount of money we set up has grown to $25 billion.
    You could argue that maybe there is more, and I am sure 
there is more. You got the chart. But I would point out to you 
the other statistics, that the corporate receipts as a 
percentage of GDP have increased during this period, corporate 
profits have increased, but they have gone to their highest 
level as a percentage of the GDP in 18 years. You have to go 
back to 1978 or--pardon me--yeah, I guess it will be 1988. It 
may be 28 years. But, anyway, it is a long time since they got 
up to 2.7 percent or wherever they are now.
    When I look at the big picture, sir, I think this is all 
working. We are doing more. We are trying to move faster. I 
don't doubt that some people don't like that.
    The other things we have done is we have changed our 
personnel policies here. We rotate people off the big 
companies. They can get too cozy, frankly, by staying 5 or 6 or 
7 or 10 years; and that is not good. So not everybody is happy.
    Chairman Spratt. Mr. Campbell of California.
    Mr. Campbell. Thank you, Mr. Chairman; and thank you, 
Commissioner Everson. I have a series of kind of unrelated 
informational questions.
    First one is, my understanding is the Senate Finance 
Committee has talked about perhaps having the IRS build online 
tax preparation software through a Web portal as a suggestion 
on the tax gap. Is that something you think will reduce the tax 
gap or not?
    Mr. Everson. This is a very important issue. It could be 
helpful.
    I would say to you, as a general matter, right now 80 
percent of the returns right now are prepared with the use of 
some computer software; and returns are so complex or the Code 
is so complex that I am sure people couldn't comply if they 
didn't go through the software.
    When you get into the issue of should there be a portal 
developed, I am reluctant to embrace that idea at this time, 
first because, going back to the chairman and other comments 
about it, the infrastructure, this is not an easy thing to do 
if you really want to do it, and I don't think we are ready to 
do it.
    The other thing I would say----
    Mr. Campbell. Have you ever estimated how much it would 
cost?
    Mr. Everson. Clearly, it is a hefty price tag.
    The other point I would make that I think is very pertinent 
here is the acceptance of the IRS, as some have indicated here 
today, is better than it was. There is a big industry out 
there, and they will go to war when this policy is pursued. 
They already did that in California when California tried to 
extend the free file alliance. They had big pictures of, you 
know, dogs eating steaks. There will be a collision here, and I 
don't welcome that as trying to run a system where people have 
trust in the IRS.
    Mr. Campbell. I am from California and was in the state 
legislature during that whole issue.
    But I will say there are a lot of privacy concerns having 
to do with this. The California proposal is going to keep track 
of entries and strokes. So if someone put in $300 of charitable 
contributions and erased it and put in $400, they would have 
kept that. There would be a whole lot of privacy----
    Mr. Everson. There would be a lot of allegations about it.
    Mr. Campbell. Another issue relating to the tax gap--and I 
am curious how we get to this. Computing the correct tax is an 
art, not a science. And you can put together everyone in this 
room and have them do the best job they can of interpreting the 
laws and regulations to come up with the correct tax, have the 
IRS do the same thing, and there could be a gap between those 
two with completely honest people.
    If there weren't ambiguity, there wouldn't be Tax Court, 
there wouldn't be revenue rulings, private letter rulings, et 
cetera. It can come all the way from anyone who gives a piece 
of furniture to the Salvation Army, and what is that worth, to 
a major corporate reorganization or something.
    Mr. Everson. Yes.
    Mr. Campbell. Is that included in the tax gap or--because 
there is a gap between honest interpretation of the law.
    Mr. Everson. You are absolutely correct. And the resolution 
of that uncertainty is a very important facet of our system, 
and the fact that it happens fairly, it happens--we have a 
group that is independent within the IRS appeals group that 
takes a real look at this, and then people do go into the 
courts. This is one of the reasons why getting the right number 
on corporations is so difficult, because it takes so many years 
off and to figure out where the courts will land on the 
interpretation of a statute. It is a real challenge. If I had 
one observation, it is the stuff takes too long to resolve, 
frankly.
    Mr. Campbell. Okay.
    The $20 billion number you gave as a delta 2010 for your 
ideas for closing, I was unclear if that was the cumulative 
total to that point or if that was the annual total at that 
point.
    Mr. Everson. It is the second, sir. It is the lift you 
would get between 2006 and 2010.
    Again, you have to fund the service. We would have to get--
and that is dependent upon adequate funding in the outyears, 
too, so you get continued productivity lists and all of the 
legislative proposals.
    Mr. Campbell. On your credit card proposal, one thing I was 
unclear about. If you get from the banks the merchant credit 
information, will it have detail or is it just going to be a 
total single number?
    Mr. Everson. It would be a total number.
    Mr. Campbell. Then the last thing is just kind of getting 
back to the preparation and privacy issues, that another thing 
with, frankly, in my view, with either online tax preparation, 
frankly, even e-mail filing and stuff, there is so much--we 
have had problems with the veterans' information with 
information getting out. If everything on an individual's tax 
return, which can include bank account numbers, all kinds of, I 
mean, everything about that individual were present on any 
computer anywhere and the only place it would be is within the 
IRS, shouldn't we have privacy concerns with that?
    Mr. Everson. This is another reason to support the 
infrastructure request, because we do have money for heightened 
security in there. We work very hard on this issue. It is a 
constant challenge, I have to say; and it is a very important 
issue. So I agree with you.
    Mr. Campbell. Thank you, Mr. Chairman.
    Chairman Spratt. Mr. Blumenauer.
    Mr. Blumenauer. Thank you, Mr. Chairman; and, Mr. 
Commissioner, we appreciate you being here.
    I don't happen to think you are one of the most unpopular 
people in the country. I get a little embarrassed when people 
joke about it. Because what you said is true. Our tax system is 
the envy of the civilized world.
    When you don't have a tax system that people can have 
confidence in, then you have bribery, then you have 
underfunding of government services, then you have back-channel 
activities, you have corruption. This is an indice of 
civilization and a democratic function.
    Mr. Everson. I agree with you entirely, sir.
    Mr. Blumenauer. I just personally find it offensive that 
people make the IRS sort of a second-class citizen, not just 
casual jokes. But what we saw this Congress do--I saw it when I 
first came here--vilifying the IRS, the people who worked for 
it, exaggerating pretty dramatically some problems and 
resulting in what we saw in terms of severely restricting your 
ability to manage the agency, you and your predecessors, 
resulted in lots of money being lost and corners being cut.
    There are people who are saying, well, this is confusing, 
and so certainly there is problems. But if it were just a 
matter of confusion, then we would see as many people being 
confused and overpaying as underpaying.
    It seems there is a pretty systematic problem with a lot of 
people who are confused in ways that cheat the government and 
put their competitors who play by the rules--and most business 
people do--put them at a disadvantage.
    Mr. Everson. I agree with that as well, sir.
    Mr. Blumenauer. So the fact that this Congress under 
Republican control, I am sad to say, while you were increasing 
the complexity of the Tax Code, talking about it being too 
complex but adding thousands of pages of regulation and new 
taxes, starve the ability of IRS for compliance.
    So I am pleased that our leadership is bringing you here 
before the Budget Committee. I hope you will have a better 
reaction from the Ways and Means Committee now so that we don't 
pile on all sorts of things, while claiming we are for 
simplification, making your job more difficult, doing it in the 
back room and the dark of the night at the last minute so that 
it is a nightmare for you to even try to comply with what 
Congress passes.
    Mr. Everson. The only thing I would say is I have been on 
the job 4 years, and I think I have been treated fairly and the 
service has been treated fairly by both sides of the aisle 
during that period of time.
    Mr. Blumenauer. I think you are a very generous man. I 
think the record of what happened--and it happened just before 
your watch----
    Mr. Everson. It happened back in the 1990s.
    Mr. Blumenauer [continuing]. In terms of dragging people 
in, flogging them, making all sorts of goofy and outrageous 
actions.
    I recently met with about a dozen tax professionals in my 
community, top-drawer people, some of whom I have known for 
years, some who are new friends, seeking advice and counsel. 
There was one that had had an audit in the last 8 years. They 
were saying, you know, it is fascinating in terms of what 
doesn't happen any more. They had suggestions in terms of our 
having some sense of the positions that are funded, in terms of 
the revenue they generate, that that is what a business would 
do. Because this pattern of mistakes is not random, it is 
purposeful.
    Mr. Chairman, my question, as much to the committee as to 
the Commissioner, deals with the bizarre notion of scoring. 
What is being suggested to us is that, by giving the resources 
to the IRS to do things like having just gross amounts of money 
reported as a little bit of enforcement action, a little bit of 
infrastructure, is going to produce far more tax revenue than 
it costs; and everybody will agree to that at some level. Yet 
under the way that our budget rules work, that is a cost right 
now. It is a difficulty for our budget--for our appropriators. 
It is difficult for you in terms of crafting the budget, even 
though in the 10-year budget window it will pay for itself 
many, many, many times over.
    I have talked to the Director of CBO about some of these 
areas where our scoring rules have a perverse effect of 
actually costing money and misstating the economic impact over 
a 5- or 10-year period. I would hope that there would be some 
way working, for example, with the Commissioner of IRS and with 
CBO and with the certified smart people and the staff on both 
sides of the aisle that we could go back and look at some of 
these scoring conventions from a present-value perspective. 
Because I think it is perverse. I think it is costing us money. 
It is preventing investments that make sense.
    We are starting to do that in some areas of government 
finance, and it is something that I planned on bringing to the 
committee later. I want to bring it up now. It is cheaper for 
the government to spend billions of dollars cleaning up after a 
disaster than spending a couple----
    Chairman Spratt. Mr. Blumenauer, that is why we are holding 
this hearing, to lay the basis for a lot of things like that.
    Mr. Blumenauer. It is the scoring, Mr. Chairman, is 
something that I would like to address.
    Chairman Spratt. I understand, but this is part of the 
exploration of that issue.
    Mr. Conaway.
    Mr. Conaway. Thank you, Mr. Chairman; and I would like to, 
curiously, agree with my good colleague, Mr. Blumenauer's rant 
about the Ways and Means Committee. We have got a bill on the 
floor today, 976, that does exactly what he said: It was done 
in the dark of night and done--and I agree with my colleague.
    Mr. Blumenauer. Will the gentleman yield?
    Mr. Conaway. No, I won't. You had about 8 minutes on your 5 
minutes. I am using mine.
    Compliance audits that--in other words, for the research 
that you do--and, again, thank you for being here. I appreciate 
that. John and I are colleagues in another realm. Appreciate 
you being here.
    Would you describe what a compliance audit looks like? Is 
it unfair to describe it as a colonoscopy?
    Mr. Everson. I think that was the way the research had been 
done in 1988, and I think that was one of the contributing 
factors that got this to stand down. We worked pretty hard in 
this last cycle to make sure we weren't going to ask for 
information that we already had or that was out of line. So we 
very much revised the procedures, and we didn't get but a 
handful of complaints in terms of those 46,000 reviews that we 
did.
    Mr. Conaway. We are now 6 years away from that research. 
Tax rates are lower now than they were in 2001, which I believe 
personally contributes to better compliance when the penalty 
for reporting or the result of reporting is not as draconian at 
the rates we currently have applied as the rates before.
    When do you think you will do your next round.
    Mr. Everson. Right now, we are working on the 1120-Ses, 
trying to get some better numbers of the corporations. But we 
will start later in the next year on updating some of the work 
on individuals. And what we will do, instead of just doing a 
huge number like that, we are going to try to do a smaller 
sample and try to get different elements on it and get updated 
on a continuing basis.
    But I am sorry to say it takes several years. Because by 
the time you go through all of the audits and then what you 
have to do is you do the work and then you have got to massage 
the data. Because it is different if you get Bill Gates' return 
rather than mine in your random sample.
    Mr. Conaway. I would have thought, given your position, 
they would have been about the same.
    Mr. Everson. I wish it worked that way. It is not a sheriff 
in a county.
    Mr. Conaway. With respect to this industry that we have 
created in effect as a result of a very complex Internal 
Revenue Code, which the IRS has nothing to do with other than 
just trying to implement it and enforce the rest of us to 
comply with it--and I will leave some of it out--all of the 
various businesses out there that seek to assist us--I use 
ProSeries or not a commercial--but, technically, I could do my 
return without a computer. I would never want to really even 
try it, because it wouldn't be close to being right.
    Does IRS work with these various preparers to make sure 
that they--the system they put in place in which millions of 
taxpayers seek to honestly comply with, that they are, in fact, 
getting it correct? Is there some sort of exchange with them?
    Mr. Everson. We work very close with them, and it gets to 
the point of the late action by the Congress on the extenders.
    One of the issues on this is we have to work and test their 
software and make sure it interacts and everything else. So we 
go through a whole series of routines to make sure that those 
products interact with us correctly.
    Mr. Conaway. I know that is on the e-filing piece but on 
the way they compute.
    Mr. Everson. The way they interpret the law? No. I would 
suggest to you that it doesn't matter whether that would be a 
vendor of a computerized product or a big accounting firm. 
Practitioners--we depend on practitioners in this country to 
help taxpayers understand the law, and that gets to the number 
of--this question your colleague asked a few minutes ago. It is 
another point. Some people say, well, if only the IRS was doing 
this, that would be very distasteful. So that is why there is 
some resistance to this idea of getting a portal where the IRS 
interprets the law for you.
    Mr. Conaway. I want to commend you for your reluctance to 
embrace an IRS-computed tax return, because I do think the 
private sector does it better. It is more nimble.
    For example, the changes made in December, there are 
certain pieces on that that 1040 itself doesn't provide for and 
you have had to issue some additional instructions. But the 
software providers have had to fold that into their system, and 
I think they are much more nimble as a result.
    Mr. Everson. They are assuredly more nimble.
    Mr. Conaway. And that is not to denigrate the IRS, but you 
have just got a different side of the table.
    In the spirit of keeping within my 5 minutes, I would yield 
back.
    Chairman Spratt. Mr. Andrews of New Jersey.
    Mr. Andrews. Thank you very much for your very thorough and 
comprehensive answers this morning. Your daughter should be 
very proud of you. I am glad she is here this morning.
    Sir, what was the number you gave us as to your forecast of 
revenue gain off this idea of the gross receipts of the credit 
card companies?
    Mr. Everson. The number that is in the current estimate is 
about 10 or 11 billion over a period of several years and----
    Mr. Andrews. I wanted to ask you how it is derived. If we 
look at the data from the 2001 study on underreporting and if 
we put aside a State tax, excise tax, and employment tax and 
simply look at corporate returns and individual returns, my 
data indicate that there is a 200--the 2001 study indicated 
$227 billion a year of underreporting. Do you have any estimate 
as to how much of that underreporting might be at least put 
into question or identified if we made this reform with the 
gross receipts of the credit cards being reported to IRS?
    Mr. Everson. I think that is what we are saying. You would 
recover that. That is a number over a period of years, as 
opposed to an annual number, and I would have to get you what 
the annual number is. It ramps up a little bit. It ramps up 
very quickly. But it goes after this underreported business 
income of a $109 billion and the understatement of the gross 
receipts by largely Schedule C filers.
    Mr. Andrews. So is it your estimate that the underreporting 
is $109 billion?
    Mr. Everson. That is on the individual income tax side, 
sir. If you want to--do you have that breakout of the 110?
    Mr. Andrews. Here is what I am trying to square here. The 
2001 study talked about annual underreporting of $227 billion 
and the two categories that I talked about. And I assume that a 
lot of that is people that are getting cash income and not 
reporting it.
    Mr. Everson. There is some cash, and what this does here, 
that takes the biggest piece of that chart, the 110, and says 
where it is.
    Mr. Andrews. And this idea that you have, which I applaud, 
is a way to sort of identify the most likely targets who are 
exploiting that. In other words, if I run a business and you 
know I am reporting that 85 percent of my receipts come from 
credit cards and history tells us in that kind of business is 
really 50-50, to use that example, I am a likely target for an 
audit, as I understand it.
    Mr. Everson. Obviously, different businesses run at 
different ratios.
    Mr. Andrews. But there would be profiles. For example, in 
dry cleaning, if the normal is 50-50 credit to cash, and I file 
a return and it shows that 85 percent--if you look at the 
credit card receipts, 85 percent of my receipts are credit card 
and only 15 percent is cash, you are probably going to take a 
look at me--that is the idea--IRS.
    I guess what you would do, it depends on what information 
we would get coming in, and I think what you are getting at is 
this doesn't get a cash--as an--but what it would do, though, 
it would give you the most prime targets for audits, I would 
think. It is a targeting tool, isn't it?
    Mr. Everson. It has got two things. One, it would indicate 
problem areas, but, two, this very real change in behaviors 
that would take place, people who know the information is 
coming to us, they respond more honestly.
    Mr. Andrews. All which makes me think this: You may be 
rather significantly underestimating the value you may get from 
this. Why is the number so low that you would get from this?
    Mr. Everson. I don't do the estimate, sir; and I do believe 
the estimates are conservative. I wouldn't put a precise number 
on them, but I think what you get is there is an historical 
reluctance to overstate the numbers. And I think JCT would feel 
that way, the joint committee, and part of it is that sometimes 
we will put a provisional law there and the IRS won't follow 
up.
    Mr. Andrews. I think this is wise to underestimate, but I, 
frankly, believe that those estimates significantly understate 
the value of this idea. Because if you had sufficient 
infrastructure and you had sufficient auditors, this would be a 
very effective targeting system as to who was understating 
income, which would let you chase cash, which would have a 
deterrent effect on people running more of a cash business and 
have the trooper sitting under the bridge.
    I will close with one other comment. Has the Service looked 
at State governments who have been particularly effective in 
reducing their own tax gaps? Have you looked at States who have 
had success in this area?
    Mr. Everson. We work very closely with the States. As you 
appreciate, most States, their income tax system thrives off of 
the Federal system. We work with them on a continuing basis 
and, an actual fact, we are in the--particularly in the shelter 
area, we are now leveraging our work with them where States 
like California and New York will--if we can't get after 
something, they will pursue an investigation, and we will ride 
their assessment, instead of the other way around.
    Mr. Andrews. My time is about up, but I would ask if you 
could submit for the record any best practices that you have 
identified from the States that the committee could take a look 
at.
    Mr. Everson. Certainly, sir.
    [The information follows:]

    We have identified the following best practices from the states.
California
    The IRS and California Franchise Tax Board (FTB) have a long 
history of working together. Examples include:
     Compliance detection and enforcement efforts to address 
the tax shelter problem.
     A Voluntary Compliance Initiative (VCI) in 2004 which 
allowed California taxpayers engaged in potentially abusive tax 
avoidance transactions to correct their state income tax returns. The 
final results of the FTB VCI were 1,202 taxpayers who reported $1.4 
billion in additional tax liabilities by filing 2,289 amended tax 
returns for tax years 1990 though 2002. Results were provided to IRS 
and federal assessments were made based upon the state findings.
    The State of California Board of Equalization (BOE) started 
publishing a list of the top delinquent taxpayers who owe sales and use 
taxes. The information is published on the agency web site and includes 
the taxpayer's name, address, and lien filing date. Since published, 
one taxpayer has paid in full and several others have come forward to 
request payment arrangements.
    FTB has adopted the same method for delinquent taxpayers who owe 
personal income taxes. The agency is issuing warning letters to the top 
250 delinquent taxpayers prior to publishing the list on the agency web 
site.
    The City & County of San Francisco Office of the Assessor-Recorder 
is interested in providing a monthly listing of all taxpayers who 
transferred their real property by recording no consideration or 
quitclaim deed and claiming that it was a gift.
Virginia
    The Virginia Department of Taxation sorts information received from 
the IRS on Forms 1099-MISC and W-2 prepared by a business by volume, 
which is then compared to the business return. If the business return 
is not compatible with the IRS documents, an assessment is made.
    The Department of Taxation also matches real estate property 
transactions received from counties to information received from the 
IRS. High dollar transactions are researched to determine if the Forms 
W-2, 1099 and 1098 information is consistent with the transactions.
Montana
    The state of Montana publishes a listing in major city newspapers 
of the top delinquent taxpayers which results in payment of accounts.

    Chairman Spratt. Thank you.
    Mr. Porter of Nevada.
    Mr. Porter. Thank you, Mr. Chairman.
    Please don't take this personal, but I think most Americans 
and most Nevadans would rather have a root canal than a visit 
by the IRS. I appreciate what you are doing. I think things 
have improved significantly. But American people are scared to 
death of having an IRS agent show up at their door, and I know 
they are all hard-working individuals that work for the IRS.
    Mr. Everson. I still twinge when I get a letter from the 
IRS, and it is usually on my health benefits.
    Mr. Porter. Well said.
    Then you take into account small businesses or mom-and-pop 
businesses or the chief cook or bottle washer, they are in at 6 
o'clock and they go home at midnight and they are having 
trouble with paperwork, making sure they stay on top of 
everything. They are afraid they are going to have any wages 
garnished by employees. Tax Code 17,000 pages, Tax Rule 66,000 
pages. The rich seem to benefit from the complexity of the tax 
laws because they can afford to hire people to take care of 
them; and, in the reports for OMB, it is 6.4 billion hours that 
are spent.
    But I guess my question is, is how has the Tax Code changed 
really fundamentally since the 1980s and do you think it has 
gotten more complex?
    Mr. Everson. First, I agree with your observation that, 
basically, that we have got to be careful here or the inference 
I think you are making because of a perception about the IRS. 
We are the government to many people and there is a wariness, 
and we don't want to overdo the enforcement, very clearly.
    The second point, clearly, the Code has gotten more 
complex.
    I also agree with your point that it is the well-to-do, the 
rich and the big companies that can find ways around this.
    I tell people--I have told this story so often, and I will 
probably never be invited back. But I gave a speech 2 years ago 
to the New York State Bar Association Taxation Section. There 
were 98 tables of 10 there, and those people are not 
representing EITC taxpayers.
    Mr. Porter. Wouldn't it just be simpler to make a 
fundamental reform to make it easier so more and more Americans 
can report accurately?
    Mr. Everson. I certainly am a big advocate of simplifying.
    Mr. Porter. Out of 10 returns, 10 are going to be 
different. There are 10 different experts;
    As we talk about a tax gift, I think most Americans would 
pay if it would be much easier.
    My next question is, part is underreported by undocumented 
and illegals that are in this country? What amount of taxes are 
we losing because they have been undocumented?
    Mr. Everson. I don't have a number for that, sir; and, in 
some ways, because what we do is our approach is we want your 
money whether you are here legally or not. The way the law 
works, if it provides a protection, we get--we do have several 
million of filers who are filing with an ITIN, and they are 
meeting their obligation. They are filing their taxes even 
though they may not be entitled to be in the country. So they 
are following that obligation.
    But I don't have a precise number on people who are 
illegally here and who are not meeting that obligation.
    Mr. Porter. So would you have for a later date any 
estimates on the amount of revenues that are being lost? Is 
there a way you can compile that?
    Mr. Everson. I don't think we would be able to answer that 
in the short term.
    Mr. Porter. Thank you, Mr. Chairman.
    Chairman Spratt. Mr. Etheridge of North Carolina.
    Mr. Etheridge. Thank you, Mr. Chairman.
    Thank you, Commissioner, for being here; and let me say as 
a Member of Congress who served at several levels and has been 
in business for 19 years, most businesses don't like to see you 
come, but it makes sure you clean your books up and get them in 
order. Been there, done that.
    But let me ask you one question: You mentioned the tax gap 
is a difference between taxes owed and taxes paid timely.
    Mr. Everson. Yes, sir. If you go back to that----
    Mr. Etheridge. I want to make sure I had the definition 
accurate. Because timely is different than taxes paid.
    Mr. Everson. That is exactly right, sir.
    Mr. Etheridge. There is a difference.
    Mr. Everson. That is when you file a return and you owe us 
$5,000 and you only send us $1,000.
    Mr. Etheridge. Now, let me ask the question a little 
differently, because it gets to--just some information. You 
said that you would have the 2006 and 2007 update finished. 
When will that be finished and available?
    Mr. Everson. You mean when we next update our research? It 
would be several years later. We are looking at how long it is 
going to take us to do that now. We will try to speed it up 
compared to what we did in the past, but if we are working on 
2007, it would certainly be several years.
    Mr. Etheridge. Would you share that with the committee?
    Mr. Everson. We absolutely will, sir, and we will have new 
numbers on the 1120-Ses. We are finishing up those.
    Mr. Etheridge. That would be helpful. Thank you.
    In looking at the data you had talked about earlier, that 
roughly 54, 55 percent of current individuals are filing 
electronically----
    Mr. Everson. That has increased steadily.
    Mr. Etheridge [continuing]. Do you have a number of the 
percent of corporate filers who are filing electronically?
    Mr. Everson. What we did was--I don't have an overall 
number. What we did was we mandated at the end of 2004 that the 
big companies, those that were in a certain asset class and 
filed 250 returns, that includes employment returns they had to 
file electronically, and they all came in this last year, and 
this will have a huge and positive impact on our work because 
we will be able to array the data and only look at things that 
are really out of line.
    Mr. Etheridge. Let me ask you a question as it relates to--
you touched on earlier I think, before. Is there a mechanism in 
the Code or in your office--I am a small business person. I 
collect Social Security, FICA taxes on my employees. If I don't 
turn it in, that is not my money. That money belongs to the 
employees who may collect it and then match it.
    Mr. Everson. Yes.
    Mr. Porter. Is there a trigger at some point if I don't 
send that money in--if I haven't filed I guess you won't know. 
If I haven't filed, is there a trigger?
    Mr. Everson. Yes. This is an area in terms of our 
collection workforce we look at the most rigorously. Because 
what happens is this can pyramid and compound very rapidly.
    What happens is, typically, I would say more often than 
not, a small business gets extended, they get in trouble, and 
they say I am not going to send it in this quarter because 
things are going to get better the next quarter. There are very 
few people who are intentionally using the government as a 
bank, but it compounds quickly, and it is very hard to work 
your way out of it.
    So our revenue officers, they get right on this to the best 
of their capability, and they work. And what they do, sir--and 
I have been out with a couple of them--they try to make a 
determination of whether the business can pay it off or not.
    What they say is, first of all, can you make current 
payments. If you are not capable of making the payments from 
now forward, then what they will do is they will basically end 
up shutting the business down itself.
    Mr. Etheridge. The reason I ask this question is that an 
employee who gets in some trouble but the employees, depending 
on who they are, how many, they have lost their quarters for 
Social Security.
    Mr. Everson. Yes.
    Mr. Etheridge. And that is delay. If it is a year, they 
lost a whole year in their retirement earnings towards Social 
Security benefits, correct, because it is not paid?
    Mr. Everson. If it is not recorded, that would be correct. 
I am not sure exactly how it works on the Social Security end.
    Mr. Etheridge. Anyway, I think that is correct. The reason 
I ask that question because I think it is important that we 
trigger that.
    Let me touch one more piece, because my time is running 
out. One of the things I think that bothers taxpayers the 
most--and we just had a case in our State of a person who was 
of some substantial position and an attorney wound up doing 
time for tax evasion using the Tax Code illegally and is going 
to spend some time thinking about it now that they have been 
caught.
    My point is that every time one of these pops up, it really 
has people losing faith in our system. Because if somebody gets 
away with at least a little, people lose faith.
    Let me thank you for your paying attention to that. Because 
I think it does help and, by and large, it helps the little guy 
who is paying every month, who has no choice.
    Mr. Everson. Thank you.
    Mr. Etheridge. Thank you, Mr. Chairman. I yield back.
    Chairman Spratt. Thank you.
    Mr. Bishop.
    Mr. Bishop. Thank you, Mr. Chairman.
    Commissioner, it is nice to see you again. Thank you.
    I have a just a couple of questions. First, an observation. 
I guess I am surprised to hear the question raised, is it worth 
it? I mean, as I understand it, there is $350 billion on the 
table in one form or another. And I mean I am just quite 
surprised to hear that the question raised of is it worth it to 
go after that or some portion of it. I cannot imagine us having 
any other problem of that magnitude either on the revenue side 
or on the expenditure side of our budget where we would ask 
that question. So my own answer is, yes decidedly, it is worth 
going after.
    Mr. Everson. Yes, sir.
    Mr. Bishop. The first question I have is, the corporate 
income tax piece of that $350 billion is, if I got your numbers 
correctly, approximately $250 billion in large corporations and 
approximately $5 billion in small corporations. I think that is 
what your chart said.
    Mr. Everson. That is what I said, sir.
    I also added the fact that that was not based--as you can 
see, these are older estimates and so I believe that was 
clearly understated.
    Mr. Bishop. My question is, I know the concern that we have 
is does enhanced enforcement run the risk of impairing the 
dynamic that exists between taxpayers and the IRS and will we 
be creating more problems than we are solving. But isn't going 
after large corporations, doesn't that constitute low-hanging 
fruit? Are we really worried about our relationship with large 
corporations who have the capacity to employ the very best tax 
advice, the very best legal advice and are thriving in our 
economy? I mean, do we really worry about whether or not 
increased enforcement is going to somehow impair their ability 
to do business?
    Mr. Everson. I think there is a different dynamic between 
the relationship between the IRS and the large corporations 
than there is between the IRS and the individuals.
    We have very high audit rates, as we talked about before. 
We are doing a lot in that area. We want to do more. There is 
$26 billion in the enforcement moneys that would go towards the 
corporations. We have got a pretty aggressive program on them.
    Mr. Bishop. If I remember your numbers right now, I think 
we are auditing something like 17 percent of returns of large 
corporations. Is that----
    Mr. Everson. That is correct, but that is the number which 
has the 10 million up--if we look at the biggest players, that 
number is much higher. It is about double that.
    Mr. Bishop. And with the increased moneys that you are 
requesting for the fiscal year 2008 budget, how will you be 
able to move that number?
    Mr. Everson. I don't think the number itself would move as 
a percentage that dramatically. It would be the way we deploy 
that money and the kinds of issues we would be going after. But 
you are not going to see that dramatically ramp up their----
    Mr. Bishop. One more question. The unreported business 
income, if I remember correctly, was estimated at about $109 
billion; and the credit card reporting proposal that you have, 
would you think it is a conservative effort, but it would pick 
up about 11 percent of that.
    Mr. Everson. But those are apples and oranges there. The 
109 or 110, that is an annual number, whereas the credit card 
number, that is over the period of the budget.
    Mr. Bishop. So $11 billion is the cumulative number.
    Mr. Everson. That is the cumulative number over the 10-year 
life of the projection.
    Mr. Bishop. So it is only about 1 percent then.
    Mr. Everson. I would have to look at the individual years. 
We have been talking about 2010. I would have to take a look at 
what we would project for that.
    Mr. Bishop. I am not trying to be difficult here, but I am 
focusing on a number here. If it is $11 billion cumulative over 
the course of the budget window, that is about a billion a 
year. So that would be about 1 percent of the total problem; is 
that about right?
    Mr. Everson. I understand your math, yes.
    Mr. Bishop. One thing I can do--and my question is, can't 
we do better? If we have a $109 billion problem, can't we come 
up with a set of these potential solutions that allow us to 
knock that down by more than 1 percent?
    Mr. Everson. We haven't gotten into it too much today. 
There are some who have said these are major proposals. The 
Secretary and I have gone over this. We are pretty clear on 
this. We want to get the funding for the IRS and sustain that. 
Then we want to get these proposals. And if these proposals, 
which I think are going to generate, sir, quite a bit of 
controversy, as you have seen here this morning----
    I was in the Small Business Committee last year, and it 
pretty well shut down because of this credit card proposal. I 
think that we will come back, and we will work with the 
Congress. If we get these through, we will talk about doing 
some more, but I think those are important steps.
    Mr. Bishop. Thank you.
    Chairman Spratt. Mr. Boyd.
    Mr. Boyd. Thank you very much, Mr. Chairman; and, 
Commissioner Everson, thank you for being here.
    I want to start, Mr. Chairman--I am sorry that Mr. Ryan 
stepped out of the room and also that Mr. Conaway and Mr. 
Blumenauer have left. I wanted to start by correcting the 
record.
    I was a little bit amazed at the statements or the rancor 
between Mr. Conaway and Mr. Blumenauer. But let the record 
reflect that the vote that we are going to take on the bill, 
the tax bill today, is a bill that was developed and written 
and cosponsored by the Democratic chairman, Charlie Rangel, and 
the Republican Ranking Member, Jim McCrery, and working 
together with each other and passed out of the Ways and Means 
Committee without a dissenting vote. So one of the things, Mr. 
Chairman, that many Members of this Congress have exhorted, you 
and the leadership of this new Congress, is to stop the 
partisan rancor and rhetoric and lower it a little bit; and I 
would challenge all of those in this committee to do that. I am 
sorry, again, that Mr. Ryan is not here, but I am sure we can 
talk about that some other time.
    Commissioner Everson, I strongly support the statements of 
many, including Mr. Porter from Nevada, who favor 
simplification. You said it best: Simplification is something 
that you strongly favor. You made an argument for that by 
saying that complexity hurts those who wanted to comply and 
helps those who want to cheat.
    Mr. Everson. Correct, sir.
    Mr. Boyd. I think that is what you said.
    Mr. Everson. Yes.
    Mr. Boyd. Given the tax gap.
    So as to my question, though, given the tax gap and ways 
that you can solve this, I don't think there has been any 
discussion today about the private collection initiative.
    Mr. Everson. Yes, that is right.
    Mr. Boyd. Could you talk a little bit about that and 
address, number one, I know how that is working, what they are 
trying to collect. I know the taxpayer advocate has some 
problems with it, what are his problems and how you are trying 
to address them.
    Mr. Everson. Certainly, sir. I think you will hear from the 
advocate in the next panel.
    The simple truth here is that, even because of attrition, 
government attrition is quite high now. It is high within the 
IRS as well. There are only so many people you can bring on and 
hire at any given time, so that even with the increment that we 
have got in the budget proposal, even if we--we are pretty well 
maxed out on what we can bring on, and it would be a period of 
years, a period of years of adding people to the IRS before we 
would get to a capacity where we could work some of these cases 
that we are giving to the private collection agency.
    This was passed into law--I think it was in the Jobs Act at 
the end of 2004. What we are doing is we are implementing this. 
We have implemented starting in September. Got about $11 
million, came in January. We have a set of standards that we 
hold the contractors to that are comparable to what the IRS has 
held, and I would say to you my assessment is so far so good. I 
know that there are many who want to stop it.
    I had a conversation with Chairman Rangel on this up in 
Harlem just a week or two ago, but I think--I was with Senator 
Grassley on that--we should give this a chance to work and see 
how it goes. We are working very hard on it. The people I have 
on it meet with me monthly to tell me how it is going, and I 
think we should stick with it for a while and see how it goes.
    Mr. Boyd. So, to refresh everybody here, that you are only 
going after taxes that people have admitted that they owe, 
return files, file returns but just didn't pay the bill.
    Mr. Everson. That is absolutely correct.
    One of the challenges that we have in our collection area 
now that--as we brought up the other enforcement and we are 
doing more audits. You audit somebody and you make an 
assessment and you have to collect that money. So our 
collection people are busier because we brought back the 
enforcement. What the collection agencies are working on is 
really the simplest thing, where somebody has agreed that they 
owe that amount of money.
    Mr. Boyd. Thank you very much. I yield back.
    Chairman Spratt. Thank you, Mr. Boyd.
    Mr. Ryan would like a moment for clarification.
    Mr. Ryan. I stepped out of the room for a second when you 
mentioned the Ways and Means Committee. I didn't hear what you 
mentioned, but I wanted to just certify and clarify that the 
tax bill we are considering was done in regular order in the 
Ways and Means Committee. It was done in a bipartisan way. I 
serve in Ways and Means. We marked it up in the middle of the 
day in the committee in regular order. Ms. Schwartz was there. 
So that, in fact, was the case. I was going to mention to the 
gentleman who mentioned it that that was, in fact, the case. So 
I want to get that for the record.
    Mr. Boyd. Thank you very much.
    Chairman Spratt. Ms. Schwartz from Pennsylvania.
    Ms. Schwartz. Thank you, Mr. Ryan, for correcting that. You 
may want to mention to Mr. Conaway that--he mentioned it was 
done in the dark of night, and it wasn't. I agree when we can 
work in a bipartisan way. When we agree, why fight about that? 
So thank you.
    I wanted to follow up on some of Mr. Boyd's comments, and 
nice to meet you, Mr. Commissioner.
    Mr. Everson. Thank you for waiting.
    Ms. Schwartz. Thank you.
    There is a specific issue I wanted to follow up on private 
collections, how that is working. As you may know, I represent 
the 13th Congressional District in Pennsylvania. There is a 
rather large IRS facility in my district, and I visit that 
facility. In spite of some of the negative comments about how 
people might feel about IRS workers, I can tell you that, 
meeting with those workers, they are very proud of the work 
they do. They feel good about it. They would like to continue 
doing it.
    The fact that there are 2,800 employees that are going to 
be laid off in that one facility in my district is very 
significant; and given these are employees, some of whom, as I 
understand it, would need some retraining to do some of the 
kind of work that is now being contracted out to private 
collection agencies and, actually, we are paying far more for 
those private collection agencies than we do if we are going to 
do it in-house, my staff gave me some information on this.
    They were talking about a net return when the IRS does it 
itself. So it is a compliment to you, I guess, and to workers. 
About $0.97 cents on the dollar. It costs about $0.03 on the 
dollar when we do it in-house. By contracting it out to these 
private collection agencies, the net return is $0.76 on the 
dollar. So that we are losing $0.21 on the dollar.
    Now these are taxpayer dollars, also. These cents add up, 
that we are actually spending more to collect these dollars.
    So my question to you is really two-fold, is that why not 
use the 2,800 people in my district who are going to lose their 
jobs who want to stay, might need some retraining, to do this 
next--this different level of job but would like to do that and 
why not use them? Particularly when we know that two factors, 
one, we are spending more when we use private collection 
agencies, not getting the dollars back that we might, and there 
have been issues raised on the other side that I agree with. 
There are concerns about the potential confidentiality of very 
personal information being out there.
    You know, one of the things, we actually may not like to 
hear from the IRS, but you kind of trust you keep this 
information to yourself. That is one of the aspects I think 
most Americans do believe in.
    So if you would address specifically, you know, the 
decision that has been made--it is an option--but the decision 
that has been made to substantially downsize our IRS workers or 
employees who are dedicated and knowledgeable and want to 
continue to do the good work in order to spend more taxpayer 
dollars by using private agencies outside.
    Mr. Everson. I presume you are in Philadelphia?
    Ms. Schwartz. Yes.
    Mr. Everson. I think there are a couple of issues in there 
that are getting a little bit mixed.
    We have talked this morning about the increase in 
electronic filing, and as the number of returns that are filed 
electronically has increased, that has resulted in a phasing 
down, obviously fewer paper returns and a smaller footprint of 
workforce in our submission processing pipeline. We have 
already--Mr. Bishop's area has a center, and we have worked 
through in Memphis as well, and Philadelphia is in line and, 
ultimately, we will get down to a much smaller footprint.
    Ms. Schwartz. What percentage of those 2,800 is that? All 
of those people?
    Mr. Everson. I don't know of exact--that is a new number 
for me. I will certainly take a look at this hearing at 
Philadelphia, but we have had a long-standing plan to phase 
out, to consolidate submission processing of paper returns as 
that grows down.
    As we have done that, we have tried to make sure that we 
are anchoring as much work in those centers and add work to 
those centers from other areas where we can. And, as you know, 
we are also making an investment in moving into the post office 
there in Philadelphia. The campus right now in Philadelphia is 
probably our worst facility of the big campuses. We want to do 
the same thing there that we have done in Kansas City, where we 
just reopened a much modernized, great facility.
    Ms. Schwartz. I was not impressed with the facility. I was 
impressed with the workers.
    Mr. Everson. We are delighted that we are going to be able 
to go down downtown and upgrade the post office.
    We are working where we can to, obviously, find opportunity 
for those individuals. We are committed to that, and I will 
relook at it since you are raising it in terms of 
opportunities.
    But, again, as to collection itself, we do have issues as 
to how many people you can bring on and train and get going. 
And I would say to you again, as I just said to your colleague, 
we do--it would be a period of several years before we would be 
able to change our employment profile and get after the same 
kinds of accounts that we are doing now in the private 
collection agency.
    I don't challenge--I am not the author of that $0.03 cost 
figure, so I am not vouching for that, but I have said readily 
that this could be done more cheaply by our people.
    Ms. Schwartz. My time is almost up now, but if you had the 
option, which you do not, but if you had the option to do it 
in-house would that--you would be able to do that. You would be 
pleased to do it. I am not sure what we are----
    Mr. Everson. We happily take on all duties that the 
Congress assigns us.
    Ms. Schwartz. I do appreciate the opportunity to follow up 
with you about the IRS.
    Mr. Everson. Maybe we can visit sometime and see how the 
work progresses in the new facility.
    Ms. Schwartz. Thank you, Mr. Chairman.
    Chairman Spratt. One housekeeping deal as we wrap up.
    I ask unanimous consent that any member who did not have 
the opportunity to ask questions today or who would like 
clarification be given authority to submit questions for the 
record. We would appreciate your cooperation in providing us 
answers.
    Mr. Everson. Certainly, sir.
    Chairman Spratt. You were an excellent witness. We 
appreciate your forthrightness and your full answers as well as 
your forbearance. Thank you very much for coming, and we look 
forward to working with you on these objectives that are set 
out in the budget this year.
    Mr. Everson. Thank you, Mr. Chairman. I appreciate the 
opportunity to be here.
    Chairman Spratt. The next panel will consist of Russell 
George, who is the IG for Tax Administration; Michael Brostek, 
who is the Director of Tax Issues; GAO Nina Olson, the National 
Taxpayer Advocate, IRS; and Chris Edward, who is with the Cato 
Institute.
    I welcome all of you before our committee, and I will say 
to each one of you that, if you have written testimony, we will 
accept it for the record and make it, in its full, as part of 
the record and allow you to summarize as we go forward. You 
have been patient to wait. You have been good to prepare and to 
come here for this hearing.
    We are notified that we need to be on the floor at around 
1:00 o'clock, so we are going to try to wrap this up in an hour 
if we can.
    Mr. George, just for a good starting point, let us start 
with you, if you will.

STATEMENTS OF THE HON. J. RUSSELL GEORGE, INSPECTOR GENERAL FOR 
 TAX ADMINISTRATION, U.S. DEPARTMENT OF THE TREASURY; MICHAEL 
  BROSTEK, DIRECTOR, TAX ISSUES, STRATEGIC ISSUES TEAM, U.S. 
   GOVERNMENT ACCOUNTABILITY OFFICE; NINA E. OLSON, NATIONAL 
TAXPAYER ADVOCATE, INTERNAL REVENUE SERVICE; AND CHRIS EDWARDS, 
         DIRECTOR OF TAX POLICY STUDIES, CATO INSTITUTE

            STATEMENT OF THE HON. J. RUSSELL GEORGE

    Mr. George. Thank you, Mr. Chairman, and at the outset, may 
I say it is an honor to appear before you. As you may recall, 
you and I worked together almost a dozen years ago when I was 
Staff Director of Chairman Stephen Horn's subcommittee and you 
were a member of that committee, and even at that time we 
looked at issues such as the very one that we are discussing 
today.
    Chairman Spratt, Ranking Member Ryan, members of the 
committee, thank you for the invitation to appear before you 
today to discuss opportunities for closing the tax gap. The tax 
gap is a complicated subject which at times appears simpler 
than it really is. It is generally accepted that, every year, 
the IRS fails to receive roughly $345 billion owed to the 
Federal Government. As has been noted, that figure is 
considered the gross amount not received. The net amount of the 
tax gap is thought to be approximately $290 billion. TIGTA, 
however, has expressed some doubts about the accuracy of these 
figures. We are concerned that the IRS does not have a complete 
picture of the magnitude of the problem, which is an essential 
starting point to addressing the problem. Nonetheless, in 2006, 
the IRS updated its estimate of the tax gap based on data from 
the 2001 tax year.
    While the updated information on individuals is important 
since they comprise the largest segment of the tax gap, there 
is no new information about employment, corporate and other 
taxpayer segments. The Service does not have firm plans to 
update the information study for these segments, as you heard 
earlier. There are opportunities for the IRS to pursue new 
initiatives related to the tax gap.
    In our reviews of IRS programs, we have made 
recommendations that would enhance the effectiveness and the 
efficiency of the IRS' tax compliance programs. The IRS has 
appropriately refocused audit attention on high-income 
taxpayers. However, this has been done through an increase in 
correspondence examinations as opposed to face-to-face reviews. 
Correspondence examinations limit the tax issues that can be 
addressed. High-income households typically have a large 
percentage of their income that is not subject to third party 
reporting and withholding. Without additional third-party 
reporting, it is difficult to determine whether these taxpayers 
have reported all of their income.
    To improve tax compliance and business tax filings, TIGTA 
has recommended that the IRS establish a comprehensive document 
matching program for the various business documents it receives 
similar to its program for verifying individual wage earnings. 
Although implementing such a program among businesses would be 
difficult, it could identify significant pockets of 
noncompliance among business taxpayers.
    Over the years, the IRS has had several strategies for 
reducing the tax gap attributable to individual nonfilers. 
Unfortunately, the IRS, since it was reorganized in 2002, each 
IRS business division has been responsible for tracking and 
monitoring its own action items. There is no formal system in 
place for coordinating and tracking across all IRS business 
divisions. In response to a 2005 audit report, the IRS took 
some steps to improve efficiency in working nonfiler cases, 
including the development of a nonfiler work plan. However, the 
IRS still does not have a single executive charged with 
overseeing its nonfiler efforts. It needs one.
    In 1993, the IRS developed a voluntary compliance program 
for the food and beverage industry, which was extended to the 
cosmetology industry. The program has been successful. In tax 
year 1994, $8.52 billion in tip wages were reported. In tax 
year 2004, the amount exceeded $19 billion. Despite this 
success, the IRS has not expanded the program to include other 
industries which I believe will further enhance tax receipts.
    The IRS needs to focus more attention on its role as a 
collector of Social Security and Medicare taxes. These taxes 
are primarily paid through payroll taxes with help from 
employees, matching amounts paid by employers as well as 
through self-employment taxes. However, the procedures the IRS 
uses to implement this program have flaws. TIGTA recently 
conducted a review of tax returns that were processed in 2005. 
We estimated that the IRS has assessed $20 million in taxes, 
but with changes to the procedures, the IRS could have assessed 
approximately $20 million more. We recommended several changes 
to this process which could result in an additional $108 
million in Social Security and Medicare taxes each year.
    Finally, to better address a growing number of investments 
made abroad by U.S. residents estimated at $7.2 trillion in 
2003, TIGTA has recommended that the IRS make better use of the 
foreign source information it receives from tax treaty 
countries. We have also recommended that prior to issuing 
refunds to foreign partners, the IRS implement an automated 
cross-check of withholding claims against available credits for 
partnerships with foreign partners.
    Mr. Chairman, while the IRS clearly needs the resources it 
has requested, it also must use the resources it has more 
efficiently and effectively.
    Chairman Spratt. Let me just stop you at that point and 
make a point.
    Has your office submitted any legislation, proposed 
legislation, to reduce these recommendations to recommendations 
that were submitted to Congress or are they simply held 
internally within the Internal Revenue Service?
    Mr. George. Well, within the budget, the Department in 
conjunction with the IRS submitted legislative proposals that 
we have not had a role in, Mr. Chairman, and we have not 
independently submitted legislation.
    Chairman Spratt. Are the recommendations you just 
enumerated part of the requests that the administration has 
made to Congress this year----
    Mr. George. Part of the budget----
    Chairman Spratt [continuing]. The 15 or 16 different things 
that the Commissioner just----
    Mr. George. We are in the process of reviewing those, Mr. 
Chairman.
    Chairman Spratt. Okay. Excuse me. Go ahead.
    Mr. George. Actually, that concludes my oral testimony, 
sir.
    [The prepared statement of J. Russell George follows:]

   Prepared Statement of Hon. J. Russell George, Treasury Inspector 
                     General for Tax Administration

                              introduction
    Chairman Spratt, Ranking Member Ryan, and Members of the Committee, 
I appreciate the opportunity to appear before you today to discuss the 
tax gap.
    The objective of our tax system is to fund the cost of government 
operations. The Internal Revenue Service (IRS) attempts to meet this 
objective by administering a tax system that provides adequate funding 
for the Federal Government while ensuring fairness to all taxpayers. 
But, as we know, the system has failed to capture a significant amount 
of the tax revenue that is owed, which we call the tax gap. The IRS 
defines the tax gap as ``the difference between what taxpayers are 
supposed to pay and what is actually paid.'' \1\
    It is worth noting, that if we were to capture the estimated annual 
tax gap of $345 billion, it would completely offset the projected 
fiscal year (FY) 2007 budget deficit of $172 billion and provide a 
surplus of $173 billion.\2\ Considering it in those terms, the tax gap 
poses a significant threat to the integrity of our voluntary tax 
system. Therefore, one of my top priorities for TIGTA is to identify 
opportunities for improvements to the IRS' administration of our tax 
system. Similar to nearly all other Federal agencies, the IRS has 
limited resources to apply to the objectives it seeks to achieve. 
Nevertheless, the IRS must face the challenge of trying to increase 
voluntary compliance and reduce the tax gap.
    When I testified on the tax gap last year, I reported that some of 
the most challenging barriers to closing the tax gap are tax law 
complexity, incomplete information on the tax gap and its components, 
and reduced IRS enforcement resources. These same barriers exist today. 
However, while tax law simplification may help close the tax gap, a 
portion of the tax gap may also be closed through more effective tax 
administration and enforcement, as well as a commitment of additional 
resources for those efforts.
    My remarks will briefly discuss the size and source of the tax gap 
and then present some of TIGTA's significant findings and 
recommendations to improve tax administration and help reduce the tax 
gap.
                   the tax gap: its size and sources
    The IRS describes the tax gap as having three primary components--
unfiled tax returns, taxes associated with underreported income on 
filed returns, and underpaid taxes on filed returns.\3\ Within the 
underreported income component, the IRS has further delineated specific 
categories of taxes, such as individual, corporate, employment, estate, 
and excise taxes.\4\
    In 2006, the IRS updated its estimate of the tax gap, which had 
been based on data for tax year (TY) 1988. The new estimate was based 
on data obtained from the National Research Program (NRP) for TY 2001 
individual income tax returns.\5\ Data from the NRP were used to update 
the 2001 tax gap figures. The IRS' most recent gross tax gap estimate 
is $345 billion with a corresponding voluntary compliance rate (VCR) of 
83.7 percent.
    In any discussion about whether a specific VCR goal can be met, the 
logical starting point would be an assessment of the reliability of the 
measurement data. In April 2006, my staff reported results of a review 
to determine whether the IRS' compliance efforts and strategies will 
enable it achieve a greater VCR by 2010.\6\ In all three compliance 
areas across the major tax gap segments--nonfiling, underreporting and 
non-payment--TIGTA has concerns about whether the tax gap projections 
are complete and accurate.\7\ While TIGTA has concerns about the 
overall reliability of the tax gap projections, the review of the tax 
gap estimates was not meant to be critical of the efforts the IRS took 
in re-establishing compliance measurement. On the contrary, TIGTA 
commended the IRS for restoring these critical measurements and for 
designing them to be much less burdensome to taxpayers than previous 
efforts. The IRS' updated estimate is based on the best available 
information.
    When considering the updated tax gap estimate, TIGTA found it 
instructive to analyze what additional amounts the IRS would have had 
to collect to increase voluntary compliance at different estimated 
intervals for TY 2001. Figure 1 shows the range for TY 2001 based upon 
the total tax liability for TY 2001, as estimated in February 2006. The 
IRS has proposed in the FY 2007 budget that the VCR will be raised from 
83.7 percent to 85 percent by 2009. Accordingly, if the total tax 
liability remained constant, the IRS would have to collect, on a 
voluntary and timely basis, $28 billion more in TY 2009, thus reducing 
the gross tax gap to $317 billion. To reach 90 percent voluntary 
compliance by TY 2010,\8\ the amount voluntarily and timely collected 
for TY 2010 would be an additional $134 billion, thus reducing the 
gross tax gap to $211 billion if the total tax liability remained 
constant.

 Figure 1: Additional Voluntary and Timely Payments Required to Reach 
                        Specified VCR Levels\9\



    Source: Treasury Inspector General for Tax Administration

    In summary, TIGTA concluded in its review of the updated tax gap 
estimate that the IRS still does not have sufficient information to 
completely and accurately assess the overall tax gap and the VCR. 
Although having new information about TY 2001 individual taxpayers is 
better when compared to the much older TY 1988 information from the 
last TCMP survey, some important individual compliance information 
remains unknown. Additionally, although individuals comprise the 
largest segment of taxpayers and were justifiably studied first, no new 
information about employment, small corporate, large corporate, and 
other compliance segments is available. With no firm plans for further 
studies or updates in many areas of the tax gap, the current tax gap 
estimate is an unfinished picture of the overall tax gap and 
compliance.
the irs needs to overcome institutional impediments to more effectively 
                          address the tax gap
    Institutional impediments in this context of tax administration are 
the established policies, practices, technologies, businesses processes 
or requirements that add unintended costs or are no longer optimal 
given changes to strategies, goals, and technologies. The costs of 
these impediments include lost opportunities and the delayed 
development of innovative solutions.
    Impediments can also be perceived as opportunities. The removal of 
an impediment creates opportunities to achieve increased efficiency and 
effectiveness in tax administration. TIGTA's perspective is that the 
current institutional impediments the IRS faces can give way to 
beneficial opportunities.
                     incomplete compliance research
    Performing a compliance measurement program is expensive and time 
consuming. The estimated cost for performing the TY 2001 individual 
taxpayer NRP was approximately $150 million. According to IRS 
officials, resource constraints are a major factor in NRP studies and 
affect how often the NRP is updated. Operational priorities must be 
balanced against research needs. From FY 1995 through FY 2004, the 
revenue agent workforce declined by nearly 30 percent while the number 
of returns filed grew by over 9 percent. This shortfall in examiner 
resources makes conducting large-scale research studies problematic.
    The IRS' budget submission to the Department of the Treasury for FY 
2007 requested funding to support ongoing NRP reporting compliance 
studies. The IRS Oversight Board \10\ supports ongoing dedicated 
funding for compliance research. Unfortunately, funding for those 
resources in previous fiscal years did not materialize. Without a 
resource commitment for continual updating of the studies, the 
information will continue to be stale and less useful in measuring 
voluntary compliance.
    The IRS' National Research Program (NRP) is designed to measure 
taxpayers' voluntary compliance, better approximate the tax gap, and 
develop updated formulas to select noncompliant returns for 
examination. The first phase of this program addressed reporting 
compliance for individual taxpayers, and data from this phase were used 
to produce the updated estimates of this portion of the tax gap. These 
initial findings should enable the IRS to develop and implement 
strategies to address areas of noncompliance among individual 
taxpayers.
    The second phase of the NRP, which has begun, focuses on Subchapter 
S corporations (Forms 1120S). TIGTA recently reviewed the on-going NRP 
study of Subchapter S corporations and reported that the study was 
effectively planned.\11\ The NRP study is on target, with just over 17 
percent of the examinations closed as of November 3, 2006. Revenue 
agents conducting the examinations received appropriate and timely 
training. A multi-layered quality review process is in place, and 
feedback is provided when appropriate to resolve any problems 
identified. The study should provide valuable data when completed.
    While the IRS is actively involved in managing and monitoring the 
NRP study, TIGTA noted some areas in which there can be further 
improvement. Some NRP study results may not be complete, accurate, or 
provide information sufficient to update existing return selection 
formulas.
     The NRP study instructions contained criteria for line 
items on tax returns that are mandatory to select for examination. 
Eleven of 61 tax returns that TIGTA reviewed contained these line 
items, but the items were not identified for examination.
     The NRP study process includes capturing demographic 
information about each business examined. This information was 
available in 9 of the 62 cases reviewed (the data were not always 
available because TIGTA reviewed in-process cases). In two of the nine 
cases, some of this information was inaccurate.
     The Examination function relies in part on selection 
formulas to identify tax returns that have greater potential for tax 
adjustment. An independent review of this NRP study's sampling 
methodology and sample size\12\ expressed concern that the sample size 
may not be large enough to update the current selection formulas, and 
recommended that other techniques be explored to analyze the results.
    The three concerns TIGTA noted could reduce the reliability of the 
NRP study results. However, the IRS is taking or has planned actions 
that should reduce these risks. Final decisions on how to address these 
concerns cannot be made until more of the examinations are completed. 
As a result, TIGTA did not recommend any additional actions the IRS 
should take. However, TIGTA will monitor the adequacy of the IRS' 
decisions and actions to address the concerns in future reviews.
    The individual and Subchapter S corporation NRP initiatives allow 
the IRS to update return-selection models for more effective return 
selection for its compliance efforts.
    In 2005, TIGTA reported that the return-selection formulas, 
developed in the 1980s, only accounted for the selection of 22 percent 
of the corporate returns selected for examination in FY 2004.\13\ 
Updated selection models should contribute to more effective use of the 
IRS' compliance resources.
    In April 2006, TIGTA recommended that the IRS Commissioner continue 
to conduct NRPs on a regular cycle for the major segments of the tax 
gap.\14\ TIGTA also recommended that the IRS augment the direct 
measurement approach, and devise indirect measurement methods to assist 
in quantifying the tax gap. The IRS agreed with these recommendations, 
subject to available resources. In addition, TIGTA recommended that the 
IRS Commissioner consider establishing a tax gap advisory panel that 
includes tax and economic experts to help identify ways to better 
measure voluntary compliance. The IRS agreed to look into establishing 
such an advisory group with the intent of using it to validate and 
improve estimation methods.
   increase the economy, efficiency and effectiveness of compliance 
                               strategies
    TIGTA has made several recommendations to improve the efficiency 
and effectiveness of IRS operations. These improvements would help the 
IRS address the tax gap. Some of TIGTA's more significant 
recommendations concern:
     Less Effective Examination Techniques Used for High-Income 
Taxpayers.
     Incomplete Document Matching.
     Regulations for Granting Extensions of Time to File Delay 
the Receipt of Taxes Due.
     Uncoordinated Nonfiler Strategy.
     Limited Tip Program Expansion.
     Unclear Offer in Compromise Program Requirements.
     Incomplete Payroll Tax Assessments.
  less effective examination techniques used for high-income taxpayers
    In July 2006, TIGTA reported the results of its review of the IRS' 
increased examination coverage rate\15\ of high-income taxpayers.\16\ 
The increased coverage has been due largely to an increase in 
correspondence examinations,\17\ which limit the tax issues the IRS can 
address in comparison with face-to-face examinations. In addition, the 
compliance effect may be limited because over one-half of all high-
income taxpayer examination assessments are not collected timely.
    The examination coverage rate of high-income taxpayers increased 
from 0.86 percent in FY 2002 to 1.53 percent in FY 2005. Included in 
this statistic is an increase in the examination coverage rate of high-
income tax returns, Forms 1040 with a Schedule C. This examination 
coverage rate increased from 1.45 percent in FY 2002 to 3.52 percent in 
FY 2005. However, the increase in examination coverage is due largely 
to an increase in correspondence, rather than face-to-face, 
examinations. While face-to-face examinations increased by 25 percent 
from FY 2002 through FY 2005, correspondence examinations increased by 
170 percent over the same period.
    As a result, the percentage of all high-income taxpayer 
examinations completed through the Correspondence Examination Program 
grew from 49 percent in FY 2002 to 67 percent in FY 2005. The increase 
in correspondence examinations for high-income taxpayers who filed a 
Schedule C was even larger. Examinations closed by correspondence 
comprised about 30 percent of all high-income taxpayer Schedule C 
examinations from FYs 2002 through 2004. In FY 2005, approximately 54 
percent of all high-income taxpayer Schedule C examinations were 
conducted by correspondence.
    High-income households typically have a large percentage of their 
income that is not subject to third-party information reporting and 
withholding. The absence of third-party information reporting and 
withholding is associated with a relatively higher rate of 
underreporting of income among business taxpayers. It is difficult to 
determine through correspondence examination techniques whether these 
taxpayers have reported all of their income.
    In FY 2004, the IRS assessed more than $2.1 billion in additional 
taxes on high-income taxpayers through its Examination program. This 
figure includes assessments of $1.4 billion (66 percent) on taxpayers 
who did not respond to the IRS during correspondence examinations. 
Based on a statistical sample of cases,\18\ TIGTA estimates that 
approximately $1.2 billion (86 percent) \19\ of the $1.4 billion has 
been either abated \20\ or not collected after an average of 608 days--
nearly two years after the assessment was made. Our conclusion is that 
the Examination and Collection programs for high-income taxpayers may 
not be positively affecting compliance, given the substantial 
assessments that have been abated or not collected.
    TIGTA recommended that the IRS complete its plan to maximize the 
compliance effect of high-income taxpayer examinations. TIGTA also 
recommended that the plan should include the mixture of examination 
techniques, issues examined, and collection procedures. The IRS agreed 
with our recommendations.
                 incomplete document matching programs
    TIGTA has also identified improvements that should be made to 
improve compliance in business tax filing.\21\ The GAO has reported 
that more than 60 percent of U.S.-controlled corporations and more than 
70 percent of foreign-controlled corporations did not report tax 
liabilities from 1996 through 2000.\22\ Although individual wage 
earners who receive a Wage and Tax Statement (Form W-2) have their 
wages verified through a matching program, a similar comprehensive 
matching program for business documents received by the IRS does not 
exist. TIGTA has recommended that the IRS evaluate all types of 
business documents it receives to determine whether this information 
can be used to improve business compliance. In its response to our 
recommendations, the IRS wrote that it could not implement this 
recommendation at that time. However, the IRS also shared its belief 
that ongoing efforts would provide the results that our recommendation 
hoped to achieve and asked for the opportunity to continue its efforts.
    An IRS study, based on TIGTA recommendations, found that in FY 
2000, business information documents\23\ reported $697 billion of 
potential taxable income.\24\ Furthermore, business information 
documents identified 1.2 million unresolved IRS business nonfiler tax 
modules. An IRS tax module contains records of tax liability and 
accounting information pertaining to the tax for one tax period. TIGTA 
has also reported on issues related to the increasing global economy. 
Investments made abroad by U.S. residents have grown in recent years, 
nearly tripling from $2.6 trillion in 1999 to $7.2 trillion in 2003. To 
address the tax compliance challenges presented by foreign investments, 
TIGTA recommended that the IRS make better use of the foreign-source 
income information documents received from tax treaty countries. TIGTA 
also recommended that, prior to issuing refunds to foreign partners, 
the IRS implement an automated crosscheck of withholding claims against 
available credits for partnerships with foreign partners.\25\
    Implementing a comprehensive matching program to identify 
noncompliance among businesses would be difficult and could require 
some legislative changes, but it could identify significant pockets of 
noncompliance among business taxpayers.
 regulations for granting extensions of time to file delay the receipt 
                              of taxes due
    Taxpayer payment compliance means that the amounts owed are paid on 
time. However, for decades, the IRS has allowed taxpayers with extended 
return filing due dates to send in late payments and pay only interest 
and small failure-to-pay penalties. Obtaining an extension of time to 
file a tax return does not extend the due date for tax payments, and 
failure-to-pay penalties are typically assessed when payments are made 
late, even if the taxpayer has received an extension.
    In 1993, IRS management eliminated the requirement to pay all taxes 
by the payment due date in order to qualify for an extension of time to 
file. Once an extension has been granted, the taxpayer is exempt from a 
5 percent per month delinquency penalty\26\ for the period of the 
extension. TIGTA evaluated the impact of these rules on individual and 
corporate taxpayers and found that 88 percent of untimely tax payments 
for returns filed after April 15 were attributable to extended-due-date 
taxpayers.\27\ Corporations are required to pay estimates of their 
unpaid taxes in order to be granted extensions. However, TIGTA found 
corporate estimates to be highly flawed; in calendar year (CY) 1999 
alone, approximately 168,000 corporations received an extension, yet 
failed to pay $1.8 billion in taxes when they were due.
    TIGTA projected that the tax gap from extension-related individual 
income tax underpayments would amount to approximately $46.3 billion in 
CY 2008, of which approximately $29.8 billion would not be paid until 
after the end of FY 2008. Due to the more complex nature of corporate 
taxes, similar figures were not available for corporations, although 
TIGTA estimated that by TY 2008, approximately $768 million in 
additional corporate taxes would be timely paid if TIGTA's 
recommendations were adopted. The IRS agreed to study TIGTA's 
recommendations.
                    uncoordinated nonfiler strategy
    According to the IRS' February 2006 tax gap estimate, individual 
and estate tax non-filers accounted for about 8 percent of the total 
tax gap\28\ for TY 2001. Corporate income, estate and excise tax non-
filing estimates were not available. The IRS study, together with 
previous IRS studies, indicates the tax gap for individual non-filers 
almost tripled from $9.8 billion in TY 1985 to about $27 billion\29\ in 
TY 2001.
    In the past, the IRS has had several strategies for reducing the 
tax gap attributable to individual non-filers. The most recent National 
Non-filer Strategy, which was developed for FY 2001 through FY 2003, 
was made obsolete in July 2002 when the IRS was reorganized. Since 
then, each IRS business division has been responsible for tracking and 
monitoring completion of its own action items. Consequently, there has 
been no formal system in place for coordinating and tracking all 
actions across all IRS divisions.
    In November 2005, TIGTA reported that as increasing voluntary 
compliance remains an organization-wide effort, the individual business 
divisions within the IRS have taken steps to improve efficiency in 
working non-filer cases.\30\ The actions taken by business divisions 
included:
     Consolidation of the Automated Substitute for Return 
Program\31\ into one campus.\32\
     Computer programming changes to enhance automated 
processing of returns created by the IRS for non-filing businesses, as 
authorized under Section 6020(b) of the Internal Revenue Code.\33\
     Refinement of the processes for selection and modeling of 
non-filer cases each year through risk-based compliance approaches. The 
intention is to identify and select the most productive non-filer work 
and to apply appropriate compliance treatments to high-priority cases.
     Increased outreach efforts by the SB/SE Division through 
its Taxpayer Education and Communication function.
     An increase in the number of cases recommended for 
prosecution by the Criminal Investigation Division from 269 in FY 2001 
to 317 in FY 2004 (an increase of 17.8 percent).
    However, these were not coordinated activities that were planned 
and controlled within the framework of a comprehensive strategy. Since 
FY 2001, each business division has independently directed its own non-
filer activities. The IRS did not have a comprehensive, national non-
filer strategy or an executive charged with overseeing each business 
division's non-filer efforts. TIGTA concluded that the IRS needed 
better coordination among its business divisions to ensure resources 
are being effectively used to bring non-filers into the tax system and 
ensure future compliance. The IRS also needed an organization-wide 
tracking system to monitor the progress of each business division's 
actions.
    In addition to better coordination and an organization-wide 
tracking system, the IRS also needed measurable program goals. TIGTA 
suggested three measurable goals that could be established:
     The number of returns secured from non-filers.
     Total payments received.
     The recidivism rate.
    Without such measurable program goals, the IRS is unable to 
determine whether efforts to improve program efficiency and 
effectiveness are achieving desired results. The IRS agreed with all of 
TIGTA's recommendations. For FY 2006, the IRS developed its first 
comprehensive non-filer work plan.
                     limited tip program expansion
    Historically, the IRS has been concerned about employees not 
reporting tips earned in industries in which tipping is customary. An 
IRS study showed that the amount of tip income reported in CY 1993 was 
less than one-half of the tip income, leaving over $9 billion 
unreported. To address this underreporting, the IRS developed the Tip 
Rate Determination and Education Program (the Tip Program), which is a 
voluntary compliance program originally designed for the food and 
beverage industry. It was modeled after the tip compliance agreement 
used by casinos in the former IRS Nevada District. The Tip Program 
offers employers multiple voluntary agreement options designed to 
provide nonburdensome methods for employers and employees to comply 
with tip reporting laws. The Tip Program was extended to the 
cosmetology industry in 1997 and the barber industry in 2000.
    Since the Tip Program was introduced, voluntary compliance has 
increased significantly. In TY 1994, tip wages reported were $8.52 
billion. For TY 2004, the amount exceeded $19 billion. To date, over 
16,000 employers, representing over 47,000 individual establishments, 
have entered into tip agreements.
    TIGTA reviewed the Tip Program and reported that the IRS has not 
consistently monitored the establishments in the food and beverage and 
cosmetology industries that had entered into tip agreements since FY 
2000 to determine if tip agreements secured actually increased tip 
income for these establishments.\34\ Additionally, due to the voluntary 
nature of participation and limited IRS resources, disparity with the 
number of tip agreements secured between various locations across the 
country is an issue.
    In FY 2006, the IRS did not plan to actively solicit any new tip 
agreements beyond the gaming industry. The majority of FY 2006 Tip 
Program staffing was to be expended on soliciting and monitoring tip 
agreements with the gaming industry and on audits of casino employees.
    Recognizing that the Tip Program has not reached some small 
businesses in the food and beverage industry, the IRS developed the 
Attributed Tip Income Program (ATIP). The Department of the Treasury 
approved the ATIP Revenue Procedure on July 11, 2006 and the ATIP 
Revenue Procedure was issued on July 28, 2006. The ATIP Revenue 
Procedure aims at increasing tip reporting for small businesses that 
report at least 20 percent of their tip income as charged tips. It 
should provide benefits similar to those of previous tip reporting 
agreements for employers and employees who report tips at or above a 
minimum level of gross receipts.
    The IRS plans to test the ATIP with the food and beverage industry 
for three years. The ATIP Revenue Procedure was designed as a three-
year pilot to provide time to assess its impact on tip reporting 
compliance. It will take up to this length of time to assess whether 
the ATIP Revenue Procedure has achieved its goal and to consider 
whether it is appropriate to expand and modify it for other industries.
    TIGTA recommended several improvements to the IRS' Tip Program, 
including expansion to the cosmetology and taxi/limo industries. The 
Tip Program has not expanded to the taxi/limo industry. TIGTA estimated 
that the IRS could achieve $342 million in additional tax assessments 
over five years if it resumes soliciting new tip agreements with the 
cosmetology industry and expands the agreements to the taxi/limo 
industry.
    The IRS agreed with TIGTA's recommendations, including 
consideration of expanding the Tip Program after evaluating the results 
of the ATIP with the food and beverage industry. If the ATIP proves 
successful, the IRS should develop similar procedures for specific 
industries, including the cosmetology and tax/limo industries.
            unclear offer in compromise program requirements
    The IRS has the authority to settle or compromise Federal tax 
liabilities by accepting less than full payment under certain 
circumstances. This is accomplished through an Offer in Compromise 
(OIC). An OIC is an agreement between a taxpayer and the Federal 
Government that settles a tax liability for payment of less than the 
full amount owed. Improving the methods for identifying candidates for 
the OIC could result in substantial benefits since taxpayers generally 
do remain in compliance when offers are accepted. However, between FYs 
1996 and 2005, only approximately 24 percent of the 1.1 million offers 
received by the IRS were accepted. Over this same 10-year period, 50 
percent either did not meet preconditions of filing an offer or were 
returned to the taxpayer (e.g., for missing information) during the 
offer evaluation.
    Taxpayers who wish to participate in the program initiate an offer; 
however, this attracts offer applications from taxpayers who do not 
qualify for the program or taxpayers who do not fully understand the 
depth of financial verification the IRS conducts before accepting an 
offer. TIGTA analyzed offer dispositions and reported the following: 
\35\
     A significant number of offer applications do not meet the 
preconditions of filing an offer. Those offers not meeting the 
preconditions are returned to the taxpayers (as not-processable 
returned offers) without further consideration. However, the IRS must 
evaluate the processability of all offers received except those based 
upon Doubt As to Liability.\36\
     The IRS returns a substantial number of the offers 
determined to meet the preconditions to taxpayers during the offer 
evaluation process, without having fully evaluated the offers. This 
occurs, for example, when taxpayers no longer meet the preconditions of 
offer filing or did not provide information requested during the course 
of the offer evaluation. The IRS closes these cases as processable 
returns.
    The high rates of returned offers occurred because requirements of 
the OIC program were not always clear to taxpayers. In addition, 
taxpayers had little to lose; if their offers were not accepted, 
collection of their taxes was, in effect, delayed. The OIC application 
fee implemented by the IRS during FY 2004 was intended to reduce the 
number of frivolous offers; however, this fee is not applicable to 
offers that are considered to be not-processable. Also, in light of the 
potential benefit of a fresh start, the fee may not be significant to 
some taxpayers.
    The IRS effectively monitors accepted offers to ensure compliance 
with the terms of the offers. TIGTA reviewed a sample of 84 taxpayers 
whose offers were accepted during FY 1999. The IRS had identified 
noncompliance in 33 (39 percent) instances and took appropriate action 
to resolve the noncompliance. At the time of TIGTA's review, 96 percent 
of the 84 taxpayers were in compliance with the OIC payment terms and 
the five-year compliance requirements for filing their returns and 
paying the taxes due.
    The IRS conducted a more comprehensive analysis\37\ of individual 
taxpayer compliance with filing and paying requirements for offers 
accepted during CYs 1995 through 2001. According to that analysis, 
approximately 80 percent of the individual taxpayers remained in 
compliance. This includes taxpayers who received the first collection 
notice but did not receive any subsequent notices.
    Also, taxpayers remain in compliance after the five-year monitoring 
period. TIGTA's review of a sample of 245 taxpayers whose offers were 
accepted between October 1, 1994, and December 31, 1998, determined 
that 220 taxpayers (90 percent) were compliant with filing and payment 
requirements on tax periods subsequent to the five-year monitoring 
period.\38\
                   incomplete payroll tax assessments
    Social Security and Medicare taxes are paid to the Department of 
the Treasury from two primary sources (1) payroll taxes consisting of 
amounts withheld from employees and matching amounts paid by employers 
and (2) self-employment taxes. Employers are generally required by law 
to withhold from their employees' incomes the employees' shares of 
Social Security and Medicare taxes. Included in the employer's 
calculation of these taxes are wages earned by the employees and tips 
received by the employees and reported to the employer. One-half of the 
calculated tax amount is withheld from the employee's wages and the 
employer pays a matching amount. Self-employed taxpayers must pay the 
entire amount of Social Security and Medicare taxes themselves in the 
form of self-employment taxes.
    Social Security and Medicare Tax on Unreported Tip Income (Form 
4137) was originally designed to calculate only the Social Security and 
Medicare taxes owed on tips not reported to an employer, including any 
allocated tips\39\ shown on the Wage and Tax Statement (Form W-2). 
Forms 4137 are filed as attachments to U.S. Individual Income Tax 
Returns (Form 1040). Form 4137 has the effect of assessing only the 
worker's share of these taxes on the tip income. Although not 
originally developed for this purpose, Form 4137 is also used by 
certain taxpayers to report wages other than tips.\40\ These taxpayers 
include employees whose employers are granted Section 530\41\ relief 
and workers in dispute with their employers as to their employment 
status (employee or self-employed).
    Because Form 4137 can be used to report wages, it is possible for 
some taxpayers to use the form inappropriately. This occurs when 
taxpayers who are truly independent contractors or self-employed 
individuals use the form to avoid paying their full share of Social 
Security and Medicare taxes. By using the form inappropriately, 
taxpayers reduce their share of these taxes by almost one-half. Self-
Employment Tax (Schedule SE), not Form 4137, should be used by these 
taxpayers to pay their legitimate share of Social Security and Medicare 
taxes. Even when taxpayers rightfully report wages on Form 4137 because 
their employers have misclassified them as self-employed, Social 
Security and Medicare taxes are underpaid, in this case by the 
employers who failed to pay their share of the taxes.
    TIGTA reviewed a statistical sample of 350 Forms 1040 with 357 
Forms 4137 attached (each Form 1040 can have up to two Forms 4137 
attached) processed in CY 2005 and determined that:
     The IRS is not assessing the employer's share of Social 
Security and Medicare taxes on unreported tip income. TIGTA estimated 
$20 million in Social Security and Medicare taxes on tips were 
assessed, and the IRS could have assessed approximately $20 million 
more in Social Security and Medicare taxes on tips reported on Form 
4137.
     The lack of a specific form or adequate written 
instructions increases the burden on taxpayers trying to report Social 
Security and Medicare taxes on wages. TIGTA estimated this burden 
increase affected about 377,850 taxpayers filing Forms 4137 during CY 
2005.
     Many taxpayers appear to be reporting self-employment 
income as wages on Form 4137 to pay less Social Security and Medicare 
taxes. TIGTA estimated the IRS could have assessed approximately $88 
million more in Social Security and Medicare taxes on these wages each 
year.\42\
    TIGTA recommend that the IRS revise Form 4137 to capture the data 
necessary to properly assess the employer's share of Social Security 
and Medicare taxes on unreported tip income, revise instructions 
regarding use of the form, and revise IRS training and procedures to 
reflect the changes. Using the revised Form 4137, the IRS should 
develop a compliance program to assess the employer's share of taxes on 
the unreported tip income. In addition, TIGTA recommended that the IRS 
create a new form to properly assess the worker's share of Social 
Security and Medicare taxes on wage income, provide instructions 
regarding use of the form, create IRS training and procedures regarding 
the form, and develop a compliance program to ensure the form is used 
properly and the appropriate amounts of Social Security and Medicare 
taxes are assessed.
    As the tax collectors for the Social Security program, the IRS must 
help taxpayers meet their tax responsibilities by assessing and 
collecting the proper amount of employment taxes in this area. By 
making TIGTA's recommended changes, the IRS could assess an additional 
estimated $108 million\43\ in Social Security and Medicare taxes each 
year.
          increase resources in the irs enforcement functions
    Increased resources would help the IRS with its efforts to close 
the tax gap. However, in addition to increased resources, the IRS must 
also focus its efforts on ways to increase the economy, efficiency, and 
effectiveness of its operations, which would allow the IRS to devote 
more resources to its efforts to close the tax gap.
    In September 1979, the GAO testified before Congress that ``The 
staggering amount of income, at least $135 billion, on which taxes are 
not paid is shocking.'' \44\ The GAO's testimony focused on the actions 
the government should take. The recommended actions included ensuring 
that the level of the IRS' audit activity did not decline. 
Unfortunately, while there have been periods of increases in compliance 
staffing, the IRS has also experienced declines over the years.
    The combined Collection and Examination functions enforcement 
personnel \45\ declined from approximately 22,200 at the beginning of 
FY 1996 to 14,500 at the end of FY 2005, a 35 percent decrease. Even 
though the IRS has started to reverse many of the downward trends in 
compliance activities, the Collection and Examination functions' 
enforcement staffing level is not much higher than the 10-year low 
experienced in FY 2003. The President's FY 2008 proposed budget for 
enforcement is approximately 5.7 percent more than the FY 2007 
Continuing Resolution (CR) and requests an additional $246 million to 
expand enforcement activities. Without this additional funding, the IRS 
will not be positioned to increase enforcement activity above the level 
provided for in the FY 2007 CR. Additionally, the FY 2007 CR amount for 
enforcement is almost $48 million less than the FY 2006 funding.

                     Figure 4: Examination Staffing



    Source: TIGTA analysis of IRS' Audit Information Management System 
Table 37

    The numbers in the preceding chart represent the number of 
Examination function staff conducting examinations of tax returns, 
excluding management and overhead staff. During FY 2005, revenue agent 
and tax compliance officer (formerly referred to as tax auditor) 
staffing decreased, and the combined total is now nearly 35 percent 
lower than it was at the beginning of FY 1996.

                 Figure 5: Collection Function Staffing



    Source: IRS Collection Reports

    The numbers in the preceding chart represent the Collection field 
function staffing at the end of each FY 1995 through 2005. The number 
of revenue officers working assigned delinquent cases, excluding 
management and overhead staff, decreased slightly during FY 2005 and is 
nearly 38 percent fewer than at the start of FY 1996.
    One effect of the lack of resources in the Collection function is 
that the Queue,\46\ has increased significantly since FY 1996. In FY 
1996, there were over 317,000 balance-due accounts worth $2.96 billion 
in the Queue. In FY 2004, these figures had increased to over 623,000 
balance-due accounts worth $21 billion. Additionally, the number of 
unfiled tax return accounts in the Queue increased from over 326,000 in 
FY 1996 to more than 838,000 in FY 2004.
    The number of balance-due accounts ``shelved,'' or removed from the 
Queue altogether because of lower priority, has also increased 
significantly. In FY 1996, less than 8,000 of these balance due 
accounts were shelved, but in FY 2004, more than 1 million of these 
accounts were removed from inventory. From FY 2001 to FY 2004, 
approximately 5.4 million accounts with balance-due amounts totaling 
more than $22.9 billion were removed from Collection function inventory 
and shelved. Additionally, in FY 2004 alone, more than 2 million 
accounts with unfiled returns were shelved.
    If increased funds for enforcement are provided to the IRS in 
upcoming budgets, the resource issues in the Enforcement functions will 
be addressed to some degree. In addition, use of Private Collection 
Agencies is allowing the IRS to collect more outstanding taxes. The IRS 
needs to be vigilant in overseeing these contractors to ensure that 
abuses do not occur. However, past experiences with lockbox thefts and 
insufficient contractor oversight provide valuable lessons toward 
reducing the likelihood of similar issues occurring when contracting 
out collection of tax debt.\47\
    Overseeing the IRS' private debt-collection initiative is a top 
priority for TIGTA. TIGTA has coordinated with the IRS during the 
initial phases of implementation of this initiative by addressing 
security concerns with the contracts and protection of taxpayer rights 
and privacy, and by developing integrity and fraud awareness training 
for the contract employees. TIGTA has also developed a three-phase 
audit strategy to monitor this initiative and provide independent 
oversight.
    There are many areas in which increased enforcement could address 
noncompliance. For example, a TIGTA audit found that a significant 
number of single shareholder owners of Subchapter S corporations 
avoided paying themselves salaries to avoid paying employment 
taxes.\48\ We estimated this would cost the Treasury approximately $60 
billion in employment taxes over five years. Under current law, the IRS 
must perform an examination of these taxpayers to determine reasonable 
compensation. To accomplish this on any scale would require significant 
compliance resources.
    Additional resources might also help the IRS address the growth in 
fraudulent returns filed by incarcerated individuals. On June 29, 2005, 
I testified before the House Committee on Ways and Means' Subcommittee 
on Oversight about this growing problem.\49\ Although prisoner tax 
returns account for only 0.43 percent of all refund returns, they 
account for more than 15 percent of the fraudulent returns identified 
by the IRS. Refund fraud committed by prisoners is growing at an 
alarming rate. The number of fraudulent returns filed by prisoners and 
identified by the IRS' Criminal Investigation function grew from 4,300 
in processing year 2002 to more than 18,000 in processing year 2004 (a 
318 percent increase).\50\ During that same period, all fraudulent 
returns identified grew by just 45 percent.
    The IRS' Fraud Detection Centers screen tax returns based on 
criteria that identify potentially fraudulent filings. The number of 
returns screened is based on these criteria and the available 
resources. During processing year 2004, Fraud Detection Centers 
screened about 36,000 of the approximately 455,000 refund returns 
identified as filed by prisoners. Resources were not available to 
screen the remaining 419,000 tax returns. Those returns claimed 
approximately $640 million in refunds and approximately $318 million of 
Earned Income Tax Credit (EITC). For those unscreened returns, over 
18,000 prisoners incarcerated during all of CY 2003 filed returns with 
a filing status as ``Single'' or ``Head of Household'' and claimed more 
than $19 million in EITC. Since prisoners were incarcerated for the 
entire year, they would have had neither eligible earned income to 
qualify for the EITC nor a qualified child who lived with them for more 
than six months.
    The IRS also needs to focus efforts on improving the economy, 
efficiency and effectiveness of its operations. For example, in 2002, 
the IRS decided to reduce the number of its human resource positions 
and to consolidate some of its support operations. The IRS determined 
that 741 Full-Time Equivalents (FTE) \51\ could be eliminated from its 
headquarters and field offices. This was just one part of a series of 
initiatives the IRS intended to use to realign approximately 12,000 
positions to front-line tax professional positions over the following 
two years.
    Through the use of early retirements, buyouts, normal attrition, 
placements elsewhere, and involuntary separations,\52\ the IRS was able 
to meet its desired reduction of human resource positions. However, the 
IRS does not track vacated and reassigned individual positions. While 
the other IRS initiatives involved in the effort to reassign 12,000 
positions to the front-line were not reviewed, TIGTA determined that 
from FY 2003 to FY 2005, the number of employees in mission critical 
positions\53\ increased by only 1,216, far short of the goal the IRS 
documented in its request to the OPM.\54\ TIGTA did not determine why 
the IRS did not achieve its goal.
    In a plan submitted to the OPM, the IRS cited specific benefits 
that would be realized if it received authorization to offer early 
retirements and buyouts. The plan indicated that the IRS would save an 
average of $2,746 per employee. However, neither TIGTA nor the IRS 
could determine if savings were realized. The IRS' Human Capital Office 
did not prepare any analysis to determine the total costs of, or any 
savings associated with, offering the early retirements and buyouts. 
After the IRS was granted the early retirement and buyout authorities, 
it did not formally assign responsibility for overseeing the 
reorganization to any single office or individual. As a result, no one 
was responsible for monitoring the reorganization to ensure that the 
benefits outlined in the plan to the OPM, such as the realignment of 
staff to mission critical positions and cost savings, were actually 
achieved.
    TIGTA recommended that the IRS monitor and report on the progress 
of any IRS reorganization initiative, including how effectively the IRS 
achieves proposed reductions or staffing realignments. TIGTA also 
recommended that the IRS identify and track all costs incurred and any 
savings realized and that the IRS follow all early retirement and 
buyout rules and regulations. The IRS agreed with TIGTA's 
recommendations.
    The FY 2008 IRS proposed budget shows a net increase of $409.5 
million to enhance the IRS' infrastructure and invest in modernization. 
This increased investment in the IRS infrastructure is necessary to 
ensure the capability to administer the tax laws, collect the revenue 
and to better position the IRS to reduce the tax gap.
    According to the IRS, the $409.5 million will allow the IRS to 
increase enforcement revenue by $699 million by 2010. The legislative 
proposals contained in the budget are projected to increase revenue by 
approximately $2.9 billion a year. At these levels, the tax gap will 
not be seriously reduced. Even if these initiatives indirectly 
increased compliance 10 fold, the tax gap would still exceed $300 
billion.
    The budget also contains $41 million for non-NRP research. TIGTA 
believes that by employing enhanced research methods, the IRS will be 
better positioned to develop more effective and efficient solutions to 
non compliance, which should lead to reductions in the tax gap.
    Although increasing enforcement is important in addressing the tax 
gap, the IRS must exercise great care not to emphasize enforcement at 
the expense of taxpayer rights and customer service. Customer service 
goals must be met and even improved upon, or people will lose 
confidence in the IRS' ability to meet part of its mission to provide 
America's taxpayers with quality service by helping them understand and 
meet their tax responsibilities.
                              conclusions
    The IRS faces formidable challenges in completely and accurately 
estimating the tax gap and also in finding effective ways to remove 
institutional impediments and optimize its opportunities to increase 
voluntary compliance. Strategies have been identified to decrease the 
tax gap and improvements can be realized; however, sufficient resources 
are needed to ensure compliance with the tax laws.
    Mr. Chairman and members of the committee, I appreciate the 
opportunity to share my views on the tax gap and the work TIGTA has 
done in this area. I would be happy to answer any questions you may 
have.
                                endnotes
    \1\ Hearings on Bridging the Tax Gap Before the Senate Committee on 
Finance, 108th Cong. (2004) (statement of Mark Everson, Commissioner of 
Internal Revenue).
    \2\ In January 2007, the Congressional Budget Office estimated that 
if today's laws and policies did not change, Federal spending would 
total $2.7 trillion in 2007 and revenues would total $2.5 trillion, 
resulting in a budget deficit of $172 billion. The additional funding 
that is likely to be needed to finance military operations in Iraq and 
Afghanistan would put that deficit in the vicinity of $200 billion.
    \3\ This definition and the associated categories have evolved over 
time. IRS tax gap estimates in 1979 and 1983 included unpaid income 
taxes owed from illegal activities such as drug dealing and 
prostitution. That practice was discontinued in the 1988 estimate. 
Reasons given for excluding this category are: 1) the magnitude of the 
illegal sector is extremely difficult to estimate; and 2) the interest 
of the government is not to derive revenue from these activities, but 
to eliminate the activities altogether. Earlier tax gap figures such as 
those for 1965 and 1976 only included underreporting. While figures for 
more recent years (1992, 1995, 1998 and 2001) are more comparable, they 
are essentially the same estimates adjusted for the growth in the 
economy. Thus, comparing the figures does not show real growth in the 
tax gap. Lastly, comparisons among years are not done in constant 
dollars, so any real growth in the tax gap cannot be determined through 
this IRS data.
    \4\ This category includes the lesser amounts of overclaimed 
credits and deductions.
    \5\ Prior to the National Research Program, tax gap estimates were 
based on the results of the IRS Taxpayer Compliance Measurement Program 
(TCMP), which was a systematic program of tax return examinations 
conducted to facilitate the compilation of reliable compliance data. 
The last TCMP process involved TY 1988 individual income tax returns.
    \6\ Some Concerns Remain About the Overall Confidence That Can Be 
Placed in Internal Revenue Service Tax Gap Projections (TIGTA Reference 
Number 2006-50-077, dated April 2006.
    \7\ The IRS defines the gross tax gap as the difference between the 
estimated amount taxpayers owe and the amount they voluntarily and 
timely pay for a tax year. The portion of the gross tax gap that is not 
eventually collected is called the net tax gap.
    \8\ This is the amount previously described in this report that was 
called for by Senator Baucus. See Some Concerns Remain About the 
Overall Confidence That Can Be Placed in Internal Revenue Service Tax 
Gap Projections (TIGTA Reference Number 2006-50-077, dated April 2006.
    \9\ Payment of the $55 billion estimated by the IRS as late or 
enforced payments does not affect the VCR. However, it does affect the 
total amount collected by the IRS. Therefore, TIGTA developed the 
Eventual Compliance Rate term that shows the effect of these payments 
when coupled with additional voluntary and timely payments that do 
affect the VCR.
    \10\ According to the IRS Oversight Board Web site 
(irsoversightboard.treas.gov), it is an ``independent body charged to 
oversee the IRS in its administration, management, conduct, direction, 
and supervision of the execution and application of the internal 
revenue laws and to provide experience, independence, and stability to 
the IRS so that it may move forward in a cogent, focused direction.''
    \11\ The National Research Program Study of S Corporations Has Been 
Effectively Implemented, but Unnecessary Information Was Requested From 
Taxpayers (TIGTA Reference Number 2007-30-027, dated January 30, 2007).
    \12\ An Evaluation of The Sample Design for The National Research 
Program Study of Subchapter S Corporations (Mathematica Policy Research 
Inc., dated May 12, 2005).
    \13\ The Small Business/Self-Employed Division Is Beginning to 
Address Challenges That Affect Corporate Return Examination Coverage 
(TIGTA Reference Number 2005-30-130, dated August 2005).
    \14\ Some Concerns Remain About the Overall Confidence That Can Be 
Placed in Internal Revenue Service Tax Gap Projections (TIGTA Reference 
Number 2006-50-077, dated April 2006).
    \15\ The examination coverage rate is calculated by dividing the 
number of examined returns in a category by the number of returns in 
the same category filed in the previous year.
    \16\ While Examinations of High-Income Taxpayers Have Increased, 
the Impact on Compliance May Be Limited (TIGTA Reference Number 2006-
30-105, dated July 25, 2006).
    \17\ Correspondence examinations are important compliance 
activities focusing on errors and examination issues that typically can 
be corrected by mail. They are conducted by sending the taxpayer a 
letter requesting verification of certain items on the tax return. 
These examinations are much more limited in scope than office and field 
examinations in which examiners meet face to face with taxpayers to 
verify information.
    \18\ TIGTA selected the sampled cases from those completed in FY 
2004 to provide sufficient time for collection activities.
    \19\ Margin of error + 5.05 percent.
    \20\ Abatement occurs when the IRS reduces an assessment, in this 
case from reversing examination findings that had uncovered apparent 
misreported income, deductions, credits, exemptions, or other tax 
issues.
    \21\ The IRS Should Evaluate the Feasibility of Using Available 
Documents to Verify Information Reported on Business Tax Returns (TIGTA 
Reference Number 2002-30-185, dated September 2002).
    \22\ General Accounting Office, Pub. No. GAO-04-358, TAX 
ADMINISTRATION: Comparison of the Reported Tax Liabilities of Foreign- 
and U.S.-Controlled Corporations, 1996-2000 (2004).
    \23\ The IRS receives over 30 different types of business 
information documents yearly. Most of these forms have a legal 
requirement for issuance to corporations. The three information 
documents most often issued to business nonfilers are Forms 1099-B 
(Proceeds from Broker and Barter Exchange Transactions), 1099-MISC 
(Miscellaneous Income), and 4789 (Currency Transaction Reports).
    \24\ Internal Revenue Service, Report of BMF IRP Nonfilers for TY 
2000 (Corporations, Partnerships, and Trusts), Research Project 
02.08.003.03, SB/SE Research (July 2004).
    \25\ Stronger Actions Are Needed to Ensure Partnerships Withhold 
and Pay Millions of Dollars in Taxes on Certain Income of Foreign 
Partners (TIGTA Reference Number 2001-30-084, dated June 2001); 
Compliance Opportunities Exist for the Internal Revenue Service to Use 
Foreign Source Income Data (TIGTA Reference Number 2005-30-101, dated 
July 2005).
    \26\ The Delinquency Penalty is also known as the Failure-to-File 
Penalty, although it only applies to taxpayers who both file late and 
fail to pay all taxes by the tax payment deadline.
    \27\ The Regulations for Granting Extensions of Time to File Are 
Delaying the Receipt of Billions of Tax Dollars and Creating 
Substantial Burden for Compliant Taxpayers (TIGTA Reference Number 
2003-30-162, dated August 2003); Changes to the Regulations for 
Granting Extensions of Time to File Corporate Returns Are Needed to 
Alleviate Significant Problems With Administering the Tax Laws (TIGTA 
Reference Number 2004-30-106, dated June 2004).
    \28\ The non-filer tax gap is the dollar amount of taxes not paid 
timely on delinquent and non-filed returns.
    \29\ The estimated tax gap of $27 billion in TY 2001 was comprised 
of $25 billion for individual income tax non-filing and $2 billion 
associated with estate and gift tax. The estimate is developed from 
other tax gap data sources and is not derived from direct data sources. 
So, the growth in the dollar amounts in the estimate track the 
increases in other tax gap estimates.
    \30\ The Internal Revenue Service Needs a Coordinated National 
Strategy to Better Address an Estimated $30 Billion Tax Gap Due to Non-
filers (TIGTA Reference Number 2006-30-006, dated November 2005).
    \31\ The Automated Substitute for Return Program focuses on high-
income taxpayers who have not filed individual income tax returns but 
appear to owe significant income tax liabilities based on available 
Information Reporting Program information.
    \32\ The campuses are the data processing arm of the IRS. They 
process paper and electronic submissions, correct errors, and forward 
data to the Computing Centers for analysis and posting to taxpayer 
accounts.
    \33\ Internal Revenue Code Section 6020(b) (2005) provides the IRS 
with the authority to prepare and process certain returns for a non-
filing business taxpayer if the taxpayer appears to be liable for the 
return, the person required to file the return does not file it, and 
attempts to secure the return have failed.
    \34\ Additional Enhancements Could Improve Tax Compliance of 
Employees Who Receive Tips (TIGTA Reference Number 2006-30-132, dated 
September 15, 2006).
    \35\ The Offer in Compromise Program Is Beneficial but Needs to Be 
Used More Efficiently in the Collection of Taxes (TIGTA Reference 
Number 2006-30-100, dated July 2006).
    \36\ Offers submitted on the basis of Doubt As to Liability 
represent disputes over the existence or amount of the tax liability 
and apply to the specific tax periods that are in question.
    \37\ IRS Offers in Compromise Program, Analysis of Various Aspects 
of the OIC Program, September 2004.
    \38\ The number of tax years for which taxpayers were compliant 
after completion of the offer monitoring period varies based on the 
offer acceptance date. At the time of TIGTA's review, taxpayers in the 
sample had been compliant from one to five tax years after the offer 
monitoring period.
    \39\ When the amount of tips reported by an employee of a large 
food or beverage establishment is less than 8 percent (or an approved 
lower rate) of the gross receipts, other than nonallocable receipts, 
for the given period, the employer is required to allocate tips to the 
employee. If the employee is reporting more than the 8 percent, there 
would be no allocated tip amount.
    \40\ For tax purposes, tips are generally considered to be wages. 
However, for purposes of this report, wages are defined as compensation 
other than tips paid to an employee.
    \41\ Revenue Act of 1978, Pub. L. No. 95-600, Section 530, 92 Stat. 
2763, 2885-86 (current version at Internal Revenue Code Section 3401 
note).
    \42\ Draft Report: Social Security and Medicare Taxes Are Not Being 
Properly Assessed on Some Tips and Certain Types of Wage Income (TIGTA 
Audit Number 200630005, dated February 13, 2007).
    \43\ This is comprised of approximately $20 million in Social 
Security and Medicare taxes on tips and approximately $88 million in 
Social Security and Medicare taxes on wages.
    \44\ Statement of Richard L. Fogel, Associate Director, General 
Government Division before the Subcommittee on Commerce, Consumer and 
Monetary Affairs of the House Committee on Government Operations, 
September 6, 1979.
    \45\ Collection and Examination function staff located in field 
offices, excluding management and overhead staff.
    \46\ An automated holding file for unassigned inventory of lower 
priority delinquent cases that the Collection function does not have 
enough resources to immediately assign for contact.
    \47\ Federal Requirements Need Strengthening at Lockbox Banks to 
Better Protect Taxpayer Payments and Safeguard Taxpayer Information 
(TIGTA Reference Number 2002-30-055, dated February 2002); Insufficient 
Contractor Oversight Put Data and Equipment at Risk, (TIGTA Reference 
Number 2004-20-063, dated March 2004).
    \48\ Actions Are Needed to Eliminate Inequities in the Employment 
Tax Liabilities of Sole Proprietorships and Single-Shareholder S 
Corporations (TIGTA Reference Number 2005-30-080, dated May 2005).
    \49\ Hearing to Examine Tax Fraud Committed by Prison Inmates, 
109th Cong. (2005) (statement of J. Russell George, Inspector General) 
and The Internal Revenue Service Needs to Do More to Stop the Millions 
of Dollars in Fraudulent Refunds Paid to Prisoners (TIGTA Reference 
Number. 2005-10-164, dated September 2005).
    \50\ Processing year refers to the year in which taxpayers file 
their returns at the Submission Processing Sites. Generally, returns 
for 2003 were processed during 2004, although returns for older years 
were also processed.
    \51\ A measure of labor hours in which 1 FTE is equal to 8 hours 
multiplied by the number of compensable days in a particular fiscal 
year. For FY 2005, 1 FTE was equal to 2,088 hours. For purposes of this 
report, we are using the terms FTEs, employees, and positions 
synonymously.
    \52\ An involuntary separation is any separation against the will 
and without the consent of the employee, other than for misconduct or 
delinquency. The most common cause for an involuntary separation is a 
reduction in force.
    \53\ The IRS uses the term mission critical occupations to define 
occupations deemed critical to front-line operations as well as those 
occupations that provide direct support to front-line operations. 
Mission critical positions are specific positions within those 
occupations.
    \54\ Staff Reductions in Support Operations Did Not Result in 
Significant Increases in Mission Critical Positions (TIGTA Reference 
Number 2006-10-175, dated September 28, 2006).

    Chairman Spratt. Thank you very much.
    Ms. Olson.

                   STATEMENT OF NINA E. OLSON

    Ms. Olson. Thank you, Mr. Chairman, Mr. Ryan and members of 
the committee. Thank you for inviting me to testify today about 
the tax gap. I believe there are three principal steps that can 
be taken to address this gap.
    First, Congress should simplify the Tax Code. Corporate tax 
shelters and abusive schemes pursued by individual taxpayers 
exist solely because there are ambiguities and complex laws 
that they can exploit. At the same time, tax law complexity 
confounds taxpayers and is responsible for the significant 
majority of taxpayer reporting errors.
    Second, Congress should consider expanding third-party 
information reporting and, in certain situations, withholding 
requirements. IRS data show a direct correlation between third-
party information reporting by payers of income and tax 
reporting compliance by the recipients of income. Where tax is 
withheld from income, taxpayer reporting compliance is above 99 
percent. Where income is reported to the IRS, such as interest 
on dividends on a Form 1099, taxpayer reporting compliance is 
above 95 percent. Where income is not reported to the IRS, 
taxpayer reporting compliance drops below 50 percent. Expanded 
information reporting would reduce the tax gap significantly, 
and backup withholding can be used where taxpayers repeatedly 
underpay their taxes, but both must be done with care to avoid 
placing undue burdens on the payers of income tax. I discuss 
this issue in more detail in my written statement.
    I will devote the rest of my testimony today to my third 
point because it falls squarely within your committee's 
jurisdiction.
    I believe the rules by which the IRS is funded need to be 
fixed so that the IRS receives adequate resources to collect 
taxes. As a starting point, we should keep in mind that the IRS 
functions as the Accounts Receivable Department of the Federal 
Government. On a budget of about $10.6 billion, the IRS 
currently collects about $2.24 trillion a year. That translates 
to an average return on investment, or ROI, of about 210 to 1, 
but the congressional budget rules do not recognize the IRS' 
unique role as the revenue generator for the Federal 
Government. Rather, the budget rules treat spending for the IRS 
exactly the same way they treat spending for all other Federal 
programs. The IRS is placed within a category of spending 
programs that is subject to a spending ceiling, and the 
relevant appropriations subcommittee then allocates dollars 
between the IRS and the other agencies. Thus, the IRS competes 
dollar for dollar against classic spending programs for 
resources, and there is no explicit mechanism in the budget 
process for recognizing the revenue that the IRS collects. 
These procedures make little sense. If the Federal Government 
were a private company, its management clearly would fund the 
Accounts Receivable Department at a level that it believed 
would maximize the company's bottom line.
    Since the IRS is not a private company, maximizing the 
bottom line is not and in and of itself should not be an 
appropriate goal, but the public sector analogy should be to 
maximize tax compliance, especially voluntary tax compliance, 
with due regard for protecting taxpayer rights and minimizing 
taxpayer burden. No one seems to dispute this premise, but the 
current budget rules treat the IRS as a classic spending 
program, and a change in the rules will be required if the IRS 
is to be treated the way a company would treat its Accounts 
Receivable Department.
    In the last 3 years, the administration has proposed and 
Congress has considered a mechanism known as ``program 
integrity caps'' to give the IRS additional funding. While 
these cap adjustments are better than nothing, they suffer from 
two flaws. First, they do not address the fundamental problem I 
am raising, which is that decisions about IRS funding levels 
should be made on the basis of maximizing tax compliance, not 
fitting within a cap. Second, the program integrity caps have 
generally been used to provide additional funding for tax law 
enforcement without providing any additional funding for 
taxpayer service. This is happening because the IRS can 
document that it collected $48.7 billion through direct 
enforcement actions last year, and budget crunchers can compare 
this figure with the dollars spent on enforcement to compute a 
positive return on investment.
    The problem with this approach is that $48.7 billion is 
only 2 percent of the revenue that the IRS collected. The 
remaining 98 percent of revenues were collected through some 
combination of taxpayer service and the indirect or deterrent 
effects of enforcement. The IRS current strategic plan is based 
on the formula of taxpayer service plus enforcement equals 
compliance, but there are no data that show whether there is a 
greater need at this time for service or enforcement. In the 
absence of such data, I think it is misguided to provide 
disproportionate increases to enforcement simply because we 
have measurement tools to compute the ROI with respect to 2 
percent of our collections.
    In my written statement, I describe some recent and 
expected reductions in taxpayer service and the negative 
effects these reductions could have on compliance.
    In conclusion, I urge the committee to consider making 
changes to the budget rules to provide funding for the IRS at a 
level designed to maximize tax compliance and that does not 
short-change taxpayer service as taxpayer service may provide 
an equal or greater ROI than enforcement. In focusing on what 
the IRS can do to reduce the tax gap, I suggest that giving the 
IRS the tools to do the job in conjunction with proper 
oversight is the single most helpful step Congress can take.
    Thank you.
    [The prepared statement of Nina E. Olson follows:]

    Prepared Statement of Nina E. Olson, National Taxpayer Advocate

    Mr. Chairman, Ranking Member Ryan, and distinguished Members of the 
Committee, thank you for inviting me to testify today about ``The IRS 
and the Tax Gap.''\1\ In the National Taxpayer Advocate's 2006 Annual 
Report to Congress, issued last month, I made a recommendation to 
address the tax gap that falls squarely within the jurisdiction of the 
Budget Committee--namely, to change the budget rules by which IRS 
funding decisions are made to provide funding at whatever level will 
maximize tax compliance, with due regard for protecting taxpayer rights 
and minimizing taxpayer burden. I will describe my proposal in more 
detail below after first summarizing the components of the tax gap and 
describing my perspective on the best strategies to address it.

                       I. Why the Tax Gap Matters

    In my 2006 report, I designated the tax gap as the second most 
serious problem facing taxpayers (after the alternative minimum tax). 
From a taxpayer perspective, I am deeply concerned that compliant 
taxpayers are paying a great deal of money to subsidize noncompliance 
by others. Using data from the IRS's 2001 National Research Program 
study, if we divide the estimated 2001 net tax gap of $290 billion\2\ 
by the estimated 108,209,000 households that existed in the United 
States in that year\3\ we see that each household was effectively 
assessed an average ``surtax'' of about $2,680 to subsidize 
noncompliance.\4\ That is an extraordinary burden to ask our nation's 
compliant taxpayers to bear every year, and it is imperative that we 
take steps to reduce that burden.\5\
    Noncompliance has a corrosive effect on tax compliance. If 
compliant taxpayers believe that everyone else is paying his or her 
fair share, they are likely to remain compliant. But no one wants to 
feel like a ``tax chump.'' If compliant taxpayers feel like they are 
overpaying, some will reach a point where they resent it and stop 
complying or comply at a lower level.
    In other words, there is a degree to which compliance breeds more 
compliance and noncompliance breeds more noncompliance. That is largely 
why each additional dollar the IRS collects is thought to increase 
federal revenue by substantially more than a dollar. Greater 
compliance--whether brought about through taxpayer service or 
enforcement--can pay for itself many times over.

           II. Overview of the Primary Causes of the Tax Gap

    Last year, the IRS substantially updated its tax gap estimates as a 
result of a set of audits it performed on individual income tax returns 
filed for 2001. The results of the audits show that withholding and 
third-party information reporting are the key drivers of tax 
compliance. Reporting compliance rates are about 99 percent on wages 
subject to withholding and third-party information reporting, about 96 
percent on income subject to full third-party information reporting 
(e.g., interest and dividends)--yet less than 50 percent on income not 
subject to third-party information reporting.\6\
    At the same time, the complexity of the tax code is a driver of 
noncompliance because it creates loopholes that aggressive taxpayers 
can exploit. Corporate tax shelters and abusive schemes pursued by 
individual taxpayers exist largely because of ambiguities in the law. 
Tax-law or procedural complexity is also responsible for the 
significant majority of taxpayer reporting errors.\7\
    Finally, the lack of funding provided to the IRS to maximize 
taxpayer service (especially outreach and education) and enforcement 
(where the IRS was only able to conduct face-to-face audits of one out 
of every 435 taxpayers last year) prevents the IRS from maximizing tax 
compliance.\8\

              III. Broad Strategies to Address the Tax Gap

    Broadly speaking, I have advocated three strategies for closing the 
tax gap: (1) fundamental tax simplification, with an emphasis on making 
economic transactions more transparent; (2) expanded third-party 
information reporting and, in certain situations, tax withholding on 
non-wage income; and (3) a more robust IRS compliance program that 
appropriately balances taxpayer service and enforcement.
                         a. tax simplification
    In my annual reports to Congress, I have highlighted numerous 
examples of tax law complexity and described the consequences of that 
complexity for taxpayers and tax administration. For taxpayers seeking 
to comply with the law, complexity presents a huge obstacle. To cite a 
few examples, the alternative minimum tax (AMT) and the earned income 
tax credit (EITC) affect millions of taxpayers yet present substantial 
compliance burdens. The sheer number of alternative incentives that the 
tax code provides for saving for education and retirement baffles many 
taxpayers, including sophisticated taxpayers.
    For taxpayers seeking to exploit loopholes, complexity presents 
countless opportunities. Many law firms, accounting firms, and 
investment banking firms have made tens of millions of dollars by 
scouring the Code for ambiguities and then advising taxpayers to enter 
into transactions, with differing levels of business purpose or 
economic substance, to take advantage of those ambiguities. The IRS 
devotes significant resources to identifying these transactions and 
challenging them, where appropriate, but many are legitimate under 
existing law and many more fall into a grey area.
    A simpler tax code could reduce these administrative challenges 
enormously.
    Moreover, traditional economic analysis focuses on the goals of 
equity and efficiency in writing the tax laws. To those, I would add 
transparency. To the extent we can revise the Code to provide greater 
transparency of payments of income without imposing undue burden on 
taxpayers, the higher compliance rates associated with third-party 
information reporting can be more readily achieved in a broader array 
of transactions.
             b. expanded third-party information reporting
    Expanding third-party information reporting would clearly improve 
compliance, but we must be realistic in taking into account the burden 
third-party information reporting imposes on payors of income. If our 
sole objective were to maximize the amount of tax revenue, we could 
simply require that anyone making a taxable payment to another person 
report the payment to the IRS. But requiring everyone making a taxable 
payment to file a report with the government would impose more burden 
than most of us would be willing to bear. No one wants to be obligated 
to file a document with the IRS every time he takes a cab ride, has 
someone mow his lawn, or calls a plumber to fix a broken faucet.
    To address the tax gap, we should begin by identifying various 
categories of transactions that currently are not subject to 
information reporting and determine, on a case-by-case basis, whether 
the benefits of requiring reporting outweigh the burdens such a 
requirement would impose. In many cases, we will ultimately decide that 
it is inappropriate to impose a reporting requirement. But in some 
cases, we may decide that requiring reporting is appropriate.
    To cite one example, I recommended in my 2005 Annual Report to 
Congress that Congress consider requiring broker-dealers to track and 
report their customer's cost-basis in stocks and mutual funds when 
sales are made. Under existing rules, brokers are required to file a 
Form 1099-B (Proceeds from Broker and Barter Exchange Transactions) 
with the IRS whenever a customer sells a security. However, the 
reporting rules only require the broker to report the gross proceeds 
the customer receives upon the sale. The broker does not have to report 
the customer's cost basis in the security. That omission is significant 
because a taxpayer's gain or loss on the sale of a security is measured 
by the excess of gross proceeds over cost basis. Thus, the absence of 
cost-basis reporting provides an opportunity for noncompliance that the 
IRS rarely will detect without an audit.
    The absence of a requirement that brokers track and report 
customers' cost basis in securities has two consequences. First, it 
often imposes significant compliance burdens on taxpayers who may not 
have kept track of their cost basis. To illustrate, a taxpayer who has 
held AT&T stock since the 1980s has received shares in more than a 
dozen companies over the years, and on each such occasion, the 
taxpayer's cost basis had to be split between his existing holding and 
the spun-off company. Similarly, most mutual fund customers elect to 
have dividend and capital gain distributions automatically reinvested, 
and the customer's aggregate basis in a mutual fund holding changes 
upon each such distribution. If taxpayers don't have complete records, 
they will be unable to determine or substantiate their basis in many 
instances. We recommended requiring brokers to track and report cost 
basis primarily because it would make compliance much easier for honest 
taxpayers.
    But the second consequence of the absence of cost basis reporting 
is that it affords less honest taxpayers with significant opportunities 
to overstate their basis and therefore understate their tax 
liabilities. Reliable estimates of the amount of underreporting in this 
area are difficult to come by, but two professors have sized the 
problem at about $25 billion a year.\9\ IRS officials studying the NRP 
data believe the revenue loss is substantially lower, but they agree 
that the level of underreporting reaches into the billions of 
dollars.\10\ We have spoken with representatives of the brokerage 
industry and believe on balance that the revenue benefits of requiring 
brokers to track and report cost basis exceed the burdens the 
requirement would impose.
    I am pleased that bills were introduced in both the House and the 
Senate last year to implement our proposal, and I am pleased that the 
Treasury Department has included it among the revenue proposals it sent 
to Congress earlier this month. Bipartisan bills have been introduced 
in the new Congress by Congressmen Rahm Emanuel and Walter Jones in the 
House and by Senators Evan Bayh, Tom Coburn and 11 other original co-
sponsors in the Senate. I strongly urge Congress to enact this measure.
    Another example: Under current law, an individual taxpayer can 
escape information reporting by incorporating. This is true even if the 
taxpayer is performing the same services that would be subject to Form 
1099-MISC (Miscellaneous Income) reporting if the taxpayer were 
conducting business as an unincorporated entity.
    For Form 1099-MISC information reporting purposes, I believe there 
should be no distinction between taxpayers providing the same services 
for compensation merely because one taxpayer has incorporated and 
another has not. There are, of course, many valid reasons for choosing 
to conduct business as a corporation, but information-reporting 
avoidance should not be such a reason. Corporate taxpayers who intend 
to comply with the tax law should have no objections to receiving a 
Form 1099-MISC for compensation for services performed or to IRS 
awareness of this compensation. Thus, we recommend that corporate 
taxpayers (including Subchapter S corporations) be subject to Form 
1099-MISC reporting requirements to the same extent that unincorporated 
businesses are today.
    We also recommend that Congress consider requiring information 
reporting on gross proceeds from sales conducted on Internet auction 
and sales sites. As with current rules governing Form 1099 reporting, 
such reports could be subject to a de minimis annual exemption (say, 
$600). One recent study found that 700,000 Americans reported that eBay 
sales constitute their primary or secondary source of income.\11\ The 
IRS must have the tools needed to address under-reporting of this 
income.
    My office has made a number of proposals to reduce the tax gap both 
through more third-party information reporting and through other 
methods. The Exhibits that follow my statement summarize our main 
recommendations.
  c. a more robust irs compliance program that appropriately balances 
               taxpayer service and enforcement measures
    The IRS can do more--much more--to improve tax compliance.
    Despite a finding by a leading IRS researcher that the direct and 
indirect benefits of IRS's preparing tax returns for low income 
taxpayers pays for itself many times over,\12\ the IRS has reduced by 
about half the number of tax returns it helps low-income taxpayers 
prepare in its walk-in sites.\13\ Despite the challenges individuals 
who start small businesses face in learning for the first time about 
the legal requirements they face as employers (including the payroll 
responsibilities of income and employment tax withholding, paying over 
tax to the IRS, reporting to the IRS, and reporting to the employee), 
the IRS has substantially reduced its field outreach operation.\14\ 
Despite the number of taxpayers in certain states with taxable income 
from farming activities, the IRS has apparently declared questions 
about farm income and expenses ``out of scope'' for IRS walk-in sites 
in those areas.\15\
    On the enforcement side, the IRS is currently conducting face-to-
face audits of only about one out of every 435 tax returns.\16\ It does 
not have the resources to pursue a significant percentage of its 
accounts receivable. And the private debt collection initiative, a 
controversial program that is projected to raise only about $1.4 
billion over the next 10 years,\17\ results from the IRS's lack of 
resources to pursue these cases itself.

IV. A Proposal to Revise the Congressional Budget Rules to Improve IRS 
                           Funding Decisions

             a. overview of the problem of irs underfunding
    The Internal Revenue Service is effectively the Accounts Receivable 
Department of the United States Government. On a budget of about $10.6 
billion,\18\ the IRS currently collects about $2.24 trillion a 
year.\19\ That translates to an average return-on-investment (ROI) of 
about 210:1.\20\
    Rather than recognizing the IRS's unique role as the revenue 
generator for the federal government, however, the congressional budget 
rules treat spending for the IRS exactly the same way they treat 
spending for all other federal agencies.
    The current budget procedures work essentially as follows: Early 
each year, a spending ceiling is established for a category of programs 
that in recent years included the Department of Transportation, the 
Department of the Treasury (of which the IRS is a part), the Department 
of Housing and Urban Development, the Judiciary, the District of 
Columbia, and independent federal agencies.\21\ The House and Senate 
Appropriations subcommittees with jurisdiction over this grouping of 
federal programs must apportion the total number of dollars it receives 
among them. If more funding was provided for transportation programs, 
for example, less funding was available for the IRS. Thus, the IRS 
competes dollar-for-dollar against many other federal programs for 
resources.
    These procedures make little sense. The IRS collects about 96 
percent of all federal revenue.\22\ The more revenue the IRS collects, 
the more revenue Congress may spend on other programs or may use to cut 
taxes or reduce the deficit. The less revenue the IRS collects, the 
less revenue Congress has available for other purposes.
    If the federal government were a private company, its management 
clearly would fund the Accounts Receivable Department at a level that 
it believed would maximize the company's bottom line.
    Since the IRS is not a private company, maximizing the bottom line 
is not--in and of itself--an appropriate goal. But the public sector 
analogue should be to maximize tax compliance, especially voluntary 
compliance, with due regard for protecting taxpayer rights and 
minimizing taxpayer burden. If the IRS were given more resources, 
studies show the IRS could collect substantially more revenue.
    Former IRS Commissioner Charles Rossotti has written:
    When I talked to business friends about my job at the IRS, they 
were always surprised when I said that the most intractable part of the 
job, by far, was dealing with the IRS budget. The reaction was usually 
``Why should that be a problem? If you need a little money to bring in 
a lot of money, why wouldn't you be able to get it?'' \23\
    Yet obtaining a little extra money to bring in a lot of extra money 
remains an intractable challenge for the IRS. Over the past few years, 
Congress has focused increasing attention on the ``tax gap''--the 
difference between taxes owed and taxes paid. As part of this 
discussion, it should be recognized that the IRS currently suffers from 
a ``resources gap,'' and the IRS's lack of resources is a significant 
impediment to its ability to help close the tax gap and thereby reduce 
the federal budget deficit.\24\
              b. the consequences of underfunding the irs
    The failure to fund the IRS at appropriate levels leads to two sets 
of consequences. First, the IRS lacks the resources to collect a 
significant amount of unpaid tax, resulting in a larger tax gap and a 
larger budget deficit. Second, the lack of resources often leads the 
IRS to take steps that are, in my judgment, unwise from the standpoint 
of tax compliance and taxpayer rights.
1. Failure to Collect Unpaid Taxes
    In his final report to the IRS Oversight Board in 2002, former 
Commissioner Rossotti presented a discussion titled ``Winning the 
Battle but Losing the War'' that detailed the consequences of the lack 
of adequate funding for the IRS. He identified 11 specific areas in 
which the IRS lacked resources to do its job, including taxpayer 
service, collection of known tax debts, identification and collection 
of tax from non-filers, identification and collection of tax from 
underreported income, and noncompliance in the tax-exempt sector.
    Commissioner Rossotti provided estimates of the revenue cost in 
each of the 11 areas based on IRS research data. In the aggregate, the 
data indicated that the IRS lacked the resources to handle cases worth 
about $29.9 billion each year. It placed the additional funding the 
agency would have needed to handle those cases at about $2.2 
billion.\25\
    Significantly, this estimate reflects only the potential direct 
revenue gains. Economists have estimated that the indirect effects of 
an examination on voluntary compliance provide further revenue gains. 
While the indirect revenue effects cannot be precisely quantified, two 
of the more prominent studies in the area suggest the indirect revenue 
gains are between six and 12 times the amount of the proposed 
adjustment.\26\
    I want to emphasize that the existing modeling in this area is not 
especially accurate, and estimates of both the direct and indirect 
effects of IRS programs vary considerably. As I will discuss below, the 
IRS needs to develop better modeling to produce more accurate return-
on-investment estimates. But I also want to emphasize that almost all 
studies show that, within reasonable limits, each additional dollar 
appropriated to the IRS should generate substantially more than an 
additional dollar in additional federal revenue assuming the funding is 
wisely spent.
2. Bad Results
            a. Outsourcing Tax Collection
    In the same report, former Commissioner Rossotti reported the IRS 
was receiving sufficient resources to work only 40 percent of some 4.5 
million accounts receivable cases each year. IRS research estimated 
that with an additional $296.4 million, the agency could collect $9.47 
billion.\27\ That translates to a return on investment of 32:1. Among 
collection cases handled solely through phone calls, the IRS has 
estimated an ROI of about 13:1.\28\
    Because Congress has not provided IRS with sufficient funding to 
work these accounts, the Administration requested the authority to 
outsource the collection of certain tax debts to private collection 
agencies. Congress granted the requested authority in 2004,\29\ and the 
IRS began to send cases to private debt collectors in September of 
2006.
    Under the terms of the program, the IRS is paying out commissions 
of up to 25 percent of each dollar collected to the private collection 
agencies. The IRS is also bearing significant additional costs to 
create, maintain, and oversee the program.\30\
    Internal IRS estimates show that the IRS, if given the funding, 
could generate a substantially higher ROI than private contractors 
receiving commissions of nearly 25 percent can produce. For each dollar 
a PCA collects, the IRS will receive about 75 cents and the PCA will 
keep about 25 cents, resulting in an ROI of, at best, about 3:1. The 
significant administrative costs the IRS is incurring to run the 
program, including the opportunity costs of pulling experienced IRS 
personnel off higher dollar work to assist with this initiative, reduce 
the ROI further. Despite supporting the use of private debt collectors 
because of IRS resource limitations, IRS Commissioner Mark Everson has 
repeatedly acknowledged that IRS employees could collect unpaid taxes 
more cheaply and efficiently.\31\
    The result of underfunding the IRS in this area is that the 
government is not maximizing its revenue collection and the risk of 
taxpayer rights violations has been heightened due to the use as 
collectors of non-governmental employees who will receive only limited 
taxpayer-rights training.\32\
            b. Neglect of Important Taxpayer Service Programs
    The IRS has long acknowledged that taxpayer service plays a 
significant role in promoting tax compliance. In fact, its current 
strategic plan is based on the principle: ``Service + Enforcement = 
Compliance.'' \33\ Yet two examples illustrate the neglect of important 
services that likely is resulting in a higher tax gap.
    Tax Return Preparation. The IRS historically has prepared tax 
returns for low income taxpayers at its walk-in sites (called 
``Taxpayer Assistance Centers,'' or ``TACs ''). Low income taxpayers 
generally qualify for the earned income tax credit (EITC), which is a 
refundable credit that caps out at $4,536 in 2006. Studies show that 
the average overclaim rate for EITC benefits is between 27 percent and 
32 percent.\34\ IRS personnel who prepare tax returns are trained to 
ask questions that minimize the likelihood of EITC overclaims and thus 
can save the government hundreds of dollars per return. Yet to free up 
resources for other program initiatives, the IRS has substantially 
reduced return preparation at its TACs. The number of tax returns it 
prepared dropped from 665,868 in FY 2003 to a projected 305,000 in FY 
2006.
    IRS data for tax years 2002 through 2004 suggest that EITC returns 
prepared by IRS TACs may be significantly more compliant than self-
prepared and commercially prepared returns. Discriminant Function (DIF) 
scores\35\ for self-prepared returns were between 21 and 26 percent 
higher than returns prepared at the TACs and between 25 and 31 percent 
higher than returns prepared by commercial preparers.\36\
    These findings are corroborated by examination results for EITC 
returns for these tax years. As compared with TAC-prepared returns, 
average audit assessments among EITC returns for tax years 2002--2004 
ranged from about $640 to $1,300 higher for self-prepared returns and 
from about $820 to $1,300 higher for commercially prepared returns.\37\ 
Similarly, a study conducted in 1996 that examined the relationship 
between IRS return preparation and compliance over a ten-year period 
showed that an increase in the number of returns prepared by the IRS 
correlates with improvements in compliance among filers of individual 
returns.\38\
    Small Business Outreach. IRS data show that self-employed taxpayers 
account for the largest chunk of the tax gap and indicate that the tax 
compliance rate for self-employed taxpayers runs at about 43 
percent.\39\ Much of the underreporting is deliberate, but some is not. 
For example, many small businesses are started by individuals who lack 
detailed knowledge of the tax laws and do not have the resources to 
hire tax attorneys or accountants. When they hire a few workers, they 
often do not realize that they are assuming tax reporting, tax 
withholding, and tax payment obligations, and they often do not 
understand enough about the details of complying with the requirements 
to do so with reasonable effort.
    After the IRS Restructuring and Reform Act of 1998, the IRS 
developed a function known as Taxpayer Education and Communications, or 
``TEC.'' TEC was the IRS's outreach arm to small businesses to try to 
educate them about the complexity of their tax obligations. For 2002, 
TEC was named the Small Business Administration's agency of the year 
for what the SBA called its outstanding progress in creating an 
effective education and compliance assistance program for small 
business and self-employed taxpayers.\40\ Yet in the name of achieving 
``efficiencies,'' TEC was ``realigned'' in February 2005 through a 
merger with other outreach functions and redesignated as ``Stakeholder 
Liaison.'' Prior to the realignment, TEC had 536 employees. After the 
realignment, Stakeholder Liaison staffing included 219 employees.\41\ 
In my view, the reduction in TEC staffing will reduce tax compliance 
and place a greater burden on IRS enforcement personnel.
    I cite these examples to make two points. First, although I 
disagree with certain decisions the IRS has made, the failure to 
provide the IRS with adequate resources to collect taxes has forced the 
IRS to cut corners in places where corners should not have to be cut. 
Second, I cite the examples of tax return preparation and TEC to 
underscore the important role taxpayer service plays in promoting tax 
compliance. As I discuss below, additional funding for the IRS should 
be provided in a balanced manner. The revenue derived from direct 
enforcement actions may be easier to measure, but the effects of 
taxpayer service may be equally significant and perhaps more 
significant.
                           c. recommendations
1. Congress should consider revising its budget rules in a manner that 
        allows the budget and appropriations committees to make a 
        judgment about the answer to the question: ``What level of 
        funding will maximize tax compliance, particularly voluntary 
        compliance, with our nation's tax laws, with due regard for 
        protecting taxpayer rights and minimizing taxpayer burden?'' 
        and then set the IRS funding level accordingly, without regard 
        to spending caps.
    This recommendation, in my view, boils down to simple common sense. 
Just as a business could not survive if it did not seek to maximize 
revenue collection, the federal government has less revenue to spend 
(or use to reduce the deficit or cut taxes) if it fails to optimize tax 
collection. Taxes are truly the lifeblood of government, for without 
tax revenue, there would be no government programs. As the National 
Taxpayer Advocate, I will be the first to raise objections if the 
pursuit of revenue proceeds without due regard for protecting taxpayer 
rights and minimizing taxpayer burden. But the existing budget rules, 
which pit the revenue center of the government in direct competition 
with cost centers and do not have a mechanism for explicitly taking 
into account the revenue the IRS is likely to generate, are not 
logical. The congressional budget rules are the one piece of the tax 
gap over which your committee has direct control, and I urge you to 
consider improvements to the process.
    One way to implement the proposal I have outlined would be to keep 
the IRS within its existing appropriation bill but break that bill into 
two parts--one providing a funding cap for the IRS and one providing a 
funding cap for all other programs under that bill. The budget 
committees would set the funding cap for the IRS.\42\ The 
appropriations committees then would retain discretion to appropriate 
funds at the cap or at a lesser level and to provide direction 
concerning how the funds are to be spent. The rules should explicitly 
authorize the committees to set the cap at a level that they believe 
will maximize tax compliance, especially voluntary compliance, with due 
regard for the protection of taxpayer rights and minimization of 
taxpayer burden. In setting the cap and making funding decisions, the 
budget and appropriations committees would consider the President's 
budget request as well as input from the tax-writing committees, the 
Congressional Budget Office, the Joint Committee on Taxation, the 
Government Accountability Office, the Congressional Research Service 
and any other office that they choose to consult to obtain revenue 
estimates and guidance concerning the likely return on IRS spending.
    We offer this approach only as an illustration of a way to 
implement the general principle we are recommending. We do not have 
sufficient expertise in the congressional budget process to craft a 
comprehensive solution, and we are cognizant of the important roles 
that the budget committees, the appropriations committees, and the tax-
writing committees play. Our overriding recommendation is simply that 
the committees of jurisdiction collaborate to devise and implement 
procedures that reflect the general principles we have outlined.
    We note that in each of the past three years, the Administration 
has proposed a contingent budgetary mechanism known as a ``program 
integrity cap'' in an attempt to provide the IRS with additional 
funding. Under this mechanism, additional funding for tax-law 
enforcement would have been provided if, but only if, Congress agreed 
to fund at least the existing base of enforcement activities. The 
Senate has endorsed the concept, but the House did not go along. 
Although there may have been subtle differences in detail, a similar 
approach was used in FY 1995 to give the IRS additional funding.\43\ 
Because the Budget and Appropriations committees have become familiar 
with this mechanism, it may be a viable way to channel additional 
funding to the IRS.
    However, we have two concerns about the use of program integrity 
caps. First, the mechanism operates simply to mitigate the effects of 
what we are arguing is a flawed conceptual approach to funding the IRS. 
It would not alter the existing framework under which the IRS competes 
for funding against other government programs, and it would not peg 
future IRS funding decisions to the goal of maximizing tax compliance. 
I believe a change to the process along the lines of what I am 
recommending would be far preferable in the long run and would be more 
likely to result in a consistent ramp-up in funding year-over-year. 
Second, the mechanism in the past has been proposed solely to boost 
enforcement spending (i.e., the additional funding could be used only 
for tax-law enforcement and would only be provided if Congress agreed 
to fund at least the existing base of enforcement activities). As 
discussed below in more detail, tax compliance is a function not only 
of enforcement but also of taxpayer service, and it is important to 
maintain a balanced approach between the two. If program integrity caps 
are used in the future, we urge that consideration be given to 
providing additional funding for taxpayer service as well as 
enforcement.
2. In allocating IRS resources, Congress should keep in mind that tax 
        compliance is a function of both high quality taxpayer service 
        and effective tax-law enforcement, and it is essential that the 
        IRS continue to maintain a balanced approach to improving tax 
        compliance.
    As noted, recent attempts to give the IRS additional funding beyond 
the levels provided under the spending caps have focused exclusively on 
providing additional funding for enforcement activities. That is so 
largely because the direct ROI resulting from enforcement actions is 
somewhat susceptible to measurement, while the deterrent effect of 
enforcement actions and the effect of taxpayer service are too 
amorphous to quantify. However, it is important to emphasize that 
direct enforcement revenue in FY 2006 came to only $48.7 billion, or 2 
percent, of total IRS tax collections of $2.24 trillion.\44\ The 
remaining 98 percent of IRS tax collections resulted from a combination 
of taxpayer service programs and the indirect (i.e., deterrent) effect 
of IRS enforcement actions. To make budgeting decisions by striving to 
maximize the 2 percent of collections without grappling adequately with 
what is required to maximize the remaining 98 percent of collections is 
a bit like letting the tail wag the dog.
    The Administration's FY 2008 budget request acknowledges this 
dilemma. It states: ``The IRS cannot currently measure either the 
impact of deterrence or service, but they are positive.'' \45\ In fact, 
there are no reliable data that show whether the IRS would achieve a 
greater ROI if it spends additional funds on service or on enforcement. 
In the absence of such data, one might think the government would err 
on the side of assisting taxpayers in complying with the law rather 
than disproportionately ramping up enforcement. If Congress continues 
to provide the IRS with greater increases for enforcement each year 
simply because the ROI of direct enforcement can be quantified, the 
cumulative effect of those increases over time will be to relatively 
shift the IRS away from taxpayer service and toward tougher 
enforcement--with no evidence that such a shift will increase revenues 
and with the possibility that such a shift might decrease revenues.
    As former Commissioner Rossotti has written:
    Some critics argue that the IRS should solve its budget problem by 
reallocating resources from customer support to enforcement. In the 
IRS, customer support means answering letters, phone calls, and visits 
from taxpayers who are trying to pay the taxes they owe. Apart from the 
justifiable outrage it causes among honest taxpayers, I have never 
understood why anyone would think it is good business to fail to answer 
a phone call from someone who owed you money.\46\
    Because of recent budget pressures and additional service 
obligations brought about by the late passage of the tax extenders bill 
and the administration of telephone excise tax refunds, the IRS is 
actually expecting that it will reduce the percentage of phone calls it 
answers from the mid-80s to the mid-70s this year, if not lower. The 
IRS has been working hard on a five-year taxpayer service strategic 
plan, developed in response to a Senate Appropriations directive in FY 
2006. This plan was developed in collaboration with my office and the 
IRS Oversight Board. It is an excellent product, and it describes well 
how the IRS can improve its ability to meet taxpayer service needs.
    I urge you to keep in mind that taxpayer service provides a 
positive ROI, and the ROI of taxpayer service may even exceed the ROI 
of enforcement. The budget rules should be crafted to ensure that the 
ability to score direct revenue gains resulting from enforcement does 
not drive results that may be counterproductive. Perhaps the 
``scorekeepers'' could use a blended ROI of taxpayer service and 
enforcement actions to support a balanced approach to additional IRS 
funding.
    Many aspects of taxpayer service are akin to a wholesale operation 
that reaches groups of taxpayers (e.g., outreach and education), while 
IRS audits constitute a far more costly retail operation that requires 
individual taxpayer contact. The IRS should pursue a balanced approach 
to tax compliance that puts priority emphasis on improving IRS outreach 
and education efforts, while reserving targeted enforcement actions to 
combat clear abuses and send a message to all taxpayers that 
noncompliance has consequences.\47\
3. Congress should provide increases in IRS personnel funding at a 
        steady but gradual pace, perhaps two percent to three percent a 
        year above inflation. We do not think the IRS can ramp up its 
        staffing more quickly without encountering significant 
        transitional difficulties. However, Congress should consider 
        providing more rapid funding increases for technology and 
        research improvements, as the transitional challenges of 
        absorbing additional resources are probably less significant in 
        these areas and the potential exists to generate substantial 
        productivity gains.
    In former Commissioner Charles Rossotti's final report to the IRS 
Oversight Board in 2002, he described the serious total staffing 
shortages the IRS was facing. He stated that the IRS needed ``steady 
growth in staff in the range of 2 percent per year.''\48\ The context 
shows he was discussing real increases (i.e., increases above those 
required to maintain current services).
    At first blush, real annual staff growth of two percent might 
appear to be an extremely limited request, but the IRS faces 
significant challenges in adding and training staff. Examination and 
collection procedures, in particular, are complex, as is the underlying 
tax law, and experienced personnel must be pulled off revenue-producing 
priority cases to provide extensive training to new hires. Moreover, 
new hires generally have lower productivity rates and require 
significantly closer supervision than experienced employees to ensure 
they do not take incorrect actions, including actions that impair or 
violate taxpayer rights.
    However, the IRS probably can absorb more rapid funding increases 
in technology and research, both of which have the potential to 
increase IRS productivity substantially.
    Better technology would allow the IRS to achieve significant 
efficiencies in a broad range of taxpayer service and enforcement 
areas. For example, it would allow the IRS to offer taxpayers a wider 
range of e-filing options to increase the number of taxpayers who file 
their returns electronically rather than on paper (which would save IRS 
the cost of manually entering data from the roughly 64 million 
individual income tax returns it received on paper in FY 2005),\49\ and 
it would allow the IRS to expand its document-matching capabilities, 
which tend to produce high returns on investment because automated 
processes are relatively inexpensive to operate and maintain.
    Better research would allow the IRS to assess the most cost 
effective ways of meeting taxpayer service needs and to target its 
limited enforcement resources to maximize its return on investment. We 
discuss the importance of obtaining more accurate ROI estimates for the 
IRS's major categories of work under Recommendation #4 below.
    In the past, congressional support for additional IRS funding has 
come in fits and starts. It will not be helpful to provide too much 
additional funding immediately. It also will not be helpful to provide 
additional funding for a year or two and then to change direction. To 
maximize the IRS's ability to do its job, the IRS needs to receive 
gradual but steady real increases in its total funding every year for 
at least the next five to ten years.
4. To assist Congress in performing its oversight responsibilities and 
        determining the appropriate IRS funding level in future years, 
        Congress should require the IRS to provide annual or semiannual 
        reports detailing IRS's progress in handling all significant 
        categories of work, including the known workload, the 
        percentage of the known workload the IRS is able to handle and 
        the percentage of the known workload the IRS is not able to 
        handle, the additional resources the IRS would require to 
        perform the additional work, and the likely return-on-
        investment of performing that work.\50\
    In this connection, Congress should consider directing the IRS to 
undertake additional research studies, perhaps utilizing the expertise 
of outside experts, to improve the accuracy of its ROI estimates for 
various categories of work, especially taxpayer service and the 
indirect effect of enforcement actions, including the downstream costs 
of such work. Improved methods should also be developed to verify, 
retrospectively, the marginal ROI that the IRS has achieved for each 
category of work.
    To provide Congress with meaningful information, the IRS will need 
to conduct more research to improve the accuracy of its ROI 
calculations. As we have noted above, direct enforcement revenue 
constitutes only about two percent of the revenue the IRS collects. 
Ninety-eight percent of the revenue the IRS collects derives from its 
taxpayer service programs and the indirect deterrent effect of its 
enforcement activities. Yet the IRS currently does not have adequate 
data on which to make accurate estimates of the ROI of its various 
categories of work, including taxpayer service programs and the 
indirect effect of its enforcement activities as a whole and broken 
down by their key components. Developing better data should be made a 
priority objective. Moreover, ROI estimates should include costs 
relating to the downstream consequences--such as increased phone calls 
or correspondence, Appeals conferences, and Taxpayer Advocate Service 
cases--of the various categories of IRS work.
    We acknowledge that developing reasonably accurate modeling is a 
significant challenge and will require a commitment of resources. 
Nonetheless, we have recommended in the past and continue to believe 
that this information will aid the IRS substantially in making resource 
allocation decisions and will provide Members of Congress with 
additional information on which to base future funding decisions.\51\

                             V. Conclusion

    The tax gap is a serious problem because it deprives the government 
of revenue it needs and it creates inequities between compliant 
taxpayers and noncompliant taxpayers. There is no silver bullet that 
will eliminate the tax gap. I believe significant progress can be made, 
however, by following an approach that emphasizes fundamental tax 
simplification, expanded third-party information reporting, and a more 
robust IRS compliance program.
    The Budget Committee has the jurisdiction to change the existing 
budget rules that, in my view, have unreasonably constrained IRS 
funding and limited the agency's ability to maximize tax compliance. I 
urge the Committee to use its jurisdiction to improve the process by 
which IRS funding decisions are made.

       VI. EXHIBIT A: CASH ECONOMY--ADMINISTRATIVE RECOMMENDATIONS
------------------------------------------------------------------------
               Recommendation     Summary              Reason
------------------------------------------------------------------------
      1      Expand use of      Send self-  Self-employed taxpayers who
              Electronic         employed    want to comply with their
              Federal Tax        taxpayers   estimated tax payment
              Payment System     a letter    obligations sometimes fail
              (EFTPS)            to remind   because they have
                                 them when   difficulty estimating
                                 estimated   income, remembering oddly
                                 tax         spaced payment dates (April
                                 payments    15, June 15, September 15
                                 are due     and January 15), and saving
                                 and offer   enough money each quarter.
                                 the         When they fail to pay
                                 option of   enough estimated taxes,
                                 paying      they are more likely to
                                 electroni   understate their liability.
                                 cally, by
                                 phone or
                                 via
                                 automatic
                                 monthly
                                 (or
                                 biweekly)
                                 withdrawa
                                 ls from
                                 the
                                 taxpayer'
                                 s bank
                                 account
                                 free of
                                 charge.------------------------------------------------------------------------
      2      Revise Form 1040,  Include     This revision would
              Schedule C         separate    encourage taxpayers to
                                 lines       report income even if it is
                                 showing     not subject to information
                                 (1) the     reporting. Taxpayers are
                                 amount of   more likely to report
                                 income      income that is reported to
                                 reported    the IRS by third parties on
                                 on Forms    information returns, such
                                 1099 and    as Forms 1099. Some
                                 (2) other   taxpayers appear to believe
                                 income      that income not reported on
                                 not         information returns is not
                                 reported    subject to tax or at least
                                 on Forms    that the IRS will not
                                 1099.       notice if they do not
                                             report it. Separating out
                                             gross receipts on the
                                             income tax form as we
                                             propose would likely
                                             improve compliance by
                                             emphasizing to taxpayers
                                             that income not reported on
                                             information returns is
                                             still subject to tax. It
                                             may also suggest to them
                                             that the IRS will notice if
                                             they do not report any
                                             other income. Another
                                             benefit of such a revision
                                             is that it would allow the
                                             IRS to match the income
                                             reported on Schedule C with
                                             income reported on Forms
                                             1099 more easily.------------------------------------------------------------------------
      3      Revise business    Include     These two questions would
              income tax         two         encourage taxpayers to
              return forms       questions   comply with information
                                 : (1) Did   reporting requirements.
                                 you make    They would also suggest to
                                 any         taxpayers that the IRS is
                                 payments    looking at information
                                 over $600   reporting compliance and
                                 in the      that there is additional
                                 aggregate   risk to avoiding the
                                 during      information reporting
                                 the year    requirements by paying
                                 to any      contractors ``under the
                                 unincorpo   table.'' Payments reported
                                 rated       to the IRS on information
                                 trade or    returns are much more
                                 business?   likely to be reported on
                                 (2) If      the payee's income tax
                                 yes, did    return. Thus, increased
                                 you file    information reporting
                                 all         compliance would cause
                                 required    contractors (payees) to
                                 Forms       report more of their
                                 1099?       income.------------------------------------------------------------------------
      4      Implement more     Encourage   Research shows that
              voluntary          taxpayers   taxpayers are most
              withholding        to enter    compliant in paying taxes
              agreements         into        on income subject to
                                 voluntary   withholding. Unlike
                                 withholdi   payments to employees,
                                 ng          payments to independent
                                 agreement   contractors are generally
                                 s by        not subject to withholding.
                                 agreeing    Businesses sometimes have
                                 not to      difficulty determining
                                 challenge   whether service providers
                                 the         should be classified as
                                 classific   employees or independent
                                 ation of    contractors and the IRS
                                 workers     often challenges such
                                 who are a   determinations. These
                                 party to    agreements could reduce
                                 such an     both underreporting by
                                 agreement   payees and the controversy
                                 .           associated with worker
                                 (Statutor   classification.
                                 y
                                 authority
                                 exists
                                 under IRC
                                 sss
                                 3402(p)(3
                                 ), but
                                 the IRS
                                 may need
                                 to work
                                 with the
                                 Treasury
                                 Departmen
                                 t to
                                 issue
                                 regulatio
                                 ns before
                                 it can
                                 use its
                                 authority
                                 and may
                                 prefer
                                 additiona
                                 l
                                 legislati
                                 ve
                                 authority
                                 .)------------------------------------------------------------------------
      5      Institute backup   Require     By the time a payor receives
              withholding more   mandatory   a backup withholding notice
              quickly            backup      from the IRS, the payee
                                 withholdi   (service provider) may no
                                 ng to       longer be receiving
                                 begin       payments from the service
                                 more        recipient. Thus, the IRS
                                 quickly     has lost the opportunity
                                 when        for backup withholding. For
                                 taxpayers   additional information see
                                 provide     National Taxpayer Advocate
                                 an          2005 Annual Report to
                                 invalid     Congress 238-248 (MSP:
                                 TIN to      Limited Scope of Backup
                                 the         Withholding Rules).
                                 payor.------------------------------------------------------------------------
      6      Use more           Use more    The IRS currently uses
              available          of the      information from Forms 8300
              information        informati   to identify returns that
                                 on          may have unreported income.
                                 available   It also receives and uses
                                 from        state income tax audit
                                 state and   reports as well as sales
                                 local       tax records, which a cross-
                                 governmen   functional team has
                                 ts as       concluded could be used
                                 well as     more consistently and
                                 informati   effectively. States and
                                 on from     localities also impose
                                 Forms       business license taxes or
                                 8300        require different classes
                                 (Report     of licenses, which are
                                 of Cash     sometimes based on gross
                                 Payments    receipts. Such information
                                 Over        may be useful in detecting
                                 $10,000     unreported income. Local
                                 Received    property taxes are also
                                 in a        based on the value of real
                                 Trade or    and personal property.
                                 Business)   Taxpayers whose property
                                 when        holdings are
                                 selecting   disproportionately large in
                                 returns     comparison to the income
                                 for audit   reported on their federal
                                 and when    income tax returns may be
                                 auditing    underreporting their
                                 them.       income. The IRS could
                                             combine all of this
                                             information, perhaps in
                                             conjunction with the UI-DIF
                                             (or to improve it), for
                                             selecting returns for audit
                                             and auditing them.------------------------------------------------------------------------
      7      Establish local    A local     Because tax compliance
              compliance         planning    trends and norms are
              planning           organizat   frequently local, it will
              organizations      ion could   be difficult for the IRS to
                                 work to     effectively address them
                                 identify    without local feedback
                                 local       about how its strategies
                                 complianc   are affecting taxpayers in
                                 e           a given community. The IRS
                                 challenge   needs such information and
                                 s, direct   feedback so that it can
                                 the IRS's   adjust its strategy to
                                 local       effectively address local
                                 response,   compliance issues. If
                                 and         noncompliance is so
                                 measure     commonplace in a local
                                 its         market that the price of a
                                 effective   good or service does not
                                 ness.       reflect tax compliance
                                             costs, suppliers may be
                                             unable to both pay their
                                             taxes and compete. However,
                                             if the IRS could motivate a
                                             critical number of
                                             businesses in a given
                                             market to report their
                                             income, then the market
                                             price for their goods or
                                             services would increase so
                                             that businesses could both
                                             compete and pay their
                                             taxes. As the IRS's
                                             activity starts to affect
                                             market prices, research
                                             suggests it could produce a
                                             dramatic increase in
                                             voluntary compliance in the
                                             local cash economy as it
                                             changes local norms. A
                                             national cash economy
                                             program office could
                                             replicate successful local
                                             strategies nationwide.------------------------------------------------------------------------
      8      Create a cash      The cash    The EITC Program Office
              economy program    economy     coordinates EITC related
              office             program     activities, measures the
                                 office      results of its initiatives
                                 would       and takes responsibility
                                 coordinat   for ensuring that the
                                 e           program works as intended,
                                 research,   even though it relies on
                                 outreach,   many other parts of the IRS
                                 and         to achieve its goals. As
                                 complianc   with EITC initiatives,
                                 e efforts   responsibility for
                                 aimed at    initiatives that may
                                 improving   improve income reporting by
                                 income      cash economy participants
                                 reporting   is dispersed throughout the
                                 complianc   IRS. Nobody at the IRS with
                                 e among     the authority to coordinate
                                 cash        research, outreach, and
                                 economy     compliance efforts takes
                                 participa   primary responsibility for
                                 nts, as     reducing underreporting
                                 the EITC    among cash-economy
                                 program     participants. As a result,
                                 office      the IRS is not as effective
                                 has done    as it could be in improving
                                 with        compliance among cash-
                                 respect     economy participants. For
                                 to EITC     example, a cash-economy
                                 complianc   program office could work
                                 e.          with IRS Research to
                                             measure the impact of
                                             initiatives to reduce
                                             underreporting by cash-
                                             economy participants. TIGTA
                                             and GAO generally agree
                                             that such measures would
                                             help the IRS to reduce the
                                             tax gap. A cash-economy
                                             program office could also
                                             be justified on the basis
                                             that the EITC has a program
                                             office and the amount of
                                             the tax gap attributable to
                                             cash-economy participants
                                             dwarfs the amount of the
                                             tax gap attributable to
                                             EITC claimants.------------------------------------------------------------------------
      9      Educate cash       Educate     In addition to the
              economy            cash        satisfaction of obeying the
              participants       economy     law and avoiding potential
                                 participa   civil and criminal
                                 nts about   penalties and interest
                                 the         charges, such benefits may
                                 benefits    include, for example, an
                                 of          increase in retirement
                                 reporting   benefits; disability
                                 their       benefits; survivors
                                 income      benefits; Medicare
                                 and study   benefits; access to credit;
                                 the         earned income tax credits;
                                 effect of   and the ability to gain
                                 such        admission to the U.S. or a
                                 efforts     visa-status adjustment for
                                 to          family members or
                                 determine   employees. The IRS could
                                 whether     test this concept by
                                 they are    educating taxpayers through
                                 cost        outreach and various media
                                 effective   targeting cash-economy
                                 .           participants in communities
                                             where compliance is low and
                                             such benefits are not well
                                             known. Researchers have
                                             suggested that publicity
                                             about such benefits, when
                                             combined with other
                                             enforcement initiatives,
                                             may significantly improve
                                             reporting compliance in a
                                             given community.------------------------------------------------------------------------
     10      Obtain more and    Sponsor     IRS researchers have
              better research    research    previously estimated that
                                 to          the indirect effect of an
                                 identify    average examination on
                                 the most    voluntary compliance is
                                 effective   between six and 12 times
                                 use of      the amount of the proposed
                                 IRS         adjustment. However, not
                                 resources   all audits have the same
                                 after       effect on compliance. A
                                 taking      dollar spent auditing cash
                                 into        economy industries with
                                 account     high rates of noncompliance
                                 the         may have a very different
                                 direct      effect than a dollar spent
                                 and         auditing corporate tax
                                 indirect    shelters. On the other
                                 effects     hand, a dollar spent on
                                 of IRS      making it easier for
                                 activitie   taxpayers to comply with
                                 s on tax    their tax obligations, for
                                 revenue.    example by revising forms,
                                             improving EFTPS, and
                                             answering tax law
                                             questions, has a positive
                                             indirect effect on
                                             compliance. The IRS does
                                             not have current research
                                             to show where the next
                                             dollar is best spent. We do
                                             not even know whether the
                                             next dollar is better spent
                                             on enforcement or taxpayer
                                             service. Thus, in the
                                             absence of better research,
                                             the IRS cannot make fully
                                             informed resource-
                                             allocation decisions.
------------------------------------------------------------------------


        VII. EXHIBIT B: CASH ECONOMY--LEGISLATIVE RECOMMENDATIONS
------------------------------------------------------------------------
              Recommendation           Summary               Reason
------------------------------------------------------------------------
     1       Amend IRC sss     Amend IRC sss 3406 to   Withholding is
              3406 to           create a three-         not required on
              encourage         pronged reporting and   payments to non-
              compliance in     payment system that     employees, and
              certain cash-     encourages compliance   skirting
              economy           by:                     information
              transactions      Instituting     reporting
                                backup withholding on   requirements for
                                payments to taxpayers   payments to
                                who have demonstrated   independent
                                ``substantial           contractors is
                                noncompliance'';        easy and
                                Releasing       relatively
                                backup withholding on   painless.
                                payments to taxpayers  Payors wishing to
                                who become              comply with
                                ``substantially         their
                                compliant'' and who     information-
                                agree to schedule and   reporting
                                make future payments    obligations may
                                through the             be reporting
                                Electronic Funds        payments to
                                Transfer Payment        independent
                                System (EFTPS);         contractors who
                                Providing       have supplied
                                that payors will not    invalid TINs.
                                be required to          Under existing
                                institute backup        provisions,
                                withholding on          these payors may
                                taxpayers who present   not know that a
                                payors with a valid     payee's TIN is
                                IRS ``Compliance        invalid until
                                Certificate''.Current   several payments
                                withholding and         have been made.
                                information-reporting  Furthermore, the
                                provisions do not       motivation to
                                adequately capture      comply with
                                income from             current Forms
                                transactions in the     1099-MISC and W-
                                cash economy.           9 requirements
                                Unreported payments     is not
                                include:                particularly
                                  Deliberate    compelling. The
                                ``under the table''     toll charge for
                                cash payments.          a missing or
                                  Payments      incorrect Form
                                that are reported       1099-MISC or W-9
                                with an invalid TIN     is $50.
                                or payee/TIN
                                mismatch.
                                  Payments
                                subject to
                                information reporting
                                that are not
                                reported.------------------------------------------------------------------------
     2       Amend IRC sss     Current law requires    Making estimated
              6302(h) to        IRS to use EFTPS to     tax payments can
              require IRS to    collect at least 94     be cumbersome,
              promote           percent of depository   particularly for
              estimated tax     taxes. In contrast,     self-employed
              payments          the IRS received less   taxpayers. EFTPS
              through EFTPS.    than one percent of     has the
              Amend IRC sss     all estimated tax       potential to
              6302(h) to        payments through        alleviate some
              require IRS to    EFTPS in tax year       estimated tax
              promote           2004.                   problems because
              estimated tax                             it is convenient
              payments                                  and relatively
              through EFTPS                             easy to use.
              and establish a                           Moreover,
              goal of                                   taxpayers can
              collecting at                             use EFTPS to
              least 75                                  schedule
              percent of all                            automatic
              estimated tax                             estimated
              payment dollars                           payments.
              through EFTPS
              by FY 2012.------------------------------------------------------------------------
     3       Amend IRC sss     Amend IRC sss           Some independent
              3402(p)(3) to     3402(p)(3) to           contractors may
              specifically      specifically            wish to enter
              authorize         authorize voluntary     into withholding
              voluntary         withholding between     agreements with
              withholding       independent             their payors. It
              between           contactors and          is currently
              independent       service-recipients      unclear,
              contractors and   (as defined in IRC      however, whether
              service-          sss 6041A(a)(1)), and   statutory
              recipients.       to specify that         authority exists
                                independent             to enter into
                                contractors who enter   such agreements.
                                into voluntary          IRC sss
                                withholding             3402(p)(3) is
                                agreements with payor   silent on
                                service recipients      voluntary
                                will be treated as      withholding
                                employees only to the   agreements in
                                extent specified in     the independent
                                the agreements, and     contractor/payor
                                allow such              context. Section
                                independent             3402(p)(3) is
                                contractors to          the only section
                                continue to deduct      under which a
                                ordinary and            voluntary
                                necessary business      withholding
                                expenses under IRC      agreement
                                sss 162(a).             between a payor
                                                        and an
                                                        independent
                                                        contractor would
                                                        be permitted.------------------------------------------------------------------------
     4       Amend IRC sss     Taxpayers report 96     For Form 1099-
              6041A to          percent of income       MISC information-
              require third-    from transactions       reporting
              party             subject to              purposes, there
              information       information             should be no
              reporting for     reporting. The          distinction
              applicable        percentage of           between
              payments to       reported income         taxpayers who
              corporations.     decreases               are incorporated
              Amend IRC sss     significantly,          and those who
              6041A to          however, when           are not.
              require third-    transactions are not
              party             subject to
              information       information
              reporting for     reporting. Under
              applicable        current law, an
              payments to       individual taxpayer
              corporations,     can escape Form 1099-
              as defined in     MISC information-
              IRC sss           reporting by
              7701(2)(3)        incorporating. A
              (including        taxpayer attempting
              corporations      to avoid 1099-MISC
              electing to be    reporting need only
              taxed under       include in its
              subchapter S of   business name an
              the Internal      indication that it is
              Revenue Code).    doing business as a
                                corporation in order
                                to release the
                                service-recipient
                                from the IRC sss
                                6041A reporting
                                requirements.
------------------------------------------------------------------------


   VIII. EXHIBIT C: REQUIRING BROKERS TO TRACK AND REPORT COST BASIS--
                       LEGISLATIVE RECOMMENDATION
------------------------------------------------------------------------
                Recommendation       Summary              Reason
------------------------------------------------------------------------
     1       Amend IRC sss        When           This proposal also
              6045(a) to           transactions   helps taxpayers (and
              authorize the        are subject    that was our primary
              Secretary of the     to             reason for proposing
              Treasury to          information    it.) Today, more
              require brokers to   reporting to   Americans own stocks
              track and report     the            or mutual funds than
              cost basis in        government,    ever before. Most
              connection with      tax            mutual fund investors
              the sale of mutual   compliance     elect to have their
              funds and stocks.    is generally   dividend and capital
             Amend IRC sss         very high--    gain distributions
              6045(a) to           well over 90   automatically
              authorize the        percent. The   reinvested in their
              Secretary of the     opportunity    funds, causing their
              Treasury to          for            aggregate adjusted
              prescribe            noncomplianc   bases to change upon
              regulations that     e upon sale    each such
              require brokers to   of mutual      reinvestment. Many
              report information   funds or       mutual fund companies
              not only regarding   stocks is      assist their investors
              gross proceeds but   considerable   by keeping track of
              also regarding       under          adjusted basis, but
              adjusted basis in    current law,   some do not. With
              connection with      because the    regard to stock
              the sale of mutual   taxpayer's     investors, most
              funds and stocks.    basis is not   brokers keep track of
              To facilitate        reported to    purchases their
              accurate basis       the            customers make, but
              reporting,           government.    they do not
              financial                           necessarily update
              institutions that                   their basis records to
              hold mutual funds                   reflect stock splits,
              or stocks for                       spin-offs, and other
              customers should,                   corporate
              when a customer                     restructurings. While
              transfers assets                    taxpayers are properly
              to a successor                      required to keep
              financial                           adequate records to
              institution, be                     substantiate their tax
              required to                         reporting, the reality
              provide the                         is that some investors
              customer's                          hold stocks or mutual
              adjusted basis in                   funds for decades, and
              the transferred                     it is simply not
              mutual fund and                     realistic to expect
              stock holdings to                   that all taxpayers
              the successor                       will keep perfect
              financial                           records for long
              institution.                        periods of time.
------------------------------------------------------------------------

                                endnotes
    \1\ The views expressed herein are solely those of the National 
Taxpayer Advocate. The National Taxpayer Advocate is appointed by the 
Secretary of the Treasury and reports to the Commissioner of Internal 
Revenue. The statute establishing the position directs the National 
Taxpayer Advocate to present an independent taxpayer perspective that 
does not necessarily reflect the position of the IRS, the Treasury 
Department, or the Office of Management and Budget. Accordingly, 
Congressional testimony requested from the National Taxpayer Advocate 
is not submitted to the IRS, the Treasury Department, or the Office of 
Management and Budget for prior approval. However, we have provided 
courtesy copies of this statement to both the IRS and the Treasury 
Department in advance of this hearing.
    \2\ See IRS News Release 2006-28, IRS Updates Tax Gap Estimates 
(Feb. 14, 2006) (accompanying charts). The National Research Program 
study estimated that the ``gross tax gap'' was about $345 billion and 
the ``net tax gap'' (i.e., the gross tax gap reduced by late payments 
and amounts collected as a result of IRS enforcement actions) was about 
$290 billion. The IRS's most current estimate of the tax gap is based 
primarily on audits it conducted on tax returns filed for 2001.
    \3\ U.S. Census Bureau, Population Division (data as of March 
2001).
    \4\ The IRS's most current estimate of the tax gap is based 
primarily on audits it conducted on tax returns filed for 2001.
    \5\ Significantly, the IRS Oversight Board reports there is 
substantial public support for an enhanced IRS compliance program 
provided that it is balanced. The Oversight Board conducts an annual 
survey of taxpayer attitudes and found that two-thirds of taxpayers 
support additional funding for both IRS assistance and enforcement. See 
IRS Oversight Board, 2005 Taxpayer Attitude Survey.
    \6\ See IRS News Release 2006-28, IRS Updates Tax Gap Estimates 
(Feb. 14, 2006) (accompanying charts).
    \7\ When IRS auditors conducted approximately 46,000 audits of 
individual taxpayers for purposes of the National Research Program, the 
auditors were asked, for each issue they identified, to characterize 
the reason for noncompliance. Among issues that IRS auditors examined 
that resulted in a change in tax liability, the auditors listed 67 
percent as inadvertent mistakes, 27 percent as computational errors or 
errors that flowed automatically, and only 3 percent of errors as 
intentional. Internal Revenue Service (unpublished data from National 
Research Program). The precision of these data may be open to question 
because it is impossible for an auditor to determine the intent of a 
taxpayer at the time the taxpayer prepared a return. In the absence of 
contrary data, however, these data at a minimum should persuade IRS to 
conduct significant new studies on the causes of noncompliance. A 
separate study by the Government Accountability Office analyzed the 
misreporting of capital gains transactions. The study concluded that 33 
percent of taxpayers who misreported their income from securities 
transactions reported more capital gains than they actually realized. 
Where misreporting is inadvertent, from a statistical standpoint, one 
would expect that 50 percent of errors would be on the high side and 50 
percent of errors would be on the low side. Thus, GAO's finding that 33 
percent of all taxpayer errors tended to cause overpayments of tax (and 
thus were clearly inadvertent) implies that an equal percentage of 
inadvertent errors caused taxpayers to underpay their tax--or, put 
differently, that 66 percent of all errors in capital gains 
misreporting were inadvertent and only 34 percent were intentional. 
Government Accountability Office, Ref. No. GAO-06-603, Capital Gains 
Tax Gap: Requiring Brokers to Report Securities Cost Basis Would 
Improve Compliance if Related Challenges Are Addressed at 12 (June 
2006).
    \8\ Internal Revenue Service, Fiscal Year 2006 Enforcement and 
Service Results (Nov. 20, 2006).
    \9\ Joseph M. Dodge & Jay A. Soled, Inflated Tax Basis and the 
Quarter-Billion-Dollar Revenue Question, 106 Tax Notes 453 (Jan. 24, 
2005).
    \10\ See Department of the Treasury, General Explanation of the 
Administration's Fiscal Year 2008 Revenue Proposals 64 (February 2007). 
Treasury provides a 10-year revenue estimate of just $6.7 billion. We 
note, however, that Treasury's proposal would not take effect until 
2009, and it would only require basis reporting with regard to 
securities purchased after that date. In the early years, many 
securities sold would have been purchased prior to the effective date 
of the proposal and thus would be exempt from reporting.
    \11\ John Cassidy, Going Long, The New Yorker, July 10 & 17, 2006, 
at 99 (citing an AC Nielsen study).
    \12\ See Alan H. Plumley, Pub. 1916, The Determinants of Individual 
Income Tax Compliance: Estimating the Impacts of Tax Policy, 
Enforcement, and IRS Responsiveness 41 (Oct. 1996).
    \13\ IRS Wage & Investment Operating Division, Business Performance 
Review, Wage and Investment Operating Division, FY 2006; IRS Wage & 
Investment Operating Division, Business Performance Review, Wage and 
Investment Operating Division, FY 2005; IRS Wage & Investment Operating 
Division, Business Performance Review, Wage and Investment Operating 
Division, FY 2004; IRS Wage & Investment Operating Division, Business 
Performance Review, Wage and Investment Operating Division, FY 2003.
    \14\ IRS Small Business/Self Employed Operating Division, Response 
to Taxpayer Advocate Information Request (Sept. 5, 2006).
    \15\ This concern was raised by a taxpayer during a 2006 Town Hall 
meeting with the National Taxpayer Advocate in Fargo, North Dakota.
    \16\ Internal Revenue Service, Fiscal Year 2006 Enforcement and 
Service Results (Nov. 20, 2006).
    \17\ See IRS News Release IR-2006-42, IRS Selects Three Firms to 
Take Part In Delinquent Tax Collection Effort (March 9, 2006).
    \18\ Department of the Treasury, FY 2007 Budget in Brief at 59.
    \19\ Government Accountability Office, GAO-07-136, Financial Audit: 
IRS's Fiscal Years 2006 and 2005 Financial Statements at 95 (Nov. 
2006). The IRS actually collected $2.51 trillion on a gross basis in FY 
2006, but issued $277 billion in tax refunds.
    \20\ When collecting tax from the vast majority of taxpayers who 
file returns and pay all or substantially all of the tax they owe 
voluntarily, the cost the IRS incurs per taxpayer is very low. As the 
IRS attempts to collect tax from noncompliant taxpayers through broader 
outreach efforts or through examination and collection actions, the 
cost per taxpayer rises substantially. Therefore, the marginal ROI the 
IRS achieves as it attempts to collect unpaid taxes is likely to be 
considerably lower than the average ROI of 210:1 that the IRS achieves 
on taxes paid voluntarily. But if the IRS were given more resources, 
most data indicate that the IRS could generate a substantially positive 
marginal ROI.
    \21\ In the current Congress, the Appropriations subcommittees have 
been restructured, and the IRS will be funded through the 
Appropriations Subcommittee on Financial Services and General 
Government.
    \22\ Government Accountability Office, GAO-07-136, Financial Audit: 
IRS's Fiscal Years 2006 and 2005 Financial Statements 68 (Nov. 2006).
    \23\ Charles O. Rossotti, Many Unhappy Returns: One Man's Quest to 
Turn Around the Most Unpopular Organization in America 278 (2005). On 
pages 278-286, Mr. Rossotti presents an interesting personal 
perspective on the budget process and the politics behind the chronic 
under-funding of the IRS.
    \24\ The chairman and ranking member of the Senate Budget Committee 
supported additional funding for the IRS in the FY 2007 budget 
resolution. Senator Judd Gregg acknowledged that the existing budget 
procedures have the effect of shortchanging the IRS. He said: ``We've 
got to talk to the [Congressional Budget Office] about scoring on 
[additional funding provided to IRS]. Clearly there's a return on that 
money.'' Dustin Stamper, Everson Pledges to Narrow Growing Tax Gap, 110 
Tax Notes 807 (Feb. 20, 2006). Similarly, Senator Kent Conrad stated: 
``Rather than a tax increase, I think the first place we ought to look 
. . . is the tax gap. If we could collect this money, we'd virtually 
eliminate the deficit.'' Emily Dagostino, Senate Budget Resolution 
Would Increase IRS Enforcement Funding, 110 Tax Notes 1129 (Mar. 13, 
2006).
    \25\ Commissioner Charles O. Rossotti, Report to the IRS Oversight 
Board: Assessment of the IRS and the Tax System 16 (Sept. 2002).
    \26\ Alan H. Plumley, Pub. 1916, The Determinants of Individual 
Income Tax Compliance: Estimating The Impacts of Tax Policy, 
Enforcement, and IRS Responsiveness 35-36 (Oct. 1996); Jeffrey A. 
Dubin, Michael J. Graetz & Louis L. Wilde, The Effect of Audit Rates on 
the Federal Individual Income Tax, 1977-1986, 43 Nat. Tax J. 395, 396, 
405 (1990).
    \27\ Commissioner Charles O. Rossotti, Report to the IRS Oversight 
Board: Assessment of the IRS and the Tax System 16 (Sept. 2002).
    \28\ Government Accountability Office, GAO-06-1000T, Tax 
Compliance: Opportunities Exist to Reduce the Tax Gap Using a Variety 
of Approaches, at 17 (July 26, 2006).
    \29\ Pub. L. No. 108-357, sss 881(a)(1) (enacting IRC sss 6306).
    \30\ For a detailed discussion of the private debt collection 
program, see National Taxpayer Advocate 2006 Annual Report to Congress 
at 34-61 (Most Serious Problem: True Costs and Benefits of Private Debt 
Collection).
    \31\ See, e.g., Dustin Stamper, Everson Admits Private Debt 
Collection Costs More, Defends Return Disclosure Regs, 111 Tax Notes 11 
(Apr. 3, 2006).
    \32\ Senator Max Baucus recently highlighted another example of the 
counterproductive impact of shortchanging IRS funding. In FY 2006, 
Congress imposed a one-percent across-the-board funding rescission on 
domestic discretionary spending, and the IRS absorbed a reduction of 
about $100 million as a consequence. Citing GAO data, Senator Baucus 
estimated that the $100 million in ``savings'' would ultimately cost 
the U.S. Treasury about $1 billion in lost tax collections. He stated: 
``[E]ven small reductions in collection and taxpayer services are 
penny-wise, pound-foolish. Sparing the IRS budget may be the best way 
to bring in more owed revenue and end deficit spending.'' News Release, 
Senator Max Baucus, $100 Million Budget Cut to IRS May Cost $1 Billion 
or More in 2006 Tax Collections (May 22, 2006).
    \33\ In the preface to the National Taxpayer Advocate 2006 Annual 
Report to Congress, I argue that compliance should be viewed as a third 
category or IRS emphasis rather than as the sum of service and 
enforcement. There are many compliance activities the IRS undertakes, 
such as document matching, that catch errors taxpayers make either 
inadvertently or negligently. In my view, these activities should be 
classified as ``compliance'' activities, and the ``enforcement'' label 
should be reserved for cases of willful violation of the laws. I argue 
that nomenclature matters in this area because if the IRS treats 
willful and inadvertent compliance the same way, IRS personnel will 
treat innocent taxpayers harshly and taxpayers will feel that the IRS 
has dealt with them unfairly, perhaps alienating them from the tax 
system and reducing their future compliance.
    \34\ Internal Revenue Service, Compliance Estimates for Earned 
Income Tax Credit Claimed on 1999 Returns 3 (Feb. 28, 2002).
    \35\ The DIF score is an estimate of the likelihood of non-
compliance on a return. A higher score indicates a higher likelihood of 
non-compliance.
    \36\ IRS Compliance Data Warehouse, Individual Returns Transaction 
File data for tax years 2002-2004.
    \37\ IRS Compliance Data Warehouse, Audit Inventory Management 
System data for tax years 2002-2004.
    \38\ See Alan H. Plumley, Pub. 1916, The Determinants of Individual 
Income Tax Compliance: Estimating The Impacts of Tax Policy, 
Enforcement, and IRS Responsiveness 41 (Oct. 1996).
    \39\ See IRS News Release, IRS Updates Tax Gap Estimates, IR-2006-
28 (Feb. 14, 2006) (accompanying charts).
    \40\ See Closing the Tax Gap and the Impact on Small Business, 
Hearing Before the House Comm. on Small Business, 109th Cong. (Apr. 27, 
2005) (testimony of John Satagaj, President and General Counsel, Small 
Business Legislative Council).
    \41\ IRS Small Business/Self Employed Division response to Taxpayer 
Advocate Service Information Request (Sept. 5, 2006).
    \42\ Two caps would have to be established for total 
appropriations--one for the IRS and one for all other discretionary 
spending.
    \43\ For FY 1995, the congressional budget resolution provided for 
an adjustment of budget resolution spending levels to allow additional 
funding for an ``Internal Revenue Service Compliance Initiative.'' H. 
Con. Res. 218, 103rd Cong. sss 25 (1994). The provision authorized an 
adjustment to reflect amounts of additional new budget authority or 
additional outlays of up to $405 million per year provided certain 
conditions were met. Although there is no indication the initiative 
failed or generated strong opposition, control of Congress changed the 
next year and the provision was subsequently repealed. H. Con. Res. 67, 
104th Cong. sss 209 (1995). The joint explanatory statement 
accompanying the conference report on the FY 1995 budget resolution 
provision (which originated as Section 54 of the Senate amendment to 
the House-passed budget resolution) provided additional information 
about the specifics of the approach:
    Section 54 of the Senate amendment allows for additional 
appropriations for an Internal Revenue Service Compliance initiative. 
If the Congress appropriates the base amounts requested for the 
Internal Revenue Service in the President's budget for fiscal year 1995 
and a variety of other conditions are met, then Congress can also 
appropriate additional amounts for a compliance initiative without 
triggering points of order that might otherwise lie against such 
legislation.
    Under sections 54(a) and 54(b) of the Senate amendment, upon the 
reporting of an appropriation bill funding the compliance initiative 
and the satisfaction of the conditions listed, the Chairman of the 
appropriate Budget Committee must file revised appropriations caps, 
allocations to the Appropriations Committee, functional levels, and 
aggregates to clear the way for the incremental spending for the 
initiative. This procedure parallels that used in reserve funds . . . , 
which allow deficit-neutral legislation to proceed without points of 
order even if that legislation pays for direct spending with revenues. 
Similarly, section 54 of the Senate amendment allows appropriations 
legislation to proceed without points of order if it is demonstrated 
that the revenues raised by those appropriations would offset the costs 
of the appropriations.
    The first parenthetical language in the matter after subsection 
(a)(3) establishes the first condition precedent, that the Congress 
appropriate the base amounts requested for the Internal Revenue Service 
in the President's Budget for fiscal year 1995. Subsection (d) lists 
the other conditions: enactment of a Taxpayer Bill of Rights 2, 
initiation of an Internal Revenue Service educational program as 
mandated by the Taxpayer Bill of Rights 1 and 2, a finding by the 
Congressional Budget Office that by virtue of revenues raised, the 
appropriations will not increase the deficit, and a restriction of 
funds made available pursuant to this authority to carrying out 
Internal Revenue Service compliance initiative activities.
    The House resolution contains no such provision.
    The conference agreement contains as section 25 a provision similar 
to that in Section 54 of the Senate amendment. In particular, section 
25(a)(2) of the conference agreement more explicitly spells out the 
condition precedent that Congress first appropriate the base amounts 
requested for the Internal Revenue Service in the President's Budget 
for fiscal year 1995 before the provisions of this section apply. 
Similarly, the conference agreement revises subsection (d), which sets 
forth the other conditions precedent.
    H.R. Conf. Rep. No. 103-490 at 58 (1994).
    \44\ In FY 2006, IRS enforcement activities (collection actions, 
examinations, and document matching) resulted in the direct collection 
of $48.7 billion. Internal Revenue Service, Fiscal Year 2006 
Enforcement and Service Results (Nov. 20, 2006). Total tax collection 
by the IRS, after the issuance of tax refunds, was $2.24 trillion. 
Government Accountability Office, GAO-07-136, Financial Audit: IRS's 
Fiscal Years 2006 and 2005 Financial Statements 95 (Nov. 2006).
    \45\ Department of the Treasury, FY 2008 Budget-in-Brief at 56.
    \46\ Charles O. Rossotti, Many Unhappy Returns: One Man's Quest to 
Turn Around the Most Unpopular Organization in America 285 (2005).
    \47\ For research purposes, we believe it is important to study 
inadvertent errors as well as deliberate misreporting. Knowledge about 
inadvertent errors can be used to clarify ambiguous laws or 
administrative guidance both to help increase future compliance and to 
better apply IRS outreach, education, and other voluntary compliance 
initiatives.
    \48\ Commissioner Charles O. Rossotti, Report to the IRS Oversight 
Board: Assessment of the IRS and the Tax System 18 (Sept. 2002).
    \49\ Internal Revenue Service Data Book: 2005, table 3 (showing 
that the total number of individual income tax returns filed in FY 2005 
was 132,844,632) and table 4 (showing that the total number of 
individual income tax returns filed electronically in FY 2005 was 
68,476,328). The total number of individual income tax returns filed on 
paper in FY 2005--64,368,304--is the difference between these numbers.
    \50\ Much of this information was published in former Commissioner 
Rossotti's final report to the IRS Oversight Board. Commissioner 
Charles O. Rossotti, Report to the IRS Oversight Board: Assessment of 
the IRS and the Tax System 16 (Sept. 2002). However, we have not seen 
updated statistics published in this format since that time.
    \51\ The congressional budget rules currently prohibit the 
Congressional Budget Office or the Office of Management and Budget from 
treating changes in discretionary appropriations to the IRS as giving 
rise to scorable increases in tax receipts. See H.R. Conf. Rep. No. 
101-964 (1990). See also Office of Management and Budget, OMB Circular 
No. A-11, Part 8, Appendix A, Principle 14 (2006). Since changes to IRS 
funding levels undoubtedly have an impact on tax collections, this 
prohibition seemingly reflects the practical difficulty of devising 
accurate estimates. Yet accurate estimates obviously would be helpful 
to Congress, and we believe the IRS should make developing better 
estimates a priority objective.

    Chairman Spratt. Thank you very much for your excellent 
testimony. Mr. Brostek.

                  STATEMENT OF MICHAEL BROSTEK

    Mr. Brostek. Chairman Spratt and members of the committee, 
I am pleased to participate in today's hearing on the tax gap. 
My statement focuses on the multiple approaches that are needed 
to successfully reduce the gap, including the importance of 
quality services to taxpayers. It then covers potential 
reductions in the tax gap that could ensue from simplifying and 
reforming the Tax Code, providing the IRS more tools to deal 
with noncompliance and dedicating more resources to tax 
enforcement.
    The tax gap is a persistent problem. Although measurement 
methodologies have varied over time, the rate at which 
taxpayers pay their taxes voluntarily and on time has tended to 
range between 81 and 84 percent over the past 3 decades. This 
suggest that materially reducing the tax gap is going to be 
challenging. Because the tax gap has multiple causes and spans 
different types of taxes and taxpayers, no one strategy is 
likely to be fully and cost-effectively efficient at reducing 
the gap. We need to try new approaches and to expand current 
effective approaches. In many cases, Congress will need to 
participate in the solution either through providing IRS new 
tools or additional resources.
    Providing quality services to taxpayers is a necessary 
foundation for high levels of voluntary compliance. Quality 
services help taxpayers who wish to comply but who do not 
understand their obligations, and such services are needed even 
in pursuing other approaches to reduce the tax gap. For 
instance, even if tax laws are simplified, the IRS needs to 
educate taxpayers and to answer the questions they are likely 
to have. Regarding tax simplification or tax reform, there is 
no reliable estimate of how much simplification could actually 
reduce the tax gap. One indication of the potential is that the 
IRS has estimated a 2001 revenue shortfall of about $32 billion 
due to errors taxpayers made in claiming various credits and 
deductions. Over the decades, more and more special provisions 
have been added to the Tax Code with the number of credits, 
deductions and the like doubling in number between 1974 and 
2005.
    By making the rules across tax provisions more uniform, by 
merging multiple related provisions and deleting provisions 
that may not be accomplishing their intended purpose at an 
acceptable revenue cost, the Tax Code could be simplified. If 
so, both intentional and unintentional noncompliance should 
decline. Further, the IRS would be able to reallocate its 
resources to other more problematic compliance problems.
    Tax reform also has the potential to reduce the tax gap, 
but it is most likely to do so if any reform system has few, if 
any, tax preferences or complex provisions and taxable 
transactions are transparent to the tax agency. These 
characteristics are difficult to achieve, and to my knowledge, 
all tax systems have tax gaps.
    Tax withholding and information reporting are among the 
most powerful tools for promoting compliance. If we can spread 
these tools over more types of income that are major 
contributors to the tax gap, tax reductions might be achieved. 
Our recent work suggests that requiring information reporting 
on the basis for securities sales, like stock transactions, has 
the potential to improve compliance with capital gains 
reporting. Importantly, a key additional benefit would be less 
taxpayer burden to understand and comply with the basis 
reporting rules.
    Finally, devoting additional resources to enforcement has 
the potential to reduce the tax gap by billions of dollars. In 
part, devoting greater resources to enforcement could reduce 
the tax gap because, every year, the IRS identifies far more 
cases of probable noncompliance than it can address. How much 
the tax gap could be reduced by dedicating more resources to 
enforcement depends critically on how well the IRS can manage 
these resources. Here, information is key.
    Which taxpayers are noncompliant? Why are they 
noncompliant? What amount of noncompliance can be corrected for 
an additional dollar of investment in IRS?
    We and others have frequently called for improved 
information like this. In part, this is why we encouraged the 
IRS to undertake compliance studies like the most recent one of 
the tax gap. We are heartened that the President's 2008 budget 
calls for annual tax gap research.
    As a caution, if additional resources are devoted to 
enforcement, returns on that investment are likely to lag as 
the IRS hires and trains new personnel, and we see that in the 
budget estimates for the President's new budget.
    Also, several years can elapse between the time the IRS 
actually assesses a tax and when those taxes are collected. For 
instance, in a study we had done earlier, we had found that 5 
years after taxes were assessed against individuals with 
business income only 48 percent of the assessed taxes had been 
collected.
    This concludes my statement. I would be happy to answer 
questions.
    [The prepared statement of Michael Brostek follows:]

    
    
    
    Chairman Spratt. Thank you very much.
    Now Mr. Edwards.

                   STATEMENT OF CHRIS EDWARDS

    Mr. Edwards. Thank you, Mr. Chairman and Mr. Cooper, for 
holding these important hearings today on the tax gap, and 
thanks to both of you over the years for your strong support of 
fiscal responsibility.
    Compliance with our tax system, as we have heard, stands at 
about 86 percent. I think, to most people, that sounds like a 
pretty high number. We rarely get 100 percent compliance with 
any law. I looked up ``compliance'' yesterday on the Internet, 
on the Department of Transportation site, regarding automobile 
seatbelt laws, and the nationwide compliance rate with 
automobile seatbelt laws is only 81 percent, and that is after 
many years of education on that issue.
    International evidence also suggests that the U.S. tax 
compliant rate is very high. Frederick Snyder, who has 
completed detailed studies for the IMF on the size of 
underground or shadow economies in different countries, finds 
that the U.S. tax compliance rate, or the U.S. shadow economy 
is very low. He finds that the average size of the shadow 
economy in the OECD countries is 16 percent of GDP. The U.S. 
shadow economy, according to his studies, is only 8 percent of 
GDP, the lowest in the OECD. So Americans do seem to be highly 
law-abiding when it comes to reporting government taxes and 
complying with regulations.
    As we have heard earlier, the size of the U.S. tax gap does 
not seem to have increased over time. The GAO says that the tax 
gap has been about the same rate over the last 3 decades.
    For these reasons, the current intense focus in Congress 
over the tax gap is perplexing. Americans, of course, should 
pay the taxes that erode, but the tax gap, in my view, is far 
down the list of important tax system issues that we should be 
dealing with.
    I think Congress should instead focus on issues such as 
America's high corporate tax rate and how uncompetitive it is, 
especially in the globalized economy we live in, and of course 
the enormous complexity of the Tax Code. The number of tax 
expenditures, as I think we had heard earlier, has doubled 
since 1975. This is a huge problem, and I think we need to deal 
with that before we get to the issue of the tax gap.
    Interestingly, if you compare the FICA or payroll tax 
compliance, according to the IRS numbers we saw earlier, there 
is a very high compliance rate. Of course, we have got 
withholding there, but it is also a flat, simple tax with no 
deductions. Compare that to the very low compliance with the 
Federal estate tax. The Federal estate tax gap is about 28 
percent of the amount of revenue collected by that tax because 
it is a grossly complex, inefficient tax.
    Americans have a responsibility to pay their taxes, but 
Congress also has a responsibility to make tax laws that are 
simple and easy to comply with. I think Congress is failing in 
that responsibility. I say let us make the Tax Code coherent 
first before we put on more regulations to close the tax gap.
    There are a few observations on the tax gap estimates from 
the IRS that I think are interesting. The IRS data shows that 
corporations create only 9 percent of the tax gap, and yet we 
constantly hear about supposed rampant corporate tax evasion. 
In recent remarks, Senator Kent Conrad talked about the 
hemorrhaging of tax revenues from cheating by corporations with 
offices in the Cayman Islands, but corporate tax cheating is 
not such a black-and-white affair as many think, and the 
complexity of the Tax Code makes it very difficult to determine 
how much companies should actually be paying.
    Interestingly, the Joint Committee on Taxation's report on 
Enron a couple years ago, which was over 2,000 pages long, 
found hundreds of Enron subsidiaries in the Cayman Islands, but 
the Joint Committee had a very hard time showing that the 
firm's tax structures were actually illegal. They were abusive, 
but they had a very hard time saying that they were actually 
illegal, and as I think was raised by Mr. Everson earlier, 
corporate tax revenues have soared in recent years. In 2007, 
corporate tax revenues will be $342 billion, up 65 percent from 
the peak reached in 2000. So corporate tax revenues are not 
hemorrhaging. It is the small business sector that would bear 
much of the brunt of the burden of new regulations to reduce 
the tax gap, but studies have found that small businesses 
already pay higher tax compliance costs, much higher compliance 
costs, compared to revenue collected than big businesses, and 
the IRS Taxpayer Advocate in the past has found that the heavy 
compliance burden on small businesses is one of the most 
serious problems with the Tax Code. So it seems to me that 
targeting small businesses with more tax gap regulations seems 
very unfair.
    To conclude, the great attention being placed on the tax 
gap I think is out of place given that U.S. tax compliance is 
high compared to other countries and it has remained stable 
over time. Federal revenues are above historic norms at 18.5 
percent of GDP this year, and as you may know, data for the 
first 4 months of fiscal 2007 show a 10 percent increase in 
Federal revenues over the same period last year. So the fiscal 
problem in Washington is not a lack of revenue.
    In his famous book A Wealth of Nations, Adam Smith argued 
that, quote, ``subjecting the people to the frequent visits and 
odious examination of tax gatherers exposes them to much 
unnecessary trouble, vexation and oppression,'' unquote.
    So, rather than imposing more vexation on the taxpayers, I 
think we should reform the Tax Code to reduce marginal rates 
and special preferences, and I think a positive side effect 
would be to reduce the tax gap.
    Again, thanks a lot for holding these hearings.
    [The prepared statement of Chris Edwards follows:]

 Prepared Statement of Chris Edwards, Director of Tax Policy Studies, 
                             Cato Institute

    Mr. Chairman and members of the committee, thank you for inviting 
me to testify today regarding the ``tax gap,'' which is the difference 
between the amount of taxes owed and the amount of taxes actually paid.
    The net tax gap, after enforcement, is $290 billion, or 14 percent 
of what is owed, according to the Internal Revenue Service.\1\ Put 
another way, compliance with the federal tax system stands at 86 
percent. I think to most people, that compliance rate would sound quite 
high. After all, we rarely get 100 percent compliance with any law. 
Consider automobile seatbelt laws. The national compliance rate with 
seatbelt laws was 81 percent in 2006, and that is despite large 
education campaigns on that issue.\2\
    International evidence also suggests that the federal tax 
compliance rate is high. Friedrich Schneider, a professor of economics 
at Johannes Kepler University in Austria, completed a detailed study 
last year on the size of underground, or shadow, economies in 145 
countries.\3\ He is perhaps the world's top expert on underground 
economies and tax evasion. Schneider defines the shadow economy to 
include legal activities that are not reported to governments in order 
to avoid taxes and regulations. Reviewing the literature, he finds that 
``in almost all studies, it has been found that the tax and social 
security contributions are one of the main causes for the existence of 
the shadow economy.'' \4\
    Schneider finds that the shadow economies of developing countries 
are much larger than those of the advanced nations of the Organization 
for Economic Cooperation and Development. Looking at 21 OECD nations in 
2002, he found that the average size of shadow economies was 16 percent 
of gross domestic product. The United States had the smallest shadow 
economy at just 8 percent of GDP, according to Schneider's analysis.
    In a study for the International Monetary Fund in 2000, Schneider 
similarly found that the United States had a smaller shadow economy 
than nearly all other countries.\5\ In sum, Americans seem to be highly 
law-abiding when it comes to government taxes and regulations.
    Another factor to consider is that the size of the federal tax gap 
does not seem to have increased over the years. The Government 
Accountability Office noted recently that ``the rate at which taxpayers 
voluntarily comply with our tax laws has changed little over the past 
three decades.'' \6\ Thus, to the extent that the tax gap is a problem, 
it is not getting any bigger.
    For these reasons, the intense focus in Congress on the tax gap in 
recent months is perplexing. Americans should pay the amount of taxes 
that they owe, but the tax gap is far down on a long list of problems 
with the federal tax system. Congress should focus on the following 
items as more pressing problems needing attention: \7\
     America's high-rate and uncompetitive corporate income 
tax, which is a growing concern in our increasingly globalized economy.
     The excessive taxation of savings and investment under the 
income tax, which reduces the growth rate of the U.S. economy.
     High marginal tax rates on individuals and businesses, 
which are a hurdle to productive activities and encourage unproductive 
avoidance activities.
     The enormous complexity of the tax code. The number of 
pages of federal tax law and regulations increased from 40,500 in 1995 
to 66,498 by 2006.\8\
     Increasing horizontal inequity in the tax code. The 
plethora of deductions and credits added in recent years creates 
unfairness by imposing different tax burdens on people with similar 
incomes.
     The alternative minimum tax, which threatens to hit 30 
million taxpayers by the end of the decade if not reformed or repealed.
    Americans have a responsibility to pay all the taxes that they owe. 
But Congress has a responsibility to make sure that laws are as simple 
as possible and easy to comply with.
    With the tax code, Congress is utterly failing in its 
responsibility. James Madison noted that ``it will be of little avail 
to the people that the laws are made by men of their own choice, if the 
laws be so voluminous that they cannot be read, or so incoherent that 
they cannot be understood ... or undergo such incessant changes that no 
man who knows what the law is today can guess what it will be 
tomorrow.'' \9\
    Let's make the tax code coherent first before we consider any 
additional regulatory actions to close the tax gap. Focusing on the tax 
gap first puts the cart before the horse. Let's reform the code to 
increase economic efficiency and fairness, and an important byproduct 
will be to increase tax code compliance.
                 observations on the tax gap estimates
    Most of the tax gap regards individual taxes, not corporate taxes. 
IRS data shows that the corporate tax gap is only 9 percent of the 
overall gap.\10\ Yet concerns are often expressed about supposed 
rampant corporate tax abuse. In recent remarks about the tax gap, 
Senator Kent Conrad (D-ND) talked about the ``hemorrhaging'' of federal 
tax revenues from cheating by large multinationals with offices in the 
Cayman Islands.\11\
    However, the problem on the corporate side is legal tax avoidance 
by multinationals due to our high corporate tax rate, not illegal tax 
evasion. Interestingly, the Joint Committee on Taxation report on Enron 
found hundreds of Enron subsidiaries in the Caymans, but the JCT had a 
hard time showing that the firm's tax machinations were actually 
illegal.\12\ The corporate tax code encourages the creation of very 
complex corporate tax structures that are usually legal, but they do 
make tax compliance much more difficult.
    Note that corporate tax revenues have soared in recent years. 
Corporate tax revenues are expected to be $342 billion in fiscal 2007, 
which is up a remarkable 65 percent over the peak at the end of the 
last boom in fiscal 2000 of $207 billion.\13\ Corporate tax revenues 
are clearly not ``hemorrhaging.''
    The tax gap related to the estate tax is also worth looking at. At 
$8 billion, the tax gap for the estate tax is a huge 29 percent of the 
$28 billion in estate tax revenues in 2001. This large gap indicates 
the large inefficiency of the estate tax, which probably drives 
relatively more tax avoidance and evasion than any other federal tax. 
This is one reason why many tax experts support repeal of this tax.
    The federal FICA payroll tax has a very low tax gap of just $14 
billion. Experts note that the FICA tax has a low tax gap because of 
employer withholding. But another factor that promotes high compliance 
is that the payroll tax is the simplest federal tax. It has a low, flat 
rate and no deductions. It is a model to consider for reforms of the 
federal income tax. Indeed, the Hall-Rabushka flat tax for individuals 
would consist simply of a flat-rate payroll tax, and thus would likely 
have a high compliance rate.
    Major tax reforms would reduce the tax gap by reducing taxpayer 
confusion and aggressive tax planning. Many taxpayers pay the wrong tax 
amount because they are confused about what income is taxable and what 
tax breaks are allowed. And since complex tax rules are subject to 
multiple interpretations, they spur taxpayers to take risks on tax 
strategies in the hope that they are not caught by the IRS. The Joint 
Committee on Taxation noted that ``taxpayers may consciously choose to 
'play the audit lottery' by taking a questionable position on their tax 
returns, in the belief that complexity will shield them from 
discovery.'' \14\ In its report on Enron, the JCT concluded that the 
company ``excelled at making complexity an ally.'' \15\
    The IRS estimate of the tax gap includes $32 billion related to 
claiming the wrong amounts of credits and deductions. The number of 
such ``tax expenditures'' has soared in recent years. Indeed, the GAO 
found that the number of tax expenditures has more than doubled since 
1975.\16\ Table 1 shows the number of tax expenditures relating to 
energy and education have more than doubled since 1995. The explosion 
of tax credits and deductions has added complexity and increased the 
system's unfairness by promoting horizontal inequities.
    The largest source of the tax gap is the small business and self-
employed sector of the economy. It is this sector that would bear the 
burden of many proposed actions to reduce the tax gap, as it would have 
to pay higher taxes and deal with greater paperwork. If Congress and 
the IRS increased reporting requirements and tax regulations to try and 
reduce the tax gap, most of the added compliance burden would fall on 
law-abiding businesses that are already paying their full load of 
taxes.
    Note that individuals and businesses already spend more than 6 
billion hours--or more than 3 million person-years--complying with 
federal taxes. Many members of Congress, usually around April 15, decry 
that large burden. Yet trying to reduce the tax gap by imposing added 
paperwork on businesses would increase the time spent on unproductive 
compliance activities.
    Note that small businesses already have a higher ratio of tax 
compliance burdens to taxes collected than do large businesses. For 
small businesses, tax compliance costs can be larger than actual taxes 
paid.\17\ The IRS Taxpayer Advocate has found that the heavy compliance 
burden on small businesses is one of the most serious problems with the 
tax system.\18\ Thus, targeting small businesses with more regulations 
to try and close the tax gap seems especially unfair.
    Senator Kent Conrad (D-ND) recently stated that ``closing the tax 
gap is not about raising taxes on anyone.'' \19\ But in fact, it is. 
Certainly, some individuals and businesses are currently not paying all 
they owe. But taking actions to increase taxes paid would create all 
the usual ``deadweight losses,'' or inefficiency costs, that any tax 
increase would create. If a small business is required to pay more tax, 
it will have less cash flow available for capital investment and hiring 
workers. There is no free money sitting around for the federal 
government to simply grab without negative side-effects on the economy.
                               conclusion
    In conclusion, the great attention being placed on the tax gap 
seems out of place given that the problem is not excessive compared to 
other countries, nor is it getting worse over time. Federal revenues 
are up above historical norms at 18.5 percent of GDP in fiscal 2007. 
Indeed, data for the first four months of fiscal 2007 show a 10 percent 
increase over fiscal 2006.\20\
    The fiscal problem in Washington is not a lack of revenue. Thus 
burdening small businesses and the economy with more tax regulations to 
try and close the tax gap is the wrong way to go. In his classic work, 
The Wealth of Nations, Adam Smith recognized that the total cost of 
taxation is ``a great deal more'' than just the amount of revenue 
collected. For one thing, he argued that ``by subjecting the people to 
the frequent visits and the odious examination of the tax-gatherers, it 
may expose them to much unnecessary trouble, vexation, and 
oppression.''
    Rather than increase odious tax-gathering activities, we should 
instead reform the tax code to reduce marginal rates and eliminate 
special preferences. That would be beneficial for families and the 
economy, and it would have the side effect of reducing the tax gap.
    Thank you for holding these important hearings. I look forward to 
working with the committee on tax issues, particularly tax code 
simplification and reform.
                                endnotes
    \1\ The IRS estimates are discussed in Government Accountability 
Office, ``Tax Compliance,'' GAO-07-391T, January 23, 2007. See also 
U.S. Department of Treasury, ``A Comprehensive Strategy for Reducing 
the Tax Gap,'' September 26, 2006.
    \2\ National Highway Traffic Safety Administration, ``Seat Belt Use 
in 2006: Overall Results,'' November 2006, www-nrd.nhtsa.dot.gov/pdf/
nrd-30/NCSA/RNotes/2006/810677.pdf.
    \3\ ``Shadow Economies of 145 Countries all over the World: What do 
we really know?'' May 2006, www.econ.jku.at/Schneider/
ShadEconomyWorld145--2006.pdf.
    \4\ ``Shadow Economies of 145 Countries all over the World: What do 
we really know?'' May 2006, p. 5, www.econ.jku.at/Schneider/
ShadEconomyWorld145--2006.pdf.
    \5\ Friedrich Schneider and Dominik Enste, ``Shadow Economies 
Around the World: Size, Causes, and Consequences,'' International 
Monetary Fund, Working Paper 00/26, February 2000.
    \6\ Government Accountability Office, ``Tax Compliance,'' GAO-06-
1000T, July 26, 2006, p. 1.
    \7\ For a discussion of problems with the tax code, see Chris 
Edwards, ``Options for Tax Reform,'' Cato Institute Policy Analysis no. 
536, February 24, 2005, www.cato.org/pub--display.php?pub--id=3681.
    \8\ Based on the page count of the CCH Standard Federal Tax 
Reporter. See Chris Edwards, ``Income Tax Rife with Complexity and 
Inefficiency,'' Cato Institute Tax & Budget Bulletin no. 33, April 
2006, www.cato.org/pubs/tbb/tbb-0604-33.pdf.
    \9\ James Madison, The Federalist Papers, No. 62.
    \10\ For all tax gap figures, see Government Accountability Office, 
``Tax Compliance,'' GAO-07-391T, January 23, 2007. See also U.S. 
Department of Treasury, ``A Comprehensive Strategy for Reducing the Tax 
Gap,'' September 26, 2006.
    \11\ Senator Kent Conrad (D-ND), Remarks at a Senate Budget 
Committee ``Hearing on President Bush's FY2008 Budget Proposals on Tax 
Compliance,'' February 14, 2007.
    \12\ In testifying on the Enron activities, then JCT chief of 
staff, Lindy Paull, said, ``I don't know if you could call it 
illegal.'' See Peter Behr, ``Enron Skirted Taxes Via Executive Pay 
Plan,'' Washington Post, February 14, 2003, p. E1.
    \13\ Budget of the U.S. Government, FY2008, Historical Tables, p. 
30.
    \14\ Joint Committee on Taxation, ``Study of the Overall State of 
the Federal Tax System,'' JCS-3-01, April 2001, volume 1, p. 102.
    \15\ Joint Committee on Taxation, ``Report of Investigation of 
Enron Corporation and Related Entities Regarding Federal Tax and 
Compensation Issues, and Policy Recommendations,'' volume 1: Report, 
JCS-3-03, February 2003, p. 16.
    \16\ Government Accountability Office, ``Tax Compliance,'' GAO-06-
1000T, July 26, 2006. p. 7.
    \17\ Art Hall, ``Compliance Costs of Alternative Tax Systems II,'' 
Tax Foundation, March 1996.
    \18\ Internal Revenue Service, National Taxpayer Advocate, Annual 
Report to Congress, FY 1999.
    \19\ Senator Kent Conrad (D-ND), Remarks at Senate Budget Committee 
``Hearing on President Bush's FY2008 Budget Proposals on Tax 
Compliance,'' February 14, 2007.
    \20\ Congressional Budget Office, ``Monthly Budget Review,'' 
February 6, 2007.

    Chairman Spratt. Did Adam Smith say all of those things? 
Was that a quote or was that a paraphrase?
    Mr. Edwards. That was a quote, yes.
    Chairman Spratt. Let me ask each one of you, as a panel 
together, if you have an idea.
    I was trying to probe the Commissioner earlier for how much 
the tax gap is today, 2006-2007, as opposed to 2001. We had a 
useful clarification in the GAO testimony that it is 345 gross, 
55 late payments, so the net number is 290.
    Considering the 290 in 2001, what do you think the gap is 
today in 2007? Mr. George.
    Mr. George. Yes. Mr. Spratt, Mr. Chairman, we are not in a 
position to give a definitive answer there. They do not have--
--
    Chairman Spratt. Is the 2001 number scientific or is it 
just a stab itself?
    Mr. George. No. No. No. They did a detailed study, the 
national review. They did a detailed review of this, but it is 
just incomplete. They only looked at one aspect of the overall 
picture.
    Chairman Spratt. If we were in earnest about closing this 
gap, wouldn't it be useful to have that number restated every 
year, have some kind of means for at least a summary update?
    Ms. Olson. Mr. Chairman, what I have advocated is--and the 
IRS is moving in this direction as fast as I think it actually 
can--to have a 5-year cycle of studying different components of 
the tax gap so that--or the tax paying population. One year, 
you would be updating your corporate numbers. One year, you 
would be updating your pass-through numbers. In another year, 
you would be updating some components of the individual income 
tax, and as you went through those 5-year cycles, you would 
also be looking at what services those different populations 
needed since for so much of what we ask taxpayers to do they do 
need assistance from us or others in some way, and I think if 
you got on an ongoing 5-year cycle in that way, you would have 
reasonably good estimates so that if there were something that 
Congress had changed in the laws or had closed a loophole or 
something, you could back out or add to the effect of those 
changes to your bottom line estimate.
    Right now, we have so many squishy numbers in the tax gap 
chart that the Commissioner uses--you know, there are whole 
colors that are in--these are squishy numbers. That is what I 
think the blue color represents on that tax gap chart.
    Chairman Spratt. Well, that is another whole problem for 
this committee because we need current and up-to-date numbers, 
and typically the definitive revenue collection for a given 
year may not be available for as much as 12 to 18 months after 
the close of the year, which is a problem for us in knowing if 
there is a revenue spurt or if there was a revenue decline, and 
we are not for sure looking at the numbers we all have.
    Just one more question from me is a question I asked 
earlier. Mr. George, back in the 1990s when we were looking 
into the possibility or at least exploring this notion of 
having a lot more information filing, the small business 
community came down heavily on the side of saying, if you give 
us all these reams of information to the Internal Revenue 
Service, they do not have the wherewithal, the software or the 
hardware to begin to process it, correlate it and make good use 
of it. Do they now? Is the system there in such a state now 
that if they did indeed have information reporting that 
contractors would have to report certain payments to vendors, 
suppliers and subcontractors above a certain amount? Would the 
IRS have the capacity to process that meaningfully if they got 
the information?
    Mr. George. They currently do not have the wherewithal to 
do this. There is much needed infrastructure improvements in 
order to adequately address that, Mr. Chairman.
    Chairman Spratt. And how long would it take to install 
that?
    Mr. George. That is a great question. I do not have an 
answer to that.
    Chairman Spratt. Is there a software design?
    Mr. George. It is still in the process. As you may recall, 
modernization was attempted over 12 years ago. Billions of 
dollars were expended on a program that failed to do anything 
that it was designed to do. It was a complete waste. They have 
learned from that lesson and are now engaged in a business 
systems modernization program which has had some success, is 
being rolled out slowly. It has not yet delivered everything 
promised. It is slightly--it is over budget, and it is not, 
again, delivering everything promised, but they are working at 
it.
    Chairman Spratt. Other witnesses?
    Ms. Olson. Mr. Chairman, you know, I have witnessed over 
the last 3 years the IRS ramp-up of the private collection 
agency initiative where they have spent millions and millions 
of dollars both in infrastructure and staff time to bring on a 
whole new program dealing with software, conveying data, data 
security, and what I have seen is that the IRS, when it puts 
its mind to things in a laser-like fashion, can accomplish some 
amazing things. So it seems to me that if the IRS were to be 
given the authority to do these things and the directive that 
it has to focus on it as it focused on the private collection 
agency, it should be able to accomplish that and is probably 
cheaper than the cost of the private collection agency.
    Mr. Brostek. We have a separate team that looks at the 
business system modernization effort from the team that I am 
in. We have frequently found problems with the management of 
that modernization, and it certainly is behind the schedule it 
was intended to follow, and it has not had as much delivered as 
it was supposed to have delivered.
    On the other hand, they do have greater capacity now than 
they certainly did back in the period you were talking about 
earlier to do this kind of matching. It would undoubtedly take 
them additional effort to implement any new requirements. They 
would have to do software development, and they may need 
additional----
    Chairman Spratt. There would be a lag time of several years 
in all probability between the enactment of legislation and 
appropriations and the effective implementation of this; is 
that right?
    Mr. Brostek. That is certainly true, and it would depend a 
lot on the specific initiative that was implemented and how 
complex, for instance, the rule-making would be to determine 
exactly how the information reporting would be done.
    Chairman Spratt. Mr. Edwards, any observation?
    Mr. Edwards. I am happy to make an observation on your 
prior question.
    You asked about what compliance might be now in 2007. It 
does strike me--looking at the GAO, it shows the overall number 
being fairly stable and compliant over the decades, but there 
are many conflicting forces, of course, going into that that 
are probably balanced out. Tax or marginal tax rates are much 
lower than they were in the 1960s and 1970s and even to an 
extent in the 1980s. So that is good for compliance. The 
capital gains rate was cut from 20 to 15 percent in recent 
years, thus reducing the incentive to evade capital gains taxes 
by 25 percent.
    On the other hand, you have got this huge increase in tax 
expenditures. Even in the last few years, more tax credits for 
energy and education and all kinds of other things consume the 
IRS' time. They make tax paying very confusing. The globalized 
economy is probably making tax compliance worse. So all of 
these things, it seems, sort of balanced out over time.
    Chairman Spratt. Mr. Cooper.
    Mr. Cooper. Thank you, Mr. Chairman.
    First, I would like to thank the tax advocate for the new 
IRS split refund regulations which enable taxpayers to not 
spend all of their refund at one time and hopefully save a 
portion of it. So thank you for that on behalf of the 
Congressional Savings and Ownership Caucus. That was one of our 
priorities.
    I would like to focus on tax expenditures again, and as Mr. 
Edwards just noted, Congress has legislated through the Tax 
Code to an amazing degree. If you add up all of the tax 
expenditures, as I mentioned in an earlier question, it is some 
$847 billion a year. That approaches the size of all Federal 
discretionary spending, including all defense spending and all 
domestic discretionary spending, so that is how much we have 
sacrificed in revenue just to serve a remarkably undefined 
constituency here, because as I quoted the other Ms. Olson 
earlier, ``unmeasured and immeasurable, unverified and 
unverifiable.''
    So it seems to me, if you analyze it, what we have created 
here is a system in which the 17,000 Ways and Means and Finance 
Committees' lobbyists can get a tax break virtually for free 
for their clients, and as Commissioner Everson testified 
earlier, he admitted it takes the IRS some 20 years to catch up 
with law changes and who benefits and who does not and tax gap 
or tax cheating and things like that. That is a pretty scary 
prospect.
    So I wanted to experiment with you the idea that perhaps we 
should make the tax expenditures more measurable and 
verifiable. For example, if you ask for and receive a tax 
break, wouldn't it be nice if, in succeeding years, you had to 
report who benefited from it and to what degree? That would 
improve accountability, I would think. Whereas, today, we do 
not really know where the money goes, and that is an 
astonishing amount of Federal money to lose.
    Another approach would be, as Mr. Brostek reported, from 
GAO that there is a definite noncompliance rate associated with 
each tax expenditure. The more breaks you give, the more 
confusion you have in the Code and the more people do not pay 
their taxes. So these breaks create their own tax gap, and from 
Mr. Brostek's numbers, it looks like we lose $32 billion a year 
just in increased noncompliance as a result of these tax 
expenditures. That is about 4 percent of the total tax 
expenditures. So, if the government were really interested in 
collecting that money from the tax gap related to tax breaks, 
we would go ahead and have an upfront fee of about 4 percent, 
anticipating that there would be about 4 percent noncompliance, 
and I am already unpopular with the 17,000 lobbyists for the 
Ways and Means Committee.
    But if the government, just as a theoretical question, were 
interested in simplifying the Code, improving verifiability and 
measurability, wouldn't it consider undertaking those steps of 
identifying who the beneficiaries are of these breaks and to 
what extent and also going ahead and anticipating a certain 
degree of noncompliance resulting therefrom? Those steps would 
come closer toward improving accountability of government. 
Comments?
    Mr. Brostek. We did a report on tax expenditures a couple 
of years ago, and we have been updating the figures since. That 
is how we have the figure that is in my testimony today. We 
have felt that these provisions should have the same type of 
scrutiny as an outlay program. Now, there is a wide variety of 
tax expenditures. There are a lot of different purposes for the 
tax expenditures, but many of them are akin to a social program 
that is in the Internal Revenue Code. Yet, from our viewpoint, 
there is really not the same ownership that you would have if 
you had it in a line agency that is responsible for overseeing 
outlays of Federal funds.
    So we did, in fact, press for more visibility for these in 
the budget process, more research and more data collection so 
that we could determine whether or not the provisions are 
worthwhile, whether they are returning to the taxpayers a 
reasonable ROI for our revenue loss.
    Mr. Cooper. If I could just interrupt you for a second, 
when you say ``data collection,'' that makes me think that you 
are wanting to put the monkey on the government's back. These 
people are getting a special break. There is no constitutional 
right to a break. Shouldn't the monkey be on their back to 
report?
    Mr. Brostek. That certainly is a reasonable proposition to 
me. I think that would generally be the case. There would be 
the need to collect data that we do not collect already, and 
one of the things that would be an issue here is we have talked 
some about the IRS having inadequate computer systems, in many 
cases, for administering the complex Tax Code. If they were 
also to collect the use information for these tax expenditures, 
there would be a lot more data that would come into the IRS, 
and so that would increase their need for computer systems, and 
someone would need to analyze that data if it were going to be 
worth collecting.
    Mr. Cooper. I see that my time has expired.
    Thank you, Mr. Chairman.
    Chairman Spratt. You could come back--hold on if you have 
got further questions, but let us recognize Mr. Boyd, and then 
you can come back for additional questions.
    Mr. Boyd. Thank you, Mr. Chairman, and thank you, panel 
members.
    Earlier, a number of people on the committee and the 
Commissioner expressed the notion that the complexity of the 
current code does two things. It complicates it for those who 
want to abide by the rules who eventually throw up their hands, 
and the complexity allows those who want to cheat that ability. 
Do any of you disagree with that? Do any of you on the panel 
disagree? I am not asking for an editorial here, but do any of 
you disagree with that theory?
    Ms. Olson. No.
    Mr. Boyd. Okay. Thank you.
    Mr. Edwards, I read a little bit about you, and I know you 
are listed as an expert on Federal tax and budget policy. I 
listened to your statement, and you said that everything seems 
to be going pretty well, that there is nothing wrong with our 
code. If you compare it to other nations, we have got an 86 
percent compliance rate.
    Mr. Edwards. There is nothing wrong with our compliance 
rate, I think, compared to other countries. There is a lot 
wrong with our code.
    Mr. Boyd. Okay. There is nothing wrong with our compliance 
rate, but there is something wrong with the Code, but nothing 
that a lowering of the rates and a simplification would not 
fix.
    Given that and your expertise in tax and budget policy, 
what do we do about the largest deficits in the history of the 
Nation in the last 3 years?
    Mr. Edwards. Well, I mean I am very concerned about what 
has been going on on the spending side of the budget. I looked 
at the numbers the other day under President Bush from 2001 to 
2007. If you take out interest, which has been pretty stable 
over recent years, Federal outlays have gone up 54 percent just 
over those 6 years. So I think the problem is on the spending 
side of the budget.
    Mr. Boyd. With the bulk of that coming on the national 
defense side and with the entitlement program?
    Mr. Edwards. Yes, absolutely, and I think I have a big 
concern with both the defense and nondefense and entitlement 
sides of the budget. I mean all of that spending sucks money 
out of the private sector. Spending on defense is not good for 
the economy just like excess spending in the entitlement 
incentive program.
    Mr. Boyd. But you would concede, until you attack the 
defense and entitlement sides, you really do not solve that 
problem?
    Mr. Edwards. Absolutely. I agree with that entirely.
    Mr. Boyd. Okay. Thank you.
    Ms. Olson, earlier there was discussion about the Private 
Collection Initiative, and I understand that you have some 
issues with that.
    Would you care to comment what those are and what you see 
those problems as?
    Ms. Olson. Well, I have been involved with the Private 
Collection Initiative since its inception for the last 5 years, 
before it even was legislation, when Treasury asked me to 
ensure that taxpayer rights were protected in this initiative, 
and my goal was to make sure that taxpayers were being treated 
in the same manner and under the same rules and under 
essentially the same procedures as they would be treated by the 
IRS employees, and I have had employees detailed to this 
initiative full time to watch it and report back to me, and 
this year----
    Mr. Boyd. Could I ask you about that?
    Ms. Olson. Yes.
    Mr. Boyd. You have 65 Federal employees monitoring 75 
private sector employees? That is the number I have. Is that 
correct?
    Ms. Olson. That is the IRS' employees. It does not include 
the--I would say we have 3 employees looking at this pretty 
much full time.
    Mr. Boyd. Okay. The IRS has 65 monitoring 75 private 
employees, and you have 3 monitoring the IRS guys?
    Ms. Olson. Right, and all of the information in our report, 
that we have reported on, has come from the IRS, so we are 
reliant on the IRS giving us that information. So I do not know 
whether there are more IRS employees, really. I do not know who 
is in that 65 number, except I know mine are not, and it was 
some of those numbers as we looked at the program as it went 
out, as it really started rolling out, and looking at the cases 
that were going on there that led me this year in my December 
31st report to recommend that Congress repeal the authority to 
use the private collection agencies because I believe that the 
business case was not there. It was just costing taxpayers too 
much and that the IRS could do it much cheaper. I believe that 
there is a workforce that could be trained to do that inside 
the IRS that would be much more stable, would protect taxpayers 
better, and some of the very premises that the program was 
based on, such as that there were easy cases that we just were 
not getting to that we could just ship out to the private 
collection agencies and they could just do like that do not 
exist. In fact, the IRS is now having to go to higher dollar 
accounts and small business accounts and accounts where 
taxpayers have not filed other tax returns in order to make up 
the number of cases that they are shipping out.
    I guess the third concern that I had about it was that if 
you go online to the IRS Web site and you look up our Internal 
Revenue Manual, which is essentially our instructions to staff 
about how they are to treat taxpayers, you can find specific 
instructions to the collection employees about what they are 
supposed to do, and because we are contracting out to these 
employees, to these private parties as a matter of Federal 
procurement law we cannot disclose the instructions that they 
give to their employees. We cannot tell taxpayers how private 
collection agency employees are being told to treat taxpayers. 
That is a matter for the private collection agencies to agree 
because it is considered proprietary information, and I found 
that very disturbing.
    Mr. Boyd. I do, too.
    Chairman Spratt. Would the gentleman yield?
    Do the private contractors have the same authority, for 
example, the extraordinary authority, to administer, I guess, a 
search warrant, an administrative search warrant, to sequester 
the funds in a bank account, for example, without notifying the 
taxpayer?
    Ms. Olson. No, sir. They are limited under the 
Constitution. You know, it is the Federal Government that has 
the authority to assess and collect taxes, and so the way 
this----
    Chairman Spratt. And it is nondelegable?
    Ms. Olson. It is nondelegable, and so these individuals can 
only ask the taxpayer things that do not involve the exercise 
of discretion or judgment, so they can ask them ``Do you owe 
the tax in full or can you pay this in 36 months?'' one of the 
problems is if the taxpayer says, ``Well, I need 60 months'' or 
``I do not think that I should have to pay this penalty. I was 
in a coma during all of these years. I could not pay it while I 
was in a coma,'' then that case has to go back to the IRS to be 
worked. So then we have two people working a case at any given 
time.
    Mr. George. Mr. Chairman, if I could just briefly address 
this issue, my office is very closely monitoring the 
implementation of this program given the sensitive nature of 
it, and we believe it is just much too early to make an 
assessment as to its success or failure, but we will be 
reporting on this within the year.
    Chairman Spratt. What about a lien?
    Ms. Olson. No, they cannot----
    Chairman Spratt. You have got the most powerful lien known 
to the law if they want to levy a lien against the taxpayer who 
is delinquent.
    Ms. Olson. It has to go back to the IRS, and the IRS does 
it.
    Chairman Spratt. Okay.
    Excuse me, Mr. Boyd. Thank you for yielding.
    Mr. Cooper.
    Mr. Cooper. Thank you.
    Ms. Olson, you mentioned in your testimony that due to the 
special accounts receivable function of the IRS that they 
should have greater budget leeway than some other agencies.
    What should their current budget be? What would be the 
right amount of money for the IRS?
    Ms. Olson. Well, I would want to see--I am not subject to 
the same restraints as the Commissioner. You know, I get to 
speak freely in that respect, and my views do not represent the 
views of the administration nor the Commissioner nor the 
Secretary of the Treasury or pretty much anybody else, but I 
believe that the current budget is a good start, and I would 
want to see more funding for taxpayer service. We are ramping 
down some of the walk-in sites and some of the level of service 
on answering the phones, and I think I would take a good look 
at what more we need in the IT Department, and then on a going-
forward basis, I think that we just need to think that the IRS 
needs for a period of years--and I am not quite sure what that 
period would be but for at least 10--increases, roughly, in the 
2-percent to 3-percent range overall, both enforcement and 
taxpayer service and IT, to get caught up and stay abreast with 
some of the demands that we have.
    I also think that we have to look at the way the IRS 
calculates return on investment, and one of the things that we 
suggested was that the IRS report annually to Congress about 
its return on investment calculations, both on the service side 
and the enforcement side, and what you are getting for your 
investments.
    Mr. Cooper. A couple of other questions.
    There are a number of small but nuisance areas; for 
example, household employee paperwork. It is a nightmare, a 
blizzard of ink and paper.
    Is it your responsibility or whose is it to come up with 
simpler approaches for that that we can take that 
recommendation and perhaps pass it into law?
    Ms. Olson. Well, we have looked at that in the past, and we 
will continue to look at that. I agree with you that it is 
very, very complex. We have also looked at just the whole 
Federal employment tax arena because that is where so many 
small businesses get into problems. It is just the complexity 
of the rules, and we have tried to come up with some proposals.
    Mr. Cooper. Well, since you are the Taxpayer Advocate, I 
look forward to hearing from you on those things.
    Ms. Olson. Thank you.
    Mr. Cooper. Another set of questions.
    So many people just run and hide when they hear the ``T'' 
word. They do not want to understand the complexity of the 
Code. Is there a simple breakdown? I thought I remembered from 
law school or someplace that a quarter or a half of the Tax 
Code is consumed with the capital gains distinction and income 
of some amazing portion. It would help if we kind of had some 
idea. I know that these retirement accounts are wonderful, but 
just with the complexity between the IRAs and Roth IRAs and all 
of the other varieties, that is a gigantic section of 
paperwork, and perhaps it is for a good purpose, but sometimes 
we do not realize the extent to which complexity is engendered 
by what seem like relatively simple ideas.
    Mr. Edwards. Lots of tax experts will say that the capital 
gains is the single most complex part of the Tax Code, and it 
is not just individual capital gains; corporate capital gains 
is very, very complex, and often when you read about the tax 
shelters in the newspaper about some corporation doing some 
sort of machination, it revolves around the treatment of 
corporate capital gains.
    Mr. Cooper. Well, has some tax wizard made a map of the 
Code and just said, ``Hey, half is here and half is there''? 
Because I think that might help us understand sometimes the 
complexity.
    A final point. Mr. Brostek mentioned that many of these tax 
expenditures are in fact social programs, and I cannot help but 
note the irony that for discretionary spending here in Congress 
we have some 20 committees, including our friends on the 
Appropriations Committee, to oversee that $800 billion or $900 
billion worth of spending, but on the tax expenditure side we 
barely have any committees looking at how that is understood. 
So perhaps we should double the Appropriations Committee. 
Perhaps we should have another set of committees here in 
Congress to look at how that money is, in fact, being spent 
because today we are largely clueless. It is almost a shadow 
government in place, and there is little or no accountability.
    Mr. Edwards. Can I make a comment on the tax expenditure? 
There are two aspects of it. One is the complexity, which we 
have discussed. The other is the fairness issue. It seems to 
me, with this explosion in tax expenditures, you create greater 
horizontal inequities in the Code. People earning the same 
amount of money can pay substantially different amounts of tax, 
and even if you look at education tax expenditures they have 
increased from 7 to 16 just in the last 10 years.
    So what we are doing is we are subsidizing, say, you know, 
young lawyers who are going to law school on the one hand, but 
we are burdening truck drivers and garbage men on the other 
hand because they do not get that sort of tax break. So there 
is a fairness thing here as well.
    Mr. Cooper. Without data, though, we almost do not know how 
unfair or--you know, it is an amazing netherworld that we have 
entered into due to the multiplication of the size of these tax 
breaks.
    Mr. Brostek. It is, if I can jump in.
    There is a variety of levels of data that we have 
available. You know, for instance, on the earned income credit 
we have a pretty good understanding of who is receiving it and 
how much and where they live in the country and all kinds of 
things like that, but on some of the other provisions we have 
virtually nothing at all. If we have a special accelerated 
depreciation provision, that gets reported to the IRS with all 
other depreciation on one line on the tax form, and we do not 
know who is even using that benefit that is in the Tax Code.
    Mr. Cooper. On the EITC, though, the major abuse there is 
claiming dependents that you are not entitled to claim or 
claiming too many dependents, isn't it? So I cannot understand 
why there is not a matching process there. Commissioner Everson 
mentioned earlier that suddenly 5 million dependents in America 
disappeared once there was better reporting. Surely, there is a 
nonintrusive way of getting at EITC fraud.
    Ms. Olson. I think that there is a lot actually that the 
IRS is doing on EITC, and we do have a very active matching 
program, and that does stop a fair number of refunds going out. 
I think any time you have something that is in the realm of 
$4,000 on top of--that could be without any withholding and you 
could get a check back of $4,000, that is a great enticement 
for people to find ways to claim it, and with the human mind 
being what it is there are always new ways. Once we find the 
way that they are doing it, they invent a new one. It just 
requires ongoing watching, I think.
    There is a large amount, though, when we were working on 
trying to quantify this, of taxpayers who are eligible for the 
EITC who are not claiming it. We think that might be with the 
childless worker where it is not involving the children, but it 
is there. I have worked with United Kingdom and studied their 
credit and made some recommendations about how to restructure 
all of our family provisions--the child credit, the dependency 
exemption, the head of household status, and the earned income 
credit--to sort of lessen some of the complexity. It is a very 
complex area of law, not just the EITC.
    Chairman Spratt. Gentlemen, we have got to be on the floor, 
especially on the floor, at around 1:00 o'clock.
    Let me thank each one of you for excellent presentations, 
very forthright and forthcoming testimony. We appreciate your 
assistance in helping us better understand the tax gap and what 
we might hope to realize from it.
    Thank you very much for coming.
    Mr. Boyd. Mr. Chairman.
    Chairman Spratt. Mr. Boyd.
    Mr. Boyd. May I ask one--I have one quick request of Mr. 
George on the Private Collection Initiative.
    Chairman Spratt. Sure.
    Mr. Boyd. You said it is too early. How much time do you 
think you will need for your group to make an assessment, an 
evaluation, of whether it working or not?
    Mr. George. We expect to issue a report in April, 
Congressman Boyd.
    Mr. Boyd. Can you make sure that we get a copy of that 
report? I would be grateful.
    Mr. George. Yes. Certainly, sir.
    Mr. Boyd. Thank you very much.
    Chairman Spratt. I would, before adjourning, ask unanimous 
consent that members who did not have the opportunity to ask 
questions of the witnesses be given 7 days to submit questions 
for the record. Without objection, so ordered.
    Thank you very much.
    [Whereupon, at 12:57 p.m., the committee was adjourned.]

                                  
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