Tax Administration: Electronic Filing's Past and Future Impact on
Processing Costs Dependent on Several Factors (10-JAN-02,	 
GAO-02-205).							 
                                                                 
From fiscal years 1997 through 2000, the number of individual and
business tax returns filed electronically increased from 23	 
million to 41 million. During the same period, the Internal	 
Revenue Service's (IRS) expenditures for submission processing	 
grew from $795 million to $924 million, an increase of 16	 
percent. Because it costs less to process an electronic return	 
than a paper return, a growth in processing costs seemed	 
improbable. Interviews with IRS officials and an analysis of	 
relevant documentation identified several factors that limited	 
the impact of electronic filing. Specifically, (1) the overall	 
number of individual and business tax returns filed increased,	 
and the resources needed to process that increase partially	 
offset the resources saved by processing more electronic returns;
(2) the number of the most costly to process individual income	 
tax returns filed on paper essentially stayed the same; and (3)  
the number of individual income tax returns filed on paper and	 
received during the peak filing period stayed relatively the	 
same, and peak processing needs drive the resources needed to	 
process individual paper returns. Although electronic filing	 
increased, so did the demands placed on paper processing staff.  
In particular, (1) processing changes increased the workload for 
units responsible for reviewing returns for completeness and	 
coding them for entry data, and correcting errors; (2) because	 
most electronic filers still sent a paper signature document to  
IRS, the work done by paper processing staff was not entirely	 
eliminated when taxpayers filed electronically; and (3) 	 
front-line paper processing staff spent increasing amounts of	 
time on activities, including training, not specifically related 
to processing returns. Future reductions in processing costs as a
result of electronic filing are possible.			 
-------------------------Indexing Terms------------------------- 
REPORTNUM:   GAO-02-205 					        
    ACCNO:   A02645						        
  TITLE:     Tax Administration: Electronic Filing's Past and Future  
Impact on Processing Costs Dependent on Several Factors 	 
     DATE:   01/10/2002 
  SUBJECT:   Cost control					 
	     Electronic forms					 
	     Electronic government				 
	     Income taxes					 
	     Tax administration 				 
	     Tax returns					 

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GAO-02-205
     
United States General Accounting Office

GAO Report to the Chairman, Subcommittee on Oversight, Committee on Ways and
Means, House of Representatives

January 2002

TAX ADMINISTRATION

Electronic Filing's Past and Future Impact on Processing Costs Dependent on
Several Factors

GAO-02-205

Contents

Letter

Results in Brief
Background
Scope and Methodology
Several Factors Limited the Impact of Electronic Filing on the

Resources Devoted to Processing Returns Future Cost Reductions Hinge on
Increases in Electronic Filing and Changes in Processing Operations Agency
Comments and Our Evaluation

1

1 3 5

5

14 17

Appendix I Objectives, Scope, and Methodology

Appendix II Comments From the Internal Revenue Service

Tables

Table 1: Individual and Business Returns Filed From 1997 Through 2000

Table 2:  Numbers of Form 1040,  1040A, and 1040EZ Filed  on Paper From 1997
Through 2000

Table 3:  Individual Paper Returns Filed During the  Peak Filing Period From
1997 Through 2000

Table 4: Estimated Effects of Certain Processing Changes on Workload

Table 5: Differences in  Data Transcribers' Productivity (average keystrokes
per hour)

                                                                6 7 8 10 11

Figures

Figure 1: Processing Flowchart  for Paper and Electronic Returns 4 Figure 2:
Reductions in Processing Costs Based on Various

Scenarios Involving Increases in Electronic Filing and

Changes in Processing Operations 15

Abbreviations

GAO General Accounting Office IRS Internal Revenue Service

United States General Accounting Office Washington, DC 20548

January 10, 2002

The Honorable Amo Houghton
Chairman, Subcommittee on Oversight
Committee on Ways and Means
House of Representatives

Dear Mr. Chairman:

From fiscal years 1997 through 2000, the number of individual and
business tax returns filed electronically increased from almost 23 million
to almost 41 million. At the same time, the Internal Revenue Service's
(IRS) actual expenditures for submission processing (which includes
funds for processing returns filed on paper and electronically) grew from
about $795 million in 1997 to about $924 million in 2000, an increase of
16 percent, or 11 percent in inflation-adjusted dollars.1 Because it costs
less, on average, to process an electronic return compared with a paper
return, a growth in processing costs at the same time electronic filing is
growing seems contradictory.

At your request and as agreed with your office, this report addresses
(1) the factors, if any, that limited the impact of electronic filing on the
amount of resources (both dollars and staff years) devoted to processing
returns and (2) the prospects for future reductions in processing costs as a
result of electronic filing.

Results in Brief Our interviews of IRS officials and our analysis of
relevant documentation identified several factors that limited the impact of
electronic filing on the resources devoted to processing returns from fiscal
years 1997 through 2000. These factors fell into two broad categories,
namely,

* filing trends that partially offset the potential savings from increases
in electronic filing and

* increased demands on paper processing staff.

1IRS' submission processing budget for fiscal years 1997 through 2000 did
not provide sufficient information to determine the amount of resources IRS
spent on processing paper versus electronic returns. We are working with
IRS' Office of Cost Accounting to get that information for fiscal years 1997
through 2000. We will send the Subcommittee a separate report summarizing
any information we obtain along with any relevant analysis.

Several filing trends limited the impact of electronic filing. Specifically,
(1) there was an increase in the overall number of individual and business
tax returns filed, and the resources needed to process that increase
partially offset the resources saved by processing more electronic returns;
(2) the number of the most costly to process individual income tax returns
filed on paper essentially stayed the same; and (3) the number of individual
income tax returns filed on paper and received during the peak filing period
stayed relatively the same, and peak processing needs drive the resources
needed to process individual paper returns.

While electronic filing increased, so did the demands placed on paper
processing staff. In particular, (1) processing changes, such as expanded
efforts to validate Social Security numbers on tax returns, increased the
workload for units responsible for reviewing returns for completeness and
coding them for data entry, transcribing data, and correcting errors; (2)
because most electronic filers still sent a paper signature document to IRS,
the work done by paper processing staff was not entirely eliminated when
taxpayers filed electronically; and (3) front-line paper processing staff
spent increasing amounts of time on activities, including training, not
specifically related to processing returns.

Future reductions in processing costs as a result of electronic filing are
possible. In a March 2000 study prepared for IRS, a national consulting firm
presented a range of cost-reduction estimates depending on changes in
several variables, such as the number of returns filed electronically, and
assuming several operational changes, such as making additional business
forms available for electronic filing.2 Using 1999 expenditures as the
baseline, the consultant's annual cost-reduction estimates ranged from $27
million to a "best case" of $243 million starting in 2007. The best case
estimate assumed that IRS would make several operational changes and that 80
percent of individual, 45 percent of business, and 30 percent of other
returns would be filed electronically in 2007. However, the increase in
electronic filing by individuals between 2000 and 2001 fell below IRS'
goals. If this slower rate of increase continues, we projected that only
about 60 percent of individual income tax returns would be filed
electronically in 2007, which would lower the best case estimate to less
than $170 million, according to the consultant's report. Also, the
consultant's report did not focus on potential increases in the type and

2 IRS Cost  of Processing  Electronic Returns  (Booz-Allen &  Hamilton, Mar.
2000).

amount of data on paper returns that IRS would need to process due to tax
law changes or increased compliance efforts. As a result, any reductions in
processing costs would depend on the extent of any such increases.

In commenting on a draft of this report, the Commissioner said that the
report provided useful explanations for the continued increase in submission
processing costs, despite the increase in the number of electronically filed
returns. At the Commissioner's suggestion, we revised the report to clarify
the objective of the March 2000 consultant's study.

Background IRS has 10 submission processing centers located throughout the
country that are responsible for processing paper returns, 5 of which also
process electronic returns. Electronic returns are relatively easy to
process, while the processing of paper returns involves several additional
steps, as shown in figure 1.

Figure 1: Processing Flowchart for Paper and Electronic Returns

Source: IRS.

The fewer steps involved in processing electronic returns rather than paper
returns relate to a cost avoidance experienced by the IRS. In response to a
question raised by the House Appropriations Committee in 2001, IRS estimated
that 50 million individual income tax returns would be filed electronically
in fiscal year 2002. IRS estimated that it would need 3,150 more full-time
equivalent staff years if none of those returns were filed electronically.
At IRS' estimate of $36,300 per staff year, that would be a cost avoidance
of $114.3 million. Therefore, if no returns were filed electronically and
using IRS' estimates, which we did not verify, IRS' fiscal

Scope and Methodology

Several Factors Limited the Impact of Electronic Filing on the Resources
Devoted to Processing Returns

year 2002 budget request of $615 million for submission processing would
have increased to about $729 million.3 The major focus of our review was on
factors that worked against an even greater reduction in submission
processing costs.

To address our objectives, we interviewed IRS National Office officials and
officials at 2 of the 10 submission processing centers-Atlanta and
Cincinnati-to obtain their opinions about any factors that limited the
impact of electronic filing on the amount of resources devoted to processing
returns from fiscal years 1997 through 2000. We reviewed IRS documents and
GAO reports that contained information related to these factors. We analyzed
a report prepared for IRS by the consulting firm of Booz-Allen & Hamilton
about future prospects for cost reductions in submission processing and
obtained IRS officials' opinions on that subject. We performed our work
between January and October 2001 in accordance with generally accepted
government auditing standards. We discuss our scope and methodology in
greater detail in appendix I.

Several factors limited the impact of electronic filing on the resources
devoted to processing returns from fiscal years 1997 through 2000.4 These
factors fell into two broad categories-filing trends that partially offset
the potential savings from increases in electronic filing and expanded
demands on paper processing staff.

3IRS reorganized in fiscal year 2001. In doing so, the activities included
in major budget categories also changed. As a result, comparisons cannot be
made between IRS' budget for submission processing for fiscal years
1997-2000 and fiscal years 2001-2002 because the activities included in the
budget for submission processing in fiscal years 2001 and 2002 are different
than those included in prior fiscal years.

4Throughout the remainder of the report, we refer to these timeframes as
years 1997 through 2000.

Potential Savings From Increase in Electronic Filing Partially Offset by
Other Filing Trends

Even though the number of electronic returns filed from 1997 though 2000
increased, the potential savings from that increase were partially offset by
the following filing trends:

* The increase in electronically filed returns was partially offset by an
increase in total returns filed.

* The number of the most complex individual income tax returns filed on
paper-standard Form 1040s-essentially stayed the same.

* The number of paper individual income tax returns received by IRS during
the peak filing period stayed relatively the same from 1997 through 2000,
and peak processing needs drive the resources needed to process individual
paper returns.

Increase in Electronically Filed Returns Partially Offset by Increase in
Total Returns Filed

About 17.9 million more individual and business tax returns were filed
electronically in 2000 than in 1997. However, as shown in table 1, because
of an overall increase in the total number of returns filed from 1997
through 2000, the net decline in paper returns over that period was much
less than the 17.9 million net increase in electronic filings. Thus, the
increase in electronic returns had less of an impact on processing costs
than might have been expected because any savings from that increase would
be partially offset by the costs to process the overall increase in returns
filed.

    Table 1: Individual and Business Returns Filed From 1997 Through 2000
                            Numbers in thousands

    Fiscal        Type of      Total     Percent          Total    Percent        Total
     year          return      paper      paper     electronic    electronic    returns
     1997        Individual   152,657                 19,136                    171,793
                  Business     41,808                     3,785                  45,593
     Total                    194,465     89.5        22,921         10.5       217,386
     1998        Individual   151,273                 24,620                    175,893
                  Business     40,125                     4,808                  44,933
     Total                    191,398     86.7        29,428         13.3       220,826
     1999        Individual   148,216                 29,387                    177,603
                  Business     41,815                     4,986                  46,801
     Total                    190,031     84.7        34,373         15.3       224,404
     2000        Individual   145,140                 35,500                    180,640
                  Business     42,293                     5,358                  47,651
     Total                    187,433     82.1        40,858         17.9       228,291
  Change from
   1997-2000                   -7,032                 17,937                     10,905

Source: Generated by GAO based on data from IRS' Office of Research.

Number of Most Complex Paper Returns Essentially Stayed the Same

From 1997 through 2000, the number of complex individual returns filed on
paper essentially remained the same. The complexity of a return varies
according to the form on which it is filed. Complexity is determined by the
number of lines of data that need to be entered on a form. According to IRS
submission processing officials, the standard Form 1040 is the most complex.
Complexity then decreases from the Form 1040 to the Form 1040A, and finally
to the Form 1040EZ. The more complex a return, the longer it takes to
process and the greater the processing costs. For example, according to data
developed for IRS by a consulting firm for fiscal year 1999, the average
direct labor cost to process a Form 1040 filed on paper was $1.93 compared
to $1.50 to process a paper 1040A and $1.01 to process a paper 1040EZ.5

As shown in table 2, the number of Form 1040s filed on paper only decreased
by about 1 percent from 1997 through 2000, with the only decrease occurring
between 1999 and 2000. The reductions in paper 1040As and 1040EZs were much
larger during the years covered by our study-15 and 23 percent,
respectively.

Table 2:  Numbers of Form 1040,  1040A, and 1040EZ Filed  on Paper From 1997
Through 2000

           Numbers in thousands Form FY1997 FY1998 FY1999 FY2000

                                     Percentage reduction 1997 through 2000

1040 59,356 59,567 59,939 58,894

1040A 17,319 16,331 15,572 14,738

1040EZ 14,449 12,742 11,826 11,158

Note: The time period covered by the IRS study was generally the beginning
of January through the end of August.

Source: Generated by GAO based on IRS' Taxpayer Usage Study.

Any reductions in processing costs that IRS may have been able to realize as
more taxpayers filed electronically depended, in great part, on the cost of
processing those same returns filed on paper. IRS would have been able to
reduce costs more if a greater number of taxpayers who were filing the more
complex (and thus more costly to process) returns on paper had started
filing electronically.

5Booz-Allen & Hamilton, Mar. 2000. These figures include fringe benefits.

Volume of Returns Received During Peak Filing Period Drives Resource Needs;
Peak Volume Stayed About the Same From 1997 Through 2000

Another filing trend that limited the impact of electronic filing on
processing costs was the increase in the number of paper returns filed by
individuals during the peak filing period-the 2 weeks of the year when the
most individual income tax returns are filed. The peak filing period for
paper returns filed by individuals is mid-April. Business returns do not
experience the same peak phenomenon. Businesses have various fiscal years,
which affect their filing period. In addition, many business returns must be
filed quarterly.

As shown in table 3, while the overall number of individual returns filed on
paper decreased from 1997 through 2000, the number of paper returns6 filed
during the peak period stayed relatively the same.7

Table 3:  Individual Paper Returns Filed During  the Peak Filing Period From
1997 Through 2000

                         Numbers in thousands Year

Total individual returns filed

Total paper returns

Total paper returns filed during peak period

Source: Generated
by GAO based on
data from IRS'
Office of
Research.

The number of paper individual returns received during the peak filing
period drives the amount of resources needed to process individual paper
returns. According to the Director of Submission Processing, when Submission
Processing determines its resource needs, the first priority is the
resources (including staff, equipment, and space) needed during the peak
period. The Director added that, all things considered, if the number of
individual paper returns received during the peak period increases while the
total number of paper returns received during the entire year decreases, the
increase during the peak period would have more of an impact on submission
processing resources than would the overall decrease in paper receipts.

6 The number  of individual returns  differs from  those in table  1 because
table 3  does not include forms such  as 1040SS (Self-Employment Tax Return)
and 1040NR (Nonresident Alien Income Tax Return).

7 The  number of  individual  paper  returns filed  during  the peak  period
increased to over 33.6 million returns during the 2001 peak period.

IRS' goal of improving business results also directly affects the resources
needed during the peak filing period. To help achieve this goal, in 2000, 85
percent of refund checks for paper returns were to be processed within 40
days. Doing so also contributes to IRS' goal of improving taxpayer
satisfaction. Thus, to meet these goals, IRS has to ensure that there are
enough resources to process the increased number of peak period returns
within this time frame.

Demands Placed on Paper Processing Staff Were Expanded

Paper Processing Staff's Workload Increased

Another factor that limited the impact of electronic filing on the resources
devoted to paper processing was the increase in demands placed on paper
processing staff from 1997 through 2000. These increased demands included
the following:

* Numerous processing changes increased the workload for units responsible
for (a) reviewing returns for completeness and coding them for data entry,
(b) transcribing data, and (c) correcting errors.

* Because most electronic filers submitted a paper signature document, the
work done by paper processing staff was not totally eliminated when
taxpayers filed electronically and the volume of that work increased as
electronic filing increased.

* Front-line employees spent increasing amounts of time on activities,
including training, not specifically related to processing returns.

Numerous changes were made in the processing of returns from 1997 through
2000, which according to IRS officials, resulted in an increased workload.
For paper processing staff, these changes generally increased the

* amount of time spent reviewing returns and coding them for data entry,

* number of keystrokes entered, and

* number of IRS and taxpayer errors to be corrected.

Table 4 illustrates the estimated effects of some of these changes according
to IRS' data.

    Table 4: Estimated Effects of Certain Processing Changes on Workload
                    Estimated number of returns affected

       Increase in seconds needed to review and code each return Increase in
    keystrokes per return Increase in number of returns with IRS or taxpayer
                                                   errors needing correction

                               Type of change

Validate secondary Social Security numbersa

                         41,600,000 1 10 3,100,000

Validate eligibility for child care credit

                                                      5,300,000    4   25       400,000
         Transcribe student loan interest             5,000,000    1    4       100,000
                       data
           Transcribe data on education               4,000,000    2    4       200,000
                     credits

Note: Changes made from 1997 through 2000.

aIn the case of a joint tax return, the person whose name appears first on
the return is considered the primary taxpayer. The other person is
considered the secondary taxpayer.

Source: IRS data.

Some processing changes, such as the validation of secondary Social Security
numbers, were made to help ensure compliance with the tax law. Other changes
stemmed from changes in the tax law that established new credits and
deductions for which IRS had to enter data into its computer system.

Although the numbers of additional seconds and keystrokes cited in table 4
for any one change are small, the overall effect of these processing
changes, considering the number of returns involved, is to increase the
number of staff years needed to process returns. For example, the additional
second needed to review and code 41.6 million returns for secondary Social
Security number validation equates to about 11,556 hours or (on the basis of
2,088 hours per staff year) 5.5 staff years. Similarly, a total of about
584.5 million additional keystrokes would have had to be made to process the
four changes in table 4, which, we roughly estimated using IRS data on
average keystrokes per hour,8 would consume at least 78,000 additional hours
or 37.4 staff years at a cost of almost $1.4 million.9 Although these
changes in workload may not be of great

8IRS data on keystrokes per hour varies by the type of 1040 form being
processed and by year. We developed our estimate using the average
keystrokes per hour for the type of form that took the least amount of time
to process in 2000.

9Based on IRS' estimate of $36,300 per staff year in fiscal year 2002.

magnitude, they required additional resources that offset some of the
potential savings from electronic filing.

The workload of error correction staff can also be affected by changes in
the accuracy of work done by other processing staff. In that regard, the
accuracy of staff who reviewed and coded tax returns for transcription
increased from 95 percent in 1997 to 96.6 percent in 2000, while the
accuracy of data transcribers decreased from 94.7 percent to 93.9 percent.
We do not know how much, if at all, the volume of error correction work
actually changed as a net result of these increases and decreases in
accuracy.

The increase in responsibilities can also affect the staff's productivity.
Using IRS information on average keystrokes per hour for various tax forms
as a measure of data transcribers' productivity, table 5 shows that there
was a general decline in productivity in 1999, which is when transcribers
began using a new computer system, and a general improvement in productivity
in 2000.10 For example, IRS data for Other-Than-Full-Paid Form 1040s showed
that the average keystrokes per hour went from 7,503 in 1997 to 7,250 in
1998 and 6,802 in 1999 before rising to 7,108 in 2000.11

 Table 5: Differences in Data Transcribers' Productivity (average keystrokes
                         per hour) Number of forms

 Number of forms by                          1998 compared  1999 compared  2000 compared
        type               Differences           with 1997      with 1998      with 1999
 a24 business forms  Productivity decreased              8             17
                     Productivity increased             16              7
13 individual forms  Productivity decreased              5             13
                     Productivity increased              8              0

aWhen developing these data, in some cases IRS developed average keystrokes
per hour for specific business forms and in other cases, combined two or
more business forms. When forms were combined, they were counted as one form
in this table.

Source: GAO's analysis of IRS data.

10We did not have data that could be used to measure changes in the
productivity of staff who reviewed and coded returns for transcription.

11Other-Than-Full-Paid returns are returns that involve either a refund or
an unpaid liability and account for the majority of Form1040s processed.

Work Done by Paper Processing Staff Not Totally Eliminated by Electronic
Filing

Increased Time Spent by Front-Line Employees on Nonprocessing Activities

Submission Processing officials said that many factors affected accuracy and
productivity and that it would be difficult to determine specifically what
caused them to decrease. However, they believed that the learning curve
associated with using a new computer system in 1999 was probably the major
contributing factor to the decrease in data transcribers' productivity. They
added that there has been high turnover in the Submission Processing Centers
for the past few years due to the availability of higher paying jobs
elsewhere within IRS or in the private sector. As a result, they have less
experienced staff, which may have contributed to lower accuracy and
productivity rates.

During the years covered by our study, electronic filing was not entirely
paperless. Most electronic filers continued to submit a paper signature
document, even though in 1999, IRS began testing electronic options to
replace the document. Thus, any savings IRS realized when taxpayers switched
to electronic filing were partially offset by the costs incurred in
processing the increase in the volume of paper signature documents that
resulted from the increase in electronic filing.

Before 1999, individual taxpayers who filed electronically had to submit a
paper signature document that was processed by the staff who processed paper
returns. Beginning in 1999, IRS provided two options that could be used in
place of submitting a paper signature document.12 In 2000, about 6.8 million
(or about 19 percent) of the 35.4 million taxpayers who filed their
individual income tax returns electronically used one of those options.
However, that meant that IRS still had to process about 28.6 million paper
signature documents. According to a March 2000 study prepared for IRS by a
consulting firm, it cost IRS $0.26 in direct labor costs to process each
paper signature document in 1999. Assuming that same rate in 2000, it would
have cost IRS about $7.4 million in labor costs to process the 28.6 million
signature documents.

Front-line paper processing employees spent greater amounts of their time on
activities not specifically related to processing returns in fiscal year
2000 than they did in 1997. The Submission Processing Director and the
Processing Division Branch Chiefs at the Atlanta and Cincinnati

12These options allowed a taxpayer to use electronic signatures in the form
of a personal identification number or to file on-line using an E-file
Customer Number. IRS tested these options in 1999 and expanded both in 2000.
In 2001, IRS discontinued the use of the E-file Customer Number. Instead,
almost all electronic filers were eligible to sign their returns using a
self-selected personal identification number.

Submission Processing Centers said that personnel were spending more time
(1) in required training not related to processing returns and (2) on
required activities related to the Employee Satisfaction Survey.13 Some of
the required training, such as training about the circumstances under which
IRS employees can be charged with misconduct and terminated, was provided in
order to apprise staff of new statutory requirements. IRS plans to use
results from the Employee Satisfaction Survey to improve operations.
According to the Branch Chiefs, these activities, while important, reduced
the amount of time that employees were able to devote to processing returns.

According to data in IRS' Work, Planning, and Control System, the amount of
time paper processing staff spent on all training, including training
related to processing returns, and on actions related to the Employee
Satisfaction Survey increased from fiscal years 1997 through 2000. The
percentage of time spent on these activities grew from 7.8 percent to 9.9
percent. Because IRS records did not separately identify all training
related to processing and nonprocessing activities, it was not possible to
determine the change in the amount of time spent in nonprocessingï¿½related
training. Data in the Work, Planning, and Control System also showed that
the number of hours submission processing staff spent on activities related
to the Employee Satisfaction Survey increased from about 12,000 in fiscal
year 1997 to almost 96,000 in fiscal year 2000.

According to the Submission Processing Director, finding the time to spend
on nonprocessing related training and the Employee Satisfaction Survey, both
of which were required, was more difficult for Submission Processing than
other units in IRS. This was because some units could absorb these
activities by doing less direct work, such as opening fewer collection
cases. Submission Processing, on the other hand, could not process fewer
returns, so any additional required activities meant working more overtime,
keeping seasonal employees longer, or hiring more employees than originally
planned, resulting in an increase in costs. The Director added that the
Employee Satisfaction Survey was completed during the peak filing period to
help ensure that IRS obtained the views of seasonal staff.

13The training courses unrelated to processing returns covered a variety of
issues, such as preventing sexual harassment, the circumstances under which
IRS employees can be charged with misconduct and terminated, ethics, and
security awareness. Activities related to the Employee Satisfaction Survey
included not only participating in the survey but also discussing the
results and ideas for improvements.

Future Cost Reductions Hinge on Increases in Electronic Filing and Changes
in Processing Operations

According to a report prepared for IRS by a national consulting firm, future
reductions in processing costs are possible, with the amount of any
reduction dependent on the nature and extent of future increases in the
number of returns filed electronically and changes in submission
processing's operations. Whether these reductions are realized will depend
not only on the actual number of returns filed electronically and the extent
to which different operational changes are implemented, but also on the
extent of any changes in the workload of paper processing staff due to tax
law changes or increased IRS compliance efforts.

Consulting Firm's Estimates of Potential Processing Cost Reductions

In a March 2000 report prepared for IRS, the national consulting firm of
Booz-Allen & Hamilton analyzed how various scenarios might affect IRS'
processing costs starting in 2007. The firm developed eight scenarios that
involved a growth in volume of returns and a growth in electronic filing of
individual, business, and other types of forms, as well as several
operational changes, such as making additional business forms available for
electronic filing and consolidating submission processing centers.14 The
firm also developed four cost-reduction estimates for each scenario based on
differing percentages of electronic filing for individual, business, and
other returns.15 Those cost-reduction estimates ranged from $27 million to
$243 million. Figure 2 shows that the firm's estimates when using the
highest electronic filing projections-80 percent for individual returns, 45
percent for business returns, and 30 percent for other returns-ranged from
$104 million to $243 million.16

14The  firm also developed four  scenarios that did not  include a growth in
volume and a  growth in electronic filing of individual, business, and other
types of forms.

15 The  electronic filing  percentages  used were  40,  50, 65,  and 80  for
individual returns; 17,  25, 35, and 45 for business returns; and 5, 10, 20,
and 30 for other returns.

16The  cost reductions are based on a $644  million baseline for fiscal year
1999.

Figure  2:  Reductions  in  Processing  Costs  Based  on  Various  Scenarios
Involving   Increases  in   Electronic  Filing  and  Changes  in  Processing
Operations

aBased on IRS' estimates.
b80 percent of individual returns filed electronically.
c45 percent of business returns filed electronically.
d30 percent of supplemental and information returns filed electronically.
eEliminate paper signature document.
fAdditional business forms available electronically.
gConsolidate the number of submission processing centers.
hEliminate scanning and filing by telephone.
iFiscal year 1999 expenditures used to develop baseline.

Certain Factors Could The consultant's report focused on reductions that
could be realized by Alter the Consultant's making specific changes related
to processing returns and not on potential Projections increases in the type
and amount of data on paper returns that IRS would

need to process due to tax law changes or enhanced compliance efforts.19

Source: IRS Cost of Processing Electronic Tax Returns (Booz-Allen &
Hamilton, Mar. 2000) and GAO's computations.

The estimates in figure 2 assume that IRS will meet its goal of having 80
percent of all individual income tax returns filed electronically by 2007.
However, our assessment of IRS' 2001 tax filing season in response to
another request from this Subcommittee showed that (1) about 31 percent of
individual income tax returns were filed electronically in 2001 (through
October 26, 2001) and (2) fewer individuals filed electronically in 2001
than IRS had projected (40 million filed vs. 42 million projected).17 With
2001 as a starting point and assuming that the total number of individual
income tax returns filed and the number of such returns filed electronically
each continue to grow at the same annual rate as achieved between 2000 and
2001 (1.85 percent and 13.7 percent, respectively), we projected that only
about 60 percent of individual income tax returns would be filed
electronically in 2007.18 Using the estimates in the consultant's March 2000
report for a 65-percent level of individual electronic filing, the cost
reductions would range from $74 million to $170 million annually in 2007, or
about 30 percent less than at the 80-percent electronic filing level for
individuals.

Consequently, any reductions in overall processing costs would depend on the
level of any such increases.

In that regard, IRS made at least one significant change in submission
processing's workload in 2001 that increased costs. IRS' 2001 budget
included 378 additional full-time equivalent staff years in submission
processing for transcribing Schedule K-1s (Beneficiary's, Partner's, or
Shareholder's Share of Income, Deductions, Credits, etc.). IRS plans to
compare the transcribed K-1 information to that reported on the tax

17Tax Administration: Assessment of IRS' 2001 Tax Filing Season (GAO-02-144,
Dec. 21, 2001).

18We did not do the work necessary to make similar projections for business
returns and other returns.

19Examples of changes included increasing the number of business forms
available that could be filed electronically and consolidating submission
processing centers.

Agency Comments
and Our Evaluation

returns filed by beneficiaries, partners, and shareholders to determine if
income was accurately reported.

The Director of Submission Processing told us that the cost reductions in
the consultant's study may also be overstated because the study did not
consider the resources needed to process returns during the peak filing
period. The consulting firm official responsible for developing the data in
the study said that the maximum cost reductions included in the study would
not be affected by peak filing period resource needs, because the reductions
were based on the assumption that 80 percent of individual taxpayers would
file electronically. To achieve that level of electronic filing, the number
of returns filed on paper would have to decrease significantly from the
fiscal year 2000 levels previously described in this report. Once this
happens, fewer resources would be needed to process paper returns during the
peak filing period. The official added that at some lower percentage of
electronic filing, peak period filing needs would affect possible cost
reductions, but he did not know what that level would be.

The Commissioner of Internal Revenue provided written comments on a draft of
this report in a December 17, 2001, letter which is reprinted in appendix
II. The Commissioner said that our report provided useful explanations for
the continued increase in submission processing costs, despite the increase
in the number of electronically filed returns. At his suggestion, we revised
the report to clarify the objective of the March 2000 consultant's study.

The Commissioner also suggested that we revise the report to acknowledge the
steps IRS has taken to reduce the processing costs associated with
electronic filing, specifically with respect to the paper signature
document. Our report recognizes the steps IRS has taken to enable electronic
filers to sign their returns electronically. However, most electronic
returns were still filed with paper signature documents. Of the about 40
million returns filed electronically in 2001, about 9 million were filed
using an electronic signature. The other about 31 million returns were filed
using a paper signature document-an increase of about

2.4 million returns compared to 2000. Using the direct labor cost included
in the March 2000 consultant's study for processing paper signature
documents--$0.26 per document-it cost IRS about $624,000 more in 2001 than
in 2000 to process these documents.

As agreed with your office, unless you publicly announce its contents
earlier, we plan no further distribution of this report until 30 days from
the date of this report. At that time, we will send copies of this report to
the Chairmen and Ranking Minority Members of the Senate Committee on Finance
and the House Committee on Ways and Means and to the Ranking Minority Member
of this Subcommittee. We are also sending copies to the Secretary of the
Treasury; the Commissioner of Internal Revenue; the Director, Office of
Management and Budget; and other interested parties. We will also make
copies available to others on request.

This report was prepared under the direction of David J. Attianese,
Assistant Director. If you have any questions about this report, please
contact me or Mr. Attianese on (202) 512-9110. Key contributors to this
report were Julie Schneiberg, Margaret Skiba, and Shellee Soliday.

Sincerely yours,

Michael Brostek Director, Tax Issues

Appendix I: Objectives, Scope, and Methodology

Our first objective was to determine what factors, if any, limited the
impact of electronic filing on the resources devoted to processing paper
returns. To address this objective, we interviewed several Internal Revenue
Service (IRS) officials responsible for submission processing and electronic
tax administration. We also visited 2 of IRS' 10 submission processing
centers, including 1 that had an electronic filing unit- Cincinnati-and 1
that did not have an electronic filing unit-Atlanta. At both centers, we
interviewed the Center Directors and several Processing and Post Processing
Division officials. These divisions have primary responsibility for
processing returns. At Cincinnati, we also interviewed the Lead Tax Examiner
in the Electronic Filing Unit to obtain details about the Unit's role in
electronic return processing.

We selected Cincinnati from among the five centers that had an electronic
filing unit because Submission Processing's Monitoring Section was located
there and officials would be able to provide information related to
processing both paper and electronic returns.1 We selected Atlanta from
among the five centers that did not have an electronic filing unit because
it was convenient to our audit staff. Because these two centers were
judgmentally selected, our results cannot be projected to all 10 centers.
However, the Director of Submission Processing said that the opinions
provided by officials at these two centers would be representative of the
opinions that would be provided by officials at the other eight centers.

To further address the first objective, we analyzed several studies prepared
either by or for IRS, including a consulting firm's study of the costs to
process electronic returns.2 We analyzed available IRS statistics related to
several topics, including training, filings by type of return, the number of
keystrokes associated with new data to be entered into the computer by data
transcribers, and average keystrokes per hour. We also reviewed our past
reports to obtain information about the accuracy of work done by paper
processing staff.

1The Monitoring Section is responsible for determining if programs are being
executed according to plan. For example, they compare planned work to actual
work to determine if changes need to be made in work schedules. Before IRS'
reorganization, which became effective in October 2000, this section also
was responsible for determining if changes were needed in the budgets for
submission processing centers.

2Booz-Allen & Hamilton, Mar. 2000.

Appendix I: Objectives, Scope, and Methodology

Our work on the first objective focused on fiscal years 1997 through 2000.
We selected this 4-year period because (1) at the time we began our review,
fiscal year 2000 was the last complete year for which data were available
and (2) we wanted data for enough years before 2000 to be able to analyze
trends. We decided that a total of 4 years would provide sufficient trend
data. We included fiscal year 2001 data about the peak filing period and the
number of individual returns filed electronically because it was readily
available.

Our second objective was to determine the prospects for future reductions in
submission processing costs. We interviewed the Director of Submission
Processing, reviewed the previously referred to report on costs to process
electronic returns, and interviewed the consulting firm official who had
responsibility for developing the data in the report. This report presented
eight scenarios involving a growth in the volume of returns filed and a
growth in electronic filing and included estimates of the cost reductions
that IRS would realize under each scenario. The scenarios included different
combinations of several variables, including increases in electronic filing
by individual or business taxpayers, elimination of the paper signature
document, and increases in the number of business forms that can be filed
electronically. We also reviewed information that IRS provided to the House
Appropriations Committee in June 2001 on the number of additional full-time
equivalent staff years IRS would need to process returns if all returns were
filed on paper.

We performed our work between January and October 2001 in accordance with
generally accepted government auditing standards. We obtained written
comments from the Commissioner of Internal Revenue on a draft of this
report. The comments are discussed near the end of this report and are
reprinted in appendix II.

Appendix II: Comments From the Internal Revenue Service

Appendix II: Comments From the Internal Revenue Service

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