Tax Gap: Making Significant Progress in Improving Tax Compliance 
Rests on Enhancing Current IRS Techniques and Adopting New	 
Legislative Actions (15-FEB-06, GAO-06-453T).			 
                                                                 
The Internal Revenue Service's (IRS) most recent estimate of the 
difference between what taxpayers timely and accurately paid in  
taxes and what they owed was $345 billion. IRS estimates it will 
eventually recover some of this tax gap, resulting in an	 
estimated net tax gap of $290 billion. The tax gap arises when	 
taxpayers fail to comply with the tax laws by underreporting tax 
liabilities on tax returns; underpaying taxes due from filed	 
returns; or nonfiling, which refers to the failure to file a	 
required tax return altogether or in a timely manner. The	 
Chairman and Ranking Minority Member of the Senate Committee on  
the Budget asked GAO to present information on the causes of and 
possible solutions to the tax gap. This testimony addresses the  
nature and extent of the tax gap and the significance of reducing
the tax gap, including some steps that may assist with this	 
challenging task. For context, this testimony also addressed	 
GAO's most recent simulations of the long-term fiscal outlook and
the need for a fundamental reexamination of major spending and	 
tax policies and priorities.					 
-------------------------Indexing Terms------------------------- 
REPORTNUM:   GAO-06-453T					        
    ACCNO:   A46959						        
  TITLE:     Tax Gap: Making Significant Progress in Improving Tax    
Compliance Rests on Enhancing Current IRS Techniques and Adopting
New Legislative Actions 					 
     DATE:   02/15/2006 
  SUBJECT:   Financial analysis 				 
	     Financial management				 
	     Fiscal policies					 
	     Income taxes					 
	     Noncompliance					 
	     Policy evaluation					 
	     Tax administration 				 
	     Tax returns					 
	     Tax violations					 
	     Taxpayers						 
	     Underpayments					 
	     Strategic planning 				 
	     Future budget projections				 
	     Delinquent taxes					 
	     Tax nonpayment					 
	     Tax gap						 

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GAO-06-453T

     

     * Long-term Fiscal Challenge Provides Impetus to Reexamine Tax
     * Underreporting Accounted for Most of the Tax Gap Estimate
     * Reducing the Tax Gap Will Require Expanding Existing Approac
          * Regularly Measure Compliance and Set Compliance Goals
          * Simplify the Tax Code
          * Enhance Services to Taxpayers
          * Enhance Enforcement Tools Available to IRS
          * Leverage Technology
          * Optimize Resource Allocation
     * Concluding Observations
     * Contact and Acknowledgments
          * Order by Mail or Phone

Testimony

Before the Committee on Budget, U.S. Senate

United States Government Accountability Office

GAO

For Release on Delivery Expected at 10:00 a.m. EST

Wednesday, February 15, 2006

TAX GAP

Making Significant Progress in Improving Tax Compliance Rests on Enhancing
Current IRS Techniques and Adopting New Legislative Actions

Statement of David M. Walker Comptroller General of the United States

GAO-06-453T

Chairman Gregg, Senator Conrad, and Members of the Committee:

I appreciate this opportunity to discuss the annual tax gap-the difference
between what taxpayers timely and accurately pay in taxes and what they
should pay under the law-and how reducing that gap can help the nation
cope with its large and growing long-term fiscal challenges. The Internal
Revenue Service (IRS) most recently estimated a gross tax gap that reached
$345 billion for tax year 2001. IRS estimated that it would recover around
$55 billion through late payments and IRS enforcement actions, resulting
in a net tax gap of around $290 billion.1 The tax gap arises when
taxpayers intentionally or unintentionally fail to comply with the tax
laws. Their failure to pay taxes increases the burden of funding the
nation's commitments for those taxpayers who voluntarily pay their taxes.

For context in considering the tax gap, I will first provide the committee
with an overview of the federal government's fiscal condition and the
challenges we will face in funding our nation's commitments. Next, I will
discuss the size and components of the tax gap. Finally, I will discuss
the significance of reducing the tax gap and various means to achieve that
goal, including measuring the extent of, and reasons for, noncompliance;
simplifying the tax code; improving taxpayer service; enhancing IRS
enforcement through the use of tools such as withholding, information
reporting, and penalties; leveraging technology; and optimizing resource
allocation.

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.2
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.

2GAO, 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); 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); and 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).

Let me begin by highlighting three major points:

           o  GAO's long-term budget simulations show that over the long term
           we face large and growing structural deficits due primarily to
           known demographic trends, rising health care costs, and lower
           federal revenues as a percentage of the economy. Continuing on
           this unsustainable fiscal path will gradually erode, if not
           suddenly damage, our economy, our standard of living, and
           ultimately our national security. Our current path also will
           increasingly constrain our ability to address emerging and
           unexpected budgetary needs and increase the burdens that will be
           faced by our children, grandchildren, and future generations.
           Reducing the current tax gap would contribute to our fiscal
           sustainability while simultaneously improving fairness for those
           citizens who fully and timely meet their tax obligations.

           o  Underreporting of income by businesses and individuals
           accounted for most of the estimated $345 billion tax gap for 2001,
           with individual income tax underreporting alone accounting for
           $197 billion, or over half of the total gap. Corporate income tax
           and employment tax underreporting accounted for an additional $84
           billion.

           o  Given the persistence and size of the tax gap, we need not only
           to consider options that have been previously proposed but also
           explore new administrative and legislative approaches to reducing
           the tax gap. Even modest progress would yield significant revenue;
           each 1 percent reduction would likely yield nearly $3 billion
           annually. Reducing the tax gap will be a challenging, long-term
           task and progress will require attacking the gap on multiple
           fronts and with multiple strategies over a sustained period. These
           strategies could include efforts to regularly obtain data on the
           extent of, and reasons for, noncompliance; simplify the tax code;
           provide quality services to taxpayers; enhance enforcement of the
           tax laws by utilizing enforcement tools such as tax withholding,
           information reporting, and penalties; leverage technology; and
           maximize resource allocation.

           The federal government's financial condition and long-term fiscal
           outlook present enormous challenges to the nation's ability to
           respond to emerging forces reshaping American society, the United
           States' place in the world, and the future role of the federal
           government. Over the next few decades as the baby boom generation
           retires and health care costs continue to rise, federal spending
           on retirement and health programs-Social Security, Medicare,
           Medicaid, and other federal pension, health, and disability
           programs-will grow dramatically. Absent policy changes on the
           spending and/or revenue sides of the budget, a growing imbalance
           between expected federal spending and tax revenues will mean
           escalating and eventually unsustainable federal deficits and debt
           that will threaten our future economy, standard of living, and,
           ultimately, our national security. Ultimately, the nation will
           have to decide what level of federal benefits and spending it
           wants and how it will pay for these benefits.

           GAO's long-term simulations illustrate the magnitude of the fiscal
           challenges associated with an aging society and the significance
           of the related challenges the government will be called upon to
           address. Indeed, the nation's long-term fiscal outlook is daunting
           under many different policy scenarios and assumptions. For
           instance, under a fiscally restrained scenario, if discretionary
           spending grew only with inflation over the next 10 years and all
           existing tax cuts expire when scheduled under current law,
           spending for Social Security and health care programs would grow
           to consume over 80 percent of federal revenue by 2040. (See fig.
           1.) On the other hand, if discretionary spending grew at the same
           rate as the economy in the near term and if all tax cuts were
           extended, by 2040 federal revenues may just be adequate to pay
           only some Social Security benefits and interest on the growing
           federal debt. (See fig. 2.)

           Figure 1: Composition of Spending as a Share of GDP Under Baseline
           Extended

           Note: In addition to the expiration of tax cuts, revenue as a
           share of GDP increases through 2016 due to (1) real bracket creep,
           (2) more taxpayers becoming subject to the AMT, and (3) increased
           revenue from tax-deferred retirement accounts. After 2016, revenue
           as a share of GDP is held constant.

           Figure 2: Composition of Spending as a Share of GDP Assuming
           Discretionary Spending Grows with GDP After 2006 and All Expiring
           Tax Provisions are Extended

           Note: This includes certain tax provisions that expired at the end
           of 2005, such as the increased AMT exemption amount.

           Addressing the projected fiscal gaps shown here will require
           policymakers to examine the advisability, affordability, and
           sustainability of existing programs, policies, functions, and
           activities throughout the entire federal budget-spanning
           discretionary spending, mandatory spending, including
           entitlements, and tax policies and programs. Neither slowing the
           growth of discretionary spending nor allowing tax cuts to
           expire-nor both options combined-would by themselves eliminate our
           long-term fiscal imbalance. Additional economic growth is critical
           and will help to ease the burden, but the projected fiscal gap is
           so great that it is wholly unrealistic to expect that we will grow
           our way out of the problem. The President's 2007 budget released
           last week included some proposals to reduce the growth in Medicare
           spending. Whether or not these proposals are adopted, they should
           serve to raise public awareness of the importance of health care
           costs to both today's budget and tomorrow's. This could also serve
           to jump start discussion about appropriate ways to control a major
           driver of our long-term fiscal outlook-health care spending.
           Clearly, tough choices will be required. Changes in existing
           budget processes and financial, fiscal, and performance metrics
           will be necessary to facilitate these choices.

           Early action to change existing programs and policies would yield
           the highest fiscal dividends and provide a longer period for
           prospective beneficiaries to make adjustments in their own
           planning. The longer we wait, the more painful and difficult the
           choices will become and the less transition time we will have. By
           waiting, an important window is lost during which today's
           relatively large workforce can increase saving and begin preparing
           for the necessary changes in fiscal policy, Social Security, and
           health care as well as other reforms that may be necessary parts
           of the solution to this coming fiscal crunch. However, the
           long-term challenge is fast becoming a short-term one as the
           retirement of the baby boomers' generation will begin as early as
           2008 and since overall workforce growth has already begun to slow.
           While our long-term fiscal imbalance cannot be eliminated with a
           single strategy, reducing the tax gap is one approach that could
           help address the looming fiscal challenges facing the nation.

           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 timely and
           accurately paid 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 timely.3 Estimates for each type of
           noncompliance include estimates for some or all of the five types
           of taxes that IRS administers.

           IRS develops its tax gap estimates by measuring the rate of
           taxpayer compliance-the degree to which taxpayers fully and timely
           complied with their tax obligations. That rate is then used, along
           with other data and assumptions, to estimate the dollar amount of
           taxes not timely and accurately paid. For instance, IRS most
           recently estimated that for tax year 2001, 83.7 percent of owed
           taxes were paid voluntarily and timely, which translated into an
           estimated gross tax gap of $345 billion. IRS developed these
           estimates using compliance data collected through the National
           Research Program (NRP).4

           Using its recently collected compliance data, IRS has estimated
           that underreporting of income represented over 80 percent of the
           tax gap for 2001 (an estimated $285 billion out of a gross tax gap
           estimate of $345 billion), as indicated in table 1.

Long-term Fiscal Challenge Provides Impetus to Reexamine Tax Policies and
                                   Compliance

           Underreporting Accounted for Most of the Tax Gap Estimate

3 Taxpayers 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 timely.

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

Source: IRS.

Note: Figures may not sum to totals due to rounding.

Within the underreporting estimate, IRS attributed about $197 billion, or
about 57 percent of the total tax gap, to individual income tax
underreporting, including underreporting of business income, such as sole
proprietor,5 informal supplier,6 and farm income (about $109 billion);
nonbusiness income, such as wages, interest, and capital gains (about $56
billion); overstated credits (about $17 billion); and overstated income
adjustments, deductions, and exemptions (about $15 billion).
Underreporting of corporate income tax contributed an estimated $30
billion, or about 10 percent, to the 2001 tax gap, which included both
small corporations (those reporting assets of $10 million or less) and
large corporations (those reporting assets of over $10 million).

4NRP replaced the Taxpayer Compliance Measurement Program, which last
measured compliance for individuals for 1988 but then was canceled because
of concerns about costs and burdens on taxpayers. GAO, Tax Administration:
New Compliance Research Effort Is on Track, but Important Work Remains,
GAO-02-769 (Washington, D.C.: June 27, 2002); and GAO, Tax Administration:
Status of IRS' Efforts to Develop Measures of Voluntary Compliance,
GAO-01-535 (Washington, D.C.: June 18, 2001) discuss the development of
the NRP study.

5 Sole proprietors are self-employed individuals who should file a
Schedule C with their individual tax return to report profits and losses
from their business. 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.

6 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 a Schedule C.

Employment tax underreporting accounted for an estimated $54 billion, or
about 16 percent, of the 2001 tax gap and included several taxes that must
be paid by self-employed individuals and employers. Self-employed
individuals are generally required to calculate and remit Social Security
and Medicare taxes to the U.S. Treasury each quarter. Employers are
required to withhold these taxes from their employees' wages, match these
amounts, and remit withholdings to Treasury at least quarterly.
Underreported self-employment7 and employer-withheld employment taxes,
respectively, contributed an estimated $39 billion and $14 billion to
IRS's tax gap estimate. The employment tax underreporting estimate also
includes underreporting of federal unemployment taxes (about $1 billion).

Taxpayers who do not file their tax returns on time or at all and
otherwise do not pay their tax liabilities accounted for the remainder of
the 2001 tax gap-around $61 billion. For example, nonfiling and
underpayment noncompliance by individual taxpayers alone contributed an
estimated $48 billion to this portion of the tax gap.

IRS has concerns with the certainty of the overall tax gap estimate in
part because some areas of the estimate rely on old data and IRS has no
estimates for other areas of the tax gap. For example, IRS used data from
the 1970s and 1980s to estimate underreporting of corporate income taxes
and employer-withheld employment taxes. For large corporate income tax
underreporting, IRS based its estimate on the amount of tax recommended
from operational examinations rather than the tax ultimately assessed as
part of the total tax liability.8 According to IRS officials, IRS relies
on the amount of tax recommended because it is difficult to determine the
true tax liability of large corporations due to complex and ambiguous tax
laws that create opportunities for differing interpretations and that
complicate the determination. These officials further stated that because
these examinations are not randomly selected and are not focused on
identifying all tax noncompliance, the estimate produced from the
examination data is not representative of the tax gap for all large
corporations. They also explained that due to these complexities and the
costs and burdens of collecting complete and accurate data, IRS has not
systematically measured large corporation tax compliance through
statistically valid studies, even though the officials acknowledged that
such studies would be useful in estimating the related tax gap.9

7As employment taxes and income taxes for self-employed taxpayers are
largely assessed on the same income, self-employed individuals who
underreport their income consequently underreport the employment tax due
on that income.

8IRS continually examines tax returns from about 1,100 of the nation's
largest corporations, all of which have assets of more than $250 million.
For fiscal year 2002, IRS examined around 7 percent of all large
corporations.

IRS has no estimates for corporate income, employment, and excise tax
nonfiling or for excise tax underreporting. For these types of
noncompliance, IRS maintains that the data are either difficult to
collect, imprecise, or unavailable. 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.10

IRS's overall approach to reducing the tax gap consists of improving
service to taxpayers and enhancing enforcement of the tax laws. Recently,
IRS has taken a number of steps that may improve its ability to reduce the
tax gap. Favorable trends in staffing of IRS enforcement personnel;
examinations performed through correspondence, as opposed to more complex
face-to-face examinations; and the use of some enforcement sanctions such
as liens and levies are encouraging. Also, IRS has made progress with
respect to abusive tax shelters through a number of initiatives and recent
settlement offers that have resulted in billions of dollars in collected
taxes, interest, and penalties. In addition, IRS has successfully
prosecuted a number of taxpayers who have committed criminal violations of
the tax laws.

9GAO, Tax Administration: Compliance Measures and Audits of Large
Corporations Need Improvement, GAO/GGD-94-70 (Washington, D.C.: Sept. 1,
1994); Tax Administration: Factors Affecting Results from Audits of Large
Corporations, GAO/GGD-97-62 (Washington, D.C.: Apr. 17, 1997); and Tax
Administration: IRS Measures Could Provide a More Balanced Picture of
Audit Results and Costs, GAO/GGD-98-128 (Washington, D.C.: June 23, 1998).

10For a more detailed discussion about data sources and methodologies used
in estimating the tax gap, see GAO-05-753 .

Reducing the Tax Gap Will Require Expanding Existing Approaches and Considering
                            New Legislative Actions

Given its persistence and size, we need not only to consider expanding
current approaches but also explore new legislation to help IRS in
reducing the tax gap.11 Although IRS has made a number of changes in its
methodologies for measuring the tax gap over the past three decades, which
makes comparisons difficult, regardless of methodology the voluntary
compliance rate that underpins the gap has tended to range from around 81
percent to around 84 percent. Thus, although the dollar amounts of the tax
gap have changed, IRS has consistently reported a persistent, relatively
stable portion of the taxes that should have been timely and accurately
paid were not paid.

As we have reported in the past,12 closing the entire tax gap may not be
feasible nor desirable, as it could entail more intrusive recordkeeping or
reporting than the public is willing to accept or more resources than IRS
is able to commit. However, given its size, even small or moderate
reductions in the net tax gap could yield substantial returns, which could
improve the government's fiscal position. For example, based on IRS's most
recent estimate, each 1 percent reduction in the net tax gap would likely
yield nearly $3 billion annually. Thus, a 10 percent to 20 percent
reduction of the net tax gap would translate into from roughly $30 billion
to $60 billion in additional revenue annually.13

11We have suggested similar steps for the entire tax system as well as all
major spending programs in order to confront the nation's fiscal challenge
through a fundamental review, reexamination, and reprioritization of
government's capacity to align itself with the needs and demands of the
21st century. See GAO, 21st Century Challenges: Reexamining the Base of
the Federal Government, GAO-05-325SP (Washington, D.C.: February 2005).

12GAO, Taxpayer Compliance: Analyzing the Nature of the Income Tax Gap,
GAO/T-GGD-97-35 (Washington, D.C.: Jan. 9, 1997).

13Any significant reduction of the tax gap would likely depend on an
improvement in the level of taxpayer compliance. In 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 simply because the amount of tax that should
be paid has been reduced, even if the level of compliance remains
unchanged.

However, reducing the tax gap will be challenging14 and it must be
attacked on multiple fronts and with multiple strategies, some of which
follow.

Regularly Measure Compliance and Set Compliance Goals

A critical step toward reducing the tax gap is to understand the sources
and nature of taxpayer noncompliance. Regularly measuring compliance,
including the reasons why taxpayers are not compliant, can offer many
benefits, including helping IRS identify new or growing types of
noncompliance, identify changes in tax laws and regulations that may
improve compliance, understand the effectiveness of its programs to
promote and enforce compliance, more effectively target examinations of
tax returns, and determine its resource needs and allocations. Likewise,
regularly measuring compliance can provide IRS with information against
which to set goals for improving compliance and measure progress in
achieving such goals.

In our July 2005 report on reducing the tax gap, we made recommendations
to IRS to develop plans to periodically measure tax compliance; take steps
to improve its data on the reasons why taxpayers do not comply; and
establish long-term, quantitative goals for voluntary compliance levels
with an initial focus on individual income tax underreporting and total
tax underpayment. Taken together, these steps can help IRS build a
foundation to understand how its taxpayer service and enforcement efforts
affect compliance and make progress on reducing the tax gap. The
Commissioner of Internal Revenue agreed with our recommendations,
highlighted challenges associated with them, and commented on various
steps IRS would take to implement each recommendation. We are encouraged
that according to IRS's Fiscal Year 2007 Congressional Budget
Justification, IRS has recently established a voluntary compliance goal,
with a target of 85 percent voluntary compliance by 2009, and plans to
periodically measure progress against this goal.

14Recognizing these challenges, we have long been concerned about tax
noncompliance and IRS's efforts to address it. Since 1990, we have had
various aspects of tax noncompliance on our high-risk list, and last year
we have affirmed our broad concern by consolidating two prior high-risk
areas into one-Enforcement of Tax Laws. See GAO, High-Risk Series: An
Update, GAO-05-207 (Washington, D.C.: January 2005).

Simplify the Tax Code

Efforts to simplify the tax code and otherwise alter current tax policies
may help reduce the tax gap by making it easier for individuals and
businesses to understand and voluntarily comply with their tax
obligations. Among the many causes of tax code complexity is the growing
number of preferential provisions in the tax code, such as exemptions and
exclusions from taxation, deductions, credits, deferral of tax liability,
and preferential tax rates.15 Tax expenditures-as they are known by
statute16-can be a tool to further some federal goals and objectives, such
as financing higher education or funding research and development.
However, their aggregate number contributes to the complexity that
taxpayers face in doing their taxes and planning their financial
decisions. As figure 3 shows, the number of tax expenditures reported by
the Department of the Treasury has more than doubled since 1974. Figure 4
shows the Revenue Loss Estimates for the Five Largest Tax Expenditures
Reported for Fiscal Year 2005.

15GAO, 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).

16The Congressional Budget and Impoundment Control Act of 1974, Pub. L.
No. 93-344, Sec. 3, 88 Stat. 299 (July 12, 1974) (codified at 2 U.S.C.
sec. 622(3)).

Figure 3: Number of Tax Expenditures Reported by Treasury, 1974-2005

Note: The number of tax expenditures reflects all provisions reported by
Treasury, including those enacted but effective for future fiscal years.
For example, Treasury's last list included tax expenditures enacted in
2005 that will be effective in fiscal years 2006 and later. The trend also
reflects changes in Treasury's income tax baseline that defines a tax
expenditure.

Figure 4: Revenue Loss Estimates for the Five Largest Tax Expenditures
Reported for Fiscal Year 2005

Note: "Tax expenditures" refers to the special tax provisions that are
contained in the federal income taxes on individuals and corporations. OMB
does not include forgone revenue from other federal taxes such as Social
Security and Medicare payroll taxes.

aIf the payroll tax exclusion were also counted here, the total tax
expenditure for employer contributions for health insurance premiums would
be about 50 percent higher or $177.6 billion.

bThis is the revenue loss and does not include associated outlays of $14.6
billion.

The multiple tax preferences for education assistance illustrate the
consequences of the proliferation of tax expenditures. In our July 2005
report17 on postsecondary tax preferences, we found that hundreds of
thousands of taxpayers do not appear to make optimal decisions when
selecting education-related tax preferences. One explanation of these
taxpayers' choices may be the complexity of postsecondary tax preferences,
which experts have commonly identified as difficult for tax filers to use.
Also, many argue that complexity creates opportunities for tax evasion,
through vehicles such as tax shelters. Simplification may reduce
opportunities for taxpayers to avoid taxes through the creation of complex
and abusive tax shelters.

17GAO, 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).

Another area of the tax system that may deserve additional exploration,
although not directly related to the tax gap, is whether the federal
income-based tax system is sustainable and administrable in a global
economy and how we should tax the income of U.S. multinational
corporations that is earned outside of the United States.18 Every year,
U.S.-based multinational corporations transfer hundreds of billions of
dollars of goods and services between their affiliates in the United
States and their foreign subsidiaries.19 Such transactions may be a part
of normal business operations for corporations with foreign subsidiaries.
However, it is generally recognized that given the variation in corporate
tax rates across countries, an incentive exists for corporations with
foreign subsidiaries to reduce their overall tax burden by maximizing the
income they report in countries with low income tax rates, and minimizing
the income they report in or repatriate to countries with high income tax
rates. Various studies have suggested that U.S.-based multinational
corporations appear to engage in transactions such as these that shift
income from their affiliates in high-tax countries to subsidiaries in
low-tax countries to take advantage of the differences in tax rates in
foreign countries.20

The growth in multinational corporate transactions and structures has also
introduced increasing complexity in administering the tax code. The loss
of highly skilled technical employees at IRS who can examine compliance
issues arising from globalization, such as transfer pricing, underscores
the challenge that IRS faces in ensuring it has sufficient staff with
adequate skills to address these complex issues.

18Although not necessarily a solution to the tax gap, given the challenges
facing our income-based tax system, some have suggested moving more
towards a consumption-based tax system. Our recent report on understanding
the tax reform debate discusses a number of topics that tax experts have
identified as those that should be considered when evaluating tax policy.
See GAO, Understanding the Tax Reform Debate: Background, Criteria, &
Questions, GAO-05-1009SP (Washington, D.C.: September 2005).

19GAO, International Taxation: Information on Federal Contractors with
Foreign Subsidiaries, GAO-04-293 (Washington, D.C.: Feb. 2, 2004).

20A survey of studies that examine income shifting by multinational
corporations appears in Department of the Treasury, Office of Tax Policy,
The Deferral of Income Earned Through U.S. Controlled Foreign Corporations
(Washington, D.C.: December 2000), 197-213.

Enhance Services to Taxpayers

Providing quality services to taxpayers is an important part of any
overall strategy to improve compliance and thereby reduce the tax gap. One
method of improving compliance through service is to educate taxpayers
about confusing or commonly misunderstood tax requirements.21 For example,
if the forms and instructions taxpayers use to prepare their taxes are not
clear, taxpayers may be confused and make unintentional errors. One method
to ensure that forms and instructions are sufficiently clear is to test
them before use. However, we reported in 2003 that IRS had tested
revisions to only five individual forms and instructions from July 1997
through June 2002, although hundreds of forms and instructions had been
revised in 2001 alone.22

Enhance Enforcement Tools Available to IRS

In terms of enforcement, IRS will need to use multiple strategies and
techniques to identify and deter noncompliance. As figure 5 shows, one
pair of tools have been shown to lower levels of noncompliance-withholding
tax from payments to taxpayers and having third parties report information
to IRS and the taxpayers on income paid to taxpayers. For example, banks
and other financial institutions provide information returns (Forms 1099)
to account holders and IRS showing the taxpayers' annual income from some
types of investments. Similarly, most wages, salaries, and tip
compensation are reported by employers to employees and IRS through Form
W-2. Findings from NRP indicate that around 98.8 percent of these types of
income are accurately reported on individual returns.

21 GAO/T-GGD-97-35 .

22GAO, Tax Administration: IRS Should Reassess the Level of Resources for
Testing Forms and Instructions, GAO-03-486 (Washington, D.C.: Apr. 11,
2003).

Figure 5: Individual Income Tax Underreporting Categorized by Amount
Subject to Withholding and Information Reporting, 2001

In the past, we have identified a few specific areas where additional
withholding or information reporting requirements could serve to improve
compliance:23

           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 separately report on their tax returns
           the total amount of payments to independent contractors.24 IRS's
           Taxpayer Advocate Service recently recommended allowing
           independent contractors to enter into voluntary withholding
           agreements.25

           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 1997,26 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,27 and the Administration, in its
           fiscal year 2007 budget, has proposed requiring additional
           information reporting on certain goods and service payments by
           federal, state, and local governments.28

           o  Requiring more data on information returns dealing with capital
           gain income. Past IRS studies have indicated that much of the
           noncompliance associated with capital gains is a result of
           taxpayers overstating an asset's "basis," the amount of money
           originally paid for the asset. Currently, financial institutions
           are required to report the sales prices, but not the purchase
           prices, of stocks and bonds on information returns. Without
           information on purchase prices, IRS cannot use efficient and
           effective computer-matching programs to check for compliance and
           must use much more costly means to examine taxpayer returns in
           order to verify capital gain income. The Taxpayer Advocate Service
           has recommended requiring financial institutions to track cost
           basis information and report it to IRS and taxpayers.29

           Although withholding and information reporting are highly
           effective in encouraging compliance, such additional requirements
           generally impose costs and burdens on the businesses that must
           implement them. However, continued reexamination of opportunities
           to expand information reporting and tax withholding could increase
           the transparency of the tax system. Opportunities to expand
           information reporting and tax withholding could be especially
           relevant toward improving compliance in areas that are
           particularly complex or challenging to administer, such as with
           net income and losses passed through from "flow-through" entities
           such as S corporations and partnerships to their shareholders and
           partners.30

           Another enforcement tool that can potentially deter noncompliance
           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.31 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.

           Leveraging technology to improve IRS's capacity to receive,
           process, and utilize taxpayer returns could help IRS better
           determine how to allocate its resources to reduce the tax gap and
           would seem to be a prudent investment. IRS has invested heavily in
           modernizing its technology and those investments have paid off.
           Telephone service has improved and taxpayers are much more likely
           to get through to IRS and obtain assistance from IRS than before
           IRS upgraded its technology. Further, electronic filing has grown
           substantially. Tax information submitted to IRS electronically
           enables faster, more accurate processing and quicker interactions
           between IRS and taxpayers. Electronically filed returns are
           processed as they are received, therefore giving IRS access to
           more timely and accurate tax information, which can be used for
           better data analysis capability and quicker focus on issues that
           need resolution. IRS estimates it saves $2.15 on every individual
           tax return that is processed electronically. According to IRS
           data, electronic filing has allowed IRS to use more than a 1,000
           fewer staff years to process paper returns, resources that can
           then be dedicated to other service or enforcement work.32

           However, IRS's Business Systems Modernization project, through
           which the agency is modernizing its outdated technology, is far
           from complete. IRS needs to continue to strengthen management of
           this effort and make prudent technology investments to maximize
           the efficiencies that can be gained in IRS operations and services
           to taxpayers.

           Sound resource allocation is another tool for addressing the tax
           gap. The more effectively IRS can allocate its resources, the more
           progress should result. The new NRP data, for example, are to be
           used to better identify which tax returns to examine so that fewer
           compliant taxpayers are burdened by unnecessary audits and IRS can
           increase the amount of noncompliance that is addressed through its
           enforcement activities. As part of its attempt to make the best
           use of its enforcement resources, given budget constraints, IRS
           has developed rough measures of return on investment in terms of
           tax revenue that is directly assessed from uncovering
           noncompliance. Developing such measures is difficult because of
           incomplete information on all the costs and all the tax revenue
           ultimately collected from specific enforcement efforts, as well as
           on the indirect tax revenues generated when current enforcement
           actions prompt voluntary compliance improvements in the future.
           Continuing to develop the return on investment measures could help
           officials make more informed decisions about allocating resources,
           particularly during periods of budget constraints. Even with
           better data, however, officials will need to make judgments that
           take into account intangibles, such as how to achieve an equitable
           enforcement presence across the various taxpayer groups.

           Our nation's fiscal imbalance and challenges have created an
           imprudent and unsustainable path that needs to be addressed. While
           our long-term fiscal imbalance is too large to be corrected by one
           strategy, reducing the tax gap can help address the looming fiscal
           challenges. Collecting the billions of dollars that already should
           be paid, for example, would help ease the many difficult decisions
           that need to be made about our spending programs as well as the
           rest of the tax system. However, the tax gap itself has been large
           and pervasive over the years and therefore, reducing the gap will
           not only require expansions of current efforts, but also new and
           innovative solutions. While IRS takes the lead in continuing to
           find ways to significantly reduce the tax gap, support from
           Congress will be essential since legislation will likely be needed
           to implement many of the tax gap reduction ideas offered today. We
           look forward to continuing to work with Congress and IRS on these
           issues.

           Chairman Gregg, Senator Conrad and members of the committee, this
           concludes my testimony. I would be happy to answer any questions
           you may have at this time.

           Contact points for our Offices of Congressional Relations and
           Public Affairs may be found on the last page of this testimony.
           For further information on this testimony, please contact Michael
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           key contributions to this testimony include Tom Short, Assistant
           Director; Jeff Arkin; Elizabeth Fan; and Cheryl Peterson.

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23GAO, Tax Gap: Many Actions Taken, but a Cohesive Compliance Strategy
Needed, GAO/GGD-94-123 (Washington, D.C.: May 11, 1994).

24GAO, Tax Administration: Approaches for Improving Independent Contractor
Compliance, GAO/GGD-92-108 (Washington, D.C.: July 23, 1992).

25Internal Revenue Service, Taxpayer Advocate Service, National Taxpayer
Advocate 2005 Annual Report to Congress (Washington, D.C. Dec. 31, 2005).

26Taxpayer Relief Act of 1997, Pub. L. No. 105-34 (1997).

27National Taxpayer Advocate 2005 Annual Report to Congress.

28Executive Office of the President, Office of Management and Budget,
Budget of the United States Government, Fiscal Year 2007.

Leverage Technology

29National Taxpayer Advocate 2005 Annual Report to Congress.

30Partnerships and S corporations are businesses commonly referred to as
flow-through entities, as they do not generally pay taxes on income.
Instead, they distribute net income and losses to partners, shareholders,
and beneficiaries, who are subsequently required to report net income or
losses on their individual tax returns and pay any applicable taxes.

31American Jobs Creation Act of 2004, Pub. L. No. 108-357 (2004).

Optimize Resource Allocation

32Some state and federal tax experts have recognized that mandatory
electronic filing for certain categories of tax practitioners is one
remaining option with the potential to significantly increase electronic
filing. However, mandatory electronic filing would likely impose some
costs and burdens on tax practitioners.

                            Concluding Observations

                          Contact and Acknowledgments

(450475)

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Highlights of GAO-06-453T , a testimony before the Committee on the
Budget, U.S. Senate

February 15, 2006

TAX GAP

Making Significant Progress in Improving Tax Compliance Rests on Enhancing
Current IRS Techniques and Adopting New Legislative Actions

The Internal Revenue Service's (IRS) most recent estimate of the
difference between what taxpayers timely and accurately paid in taxes and
what they owed was

$345 billion. IRS estimates it will eventually recover some of this tax
gap, resulting in an estimated net tax gap of $290 billion. The tax gap
arises when taxpayers fail to comply with the tax laws by underreporting
tax liabilities on tax returns; underpaying taxes due from filed returns;
or nonfiling, which refers to the failure to file a required tax return
altogether or in a timely manner.

The Chairman and Ranking Minority Member of the Senate Committee on the
Budget asked GAO to present information on the causes of and possible
solutions to the tax gap. This testimony addresses the nature and extent
of the tax gap and the significance of reducing the tax gap, including
some steps that may assist with this challenging task. For context, this
testimony also addressed GAO's most recent simulations of the long-term
fiscal outlook and the need for a fundamental reexamination of major
spending and tax policies and priorities.

What GAO Recommends

GAO is not making any new recommendations but discusses some past
recommendations and highlights some new areas for possible attention.

Our nation's fiscal policy is on an imprudent and unsustainable course. As
long-term budget simulations by GAO show, over the long term we face a
large and growing structural deficit due primarily to known demographic
trends, rising health care costs, and lower federal revenues as a
percentage of the economy. GAO's simulations indicate that the long-term
fiscal challenge is too big to be solved by economic growth alone or by
making modest changes to existing spending and tax policies. Rather, a
fundamental reexamination of major policies and priorities will be
important to recapture our future fiscal flexibility.

Underreporting of income by businesses and individuals accounted for most
of the estimated $345 billion tax gap for 2001, with individual income tax
underreporting alone accounting for $197 billion, or over half of the
total gap. Corporate income tax and employment tax underreporting
accounted for an additional $84 billion of the gap.

Reducing the tax gap would help improve fiscal sustainability. Given the
tax gap's persistence and size, it will require considering not only
options that have been previously proposed but also new administrative and
legislative actions. Even modest progress would yield significant revenue;
each 1 percent reduction would likely yield nearly $3 billion annually.
Reducing the tax gap will be a challenging long-term task, and progress
will require attacking the gap with multiple strategies over a sustained
period. These strategies could include efforts to regularly obtain data on
the extent of, and reasons for, noncompliance; simplify the tax code;
provide quality service to taxpayers; enhance enforcement of tax laws by
utilizing enforcement tools such as tax withholding, information
reporting, and penalties; leverage technology; and optimize resource
allocation.

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

Source: IRS.

Note: Figures may not sum to totals due to rounding.
*** End of document. ***