Tax Compliance: Multiple Approaches Are Needed to Reduce the Tax 
Gap (16-FEB-07, GAO-07-488T).					 
                                                                 
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, various  
approaches to reduce it, and what the proposed budget for fiscal 
year 2008 says about 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-07-488T					        
    ACCNO:   A66004						        
  TITLE:     Tax Compliance: Multiple Approaches Are Needed to Reduce 
the Tax Gap							 
     DATE:   02/16/2007 
  SUBJECT:   Cost analysis					 
	     Excise taxes					 
	     Federal taxes					 
	     Income taxes					 
	     Noncompliance					 
	     Property taxes					 
	     Strategic planning 				 
	     Tax administration 				 
	     Tax evasion					 
	     Tax law						 
	     Tax nonpayment					 
	     Tax violations					 
	     Tax gap						 

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GAO-07-488T

   

     * [1]Background
     * [2]Multiple Approaches Are Needed to Reduce the Tax Gap
     * [3]Reducing the Tax Gap through Tax Simplification or Tax Syste
     * [4]Providing IRS with Additional Enforcement Tools Potentially
     * [5]Devoting Additional Resources to Enforcement Likely Could Re
     * [6]Concluding Observations
     * [7]Contact and Acknowledgments

          * [8]Order by Mail or Phone

Testimony

Before the Committee on the Budget, House of Representatives

United States Government Accountability Office

GAO

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

Friday, February 16, 2007

TAX COMPLIANCE

Multiple Approaches Are Needed to Reduce the Tax Gap

Statement of Michael Brostek Director, Tax Issues Strategic Issues

GAO-07-488T

Chairman Spratt, Mr. Ryan, 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 toward 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 reporting2 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.

           The administration's budget request for fiscal year 2008
           recognizes the need for multiple approaches to tax gap reduction.
           It offers 16 legislative proposals and hundreds of millions of
           dollars for new IRS initiatives to reduce the tax gap. Among other
           things, these proposals address taxpayer services as well as two
           other approaches--expanded information reporting and additional
           enforcement resources for IRS. Even with these efforts, however,
           the dollar amounts expected to be raised are quite small compared
           to the size of the tax gap. This underscores the likelihood that
           more significant reductions in the tax gap will require many
           additional actions under a multiple approaches strategy given the
           variety of taxes, taxpayers, and types of noncompliance that
           contribute to the tax gap.
			  
			  Background

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

4GAO, Tax Compliance: Multiple Approaches Are Needed to Reduce the Tax
Gap, [9]GAO-07-391T (Washington, D.C.: Jan. 23, 2007); Tax Compliance:
Opportunities Exist to Reduce the Tax Gap Using a Variety of Approaches,
[10]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,
[11]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, [12]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,
[13]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, [14]GAO-05-527T (Washington, D.C.: Apr.
14, 2005).

Background

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

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

Source: IRS.

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

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

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 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

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

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 [15]GAO-05-753 .

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 toward
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 steps 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. Furthermore, the document mentioned the
importance of establishing benchmarks against which progress on each step
under the strategy could be measured. It said that after the fiscal year
2008 budget request was released, Treasury and IRS would issue more
details in March or April 2007 about the steps they would take to reduce
opportunities for evasion and address the tax gap.

The 2008 budget request issued on February 5, 2007, suggested 16
legislative changes to expand or improve information reporting, improve
compliance by businesses, strengthen tax administration, and expand
penalties. It also proposed additional funding for new initiatives aimed
at reducing the tax gap.

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.

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 about 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 should be completed in fiscal year 2007, which is to include, among
other things, a multiyear plan for taxpayer service activities and
improvement initiatives.

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:

9GAO, Internal Revenue Service: Assessment of the Interim Results of the
2006 Filing Season and Fiscal Year 2007 Budget Request, [16]GAO-06-499T
(Washington, D.C.: Apr. 27, 2006).

           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 1 tax year, to allow IRS to track compliance
           trends annually. The administration's fiscal year 2008 budget
           proposal offers this idea by requesting funds to annually study
           compliance based on a smaller sample size than the 2001 NRP study.

           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 effects
           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. The administration's fiscal year 2008 budget
           proposal requests additional funds under its Business Systems
           Modernization initiatives.
			  
			  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 report11 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, we15 and the National Taxpayer Advocate16 have
           previously reported that confusion over the complex rules
           governing eligibility for claiming the credit could cause
           taxpayers to fail to comply inadvertently. The administration's
           fiscal year 2008 budget proposes legislative language to simplify
           eligibility requirements for the credit as well as to clarify the
           uniform definition of a qualifying child.

           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 statute17 as tax expenditures, such as tax
           exemptions, exclusions, deductions, credits, and deferrals.18 The
           number of these tax expenditures has more than doubled from 67 in
           1974 to 161 in 2006, and the sum of tax expenditure estimates rose
           to nearly $847 billion.19 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.20

           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.21 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.

           Figure 1 shows how much voluntary reporting compliance improves
           for income subject to withholding or information reporting. 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.22 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.23

           o Requiring information return reporting on payments made to
           corporations. Unlike payments made to sole proprietors, payments
           made to corporations for services are generally not required to be
           reported on information returns. IRS and GAO24 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 1997,25 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.

           Withholding and information reporting lead to high levels of
           compliance. Designing new requirements to address underreporting
           would need to address the challenge 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 income26 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.

           The administration's proposed budget for fiscal year 2008 has 16
           legislative proposals on tax gap reduction of which 7 relate to
           expanded information reporting.27 Two of these proposals involve
           information reporting on payments to corporations and on the cost
           basis of security sales, which we discussed earlier in this
           section of the testimony. The administration also proposes
           requiring a certified tax identification number from nonemployee
           service providers (contractors), increased information reporting
           for certain government payments for property and services, and
           increased information return penalties. We have done past work
           related to these proposals and suggested them as options for
           reducing the tax gap.28 The remaining 2 proposals would expand
           broker information reporting and require information reporting on
           merchant card payment reimbursements.

           The 7 proposals relating to information reporting account for
           virtually all the revenue that the budget request's 16 tax gap
           legislative proposals are projected to raise. The 16 proposals are
           expected to raise about $29 billion over 10 years, or about 1
           percent per year of the 2001 net tax gap amount of $290 billion.
           About 98 percent of the $29 billion would come from the
           information reporting proposals. About 85 percent would come from
           3 of them--those relating to payments to corporations, basis
           reporting on security sales, and merchant payment card
           reimbursements.
			  
			  Providing IRS with Additional Enforcement Tools Potentially Could
			  Improve Compliance Significantly, but Identifying and Designing
			  Such Tools Can Be Challenging

           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.29 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.30 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.31

           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 amount of additional
           resources. 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.32

           These various factors need to be taken into account in estimating
           revenue to be obtained from increased funding. In doing such
           estimates for its fiscal year 2007 budget, 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.33 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.34

           As table 2 shows, the administration's budget request for fiscal
           year 2008 proposes additional revenue-producing initiatives,
           legislative proposals, and non-revenue-producing initiatives. The
           revenue-producing initiatives generally would fund additional
           staff to enforce tax laws; the legislative proposals include, for
           example, new information return requirements that would increase
           revenue; and the non-revenue-producing initiatives generally would
           fund infrastructure and Business Systems Modernization changes to
           support IRS operations.

10 [17]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, [18]GAO-05-684
(Washington, D.C.: July 29, 2005).

12GAO, Paid Tax Return Preparers: In a Limited Study, Chain Preparers Made
Serious Errors, [19]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 [20]GAO-06-208T .

16Internal Revenue Service, Taxpayer Advocate Service, National Taxpayer
Advocate 2004 Annual Report to Congress (Washington, D.C.: Dec. 31, 2004).

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

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

19Summing tax expenditure estimates does not take into account
interactions between individual provisions.

20The 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.

21For 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.

22GAO, Capital Gains Tax Gap: Requiring Brokers to Report Securities Cost
Basis Would Improve Compliance if Related Challenges Are Addressed,
[22]GAO-06-603 (Washington, D.C.: June 13, 2006).

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

24GAO, Tax Administration: Benefits of a Corporate Document Matching
Program Exceed the Costs, [24]GAO/GGD-91-118 (Washington, D.C.: Sept. 27,
1991).

25Taxpayer Relief Act of 1997, Pub. L. No. 105-34 (1997).

26Nonfarm 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.

27In general, the other 9 proposals involve e-filing, clarifying
employment tax liability for employee leasing companies and under
collection due process procedures, sharing information related to the
national directory of new hires and prison tax scams, making repeated and
willful tax nonfiling a felony, and expanding IRS's penalty authority in
certain areas.

28 [25]GAO/GGD-92-108 ; Tax Administration: Federal Agencies Should Report
Service Payments Made to Corporations, [26]GAO/GGD-92-130 (Washington,
D.C.: Sept. 22, 1992), and Tax Gap: Many Actions Taken, but a Cohesive
Compliance Strategy Needed, [27]GAO/GGD-94-123 (Washington, D.C.: May 11,
1994).

29For examples, see GAO, Tax Administration: Impact of Compliance and
Collection Program Declines on Taxpayers, [28]GAO-02-674 (Washington,
D.C.: May 22, 2002); High Risk Series: An Update, [29]GAO-05-207
(Washington, D.C.: January 2005); and our tax gap products cited earlier
in this statement, [30]GAO-06-1000T , [31]GAO-06-453T , [32]GAO-06-208T ,
[33]GAO-05-753 , and [34]GAO-05-527T .

30Commissioner of Internal Revenue Charles O. Rossotti, Report to the IRS
Oversight Board: Assessment of IRS and the Tax System, October 2002.

31The 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.

32GAO, Tax Administration: IRS Measures Could Provide a More Balanced
Picture of Audit Results and Costs, [35]GAO/GGD-98-128 (Washington, D.C.:
June 23, 1998).

33Two 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.

34Economists 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," National Tax Journal, vol. 43 (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).

Table 2: Cost and Estimated Revenue of IRS Tax Gap Proposals for Fiscal
Years 2008 through 2010

Dollars in millions                                         
                                                       Estimated revenue from
                                    Cost of proposal          proposal
                                  Fiscal Fiscal Fiscal  Fiscal  Fiscal Fiscal 
                                    year   year   year    year    year   year 
Type of proposal                 2008   2009   2010    2008    2009   2010 
Revenue-producing initiatives    $198   $163   $163    $317    $526   $699 
Legislative proposals              23     23     23     378   1,171  1,898 
Non-revenue-producing             188    168    168       0       0      0 
initiatives                                                                
Total                            $410   $355   $355    $695  $1,697 $2,597 

Source: GAO (analysis); IRS and Department of the Treasury (data).

Note: Figures may not sum to totals because of rounding. Data are from IRS
and from Treasury's February 2007 General Explanations of the
Administration's Fiscal Year 2008 Revenue Proposals.

Over the 3 years, the requested funding decreases while the estimated
resulting revenue increases. About $410 million is requested for fiscal
year 2008 to fund all of these initiatives, which are estimated to bring
in about $695 million in increased revenue that year. The estimated cost
for the initiatives declines to $355 million in fiscal years 2009 and 2010
and the projected revenues increase to about $2.6 billion in 2010. Costs
decline due to start up costs applying only in fiscal year 2008. Revenues
increase in part due to improved annual returns from the hiring, training,
and deployment of additional staff, but more so due to the phase in of the
legislative proposals, particularly the information reporting
requirements. The legislative proposals alone are estimated to produce
$1.9 billion of the $2.6 billion total additional revenues expected to
come from the administration's budget proposals in fiscal year 2010. The
revenue effects of the revenue-producing initiatives exclude the likely
deterrent effect from IRS enforcement programs as well as any improvement
in voluntary compliance due to improved taxpayer services.

The revenues expected from these initiatives are small compared to the
estimated $290 billion net tax gap for tax year 2001. For instance, all of
the revenue-producing initiatives coming largely from additional
enforcement staffing are expected to yield about $699 million in fiscal
year 2010, or about one-quarter of 1 percent of the tax year 2001 net tax
gap. In 2010, the total estimated increased revenues from both the
revenue-producing and legislative initiatives, or about $2.6 billion, is
about 0.9 percent of the 2001 net tax gap.

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. The various proposals in the
administration's budget request raise modest dollar amounts compared to
the size of the tax gap. This underscores the likelihood that a wide
variety of efforts will be needed to make significant progress in
addressing the tax gap. We look forward to seeing the administration's
expanded outline of steps it will be taking.

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 [email protected]. Contact points for our Offices of
Congressional Relations and Public Affairs may be found on the last page
of this testimony. Individuals making key contributions to this testimony
include Thomas Short, Assistant Director; Jeffrey Arkin; Elizabeth Fan;
Ronald Jones; Lawrence Korb; and Ellen Rominger.

(450570)

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Highlights of [43]GAO-07-488T , a testimony to the Committee on the
Budget, House of Representatives

February 16, 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, various approaches to reduce it, and
what the proposed budget for fiscal year 2008 says about 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.

[44]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. Moreover, providing quality services to taxpayers
is a necessary foundation for voluntary compliance. Such steps as
periodically measuring noncompliance and its causes, setting tax gap
reduction goals, 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 considering such
factors as how well IRS uses its resources and the proper balance between
taxpayer service and enforcement activities. If Congress provides IRS more
enforcement resources, the amount of tax gap reduction would depend on
factors such as the size of budget increases and the indirect increase in
taxpayers' voluntary compliance resulting from expanded enforcement. The
recent budget request for fiscal year 2008 proposes legislation and new
initiatives to reduce the tax gap but expected dollar gains are modest.
Further reductions likely would require many more such changes.

References

Visible links
9. http://www.gao.gov/cgi-bin/getrpt?GAO-07-391T
  10. http://www.gao.gov/cgi-bin/getrpt?GAO-06-1000T
  11. http://www.gao.gov/cgi-bin/getrpt?GAO-06-453T
  12. http://www.gao.gov/cgi-bin/getrpt?GAO-06-208T
  13. http://www.gao.gov/cgi-bin/getrpt?GAO-05-753
  14. http://www.gao.gov/cgi-bin/getrpt?GAO-05-527T
  15. http://www.gao.gov/cgi-bin/getrpt?GAO-05-753
  16. http://www.gao.gov/cgi-bin/getrpt?GAO-06-499T
  17. http://www.gao.gov/cgi-bin/getrpt?GAO-05-753
  18. http://www.gao.gov/cgi-bin/getrpt?GAO-05-684
  19. http://www.gao.gov/cgi-bin/getrpt?GAO-06-563TEUR
  20. http://www.gao.gov/cgi-bin/getrpt?GAO-06-208T
  21. http://www.gao.gov/cgi-bin/getrpt?GAO-05-690
  22. http://www.gao.gov/cgi-bin/getrpt?GAO-06-603
  23. http://www.gao.gov/cgi-bin/getrpt?GAO/GGD-92-108
  24. http://www.gao.gov/cgi-bin/getrpt?GAO/GGD-91-118
  25. http://www.gao.gov/cgi-bin/getrpt?GAO/GGD-92-108
  26. http://www.gao.gov/cgi-bin/getrpt?GAO/GGD-92-130
  27. http://www.gao.gov/cgi-bin/getrpt?GAO/GGD-94-123
  28. http://www.gao.gov/cgi-bin/getrpt?GAO-02-674
  29. http://www.gao.gov/cgi-bin/getrpt?GAO-05-207
  30. http://www.gao.gov/cgi-bin/getrpt?GAO-06-1000T
  31. http://www.gao.gov/cgi-bin/getrpt?GAO-06-453T
  32. http://www.gao.gov/cgi-bin/getrpt?GAO-06-208T
  33. http://www.gao.gov/cgi-bin/getrpt?GAO-05-753
  34. http://www.gao.gov/cgi-bin/getrpt?GAO-05-527T
  35. http://www.gao.gov/cgi-bin/getrpt?GAO/GGD-98-128
  43. http://www.gao.gov/cgi-bin/getrpt?GAO-07-488T
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