Tax Compliance: Opportunities Exist to Reduce the Tax Gap Using a
Variety of Approaches (26-JUL-06, GAO-06-1000T).		 
                                                                 
The tax gap--the difference between the tax amounts taxpayers pay
voluntarily and on time and what they should pay under the	 
law--has been a long-standing problem in spite of many efforts to
reduce it. Most recently, the Internal Revenue Service (IRS)	 
estimated a gross tax gap for tax year 2001 of $345 billion and  
estimated it would recover $55 billion of this gap, resulting in 
a net tax gap of $290 billion. When some taxpayers fail to	 
comply, the burden of funding the nation's commitments falls more
heavily on compliant taxpayers. Reducing the tax gap would help  
improve the nation's fiscal stability. For example, each 1	 
percent reduction in the net tax gap would likely yield $3	 
billion annually. GAO was asked to discuss the tax gap and	 
various approaches to reduce it. This testimony discusses to what
extent the tax gap could be reduced through three		 
approaches--simplifying or reforming the tax system, providing	 
IRS with additional enforcement tools, and devoting additional	 
resources to enforcement--as well as various factors that could  
guide decision-making when devising a strategy to reduce the tax 
gap. This statement is based on prior GAO work. 		 
-------------------------Indexing Terms------------------------- 
REPORTNUM:   GAO-06-1000T					        
    ACCNO:   A57483						        
  TITLE:     Tax Compliance: Opportunities Exist to Reduce the Tax Gap
Using a Variety of Approaches					 
     DATE:   07/26/2006 
  SUBJECT:   Delinquent taxes					 
	     Financial analysis 				 
	     Fiscal policies					 
	     Future budget projections				 
	     Income taxes					 
	     Noncompliance					 
	     Policy evaluation					 
	     Strategic planning 				 
	     Tax administration 				 
	     Tax nonpayment					 
	     Tax returns					 
	     Tax violations					 
	     Taxpayers						 
	     Underpayments					 
	     Tax gap						 

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GAO-06-1000T

     

     * Background
     * Reducing the Tax Gap through Tax Simplification or Tax Syste
     * Providing IRS with Additional Enforcement Tools Potentially
     * Devoting Additional Resources to Enforcement Likely Could Re
     * Various Factors Should Be Considered in Devising Strategies
     * Concluding Observations
     * Contact and Acknowledgments
          * Order by Mail or Phone

Testimony

Before the Subcommittee on Taxation and IRS Oversight, Committee on
Finance, U.S. Senate

United States Government Accountability Office

GAO

For Release on Delivery Expected at 2:00 p.m. EDT

Wednesday, July 26, 2006

TAX COMPLIANCE

Opportunities Exist to Reduce the Tax Gap Using a Variety of Approaches

Statement of Michael Brostek Director, Tax Issues Strategic Issues Team

GAO-06-1000T

Mr. Chairman and Members of the Subcommittee:

I appreciate this opportunity to discuss the tax gap-the difference
between what taxpayers pay in taxes voluntarily and on time and what they
should pay under the law-and what is achievable in reducing the gap. Most
recently, the Internal Revenue Service (IRS) estimated that for tax year
2001, taxpayers paid about 84 percent of the taxes that should have been
paid on time under the law, resulting in an estimated gross tax gap of
$345 billion. IRS estimated that it would eventually recover around $55
billion of the 2001 tax gap through late payments and IRS enforcement
actions, leaving a net tax gap of $290 billion.1 Because of taxpayer
noncompliance, the burden of funding the nation's commitments falls more
heavily on taxpayers who willingly and accurately pay their taxes.
Reducing the tax gap would help improve the nation's fiscal stability. For
example, based on IRS's estimate, each 1 percent reduction in the net tax
gap would likely yield nearly $3 billion annually. However, the tax gap
has been a persistent problem in spite of a myriad of congressional and
IRS efforts to reduce it, as the rate at which taxpayers voluntarily
comply with our tax laws has changed little over the past three decades.
Likewise, factors such as globalization and the ever-increasing complexity
of the tax code further challenge IRS's ability to administer the tax
code.

My remarks focus on what is achievable in reducing the tax gap through a
variety of approaches, specifically by (1) simplifying or reforming the
tax system; (2) providing IRS additional enforcement authority and tools,
such as information reporting2 and tax withholding,3 through changes to
the tax laws; and (3) devoting additional resources to enforcement under
the existing tax laws. I will also discuss various factors that could
guide decision making when devising a strategy to reduce the tax gap. My
remarks are based on our previous work on a variety of issues, in
particular, recent testimonies and a report on reducing the tax gap.4
These efforts were conducted in accordance with generally accepted
government auditing standards.

1Throughout this statement, references to the tax gap refer to the gross
tax gap unless otherwise noted.

2Information reporting involves the filing of information returns with IRS
and taxpayers that contain information on certain transactions, such as
wage and salary information employers report to employees and IRS through
Form W-2.

3An example of tax withholding is when employers withhold taxes on the
wages that employees earn and remit them to IRS.

Let me begin by highlighting four major points:

           o  Simplifying the tax code or fundamental tax reform has the
           potential to reduce the tax gap by many billions of dollars. For
           example, IRS estimated that errors in claiming tax credits and
           deductions for tax year 2001 contributed $32 billion to the tax
           gap. Reducing the number of such credits and deductions therefore
           has some direct potential to reduce the tax gap. However, these
           credits and deductions serve purposes Congress has judged to be
           important, and eliminating them likely would be complicated.
           Fundamental tax reform, such as shifting to a consumption tax
           system, would most likely result in a smaller tax gap if the new
           system has few, if any, exceptions (e.g., few or no tax
           preferences) and taxable transactions are transparent to tax
           administrators. These characteristics are difficult to achieve in
           any system, and any tax system could be subject to noncompliance.

           o  Providing IRS with more enforcement tools, particularly
           withholding and information reporting, also has the potential to
           reduce the tax gap by billions of dollars, especially if those
           tools help IRS deal with the largest contributor to the tax
           gap-underreported income. Tax withholding and information
           reporting have been shown to lead to high, sustained levels of
           taxpayer compliance because the income taxpayers earn is
           transparent to them and IRS. Also, using these tools can help IRS
           better allocate its resources by improving its ability to identify
           and prioritize noncompliant taxpayers it contacts. For example, we
           found that having third parties report to taxpayers and IRS the
           cost, or basis, of stocks and mutual funds that taxpayers sell
           could help taxpayers improve their voluntary compliance and help
           IRS allocate its enforcement efforts concerning these
           transactions. However, designing withholding or information
           reporting requirements to address underreporting may be
           challenging given that many types of income are already subject to
           such requirements, there are many forms of underreporting, and any
           requirements could impose costs and burdens on the third parties
           that withhold or report.

           o  Devoting additional resources to enforcement has the potential
           to help reduce the tax gap by billions of dollars. However,
           determining the appropriate level of enforcement resources to
           provide IRS requires taking into account factors such as how
           effectively and efficiently IRS is currently using its resources,
           how to strike the proper balance between IRS's taxpayer service
           and enforcement activities, and competing federal funding
           priorities. If Congress were to provide IRS more enforcement
           resources, the amount of the tax gap that could be reduced depends
           in part on factors such as the size of budget increases, how IRS
           manages any additional resources, and the indirect increase in
           taxpayers' voluntary compliance resulting from expanded
           enforcement. Providing IRS with additional funding would enable it
           to contact millions of potentially noncompliant taxpayers it
           identifies but currently cannot contact given resource
           constraints.

           o  Each approach to reducing the tax gap-simplifying or reforming
           the tax code, providing IRS with more enforcement tools, or
           devoting additional resources to enforcement-has the potential to
           reduce the tax gap, although using multiple approaches may be the
           most effective strategy since no one approach is likely to fully
           and cost effectively address noncompliance. Some key factors to
           consider in designing a strategy to reduce the tax gap include
           periodically measuring noncompliance and its causes, setting tax
           gap reduction goals and measuring progress against the goals,
           leveraging technology to enhance IRS's efficiency, identifying and
           considering the costs and benefits of possible approaches,
           optimizing the allocation of IRS's resources, and evaluating the
           results of any initiatives to reduce the tax gap.

           Background
			  
			  The tax gap is an estimate of the difference between the
           taxes-including individual income, corporate income, employment,
           estate, and excise taxes-that should have been paid voluntarily
           and on time and what was actually paid for a specific year. The
           estimate is an aggregate of estimates for the three primary types
           of noncompliance: (1) underreporting of tax liabilities on tax
           returns; (2) underpayment of taxes due from filed returns; and (3)
           nonfiling, which refers to the failure to file a required tax
           return altogether or on time.5 IRS's tax gap estimates for each
           type of noncompliance include estimates for some or all of the
           five types of taxes that IRS administers. As shown in table 1,
           underreporting of tax liabilities accounted for most of the tax
           gap estimate for tax year 2001.

4GAO, Tax Gap: Making Significant Progress in Improving Tax Compliance
Rests on Enhancing Current IRS Techniques and Adopting New Legislative
Actions, GAO-06-453T (Washington, D.C.: Feb. 15, 2006); Tax Gap: Multiple
Strategies, Better Compliance Data, and Long-Term Goals Are Needed to
Improve Taxpayer Compliance, GAO-06-208T (Washington, D.C.: Oct. 26,
2005); Tax Compliance: Better Compliance Data and Long-term Goals Would
Support a More Strategic IRS Approach to Reducing the Tax Gap, GAO-05-753
(Washington, D.C.: July 18, 2005); and Tax Compliance: Reducing the Tax
Gap Can Contribute to Fiscal Sustainability but Will Require a Variety of
Strategies, GAO-05-527T (Washington, D.C.: Apr. 14, 2005).

                                   Background

Table 1: IRS's Tax Year 2001 Gross Tax Gap Estimates by Type of
Noncompliance and Type of Tax

Dollars in billions
                                            Type of tax
Type of            Individual  Corporate  Employment Estate   Excise       
noncompliance      income tax income tax         tax    tax      tax Total
Underreporting           $197        $30         $54     $4       No  $285 
                                                               estimate 
Underpayment               23          2           5      2       $1   $34 
Nonfiling                  25         No No estimate      2       No   $27 
                                   estimate                    estimate 
Total                    $244        $32         $59     $8       $1  $345 

Source: IRS.

Note: Figures may not sum to totals because of rounding.

IRS has estimated the tax gap on multiple occasions, beginning in 1979,
relying on its Taxpayer Compliance Measurement Program (TCMP). IRS did not
implement any TCMP studies after 1988 because of concerns about costs and
burdens on taxpayers. Recognizing the need for current compliance data, in
2002 IRS implemented a new compliance study called the National Research
Program (NRP) to produce such data for tax year 2001 while minimizing
taxpayer burden.

IRS has concerns with the certainty of the tax gap estimate for tax year
2001 in part because some areas of the estimate rely on old data, IRS has
no estimates for other areas of the tax gap, and it is inherently
difficult to measure some types of noncompliance. IRS used data from NRP
to estimate individual income tax underreporting and the portion of
employment tax underreporting attributed to self-employed individuals. The
underpayment segment of the tax gap is not an estimate, but rather
represents the tax amounts that taxpayers reported on time but did not pay
on time. Other areas of the estimate, such as corporate income tax and
employer-withheld employment tax underreporting, rely on decades-old data.
Also, IRS has no estimates for corporate income, employment, and excise
tax nonfiling or for excise tax underreporting.6 In addition, it is
inherently difficult for IRS to observe and measure some types of
underreporting or nonfiling, such as tracking cash payments that
businesses make to their employees, as businesses and employees may not
report these payments to IRS in order to avoid paying employment and
income taxes, respectively.7

5Taxpayers who receive filing extensions, pay their full tax liability by
payment due dates, and file returns prior to extension deadlines are
considered to have filed on time.

IRS's overall approach to reducing the tax gap consists of improving
service to taxpayers and enhancing enforcement of the tax laws. IRS seeks
to improve voluntary compliance through efforts such as education and
outreach programs and by attempting to simplify the tax process, such as
by revising forms and publications to make them electronically accessible
and more easily understood by diverse taxpayer communities. IRS uses its
enforcement authority to ensure that taxpayers are reporting and paying
the proper amounts of taxes through efforts such as examining tax returns
and matching the amount of income taxpayers report on their tax returns to
the income amounts reported on information returns it receives from third
parties. IRS reports that it collected over $47 billion in 2005 from
noncompliant taxpayers it identified through its various enforcement
programs.

In spite of IRS's efforts to improve taxpayer compliance, the rate at
which taxpayers pay their taxes voluntarily and on time has tended to
range from around 81 percent to around 84 percent over the past three
decades. Any significant reduction of the tax gap would likely depend on
an improvement in the level of taxpayer compliance.8

6For these types of noncompliance, IRS maintains that the data are either
difficult to collect, imprecise, or unavailable.

7For a more detailed discussion about data sources and methodologies used
in estimating the tax gap, see GAO-05-753 .

8In some instances, the amount of the tax gap can change without a
corresponding change in the level of compliance. For example, a reduction
in marginal tax rates could result in a smaller tax gap even if the level
of compliance remains unchanged because the amount of taxes that should be
paid has been reduced. The tax gap would also tend to increase over time,
even if the rate of taxpayer compliance remained unchanged, because of
inflation.

Reducing the Tax Gap through Tax Simplification or Tax System Reform Depends on
            Their Design and May Have Effects Beyond Tax Compliance

Tax law simplification and reform both have the potential to reduce the
tax gap by billions of dollars. The extent to which the tax gap would be
reduced depends on which parts of the tax system would be simplified and
in what manner as well as how any reform of the tax system is designed and
implemented. Neither approach, however, will eliminate the gap. Further,
changes in the tax laws and system to improve tax compliance could have
unintended effects on other tax system objectives, such as those involving
economic behavior or equity.

Simplification has the potential to reduce the tax gap for at least 3
broad reasons. First, it could help taxpayers to comply voluntarily with
more certainty, reducing inadvertent errors by those who want to comply
but are confused because of complexity. Second, it may limit opportunities
for tax evasion, reducing intentional noncompliance by taxpayers who can
misuse the complex code provisions to hide their noncompliance or to
achieve ends through tax shelters. Third, tax code complexity may erode
taxpayers' willingness to comply voluntarily if they cannot understand its
provisions or they see others taking advantage of complexity to
intentionally underreport their taxes.

Simplification could take multiple forms. One form would be to retain
existing laws but make them simpler. For example, in our July 2005 report9
on postsecondary tax preferences, we noted that the definition of a
qualifying postsecondary education expense differed somewhat among some
tax code provisions, for instance with some including the cost to purchase
books and others not. Making definitions consistent across code provisions
may reduce taxpayer errors. Although we cannot say the errors were due to
these differences in definitions, in a limited study of paid preparer
services to taxpayers, we found some preparers claiming unallowable
expenses for books.10 Further, the Joint Committee on Taxation suggested
that such dissimilar definitions may increase the likelihood of taxpayer
errors and increase taxpayer frustration.11

9GAO, Student Aid and Postsecondary Tax Preferences: Limited Research
Exists on the Effectiveness of Tools to Assist Students and Families
through Title IV Student Aid and Tax Preferences, GAO-05-684 (Washington,
D.C.: July 29, 2005).

10GAO, Paid Tax Return Preparers: In a Limited Study, Chain Preparers Made
Serious Errors, GAO-06-563T (Washington, D.C.: Apr. 4, 2006).

11U.S. Congress, Joint Committee on Taxation, Study of the Overall State
of the Federal Tax System, vol. II, 125-6 (April 2001).

Another tax code provision in which complexity may have contributed to the
individual tax gap involves the earned income tax credit, for which IRS
estimated a tax loss of up to about $10 billion for tax year 1999.12
Although some of this noncompliance may be intentional, we13 and the
National Taxpayer Advocate14 have previously reported that confusion over
the complex rules governing eligibility for claiming the credit could
cause taxpayers to fail to comply inadvertently.

Although retaining but simplifying tax code provisions may help reduce the
tax gap, doing so may not be easy, may conflict with other policy
decisions, and may have unintended consequences. The simplification of the
definition of a qualifying child across various code sections is an
example. We suggested in the early 1990s that standardizing the definition
of a qualifying child could reduce taxpayer errors and reduce their
burden.15 A change was not made until 2004.16 However, some have suggested
that the change has created some unintended consequences, such as
increasing some taxpayers' ability to reduce their taxes in ways Congress
may not have intended.

Another form of simplification could be to eliminate or consolidate tax
expenditures. Among the many causes of tax code complexity is the growing
number of preferential provisions in the code, defined in statute17 as tax
expenditures, such as tax exemptions, exclusions, deductions, credits, and
deferrals.18 The number of these tax expenditures has more than doubled
from 1974 through 2005. Tax expenditures can contribute to the tax gap if
taxpayers claim them improperly. For example, IRS's recent tax gap
estimate includes a $32 billion loss in individual income taxes for tax
year 2001 because of noncompliance with these provisions. Simplifying
these provisions of the tax code would not likely yield $32 billion in
revenue because even simplified provisions likely would have some
associated noncompliance. However, the estimate suggests that
simplification could have important tax gap consequences, particularly if
simplification also accounted for any noncompliance that arises because of
complexity on the income side of the tax gap for individuals.19

12IRS measured the extent of noncompliance with the earned income tax
credit in a study separate from NRP.

13 GAO-06-208T .

14Internal Revenue Service, Taxpayer Advocate Service, National Taxpayer
Advocate 2004 Annual Report to Congress (Washington, D.C.: Dec. 31, 2004).

15See GAO, Tax Administration: Erroneous Dependent and Filing Status
Claims, GAO/GGD-93-60 , (Washington, D.C: Mar.19, 1993).

16Pub. L. No. 108-311 (2004).

17The Congressional Budget and Impoundment Control Act of 1974, Pub. L.
No. 93-344, S: 3, 88 Stat. 299 (July 12, 1974) (codified at 2 U.S.C. S:
622(3)).

18GAO, Government Performance and Accountability: Tax Expenditures
Represent a Substantial Federal Commitment and Need to Be Reexamined,
GAO-05-690 (Washington, D.C.: Sept. 23, 2005).

However, these credits and deductions serve purposes that Congress has
judged to be important to advance federal goals. Eliminating them or
consolidating them likely would be complicated, and would likely create
winners and losers. Elimination also could conflict with other objectives
such as encouraging certain economic activity or improving equity.

Similar trade-offs exist with possible fundamental tax reforms that would
move away from an income tax system to some other system, such as a
consumption tax, national sales tax, or value added tax. Fundamental tax
reform would most likely result in a smaller tax gap if the new system has
few tax preferences or complex tax code provisions and if taxable
transactions are transparent. However, these characteristics are difficult
to achieve in any system and experience suggests that simply adopting a
fundamentally different tax system may not by itself eliminate any tax
gap.20 Any tax system could be subject to noncompliance, and their design
and operation, including the types of tools made available to tax
administrators affect the size of any corresponding tax gap. Further, the
motivating forces behind tax reform likely include factors beyond tax
compliance, such as economic effectiveness, equity, and burden, which
could in some cases carry greater weight in designing an alternative tax
system than ensuring the highest levels of compliance.

19The tax gap for underreported individual income taxes exceeded $150
billion for tax year 2001. However, IRS does not have data on how much of
this noncompliance arose because of complexity.

20For example, in a 2004 report, the National Audit Office in the United
Kingdom reported on the 15.7 percent gap for the value added tax, which
was introduced three decades earlier.

Providing IRS with Additional Enforcement Tools Potentially Could Improve
Compliance Significantly, but Identifying and Designing Such Tools Can Be
                                  Challenging

Changing the tax laws to provide IRS with additional enforcement tools,
such as expanded tax withholding and information reporting, could also
reduce the tax gap by many billions of dollars, particularly with regard
to underreporting-the largest segment of the tax gap. Tax withholding
promotes compliance because employers or other parties subtract some or
all of the taxes owed from a taxpayer's income and remit them to IRS.
Information reporting tends to lead to high of compliance because income
taxpayers earn is transparent to them and IRS. In both cases, high levels
of compliance tend to be maintained over time. Also, because through
withholding and information reporting IRS can better identify noncompliant
taxpayers and prioritize contacting them by the potential for additional
revenue, these tools can enable IRS to better allocate its resources.
However, designing new withholding or information reporting requirements
to address underreporting can be challenging given that many types of
income are already subject to at least some form of withholding or
information reporting, there are varied forms of underreporting, and the
requirements could impose costs and burdens on third parties.

Taxpayers tend to report income subject to tax withholding or information
reporting with high levels of compliance, as shown in figure 1, because
the income is transparent to the taxpayers as well as to IRS.
Additionally, once withholding or information reporting requirements are
in place for particular types of income, compliance tends to remains high
over time. For example, for wages and salaries, which are subject to tax
withholding and substantial information reporting, the percentage of
income that taxpayers misreport report has consistently been measured at
around 1 percent over time.

Figure 1: Individual Net Income Misreporting Categorized by the Extent of
Income Subject to Withholding and Information Reporting, Tax Year 2001

In the past, we have identified a few specific areas where additional
withholding or information reporting requirements could serve to improve
compliance:

           o  Require more data on information returns dealing with capital
           gains income from securities sales. Recently, we reported that an
           estimated 36 percent of taxpayers misreported their capital gains
           or losses from the sale of securities, such as corporate stocks
           and mutual funds.21 Further, around half of the taxpayers who
           misreported did so because they failed to report the securities'
           cost, or basis, sometimes because they did not know the
           securities' basis or failed to take certain events into account
           that required them to adjust the basis of their securities. When
           taxpayers sell securities like stock and mutual funds through
           brokers, the brokers are required to report information on the
           sale, including the amount of gross proceeds the taxpayer
           received; however, brokers are not required to report basis
           information for the sale of these securities. We found that
           requiring brokers to report basis information for securities sales
           could improve taxpayers' compliance in reporting their securities
           gains and losses and help IRS identify noncompliant taxpayers.
           However, we were unable to estimate the extent to which a basis
           reporting requirement would reduce the capital gains tax gap
           because of limitations with the compliance data on capital gains
           and because neither IRS nor we know the portion of the capital
           gains tax gap attributed to securities sales.

           o  Requiring tax withholding and more or better information return
           reporting on payments made to independent contractors. Past IRS
           data have shown that independent contractors report 97 percent of
           the income that appears on information returns, while contractors
           that do not receive these returns report only 83 percent of
           income. We have also identified other options for improving
           information reporting for independent contractors, including
           increasing penalties for failing to file required information
           returns, lowering the $600 threshold for requiring such returns,
           and requiring businesses to report separately on their tax returns
           the total amount of payments to independent contractors.22 IRS's
           Taxpayer Advocate Service recently recommended allowing
           independent contractors to enter into voluntary withholding
           agreements.23

           o  Requiring information return reporting on payments made to
           corporations. Unlike payments made to sole proprietors, payments
           made to corporations for services are generally not required to be
           reported on information returns. IRS and GAO have contended that
           the lack of such a requirement leads to lower levels of compliance
           for small corporations. Although Congress has required federal
           agencies to provide information returns on payments made to
           contractors since 1997,24 payments made by others to corporations
           are generally not covered by information returns. The Taxpayer
           Advocate Service has recommended requiring information reporting
           on payments made to corporations,25 and the administration's
           fiscal year 2007 budget has proposed requiring additional
           information reporting on certain good and service payments by
           federal, state, and local governments.26

           In addition to improving taxpayer compliance, information
           reporting can help IRS to better allocate its resources to the
           extent that it helps IRS better identify noncompliant taxpayers
           and the potential for additional revenue that could be obtained by
           contacting these taxpayers. For example, IRS officials told us
           that receiving information on basis for taxpayers' securities
           sales would allow IRS to determine more precisely taxpayers'
           income for securities sales through its document matching programs
           and would allow it to identify which taxpayers who misreported
           securities income have the greatest potential for additional tax
           assessments. Similarly, IRS could use basis information to improve
           both aspects of its examination program-examinations of tax
           returns through correspondence and examinations of tax returns
           face-to-face with the taxpayer. Currently, capital gains issues
           are too complex and time consuming for IRS to examine through
           correspondence. However, IRS officials told us that receiving cost
           basis information might enable IRS to examine noncompliant
           taxpayers through correspondence because it could productively
           select tax returns to examine. Also, having cost basis information
           could help IRS identify the best cases to examine face-to-face,
           making the examinations more productive while simultaneously
           reducing the burden imposed on compliant taxpayers who otherwise
           would be selected for examination. As a result of all these
           benefits, basis reporting would allow IRS to better allocate its
           resources that focus on securities misreporting across its
           enforcement programs.

           Although withholding and information reporting lead to high levels
           of compliance, designing new requirements to address
           underreporting could be challenging given that many types of
           income, including wages and salaries, dividend and interest
           income, and income from pensions and Social Security are already
           subject to withholding or substantial information reporting. Also,
           there are challenges involved with establishing new withholding or
           information reporting requirements for certain other types of
           income where there is extensive underreporting of income.
           Challenges exist because taxable income may be difficult to
           determine because of complex tax laws, complex transactions, or
           the lack of a practical and reliable third-party source to provide
           the information. For example, with regard to reporting securities
           basis information, we reported that it would be difficult for
           brokers to report information for some types of transactions
           because of complex tax laws and that representatives from the
           securities industry told us that a set of rules would need to be
           developed to establish clearly what types of transactions would be
           subject to any reporting requirement.

           Likewise, a persistent and large part of the tax gap relates to
           nonfarm sole proprietor and informal supplier income.27 As shown
           in figure 1, this income is not subject to information reporting,
           and these taxpayers misreported about half of the income they
           earned for tax year 2001. Although establishing withholding or
           information reporting requirements for these forms of income would
           likely improve taxpayers' compliance, practical and effective
           information reporting mechanisms are difficult to identify. For
           example, informal suppliers by definition receive income in an
           informal manner through services they provide to a variety of
           individual citizens or small businesses. Whereas businesses may
           have the capacity to perform withholding and information reporting
           functions for their employees, it may be challenging to extend
           withholding or information reporting responsibilities to the
           individual citizens that receive services, who may not have the
           resources or knowledge to comply with such requirements.
           Consequently, innovative approaches likely will be needed if tools
           like withholding and information returns are to be extended to
           cover more sources of the tax gap.

           Finally, implementing tax withholding and information reporting
           requirements generally imposes costs and burdens on the businesses
           that must implement them, and, in some cases, on taxpayers. For
           example, expanding information reporting on securities sales to
           include basis information will impose costs on the brokers that
           would track and report the information. Further, trying to close
           the entire tax gap with these enforcement tools could entail more
           intrusive recordkeeping or reporting than the public is willing to
           accept. Considering these costs and burdens should be part of any
           evaluation of additional withholding or information reporting
           requirements.

           Although I have focused on information reporting and tax
           withholding, I want to mention one other enforcement tool that can
           potentially deter noncompliance, which is the use of penalties for
           filing inaccurate or late tax and information returns. Congress
           has placed a number of civil penalty provisions in the tax code.
           However, as with civil penalties related to other federal
           agencies, inflation may have weakened the deterrent effect of IRS
           penalties. For example, the Treasury Inspector General for Tax
           Administration has noted that the $50 per partner per month
           penalty for a late-filed partnership tax return, established by
           Congress in 1978, would equate to $17.22 in 2004 dollars. In its
           fiscal year 2007 budget, the administration has proposed expanding
           penalty provisions applicable to paid tax return preparers to
           include non-income tax returns and related documents. In addition,
           Congress recently increased certain penalties related to tax
           shelters and other tax evasion techniques.28 Given Congress's
           recent judgment that some tax penalties were too low and concerns
           that inflation may have weakened the effectiveness of the civil
           penalty provisions in the tax code, additional increases may need
           to be considered to ensure that all penalties are of sufficient
           magnitude to deter tax noncompliance.

           Devoting Additional Resources to Enforcement Likely Could Reduce the
			  Tax Gap, but to What Extent Is Difficult to Predict
			  
			  Devoting more resources to enforcement has the potential to help
           reduce the tax gap by billions of dollars in that IRS would be
           able to expand its enforcement efforts to reach a greater number
           of potentially noncompliant taxpayers. However, determining the
           appropriate level of enforcement resources to provide IRS requires
           taking into account many factors, such as how effectively and
           efficiently IRS is currently using its resources, how to strike
           the proper balance between IRS's taxpayer service and enforcement
           activities, and competing federal funding priorities. If Congress
           were to provide IRS more enforcement resources, the amount of the
           tax gap that could be reduced depends in part on the size of any
           increase in IRS's budget, how IRS would manage any additional
           resources, and the indirect increase in taxpayers' voluntary
           compliance that would likely result from expanded IRS enforcement.

           As I previously mentioned, IRS is able to secure tens of billions
           of dollars in tax revenue from noncompliant taxpayers it
           identifies through its various enforcement programs. However,
           given resource constraints, IRS is unable to contact millions of
           additional taxpayers for whom it has evidence on potential
           noncompliance. With additional resources, IRS would be able to
           assess and collect additional taxes and further reduce the tax
           gap. In 2002, IRS estimated that a $2.2 billion funding increase
           would allow it to take enforcement actions against potentially
           noncompliant taxpayers it identifies but cannot contact and would
           yield an estimated $30 billion in revenue.29 For example, IRS
           estimated that it contacted about 3 million of the over 13 million
           taxpayers it identified as potentially noncompliant through its
           matching of tax returns to information returns. IRS estimated that
           contacting the additional 10 million potentially noncompliant
           taxpayers it identified, at a cost of about $230 million, could
           yield nearly $7 billion in potentially collectible revenue.
           However, we did not evaluate the accuracy of the estimate, and as
           will be discussed below, many factors suggest that it is difficult
           to estimate reliably net revenue increases that might come from
           additional enforcement efforts.30

           Although additional enforcement funding has the potential to
           reduce the tax gap, the extent to which it would help depends on
           several factors. First, and perhaps most obviously, the amount of
           tax gap reduction would depend in part on the size of any budget
           increase. Generally, larger budget increases should result in
           larger reductions in the tax gap. IRS prioritizes the cases of
           potentially noncompliant taxpayers it reviews through its
           enforcement programs based on factors, such as the likelihood that
           a taxpayer is noncompliant, the potential amount of additional
           taxes that could be assessed, and collection potential. As such,
           it is likely that IRS would begin to experience diminishing
           returns as it began to review additional, lower priority cases of
           potentially noncompliant taxpayers. Given the diminishing returns
           IRS would likely experience as it moves to working less and less
           productive cases, the amount of expected reduction in the tax gap
           for each additional dollar of funding would decline. Further,
           reductions in the tax gap that could be derived from additional
           enforcement funding may not be immediate. The reductions may occur
           gradually as IRS is able to hire and train enforcement personnel.

           Recently, IRS obtained some additional funding targeted for
           enforcement activities that it estimated will result in additional
           revenue. In its fiscal year 2006 budget request, IRS requested
           millions of dollars to expand its tax return examination and tax
           collection activities with the goal of increasing individual
           taxpayer compliance and addressing concerns raised by GAO31 and
           others regarding the erosion of IRS's enforcement presence and the
           continued growth in noncompliance. In estimating the revenue that
           it would obtain from the increased funding, IRS took several
           factors into account, including opportunity costs because of
           training, which draws experienced enforcement personnel away from
           the field; differences in average enforcement revenue obtained per
           full-time employee by enforcement activity; and differences in the
           types and complexity of cases worked by new hires and experienced
           hires. IRS forecasted that in the initial year after expanding
           enforcement activities, the additional revenue it expects to
           collect is less than half the amount it expects to collect
           annually in later years. This example underscores the logic that
           if IRS is to receive a relatively large funding increase, it
           likely would be better to provide it in small but steady amounts.

           The amount of tax gap reduction likely to be achieved from any
           budget increase Congress may choose to provide also depends on how
           well IRS can manage the additional resources. As previously
           mentioned, IRS does not have compliance data for some segments of
           the tax gap and others are based on old data. Periodic
           measurements of compliance levels can indicate the extent to which
           compliance is improving or declining and provide a basis for
           reexamining existing programs and triggering corrective actions,
           if necessary. Also, regardless of the type of noncompliance, IRS
           has concerns with its information on whether taxpayers
           unintentionally or intentionally fail to comply with the tax laws.
           Knowing the reasons why taxpayers are noncompliant can help IRS
           decide whether its efforts to address specific areas of
           noncompliance should focus on nonenforcement activities, such as
           improved forms or publications, or enforcement activities to
           pursue intentional noncompliance. For those portions of the tax
           gap that rely on old data and where IRS does not know the reason
           for taxpayers' noncompliance, IRS may be less able to target
           resources efficiently to achieve the greatest tax gap reduction at
           the least burden to taxpayers.

           As part of an effort to make the best use of its enforcement
           resources, IRS has developed rough measures of return on
           investment in terms of tax revenue that it assesses from
           uncovering noncompliance. Generally, IRS cites an average return
           on investment for enforcement of 4:1, that is, IRS estimates that
           it collects $4 in revenue for every $1 of funding. Where IRS has
           developed return on investment estimates for specific programs, it
           finds substantial variation depending on the type of enforcement
           action. For instance, the ratio of estimated tax revenue gains to
           additional spending for pursuing known individual tax debts
           through phone calls is 13:1 versus a ratio of 32:1 for matching
           the amount of income taxpayers report on their tax returns to the
           income amounts reported on information returns. However, in
           addition to current returns on investment estimated being rough,
           IRS also lacks information on the incremental returns on
           investment for some enforcement programs. Developing such measures
           is difficult because of incomplete information on all the costs
           and all the tax revenue ultimately collected from specific
           enforcement efforts. Because IRS's current estimates of the
           revenue effects of additional funding are imprecise, the actual
           revenue that might be gained from expanding differing enforcement
           efforts is subject to uncertainty.

           Given the variation in estimated returns on investment for
           differing types of IRS compliance efforts, the amount of tax gap
           reduction that may be achieved from an increase in IRS's resources
           would depend on IRS's decisions about how to allocate the
           increase. Although it might be tempting to allocate resources
           heavily toward those areas with the highest estimated return,
           allocation decisions must take into account diverse and difficult
           issues. For instance, although one enforcement activity may have a
           high estimated return, that return may drop off quickly as IRS
           works its way through potential noncompliance cases. In addition,
           IRS dedicates examination resources across all types of taxpayers
           so that all taxpayers receive some signal that noncompliance is
           being addressed. Further, issues of fairness can arise if IRS
           focuses its efforts only on particular groups of taxpayers.

           Importantly, expanded enforcement efforts could reduce the tax gap
           more than through direct tax revenue collection, as widespread
           agreement exists that IRS enforcement programs have an indirect
           effect through increases in voluntary tax compliance.32 The
           precise magnitude of the indirect effects of enforcement is not
           known with a high level of confidence given challenges in
           measuring compliance; developing reasonable assumptions about
           taxpayer behavior; and accounting for factors outside of IRS's
           actions that can affect taxpayer compliance, such as changes in
           tax law. However, several research studies have offered insights
           to help better understand the indirect effects of IRS enforcement
           on voluntary tax compliance and show that they could exceed the
           direct effect of revenue obtained.33

           Various Factors Should Be Considered in Devising Strategies to
			  Reduce the Tax Gap
			  
			  Although closing the entire tax gap is neither feasible nor
           desirable due to costs and intrusiveness, reducing the tax gap is
           worthwhile for many reasons, including fairness to those who are
           compliant and also because it is a means to improve our nation's
           fiscal position. Each of the three approaches I have discussed
           could make a contribution to reducing the tax gap, although using
           multiple approaches may be the most effective strategy since no
           one approach is likely to address noncompliance fully and cost
           effectively. However, in deciding on one or more of the three
           broad approaches to use, many factors or issues could affect
           strategic decisions. Among the broad factors to consider are the
           likely effectiveness of any approach, fairness, enforceability,
           and sustainability. Beyond these, our work points to the
           importance of the following:

           o  Measuring compliance levels periodically. Regularly measuring
           the magnitude of, and the reasons for, noncompliance provides
           insights on how to reduce the gap through potential changes to tax
           laws and IRS programs. In July 2005, we recommended that IRS
           periodically measure tax compliance, identify reasons for
           noncompliance, and establish voluntary compliance goals.34 IRS
           agreed with the recommendations and established a voluntary tax
           compliance goal of 85 percent by 2009. In terms of measuring tax
           compliance, we have also identified alternative ways to measure
           compliance, including conducting examinations of small samples of
           tax returns over multiple years, instead of conducting
           examinations for a larger sample of returns for one tax year, to
           allow IRS to track compliance trends annually.

           o  Leveraging technology. Better use of technology could help IRS
           be more efficient in reducing the tax gap. IRS is modernizing its
           technology, which has paid off in terms of telephone service,
           resource allocation, electronic filing, and data analysis
           capability. However, this ongoing modernization will need strong
           management and prudent investments to maximize potential
           efficiencies.

           o  Considering the costs and burdens. Any action to reduce the tax
           gap will create costs and burdens for IRS; taxpayers; and third
           parties, such as those who file information returns. As discussed
           earlier, for example, withholding and information reporting
           requirements impose some costs and burdens on those that track and
           report information. These costs and burdens need to be reasonable
           in relation to the improvements expected to arise from new
           compliance strategies.

           o  Optimizing resource allocation. As previously discussed,
           developing reliable measures of the return on investment for
           strategies to reduce the tax gap would help inform IRS resource
           allocation decisions. IRS has rough measures of return on
           investment based on the additional taxes it assesses. Developing
           such measures is difficult because of incomplete data on the costs
           of enforcement and collected revenues. Beyond direct revenues,
           IRS's enforcement actions have indirect revenue effects, which are
           difficult to measure. However, indirect effects could far exceed
           direct revenue effects and would be important to consider in
           connection with continued development of return on investment
           measures.

           o  Evaluating the results. Evaluating the actions taken by IRS to
           reduce the tax gap would help maximize IRS's effectiveness.
           Evaluations can be challenging because it is difficult to isolate
           the effects of IRS's actions from other influences on taxpayers'
           compliance. Our work has discussed how to address these
           challenges, for example by using research to link actions with the
           outputs and desired effects.

           Concluding Observations
			  
			  When taxpayers do not pay all of their taxes, honest taxpayers
           carry a greater burden to fund government programs and the nation
           is less able to address its long-term fiscal challenges. Thus,
           reducing the tax gap is important, even though closing the entire
           tax gap is neither feasible nor desirable because of costs and
           intrusiveness. All of the approaches I have discussed have the
           potential to reduce the tax gap alone or in combination, and no
           one approach is clearly and always superior to the others. As a
           result, IRS needs a strategy to attack the tax gap on multiple
           fronts with multiple approaches.

           Mr. Chairman and Members of the Subcommittee, this concludes my
           testimony. I would be happy to answer any question you may have at
           this time.

           Contact and Acknowledgments
			  
			  For further information on this testimony, please contact Michael
           Brostek on (202) 512-9110 or [email protected] . Contact points for
           our Offices of Congressional Relations and Public Affairs may be
           found on the last page of this testimony. Individuals making key
           contributions to this testimony include Tom Short, Assistant
           Director; Jeff Arkin; Cheryl Peterson; and Jeff Procak.

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21GAO, Capital Gains Tax Gap: Requiring Brokers to Report Securities Cost
Basis Would Improve Compliance if Related Challenges Are Addressed,
GAO-06-603 (Washington, D.C.: June 13, 2006).

22GAO, Tax Administration: Approaches for Improving Independent Contractor
Compliance, GAO/GGD-92-108 (Washington, D.C.: July 23, 1992).

23Internal Revenue Service, Taxpayer Advocate Service, National Taxpayer
Advocate 2005 Annual Report to Congress (Washington, D.C.: Dec. 31, 2005).

24Taxpayer Relief Act of 1997, Pub. L. No. 105-34 (1997).

25Internal Revenue Service, Taxpayer Advocate Service, 2005.

26Executive Office of the President, Office of Management and Budget,
Budget of the United States Government, Fiscal Year 2007.

27Nonfarm proprietors are self-employed individuals other than farmers who
should file Schedule C with their individual tax returns to report profits
and losses from their businesses. Sole proprietors include those who
provide services, such as doctors or accountants; produce goods, such as
manufacturers; and sell goods at fixed locations, such as car dealers and
grocers. Informal suppliers are sole proprietors who work alone or with
few workers and, by definition, operate in an informal manner. Informal
suppliers include those who make home repairs, provide child care, or sell
goods at roadside stands. These taxpayers should report business profits
or losses on Schedule C.

28American Jobs Creation Act of 2004, Pub. L. No. 108-357 (2004).

29Commissioner of Internal Revenue Charles O. Rossotti, Report to the IRS
Oversight Board: Assessment of IRS and the Tax System, October 2002.

30There are many aspects to the overall tax gap. Thus, if the tax gap in a
specific area is reduced either through congressional actions like
simplifying provisions or through IRS actions, the size of the overall gap
may not be reduced if other portions of the gap increase.

31GAO issued a number of products regarding the erosion of IRS's
enforcement presence and a continued growth in noncompliance. See GAO,
Internal Revenue Service: Assessment of Fiscal Year 2005 Budget Request
and 2004 Filing Season Performance, GAO-04-560T (Washington, D.C: Mar. 30,
2004); Internal Revenue Service: Assessment of Fiscal Year 2004 Budget
Request and 2003 Filing Season Performance to Date, GAO-03-641T
(Washington, D.C: Apr. 8, 2003); Internal Revenue Service: Assessment of
Fiscal Year 2003 Budget Request and Interim Results of the 2002 Tax Filing
Season, GAO-02-580T (Washington, D.C: Apr. 9, 2003); Tax Administration:
Impact of Compliance and Collection Program Declines on Taxpayers,
GAO-02-674 (Washington, D.C.: May 22, 2003); Compliance and Collection:
Challenges for IRS in Reversing Trends and Implementing New Initiatives,
GAO-03-732T (Washington, D.C.: May 7, 2003); IRS Modernization: Continued
Progress Necessary for Improving Service to Taxpayers and Ensuring
Compliance, GAO-03-796T (Washington, D.C.: May 20, 2003); High Risk
Series: An Update, GAO-05-207 (Washington, D.C.: January 2005); and our
products on the tax gap mentioned earlier in this statement, GAO-06-453T ,
GAO-06-208T , GAO-05-753 , and GAO-05-527T .

32Two types of indirect effect are (1) the increase in voluntary
compliance in the larger population resulting from examinations or other
enforcement and nonenforcement actions on targeted taxpayers, and (2) the
increase in voluntary compliance of the targeted taxpayer in subsequent
years.

33Economists have estimated the indirect effect of an examination on
voluntary compliance to range from 6 to 12 times the amount of proposed
tax adjustments. See Alan H. Plumley, The Determinants of Individual
Income Tax Compliance: Estimating The Impacts of Tax Policy, Enforcement,
and IRS Responsiveness, Publication 1916 (Rev. 11-96) (Washington, D.C.:
November 1996), 2, 35-36; Jeffrey A. Dubin, Michael J. Graetz and Louis L.
Wilde, "The Effect of Audit Rates on the Federal Individual Income Tax,
1977-1986," 43 National Tax Journal, (1990), 395, 396, 405; and Jeffrey A.
Dubin, "Criminal Investigation Enforcement Activities and Taxpayer
Noncompliance" (paper written for the IRS Research Conference, June 2004),
http://www.irs.gov/pub/irs-soi/04dubin.pdf (downloaded July 1, 2005).

34 GAO-05-753 .

(450512)

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Highlights of GAO-06-1000T , a testimony to the Subcommittee on Taxation
and IRS Oversight, Committee on Finance, U.S. Senate

July 26, 2006

TAX COMPLIANCE

Opportunities Exist to Reduce the Tax Gap Using a Variety of Approaches

The tax gap-the difference between the tax amounts taxpayers pay
voluntarily and on time and what they should pay under the law-has been a
long-standing problem in spite of many efforts to reduce it. Most
recently, the Internal Revenue Service (IRS) estimated a gross tax gap for
tax year 2001 of $345 billion and estimated it would recover $55 billion
of this gap, resulting in a net tax gap of $290 billion. When some
taxpayers fail to comply, the burden of funding the nation's commitments
falls more heavily on compliant taxpayers. Reducing the tax gap would help
improve the nation's fiscal stability. For example, each 1 percent
reduction in the net tax gap would likely yield $3 billion annually.

GAO was asked to discuss the tax gap and various approaches to reduce it.
This testimony discusses to what extent the tax gap could be reduced
through three approaches-simplifying or reforming the tax system,
providing IRS with additional enforcement tools, and devoting additional
resources to enforcement-as well as various factors that could guide
decision-making when devising a strategy to reduce the tax gap. This
statement is based on prior GAO work.

What GAO Recommends

GAO is not making any new recommendations but highlights new areas for
possible attention.

Simplifying the tax code or fundamental tax reform has the potential to
reduce the tax gap by billions of dollars. IRS has estimated that errors
in claiming tax credits and deductions for tax year 2001 contributed $32
billion to the tax gap. Thus, considerable potential exists. However,
these provisions serve purposes Congress has judged to be important and
eliminating or consolidating them could be complicated. Fundamental tax
reform would be most likely to result in a smaller tax gap if the new
system has few, if any, exceptions (e.g., few tax preferences) and taxable
transactions are transparent to tax administrators. These characteristics
are difficult to achieve, and any tax system could be subject to
noncompliance.

Withholding and information reporting are particularly powerful tools to
reduce the tax gap. They could help reduce the tax gap by billions of
dollars, especially if they can make currently underreported income
transparent to IRS. These tools have been shown to lead to high, sustained
levels of taxpayer compliance. Using these tools can also help IRS better
allocate its resources to the extent they help IRS identify and prioritize
its contacts with noncompliant taxpayers. As GAO previously suggested,
reporting the cost, or basis, of securities sales is one option to improve
taxpayers' compliance. However, designing additional withholding and
information reporting requirements may be challenging given that many
types of income are already subject to reporting, there are many forms of
underreporting, and withholding and reporting requirements impose costs on
third parties.

Devoting additional resources to enforcement has the potential to help
reduce the tax gap by billions of dollars. However, determining the
appropriate level of enforcement resources for IRS requires taking into
account many factors such as how well IRS is currently using its
resources, how to strike the proper balance between IRS's taxpayer service
and enforcement activities, and competing federal funding priorities. If
Congress decides to provide IRS more enforcement resources, the amount the
tax gap could be reduced would depend on factors such as the size of
budget increases, how IRS manages any additional resources, and the
indirect increase in taxpayers' voluntary compliance resulting from
expanded enforcement. Increasing IRS's funding would enable it to contact
millions of potentially noncompliant taxpayers it identifies but does not
have resources to contact.

Finally, using multiple approaches may be the most effective strategy to
reduce the tax gap, as no one approach is likely to fully and cost
effectively address noncompliance. Key factors to consider in devising a
tax gap reduction strategy include periodically measuring noncompliance
and its causes, setting reduction goals, leveraging technology, optimizing
IRS's allocation of resources, and evaluating the results of any
initiatives.
*** End of document. ***