IRS Guidance on Economic Analyses in Investment Business Cases	 
(09-MAY-02, GAO-02-234R).					 
                                                                 
Because the Internal Revenue Service (IRS) plans to spend $2.9	 
billion to modernize its information systems, GAO reviewed the	 
latest draft of the Investment Decision Management Business Case 
Procedure. The procedure provides guidance for the Integrated	 
Project Teams to justify information technology (IT) investments.
This letter presents GAO's observations on the guidance where	 
modifications or additions would ensure that the economic	 
analyses in IRS business cases are consistent with commonly	 
accepted principles. IRS' draft guidance on business case	 
documentation represents an important step toward ensuring that  
IRS management has relevant information on which to base its	 
critical IT investment decisions. However, some aspects of IRS'  
guidance are inconsistent with commonly held principles of public
sector cost-benefit analysis. Most important, the guidance does  
not require the computation of a comprehensive social net present
value (NPV)--the standard for deciding whether a government	 
investment can be justified on economic grounds. The two partial 
NPV computations that IRS' guidance requires are inappropriate	 
because they do not incorporate the proper values for all	 
relevant benefits and costs for investment projects with	 
significant effects outside of IRS. In addition, IRS' two NPV's  
are not additive, so even if all benefits and costs were properly
valued, decision makers would be unable to determine the overall 
net value of an investment.					 
-------------------------Indexing Terms------------------------- 
REPORTNUM:   GAO-02-234R					        
    ACCNO:   A03300						        
  TITLE:     IRS Guidance on Economic Analyses in Investment Business 
Cases								 
     DATE:   05/09/2002 
  SUBJECT:   Economic analysis					 
	     Information technology				 
	     Investments					 
	     Information systems				 
	     Internal controls					 
	     IRS Enterprise Life Cycle				 


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GAO-02-234R
     
GAO- 02- 234R IRS Guidance on Economic Analyses United States General
Accounting Office

Washington, DC 20548

May 9, 2002 The Honorable Charles O. Rossotti Commissioner of Internal
Revenue

Subject: IRS Guidance on Economic Analyses in Investment Business Cases

Dear Mr. Rossotti: Because IRS plans to spend $2.9 billion over the next 6
years to modernize its information systems, we have reviewed, at our own
initiative, the latest draft of the

Investment Decision Management Business Case Procedure. That document
contains guidance for the Integrated Project Teams that prepare business
cases to justify information technology (IT) investments. This letter
presents our observations on certain aspects of the guidance where
modifications or additions would help to ensure that the economic analyses
contained in IRS business cases are consistent with commonly accepted
principles.

The observations in this letter are based on our review of the draft
business case procedure, as it stood on November 1, 2001; relevant guidance
issued by the Office of Management and Budget (OMB); relevant economic
literature, and discussions with IRS officials from the Office of Economic
Analysis under the Chief Financial Officer and from the Office of Financial
Policy, Planning, and Programs under the Chief Information Officer. Our
review was limited to the sections of the guidance that pertain to
fundamental economic analysis. Some of our observations have particular
significance for IRS, given its specific mission; the significance of these
observations for other government agencies will depend on their specific
missions. We did not evaluate individual business cases prepared under this
guidance; therefore, we draw no conclusions with respect to any actual
investment decisions. We did our work from December 2000 through November
2001 in accordance with generally accepted government auditing standards.

Results in Brief

IRS? draft guidance relating to the preparation of business case documents
represents an important step toward ensuring that IRS management has the
most relevant available information on which to base its critical IT
investment decisions. However, some aspects of IRS? guidance are
inconsistent with commonly held principles of public sector cost- benefit
analysis. Most important, the guidance does not require the computation of a
comprehensive social net present value (NPV), which is the

GAO- 02- 234R IRS Guidance on Economic Analyses

2 standard criterion for deciding whether a government investment can be
justified on

economic grounds. The two partial NPV computations that IRS? guidance
requires are inappropriate for evaluating investment projects that have
significant effects outside of IRS because they do not incorporate the
proper values for all relevant benefits and costs. In addition, IRS? two
NPVs are not directly additive, so even if all benefits and costs were
properly valued, decisionmakers would not be able to determine the overall
net value of an investment without going through alternative computations.
We make recommendations in this letter to address the problems that we
identify.

In your written comments on a draft of this correspondence you said that our
findings were valuable for improving IRS business case methodology. You also
said that you will fully consider our recommendations as you update your
guidance in the coming months. A copy of your comment memo is reprinted in
enclosure I.

Background

The purposes of IRS business cases IRS? IT modernization effort is broad in
scope, complex, and high risk. IRS uses a system called the Enterprise Life
Cycle (ELC) to plan and manage its modernization program. The ELC
establishes a set of repeatable processes and a system of reviews,
checkpoints, and milestones that are intended to reduce the risks of system
development. Under the ELC, business cases must be prepared and updated at
several stages during the development and implementation of each investment
project.

A business case is a document that summarizes numerous technical and
business work products, analyses, and studies that provide the basis for
making investment funding decisions and for monitoring and evaluating
project performance. During the earliest planning phase for a project
related to IRS? IT modernization program, the project team prepares a ?case
for action,? which includes a high- level summary of the costs, benefits,
and risks associated with alternative potential solutions to an identified
problem. The Core Business Systems Executive Steering Committee, consisting
of senior IRS managers and representatives from the Department of Treasury,
the National Treasury Employees Union, and key contractors, reviews this
document before approving funding for work on preliminary project design. 1
During the design stage, the project team prepares a preliminary business
case to justify its recommendation for a specific solution to the problem.
If the Committee approves funding for the next stage, the project team
completes the design for the project and prepares a baseline business case
to justify the development, testing, and piloting of that specific design.
The business case is updated after the pilot is complete and if the project
is approved for deployment. For projects with multiple releases, the
business case is updated periodically thereafter.

1 The contractors? representatives are nonvoting members of the committee.

GAO- 02- 234R IRS Guidance on Economic Analyses

3 Commonly accepted principles for evaluating government investments

OMB guidance states that ?[ t] he standard criterion for deciding whether a
government program can be justified on economic principles is net present
value- the discounted monetized value of expected net benefits (i. e.,
benefits minus costs).? 2 OMB?s guidance further states that ?[ s] ocial net
benefits and not the benefits and costs to the federal government, should be
the basis for evaluating government programs or policies that have effects
on private citizens or other levels of government.? 3 This criterion for
assessing government investments is based on commonly held principles of
public finance economics. 4

It is also commonly accepted that ?transfer payments? should not be included
at face value in the social NPV. 5 Some project effects, such as resource
savings, are net gains to society and their full monetary value should be
included in the NPV computation. Other project effects, such as changes in
tax revenues and interest payments, merely transfer resources among
individual members of society. These transfer payments neither use up real
resources nor increase the resources available to society. The transfers may
achieve other outcomes that are important to society, such as equity.
However, the social values of these outcomes are difficult to determine and
are not necessarily equal to the dollar amounts being transferred. For
example, a project that results in increased tax compliance will transfer
resources from previously noncompliant taxpayers to the government for the
benefit of the general public. The very existence of IRS indicates that
society places a positive value on the aggregate transfer of resources
through the tax system, but the value of each transfer is not necessarily
equal to the number of additional tax dollars collected. Other types of
transfers may have negative social values.

In some cases, even when it is clear how to value a benefit or cost
conceptually, the actual quantification of the benefit or cost may not be
feasible, or the cost of quantification may be prohibitive. For example, in
the case of a hypothetical IRS technology investment that reduces compliance
costs for businesses, the social value of each dollar saved by businesses is
equal to one dollar. However, it may be impossible to get a reliable
estimate of how many dollars businesses save as a result

2 OMB Circular A- 94 Revised (Washington, DC: OMB, October 29, 1992),
section 5. The costs and benefits associated with investment projects are
typically spread over many years. Discounting (the computation of present
values) is necessary to reflect the fact that a dollar of benefit or cost
arising in a future year is worth less than a dollar of benefit or cost in
the current year. 3 OMB Circular A- 94 Revised, section 6. A similar
statement is repeated in OMB Circular A- 130,

Management of Federal Information Resources, November 30, 2000, section 7. 4
See, for example, discussions in Federal Budget: Choosing Between Public
Investment Programs

(GAO/ AIMD- 93- 25, July 23, 1993); Peter G. Sassone and William A.
Schaffer, Cost- Benefit Analysis: A Handbook (New York: Academic Press,
1978); John F. Due and Ann F. Friedlaender, Government Finance: Economics of
the Public Sector, 7th ed. (Homewood, IL: Richard D. Irwin, 1981); Robert
Dorfman, "Introduction," in Measuring Benefits of Government Investments,
edited by Robert Dorfman (Washington, DC: Brookings Institution, 1965). 5
See, for example, OMB Circular A- 94 Revised, section 6; GAO/ AIMD- 93- 25;
and E. J. Mishan, CostBenefit

Analysis, 3 rd ed. (Boston: George Allen & Unwin, 1982).

GAO- 02- 234R IRS Guidance on Economic Analyses

4 of the new technology. 6 When benefits or costs, including those
associated with

transfers, cannot be valued and/ or quantified, analysts are limited to
providing the best available descriptive information about those benefits or
costs, as a supplement to the data summarized in the NPV. (For simplicity in
the discussion that follows, we will say that a benefit or cost is
?measured? only if it has been quantified and the social value of that
quantity has been determined).

It is not necessary to compute a comprehensive NPV for all investment
decisions. Cost- effectiveness analyses may be used when the benefits from
competing investment alternatives are the same or when a policy decision to
achieve the objectives of an investment project has already been made. 7 In
those cases, analysts are simply required to compare the discounted net
costs of alternative approaches for meeting the target objectives.

Some Aspects of IRS? Guidance are Inconsistent with Commonly Accepted
Principles of Public Sector Cost- Benefit Analysis

IRS? business case guidance requires the computation of two partial NPVs,
rather than one comprehensive NPV. These measures are inadequate for
evaluating investment projects that have significant impacts outside of IRS
because they do not incorporate the proper values for all relevant benefits
and costs. In addition, because they cannot be added together to give a
single measure of benefits and costs, they do not provide a clear basis for
making decisions. IRS? guidance does not require a supplementary analysis
that OMB recommends for certain investments. In addition, IRS? approach to
computing cost savings and cost avoidance benefits contains an
inconsistency.

IRS? guidance requires the computation of two partial NPVs rather than a
comprehensive social NPV

IRS? draft guidance for the preparation of business cases requires the
computation of

?on- budget? and ?off- budget? net present values (NPVs) for each investment
being considered. The two NPVs are defined as follows:

On- budget NPV equals the discounted value of the stream of on- budget
benefits generated over the life of the project , minus the discounted value
of the project?s investment costs.

Off- budget NPV equals the discounted value of the stream of off- budget
benefits generated over the life of the project, minus the discounted value
of the project?s investment costs

6 This example contrasts with the aforementioned example of increased tax
collections, where the collections may be quantifiable but the social value
of the quantity collected is difficult to determine. 7 OMB Circular A- 94
Revised, section 5. As IRS? guidance notes, a cost- effectiveness analysis
is not

sufficient for comparing investment alternatives when each alternative
produces a mandated benefit, but also produces other benefits that are not
mandated.

GAO- 02- 234R IRS Guidance on Economic Analyses

5 On- budget benefits are project effects, such as staff savings, that have
positive effects

on IRS? budget. They do not include effects on other parts of the federal
budget. Offbudget benefits are those, such as reductions in compliance
burden, that accrue to individuals or entities outside of IRS. The guidance
does not indicate whether costs to individuals or entities outside of IRS
should be included in the NPV computations. 8

IRS? NPV measures exclude some benefits and costs that would be included in
a social NPV and improperly include transfer payments

IRS? guidance specifically excludes reductions in tax paperwork costs to
other federal agencies and state and local governments from their off-
budget NPV. 9 These cost savings would be treated as benefits in a social
NPV. IRS? reason for excluding these cost savings as benefits is that the
savings cannot be expressed in monetary terms. However, it is not evident
that these savings are any more difficult to measure than are savings in
taxpayer compliance costs, which IRS does count in its NPV.

Some of the project effects that IRS counts as off- budget benefits would
not be included in a social NPV because they are transfer payments.
Specifically, IRS? guidance includes increased or accelerated tax
collections resulting from investment projects as off- budget benefits.
These transfer payments are counted, dollar- fordollar (before discounting),
in the off- budget NPV computations. Revenues resulting from improved
enforcement technologies would not be valued this way in a social NPV,
unless evidence existed that society places a one- dollar value on each
dollar of revenue that the government collects from noncompliant taxpayers.
IRS has not presented evidence that supports such a valuation. 10

IRS? guidance does not explain how other broad categories of transfer
payments should be treated in the NPV computations. In fact, it makes no
distinction between transfer payments and resource savings or costs.
Although the guidance mentions reductions in Refund Anticipation Loan fees,
which are a special type of interest payment, as an example of a benefit to
include in the off- budget NPV, there is no mention of how to treat interest
payments in general. 11 Moreover, there is no discussion of whether the loss
of income by lenders should be counted as a cost in

8 IRS? guidance also requires the computation of on- budget and off- budget
returns on investments (ROI). These ROIs encompass exactly the same benefits
and costs as IRS? NPV; however, they are computed as the ratios of the
discounted benefits over the discounted costs, rather than the arithmetic
difference between the two. The shortcomings in IRS? NPVs that are
identified in this section also apply to IRS? ROIs. 9 The guidance does not
say whether cost savings to third- party reporting entities, such as
financial

institutions that send information returns to IRS and to taxpayers, which
would be included in a social NPV, are to be counted in IRS? off- budget
NPV. 10 As noted earlier, it is difficult to make such valuations. We have
found no estimates in the

economics literature or any OMB guidance on the social value of a dollar of
revenue collected through IRS enforcement efforts. 11 Tax preparers (in
conjunction with lending institutions) provide Refund Anticipation Loans to
clients

who wish to receive their tax refunds within a couple days of filing. The
borrowers, who almost always file their returns electronically, use their
anticipated refund from IRS as collateral.

GAO- 02- 234R IRS Guidance on Economic Analyses

6 the NPV. Similarly, the guidance does not say how to treat increases or
reductions in

penalty payments, which are also transfers. IRS? partial NPVs generally do
not provide a clear basis for making decisions Even if IRS? on- budget and
off- budget NPVs included all appropriate social benefits and costs between
them, the two measures would not provide a useful summary of the economic
value of projects that generate significant benefits or costs outside of
IRS. 12 The two measures cannot be added together because the complete
investment costs of a project are counted in both of the NPVs and such an
addition would result in the double counting of all of those costs. Thus,
decisionmakers are not able to determine the overall net value of an
investment without conducting an alternative set of computations.

The strength of the comprehensive social NPV is that all measurable benefits
and costs are summarized in a single measure that can be easily interpreted.
In the case of an investment where all significant benefits and costs can be
measured, the NPV shows the true economic value of that investment. Even in
cases where some benefits cannot be measured, the social NPV can be useful
in conjunction with the best descriptive information available on
nonmeasurable benefits and costs. For example, in cases where the measurable
social NPV is negative (i. e., measurable costs exceed measurable benefits)
and the investment is expected to produce nonmeasurable benefits (net of any
nonmeasurable costs), decisionmakers can make a judgment as to whether the
nonmeasurable benefits are worth the net measurable costs. 13

A separate, comprehensive discussion of nonmeasurable benefits and costs,
including those associated with transfers, would be useful to decisionmakers
when they have to weigh the net nonmeasurable benefits against net
measurable costs. OMB recommends a comprehensive enumeration of the
different types of benefits and costs generated by a project, whether they
can be measured or not. It also notes that quantitative information can be
helpful, even if it is not a measurement of social value. Quantities, such
as the expected increase in tax revenues, would at least give decisionmakers
a sense of the magnitude of the impact.

IRS? draft guidance introduces a calculation called equivalent annual net
budgetary (EANeB) cost to deal with cases where the on- budget NPV is
negative but significant nonmeasurable off- budget benefits exist. One
significant limitation of the EANeB approach prescribed by IRS is that
investment proposals are compared with only one alternative that achieves
the same objectives simply by adding resources to existing processes. IRS?
guidance states that any project can be justified as long as it is less

12 For projects that do not generate any benefits or costs outside of IRS,
the social NPV becomes equal to IRS? on- budget NPV. In those cases, the
latter measure is an acceptable criterion for making investment decisions.
13 IRS? ROI measure (see footnote 8) is not as useful as the NPV in this
situation because it does not

show how much the nonmeasurable benefits have to be worth in order to
justify the net measurable costs.

GAO- 02- 234R IRS Guidance on Economic Analyses

7 costly than that one alternative (labeled the ?enhanced reference case?).
This

statement is not necessarily true for two reasons. First, it is possible
that neither the proposed alternative nor the enhanced reference case will
be justified economically. Second, even in cases where a set of objectives
has been mandated (so that an economic case does not have to be made for
achieving the objective), there may be several feasible approaches that are
less costly than the enhanced reference case. In those cases, unless other
factors outweigh cost considerations, it is appropriate to select the least
costly approach, which cannot be determined simply by comparing only one
alternative to the enhanced reference case. The series of computations and
comparisons associated with the EANeB would not be necessary if business
cases used social NPVs in the manner described above.

IRS? guidance does not require a supplementary NPV computation that is
recommended in OMB guidance

When a public investment project does not pay for itself completely through
costsavings to the government, taxes are higher than they would have to be
in the absence of the project. For evaluations of such investments, OMB
recommends a supplementary analysis to account for the fact that taxes
generally impose an ?excess

burden? on society. 14 IRS? guidance does not require this supplementary
analysis. As a result, business cases for some projects could present
understated estimates of the true social costs of those projects.

OMB?s guidance reflects the commonly held position among economists that
taxes generally distort economic behavior and, thereby, impose efficiency
costs on society in excess of the revenues they raise. For example, a tax on
income from labor will cause some individuals to work fewer hours than they
would have preferred to work in the absence of the tax. Similarly, excise
taxes on specific goods lead to the production and consumption of a
different mix of goods than would have occurred in the absence of those
taxes. In general, these tax- induced deviations from the original
preferences of workers, consumers, and producers represent costs to society.
The conventional view among economists is that these additional costs to
society should be taken into account when evaluating the benefits and costs
of public projects.

The supplementary analysis that OMB recommends involves recomputing the NPV
by including additional costs equal to .25 times the amount of taxes
attributable to the investment. OMB says empirical studies suggest that 25
cents per dollar of revenue is a reasonable estimate of the excess burden of
taxes. 15 If specific information clearly

14 OMB Circular A- 94, section 11. OMB does not require this analysis in
cases where costeffectiveness analysis is used. 15 As more recent literature
indicates, disagreement exists over the magnitude of these costs. Feldstein

estimates that the excess burden of each additional dollar raised may exceed
one dollar (compared to the 25 cents that OMB uses. However, Ng contends
that Feldstein?s estimate may be too high because it ignores the fact that
tax distortions can also have social benefits. As an example, Ng notes that
most production and / or consumption results in environmental disruptions
and that these disruptions are reduced by taxes that reduce overall
production and consumption. He suggest that these beneficial effects of
taxes could offset most, if not all, of the excess burden. See Martin
Feldstein, ?How Big Should Government Be?? National Tax Journal, 50 No. 2
(June 1997) pp. 197- 213 and Yew- Kwang Ng,

GAO- 02- 234R IRS Guidance on Economic Analyses

8 suggests that the excess cost is lower (or higher) than 25 cents per
dollar, an

alternative figure may be used. OMB recommends that the recomputed NPV be
presented in addition to the standard NPV.

Depending on what information IRS? guidance already requires project teams
to compile, the supplementary analysis may require only minimal additional
cost to complete. The amount of additional taxes attributable to a specific
investment project equals the total public expenditures on the project,
minus any cost- savings generated by the project. IRS? guidance already
requires project teams to estimate the total discounted investment costs of
each project. If the guidance also requires teams to estimate discounted
recurring cost savings in an appropriate manner, then those teams could
simply subtract those savings from the discounted investment costs to
determine the amount of additional taxes attributable to the project. 16 The
teams could then complete the supplementary analysis by multiplying that
amount by .25 and subtracting the resulting product from their original NPV.
17 This adjusted NPV is likely to be more accurate than the unadjusted NPV
as a summary of the project?s measurable social benefits and costs.

IRS? approach to computing cost savings and cost avoidance benefits contains
an inconsistency

IRS? guidance defines two categories of benefits relating to cost
reductions- cost savings and cost avoidance. The cost savings and avoidance
benefits are computed relative to a reference level of costs. 18 If the
recurring costs for the investment alternative in question are less than the
recurring costs in the reference case, then the cost savings and avoidance
benefits are positive and they are added into IRS? onbudget NPV for that
alternative. These benefits are intended to reflect the fact that technology
investments may enable IRS to provide a specified level of service at lower
recurring costs than would be possible with the agency?s existing
technology. However, there is an inconsistency between how IRS? guidance
defines cost savings and cost avoidance benefits and how that guidance
instructs analysts to compute those benefits.

Cost savings are defined as ?a permanent reduction or elimination of actual
IRS costs due to efficiencies gained through the implementation of new
business capabilities.? Cost avoidance benefits are defined as ?a permanent
reduction or elimination of

?The Optimal Size of Public Spending and the Distortionary Cost of
Taxation,? National Tax Journal,

53 No. 2 (June 2000) pp. 253- 272. 16 As we discuss in the following
section, the current draft guidance is inconsistent regarding the

computation of cost savings. 17 If a project team has estimated discounted
cost savings to government agencies other than IRS, it

can also subtract those savings from investment costs when computing the
amount of additional taxes attributable to the project. 18 IRS also makes a
distinction between cost savings that are actually taken (i. e., they reduce
the size of

IRS? budget) and those that are reallocated to another business area. This
distinction is not relevant to the problem we discuss here because the cost
savings are computed the same way, regardless of how the savings are used.

GAO- 02- 234R IRS Guidance on Economic Analyses

9

anticipated (future year) IRS costs due to efficiencies gained within a
single business area, thus eliminating the need to hire staff or increase
resource levels to meet escalating demand.? These definitions (reinforced by
specific examples in the text) strongly imply that:

the sum of cost savings and avoidance equals the recurring costs needed to
meet an escalating workload with existing technology, minus the recurring
costs of the alternative being proposed.

However, the computational instructions in the guidance show that: the sum
of cost savings and avoidance equals the recurring costs needed to meet the
existing workload with existing technology, minus the recurring costs of the
alternative being proposed.

The correct way to define and compute a cost savings and/ or avoidance
measure depends on how that measure will be used. IRS needs to compute
recurring cost reductions relative to a reference case in order to complete
the excess burden analysis discussed above. (See enclosure II for a fuller
discussion.)

Conclusions

The business cases prepared by project teams are to be used by IRS managers
as the basis for allocating limited investment funds among projects that can
cost hundreds of millions of dollars. The economic value of each investment
project is one of the most important criteria presented in a business case.
For this reason, it is crucial that project teams present the economic
values of investments as completely and accurately as possible. We have
identified aspects of IRS? current business case guidance that could lead to
a misrepresentation of these economic values, primarily in the case of
investment projects that generate significant benefits or costs outside of
IRS. The changes we recommend below will help to ensure that IRS? guidance
provides instructions for presenting the economic values of investments in a
manner that is consistent with commonly held principles of cost- benefit
analysis.

Recommendations For Executive Action

To ensure that economic analyses contained in IRS business cases provide a
sound basis for managers? investment decisions, we recommend that IRS
business case guidance

require the use of a comprehensive social NPV as the basis for comparing the
economic values of alternative investment projects that give rise to
significant benefits or costs outside of IRS;

provide detailed instructions to ensure that the NPV includes all measurable
costs and benefits to society and does not include transfer payments at
their face value, unless evidence is provided to support such a valuation;

GAO- 02- 234R IRS Guidance on Economic Analyses

10 require that the NPV be supplemented (in a separate section of the
business case)

by clear and comprehensive descriptions of all significant transfer payments
and nonmeasurable benefits and costs that have not been included in the NPV
computation;

require business cases to include the supplementary analysis of excess
burden, when appropriate, as recommended in OMB Circular A- 94, section 11.

Agency Comments and Our Evaluation

In commenting on a draft of this report, you said that our findings are
valuable for improving IRS? business case methodology. You also said that
you will fully consider our recommendations as you update your guidance in
the coming months.

We are sending copies of this correspondence to the Secretary of the
Treasury, the Chairman of the IRS Oversight Board, and the Director of the
Office of Management and Budget, and the Chairmen and Ranking Minority
Members of the Senate and House Appropriations Committees, the Senate
Finance Committee, and the House Ways and Means Committee, as well as its
Oversight Subcommittee. The letter will also be available on GAO?s home page
at www. gao. gov.

If you have any questions, you may contact Jim Wozny or me at (202) 512-
9110. In addition, Harold Brumm and Donald Marples made key contributions to
this letter.

Sincerely yours, James R. White Director , Tax Issues

Enclosures - 2 (440013)

GAO- 02- 234R IRS Guidance on Economic Analyses

11 Enclosure I

Comments from IRS

GAO- 02- 234R IRS Guidance on Economic Analyses

12 Enclosure II

Details on Cost Savings and Cost- Avoidance Benefits

In order to accurately complete the supplementary analysis of excess burden
that OMB's guidance recommends in selected circumstances, IRS would have to
estimate the amount of additional taxes needed to fund the investment
project being evaluated. This tax amount is equal to the total discounted
investment costs of the project, minus any recurring cost savings generated
by the project. The recurring cost savings must be computed relative to a
reference level of costs. The appropriate reference case for this
computation differs depending on whether the project being evaluated is
designed to meet a specifically mandated workload or whether IRS is
proposing an investment to meet a discretionary increase in its workload.

In the case of the mandate, a decision has already been made to reach the
specified workload, even if IRS has to use existing technology to achieve
it. Therefore, it is appropriate to compute the cost savings and avoidance
for each investment alternative being evaluated as the difference between
(1) the recurring costs needed to meet the mandated workload with existing
technology and (2) the recurring costs of the alternative. In the absence of
a mandate, no one has decided that it is acceptable to increase recurring
costs to meet a higher workload. 19 For that reason, IRS cannot claim cost
savings relative to the costs needed to meet the higher workload with
existing technology. It can only claim savings relative to the costs needed
to meet the current workload with existing technology.

Except for the adjustment to account for excess burden, there is no reason
to compute cost savings or avoidance benefits relative to a reference case
for any other aspect of the economic evaluation of projects. 20 In cases
where cost- effectiveness analysis is appropriate, the businesses cases need
only compare the discounted costs of alternative approaches for meeting the
project objectives. In cases where costbenefit analysis is necessary, the
business cases would compare social NPVs for each alternative under
consideration. Each NPV would count (1) the discounted net social costs of
the alternative in question and (2) the discounted social value of the
service that IRS can provide under that alternative. Neither of these types
of comparisons requires the computation of recurring cost savings relative
to a reference case.

19 A full cost- benefit analysis is needed to justify all of the costs
associated with the decision to support an increased workload. 20 IRS may
have other reasons to identify a reference case, such as using it as a
baseline for tracking

project performance during implementation.
*** End of document. ***