Tax Compliance: Multiple Approaches Are Needed to Reduce the Tax
Gap (23-JAN-07, GAO-07-391T).
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 the
need for taking multiple approaches and to what extent the tax
gap could be reduced through three overall
approaches--simplifying or reforming the tax system, providing
IRS with additional enforcement tools, and devoting additional
resources to enforcement. This statement is based on prior GAO
work.
-------------------------Indexing Terms-------------------------
REPORTNUM: GAO-07-391T
ACCNO: A65086
TITLE: Tax Compliance: Multiple Approaches Are Needed to Reduce
the Tax Gap
DATE: 01/23/2007
SUBJECT: Allocation (Government accounting)
Data collection
Law enforcement
Noncompliance
Reporting requirements
Standards
Strategic planning
Tax administration
Tax evasion
Tax law
Tax nonpayment
Tax violations
Voluntary compliance
Tax gap
Transparency
IRS National Research Program
IRS Taxpayer Compliance Measurement
Program
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GAO-07-391T
Testimony
Before the Committee on the Budget, U.S. Senate
United States Government Accountability Office
GAO
For Release on Delivery Expected at 10:00 a.m. EST
Tuesday, January 23, 2007
TAX COMPLIANCE
Multiple Approaches Are Needed to Reduce the Tax Gap
Statement of Michael Brostek Director, Tax Issues Strategic Issues Team
GAO-07-391T
This testimony was amended on February 9, 2007, to correct the tax gap
reduction amounts on page 8 to $28 billion less and $133 billion less if
the compliance rate had been 85 percent and 90 percent, respectively.
Chairman Conrad, Senator Gregg, Members of the Committee:
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 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. First I will discuss the need for multiple
approaches towards reducing the tax gap. Then I will discuss three
specific tax gap reduction approaches: (1) simplifying or reforming the
tax system; (2) providing IRS additional enforcement authority and tools,
such as information reporting^2 and tax withholding,^3 through changes to
the tax laws; and (3) devoting additional resources to enforcement under
the existing tax laws. 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 Multiple approaches are needed to reduce the tax gap. No single
approach is likely to fully and cost-effectively address
noncompliance since, for example, it has multiple causes and spans
different types of taxes and taxpayers. Simplifying or reforming
the tax code, providing IRS more enforcement tools, and devoting
additional resources to enforcement are three major approaches
discussed below, but providing quality services to taxpayers also
is a necessary foundation for voluntary compliance. Quality
services can help taxpayers who wish to comply but do not
understand their obligations, whereas enforcement actions may be
needed for those who intentionally evade their tax obligations.
Such steps as periodically measuring noncompliance and its causes,
setting tax gap reduction goals, considering the costs and
benefits of initiatives to reduce the gap, evaluating the results
of such initiatives undertaken, optimizing the allocation of IRS's
resources, and leveraging technology to enhance IRS's efficiency
would also contribute to tax gap reduction.
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 to be contacted. 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, underreporting exists in many forms, 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 the tax gap 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.
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 Compliance: Opportunities Exist to Reduce the Tax Gap Using a
Variety of Approaches, [1]GAO-06-1000T (Washington, D.C.: July 26, 2006);
Tax Gap: Making Significant Progress in Improving Tax Compliance Rests on
Enhancing Current IRS Techniques and Adopting New Legislative Actions,
[2]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, [3]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,
[4]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, [5]GAO-05-527T (Washington, D.C.: Apr.
14, 2005).
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 tax form simplification. 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 $48 billion in fiscal year
2006 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
Multiple Approaches Are Needed to Reduce the Tax Gap
No single approach is likely to fully and cost-effectively address
noncompliance and therefore multiple approaches are likely to be needed.
The tax gap has multiple causes; spans five types of taxes; and is spread
over several types of taxpayers including individuals, corporations, and
partnerships. Thus, for example, while simplifying laws should help when
noncompliance is due to taxpayers' confusion, enforcement may be needed
for taxpayers who understand their obligations but decline to fulfill
them. Similarly, while devoting more resources to enforcement should
increase taxes assessed and collected, too great an enforcement presence
likely would not be tolerated.
^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 [6]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.
Simplifying or reforming the tax code, providing IRS more enforcement
tools, and devoting additional resources to enforcement are three major
tax gap reduction approaches discussed in more detail below, but providing
quality services to taxpayers plays an important role in improving
compliance and reducing the tax gap. IRS taxpayer services include
education and outreach programs, simplifying the tax process, and revising
forms and publications to make them electronically accessible and more
easily understood by diverse taxpayer communities. For example, if tax
forms and instructions are unclear, taxpayers may be confused and make
unintentional errors. Quality taxpayer services would also be a key
consideration in implementing any of the approaches for tax gap reduction.
For example, expanding enforcement efforts would increase interactions
with taxpayers, requiring processes to efficiently communicate with
taxpayers. Also, changing tax laws and regulations would require educating
taxpayers of the new requirements in a clear, timely, and accessible
manner. In 2006, we reported that IRS improved its two most commonly used
services--telephone and Web site assistance--for the 2006 filing season.^9
Increased funding financed some of the improvements, but a significant
portion has been financed internally by efficiencies gained from increased
electronic filing of tax returns and other operational improvements.
Although quality service helps taxpayers comply, showing a direct
relationship between quality service and compliance levels is very
challenging. As required by Congress, IRS is in the midst of a study that
is to result in a 5-year plan for taxpayer service activities, which is to
include long-term quantitative goals and to balance service and
enforcement. Part of the study focuses on the effect of taxpayer service
on compliance. A Phase I report was issued in April 2006 and a Phase II
report is due in early 2007, which is to include, among other things, a
multiyear plan for taxpayer service activities and improvement
initiatives.
^9GAO, Internal Revenue Service: Assessment of the Interim Results of the
2006 Filing Season and Fiscal Year 2007 Budget Request, [7]GAO-06-499T
(Washington, D.C.: Apr. 27, 2006).
However, in deciding on the appropriate mix of approaches to use in
reducing the tax gap, 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 and setting long-term
goals. A data-based plan is one key to closing the tax gap. To the
extent that IRS can develop better compliance data, it can develop
more effective approaches for reducing the gap. 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.^10 IRS
agreed with the recommendations and established a voluntary tax
compliance goal of 85 percent by 2009. Furthermore, we have
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 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. For example,
withholding and information reporting requirements impose some
costs and burdens on those who 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 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.
o Optimizing resource allocation. 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. In general though, the impacts
of tax gap reduction by improving voluntary tax compliance can be
quite large. For example, if the estimated 83.7 percent voluntary
compliance rate that produced a gross tax gap of $345 billion in
tax year 2001 had been 85 percent, this tax gap would have been
about $28 billion less; if it had been 90 percent, the gap would
have been about $133 billion less.
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.
Congress has been encouraging IRS to develop an overall tax gap
reduction plan or strategy that could include a mix of approaches
like simplifying code provisions, increased enforcement, and
reconsidering the level of resources devoted to enforcement. Some
progress has been made towards laying out the broad elements of a
plan or strategy for reducing the tax gap. On September 26, 2006,
the U.S. Department of the Treasury (Treasury), Office of Tax
Policy released "A Comprehensive Strategy for Reducing the Tax
Gap." However, the document generally does not identify specific
approaches that Treasury and IRS will undertake to reduce the tax
gap, the related time frames for such steps, or explanations of
how much the tax gap would be reduced. The document said that such
additional details the would be part of the fiscal year 2008 IRS
budget request that will be deliberated during early 2007 because
of the resource implications associated with tax gap reduction.
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 three 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 report^11 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.^12 Further, the Joint Committee on
Taxation suggested that such dissimilar definitions may increase
the likelihood of taxpayer errors and increase taxpayer
frustration.^13
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.^14 Although some of this noncompliance
may be intentional, we^15 and the National Taxpayer Advocate^16
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.^17 A change
was not made until 2004.^18 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.^19
Another form of simplification could be to broaden the tax base
while reducing tax rates, which could minimize incentives for not
complying. This base- broadening could include a review of whether
existing tax expenditures are achieving intended results at a
reasonable cost in lost revenue and added burden and eliminating
or consolidating those that are not. Among the many causes of tax
code complexity is the growing number of preferential provisions
in the code, defined in statute^20 as tax expenditures, such as
tax exemptions, exclusions, deductions, credits, and deferrals.^21
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.
Nevertheless, 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.^22
Despite the potential benefits that simplification may yield,
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.^23 Any tax system could be subject to noncompliance,
and its design and operation, including the types of tools made
available to tax administrators, will 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.
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 taxes owed from a taxpayer's income and
remit them to IRS. Information reporting tends to lead to high
levels 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, withholding and information
reporting help IRS to better identify noncompliant taxpayers and
prioritize contacting them, which enables 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,
underreporting exists in varied forms, 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 remain 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 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.^24 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.^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.
Information reporting helps 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.
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,
challenges arise in establishing new withholding or information
reporting requirements for certain other types of income that are
extensively underreported. Such underreporting may be difficult to
determine because of complex tax laws or transactions or the lack
of a practical and reliable third-party source to provide
information on the taxable income.
For example, while withholding or information reporting mechanisms
on nonfarm sole proprietor and informal supplier income^27 would
likely improve their compliance, comprehensive mechanisms that are
practical and effective are difficult to identify. 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. 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.
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 who
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.
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, as 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.
Given resource constraints, IRS is unable to contact millions of
additional taxpayers for whom it has evidence of 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.^28 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. 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.^29
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. The degree to which revenues
would increase from expanded enforcement depends on many
variables, such as how quickly IRS can ramp up efforts, how well
IRS selects the best cases to be worked, and how taxpayers react
to enforcement efforts. Estimating those revenue increases would
require assumptions about these and other variables. Because
actual experience is likely to diverge from those assumptions, the
actual revenue increases are likely to differ from the estimates.
The lack of reliable key data compounds the difficulty of
estimating the likely revenues. To the extent possible, obtaining
better data on key variables would provide a better understanding
of the likely results with any increased enforcement resources.
With additional resources for enforcement, IRS would be able to
assess and collect additional taxes, but the related tax gap
reductions may not be immediate. If IRS uses the resources to hire
more enforcement staff, the reductions may occur gradually as IRS
is able to hire and train the staff. Also, several years can
elapse after IRS assesses taxes before it actually collects these
taxes.
Similarly, the amounts of taxes actually collected can vary
substantially from the related tax amounts assessed through
enforcement actions by the type of tax or taxpayer involved. In a
1998 report, we found that 5 years after taxes were assessed
against individual taxpayers with business income, 48 percent of
the assessed taxes had been collected, whereas for the largest
corporate taxpayers, 97 percent of assessed taxes had been
collected.^30
Over the last 2 years, IRS has requested and received additional
funding targeted for enforcement activities that it estimated will
result in additional revenue. In its fiscal year 2007 budget
request, IRS requested an approximate 2 percent increase in
funding from fiscal year 2006 to expand its enforcement efforts,
including tax return examination and tax collection activities,
with the goal of increasing individual taxpayer compliance and
addressing concerns that we and others have raised^31 regarding
the erosion of IRS's enforcement presence. In estimating the
revenue that it would obtain from the increased funding, IRS
accounted for several factors, 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 first year
after expanding enforcement activities, the additional revenue to
be collected is less than half the amount to be collected 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 also depends on how well IRS can use information
about noncompliance to manage the additional resources. Because
IRS does not have compliance data for some segments of the tax gap
and others are based on old data, IRS cannot easily track the
extent to which compliance is improving or declining. IRS also has
concerns with its information on whether taxpayers unintentionally
or intentionally fail to comply with the tax laws. Knowing the
reasons for taxpayer noncompliance 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. To
the extent that compliance data are outdated and IRS does not know
the reason for taxpayer noncompliance, IRS may be less able to
target resources efficiently to achieve the greatest tax gap
reduction at the least taxpayer burden.
IRS has taken important steps to better ensure efficient
allocation and use. For example, the NRP study has provided better
data on which taxpayers are most likely to be noncompliant. IRS is
using the data to improve its audit selection processes in hopes
of reducing the number of audits that result in no change, which
should reduce unnecessary burden on compliant taxpayers and
increase enforcement staff productivity (as measured by direct
enforcement revenue).
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. In addition to
returns on investment estimates being rough, IRS lacks information
on the incremental returns on investment from pursuing the "next
best case" for some enforcement programs. It is the marginal
revenue gain from these cases that matters in estimating the
direct revenue from expanded enforcement. 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 different enforcement
efforts is subject to uncertainty.
Given the variation in estimated returns on investment for
different 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 how IRS allocates the increase. Although it might
be tempting to allocate resources heavily toward 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.
Beyond direct tax revenue collection, expanded enforcement efforts
could reduce the tax gap even more, 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
^10 [14]GAO-05-753 .
^11GAO, 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, [15]GAO-05-684
(Washington, D.C.: July 29, 2005).
^12GAO, Paid Tax Return Preparers: In a Limited Study, Chain Preparers
Made Serious Errors, [16]GAO-06-563T (Washington, D.C.: Apr. 4, 2006).
^13U.S. Congress, Joint Committee on Taxation, Study of the Overall State
of the Federal Tax System, vol. II, 125-6 (April 2001).
^14IRS measured the extent of noncompliance with the earned income tax
credit in a study separate from NRP.
^15 [17]GAO-06-208T .
^16Internal Revenue Service, Taxpayer Advocate Service, National Taxpayer
Advocate 2004 Annual Report to Congress (Washington, D.C.: Dec. 31, 2004).
^17See GAO, Tax Administration: Erroneous Dependent and Filing Status
Claims, [18]GAO/GGD-93-60 , (Washington, D.C: Mar.19, 1993).
^18Pub. L. No. 108-311 (2004).
^19See Nina E. Olson, "Uniform Qualifying Child Definition: Uniformity for
Most Taxpayers," Tax Notes, (April 10, 2006), 225-228; and John Buckley,
"Uniform Definition of a Child: Large Unintended Consequences," Tax Notes,
(March 20, 2006), 1345-1349.
^20The 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)).
^21GAO, Government Performance and Accountability: Tax Expenditures
Represent a Substantial Federal Commitment and Need to Be Reexamined,
[19]GAO-05-690 (Washington, D.C.: Sept. 23, 2005).
^22The 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.
^23For 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.
^24GAO, Capital Gains Tax Gap: Requiring Brokers to Report Securities Cost
Basis Would Improve Compliance if Related Challenges Are Addressed,
[20]GAO-06-603 (Washington, D.C.: June 13, 2006).
^25GAO, Tax Administration: Approaches for Improving Independent
Contractor Compliance, [21]GAO/GGD-92-108 (Washington, D.C.: July 23,
1992).
^26Taxpayer Relief Act of 1997, Pub. L. No. 105-34 (1997).
^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.
^28Commissioner of Internal Revenue Charles O. Rossotti, Report to the IRS
Oversight Board: Assessment of IRS and the Tax System, October 2002.
^29The overall tax gap has many components. 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.
^30GAO, Tax Administration: IRS Measures Could Provide a More Balanced
Picture of Audit Results and Costs, [22]GAO/GGD-98-128 (Washington, D.C.:
June 23, 1998).
^31GAO issued a number of products regarding the erosion of IRS's
enforcement presence and a continued growth in noncompliance. For
examples, see GAO, Tax Administration: Impact of Compliance and Collection
Program Declines on Taxpayers, [23]GAO-02-674 (Washington, D.C.: May 22,
2003); High Risk Series: An Update, [24]GAO-05-207 (Washington, D.C.:
January 2005); and our tax gap products cited earlier in this statement,
[25]GAO-06-1000T , [26]GAO-06-453T , [27]GAO-06-208T , [28]GAO-05-753 ,
and [29]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).
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
single 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 Committee, 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 brostekm@gao.gov. 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; and Elizabeth Fan.
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Highlights of [31]GAO-07-391T , a testimony to the Committee on the
Budget, U.S. Senate
January 23, 2007
TAX COMPLIANCE
Multiple Approaches Are Needed to Reduce the Tax Gap
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 the need for taking multiple approaches and to
what extent the tax gap could be reduced through three overall
approaches-- simplifying or reforming the tax system, providing IRS with
additional enforcement tools, and devoting additional resources to
enforcement. This statement is based on prior GAO work.
[32]What GAO Recommends
GAO is not making any new recommendations but highlights areas for
possible attention.
Multiple approaches are needed to reduce the tax gap. No single approach
is likely to fully and cost-effectively address noncompliance since, for
example, it has multiple causes and spans different types of taxes and
taxpayers. Simplifying or reforming the tax code, providing IRS more
enforcement tools, and devoting additional resources to enforcement are
three major approaches, but providing quality services to taxpayers also
is a necessary foundation for voluntary compliance. Such steps as
periodically measuring noncompliance and its causes, setting tax gap
reduction goals, evaluating the results of any initiatives to reduce the
tax gap, optimizing the allocation of IRS's resources, and leveraging
technology to enhance IRS's efficiency would also contribute to tax gap
reduction.
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 most likely 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 make underreported income transparent to IRS.
These tools have led to high, sustained levels of taxpayer compliance and
improved IRS resource allocation by helping 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, underreporting exists in
many forms, 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 IRS enforcement resources requires taking into
account such factors as how well IRS uses its resources, the proper
balance between taxpayer service and enforcement activities, and competing
federal funding priorities. If Congress provides IRS more enforcement
resources, the amount of tax gap reduction 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 contact.
References
Visible links
1. http://www.gao.gov/cgi-bin/getrpt?GAO-06-1000T
2. http://www.gao.gov/cgi-bin/getrpt?GAO-06-453T
3. http://www.gao.gov/cgi-bin/getrpt?GAO-06-208T
4. http://www.gao.gov/cgi-bin/getrpt?GAO-05-753
5. http://www.gao.gov/cgi-bin/getrpt?GAO-05-527T
6. http://www.gao.gov/cgi-bin/getrpt?GAO-05-753
7. http://www.gao.gov/cgi-bin/getrpt?GAO-06-499T
14. http://www.gao.gov/cgi-bin/getrpt?GAO-05-753
15. http://www.gao.gov/cgi-bin/getrpt?GAO-05-684
16. http://www.gao.gov/cgi-bin/getrpt?GAO-06-563TEUR
17. http://www.gao.gov/cgi-bin/getrpt?GAO-06-208T
18. http://www.gao.gov/cgi-bin/getrpt?GAO/GGD-93-60
19. http://www.gao.gov/cgi-bin/getrpt?GAO-05-690
20. http://www.gao.gov/cgi-bin/getrpt?GAO-06-603
21. http://www.gao.gov/cgi-bin/getrpt?GAO/GGD-92-108
22. http://www.gao.gov/cgi-bin/getrpt?GAO/GGD-98-128
23. http://www.gao.gov/cgi-bin/getrpt?GAO-02-674
24. http://www.gao.gov/cgi-bin/getrpt?GAO-05-207
25. http://www.gao.gov/cgi-bin/getrpt?GAO-06-1000T
26. http://www.gao.gov/cgi-bin/getrpt?GAO-06-453T
27. http://www.gao.gov/cgi-bin/getrpt?GAO-06-208T
28. http://www.gao.gov/cgi-bin/getrpt?GAO-05-753
29. http://www.gao.gov/cgi-bin/getrpt?GAO-05-527T
31. http://www.gao.gov/cgi-bin/getrpt?GAO-07-391T
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