Tax Administration: Electronic Filing Falling Short of Expectations
(Letter Report, 10/31/95, GAO/GGD-96-12).

GAO reviewed the Internal Revenue Service's (IRS) plans to maximize
electronic filing, focusing on: (1) IRS progress in broadening the use
of electronic filing; (2) the availability of data needed to develop an
electronic filing strategy; and (3) the implications for IRS if it does
not significantly reduce its paper-processing workload.

GAO found that: (1) IRS will fall far short of its 2001 goal of 80
million electronic returns if the increase in electronic filing
continues at its present pace; (2) IRS believes the decrease in the
number of returns filed electronically in 1995 was due to its actions
against electronic filing fraud; (3) IRS is having little success in
increasing the electronic filing of individual 1040 and business tax
returns which constitute the bulk of returns and take the most time to
process manually; (4) the transmittal fees for electronic filing tend to
deter filers unless they need their tax refunds quickly; (5) IRS does
not have the data needed to determine whether greater electronic filings
of 1040 and business returns would reduce its administrative costs; (6)
IRS has contracted to gather some data on why taxpayers do not use
electronic filing more and how many returns it could expect if it could
motivate people to file electronically; (7) IRS plans to use scanning
more to process paper returns, which should reduce some costs; and (9)
unless IRS can increase electronic filing, its customer service and
paper processing workloads may overwhelm its planned staffing and alter
various aspects of its modernization efforts.

--------------------------- Indexing Terms -----------------------------

 REPORTNUM:  GGD-96-12
     TITLE:  Tax Administration: Electronic Filing Falling Short of 
             Expectations
      DATE:  10/31/95
   SUBJECT:  Tax returns
             Electronic forms
             Tax administration systems
             Projections
             Income taxes
             Information processing operations
             Fees
             Administrative costs
             Taxpayers
IDENTIFIER:  IRS TeleFile Program
             IRS Tax System Modernization Program
             TSM
             
**************************************************************************
* This file contains an ASCII representation of the text of a GAO        *
* report.  Delineations within the text indicating chapter titles,       *
* headings, and bullets are preserved.  Major divisions and subdivisions *
* of the text, such as Chapters, Sections, and Appendixes, are           *
* identified by double and single lines.  The numbers on the right end   *
* of these lines indicate the position of each of the subsections in the *
* document outline.  These numbers do NOT correspond with the page       *
* numbers of the printed product.                                        *
*                                                                        *
* No attempt has been made to display graphic images, although figure    *
* captions are reproduced. Tables are included, but may not resemble     *
* those in the printed version.                                          *
*                                                                        *
* A printed copy of this report may be obtained from the GAO Document    *
* Distribution Facility by calling (202) 512-6000, by faxing your        *
* request to (301) 258-4066, or by writing to P.O. Box 6015,             *
* Gaithersburg, MD 20884-6015. We are unable to accept electronic orders *
* for printed documents at this time.                                    *
**************************************************************************


Cover
================================================================ COVER


Report to the Ranking Minority Member, Committee on Government
Affairs,
U.S.  Senate

October 1995

TAX ADMINISTRATION - ELECTRONIC
FILING FALLING SHORT OF
EXPECTATIONS

GAO/GGD-96-12

Electronic Filing

(268636)


Abbreviations
=============================================================== ABBREV

  AICPA - American Institute of Certified Public Accountants
  IRS - Internal Revenue Service

Letter
=============================================================== LETTER


B-260137

October 31, 1995

The Honorable John Glenn
Ranking Minority Member
Committee on Governmental Affairs
United States Senate

Dear Senator Glenn: 

Electronic filing is a cornerstone of the Internal Revenue Service's
(IRS) plan to move away from the traditional paper-based return
filing.  In May 1993, IRS established a goal of receiving 80 million
tax returns electronically in 2001--about 36 percent of all the tax
returns it expects to receive that year.  Our July 1995 report on
IRS' multibillion dollar modernization effort, known as Tax Systems
Modernization, included a discussion of the need for IRS to develop a
strategy to maximize electronic filing.\1 This report, prepared under
our basic legislative authority, builds on that message by assessing
(1) IRS' progress in broadening the use of electronic filing, (2) the
availability of data needed to develop an electronic filing strategy,
and (3) the implications for IRS if it does not significantly reduce
its paper-processing workload. 


--------------------
\1 Tax Systems Modernization:  Management and Technical Weaknesses
Must Be Corrected If Modernization Is To Succeed (GAO/AIMD-95-156,
July 26, 1995). 


   BACKGROUND
------------------------------------------------------------ Letter :1

IRS is in the midst of a major modernization effort, which, if
implemented as intended, will change the way IRS receives, processes,
stores, and retrieves information needed to administer the tax system
and change the way taxpayers and IRS interact.  As part of this
effort, IRS plans to (1) shift from a paper-based to an electronic
tax-processing system, (2) consolidate fragmented telephone
assistance into fewer centrally managed locations to handle almost
all taxpayer calls, and (3) develop a database that contains all
pertinent taxpayer account information and make that information
readily available to all employees who need it.  These plans are all
part of what IRS calls its new business vision. 

IRS is making organizational changes to accommodate this new vision
by (1) moving responsibility for processing electronic returns from 5
service centers to 3 computing centers; (2) consolidating in 5
submission processing centers, the paper-processing activities now
done in 10 service centers; and (3) consolidating in 23 sites, the
customer service activities now done in over 70 sites. 

Electronic filing is one of IRS' first ventures into a more modern
environment.  This alternative to the traditional filing of paper
returns started as a test in 1986 and became available nationwide in
1990.  Some taxpayers can file electronically by telephone, but most
electronic filing is done through a tax return preparer or an
electronic return transmitter.  Once received by IRS, electronic
returns are automatically edited, processed, and stored--functions
that are performed manually for paper returns. 

Electronic filing benefits taxpayers.  The benefits include receipt
of their refunds several weeks sooner than if they had filed paper
returns and greater assurance that (1) IRS has received their
returns, (2) the returns are mathematically accurate, and (3)
information on the returns has been accurately posted to the
taxpayers' accounts in IRS' records. 

Compared with IRS' current procedures for processing paper returns,
electronic filing has several benefits for IRS.  These benefits
include reduced costs of processing, storing, and retrieving returns
and faster, more accurate processing of returns and refunds.  Also,
with electronic filing, IRS gets 100 percent of the return
information in its computers compared with the approximate 40 percent
IRS inputs from paper returns. 

As part of its future business vision, IRS plans to capture 100
percent of the information on paper returns using new scanning
technology.  However, the cost of scanning the data from paper
returns will most likely be higher than the cost of obtaining it
electronically because (1) manual labor will still be required to
prepare the paper documents for scanning and (2) IRS test indicate
that scanning cannot always correctly read the information on paper
returns, thus requiring rework and manual intervention.  Therefore,
electronic filing would continue to provide a more efficient way of
obtaining tax return data than having taxpayers submit paper returns. 


   RESULTS IN BRIEF
------------------------------------------------------------ Letter :2

Since IRS first offered electronic filing in 1986, its marketing has
been targeted primarily at professional tax return preparers.  That
approach has not resulted in the level of electronic filing needed to
achieve IRS' long-term goal nor has it attracted those taxpayers who
file the kinds of returns that contribute most to IRS'
paper-processing workload and costs. 

If electronic filing continues to grow at its recent pace, IRS will
fall far short of 80 million electronic returns in 2001.\2

From 1992 through 1994, the number of returns filed electronically
grew from 12.6 million to 16.4 million, an annual growth rate of 14
percent.  In 1995, the number of electronic returns is expected to
drop to about 14.8 million, which IRS attributes to various actions
it took to crack down on refund fraud.  It is impossible to
accurately predict how the number of electronic returns will change
in future years.  For illustrative purposes, however, if 1995 is
considered an aberration, as IRS believes, and the 14 percent annual
growth rate of the preceding 2 years is resumed, we estimate that
only about 33 million returns will be filed electronically by 2001. 

Most of the electronic returns IRS received in 1994 were individual
income tax returns that could have been filed on Form 1040A or
1040EZ--forms that are among the least costly paper returns to
process.  Individual tax returns that would have otherwise been filed
on the more costly to process Form 1040 accounted for only about 20
percent of the individual tax returns filed electronically, although
59 percent of all individual income tax returns (paper and
electronic) filed in 1994 were on Form 1040.  In addition, IRS has
made little headway in increasing the number of electronically filed
business returns, which are generally more complex and thus more
costly to process on paper than individual returns.  In 1994, about
2.4 million, or 6 percent of the approximate 42 million business
returns were filed electronically. 

A major impediment to the expansion of electronic filing is its cost
to the general public.  Taxpayers must generally file an electronic
return through a preparer or electronic filing transmitter and pay
from $15 to $40 for such services.  In January 1993, we reported that
electronic filing appealed primarily to taxpayers who most needed
their refunds and that other taxpayers saw little reason to incur the
filing cost.\3

According to the American Institute of Certified Public Accountants
(AICPA), many preparers are also concerned about the costs associated
with preparing and transmitting electronic returns.  One aspect of
IRS' current electronic filing program that contributes to this cost
is the need for taxpayers to submit a paper signature document to
affirm that the information on the electronic return is accurate. 

The fact that less complex returns comprise a disproportionate share
of electronic filing may be due, at least in part, to IRS' goal of 80
million returns.  Focusing solely on this goal could cause IRS to
target its efforts at groups of taxpayers or types of returns that
provide the greatest opportunity to increase the number of electronic
returns but not the greatest opportunity to reduce IRS'
paper-processing workload and operating costs.  Although a marketing
strategy that focuses on reducing paper and costs may generate less
than 80 million returns, it could have a more significant impact on
IRS' overall operations. 

Although business returns and returns filed on Form 1040 would appear
to offer the greatest opportunity to reduce IRS' costs if filed
electronically, IRS does not have enough data to make that
determination.  Although IRS has some comparative data on the cost to
process electronic and paper returns, it does not have comparative
data on other costs (such as storage and retrieval) that can vary
depending on how a return is filed.  IRS also does not have (1)
adequate data on why taxpayers do not file electronically and what it
would take to get them to do so and (2) estimates of the number of
electronic returns IRS can expect to receive from those taxpayers
after some market intervention.  IRS awarded a contract in May 1995
that may provide at least some of this information.  With this
information IRS could (1) identify those groups of taxpayers that
offer the greatest opportunity for reducing operating costs and (2)
develop an appropriate marketing strategy for those groups. 

Assumptions about increases in electronic filing and decreases in
paper return filing were critical factors in several of IRS'
modernization decisions, such as deciding on the number of sites and
staff needed to process paper returns and provide customer service. 
Without a significant change in the trends in electronic filing, IRS'
paper-processing and customer-service workloads will exceed
expectations, and IRS may have to alter various aspects of its
modernization.  IRS does not have contingency plans for this
eventuality. 


--------------------
\2 Since establishing its electronic filing goal, IRS has modified
its definition of electronic returns to include returns filed on
magnetic media (tape and computer diskette).  IRS has said that
returns filed on magnetic media will be mostly business returns.  To
be consistent with IRS' definition, further reference to electronic
returns in this report will include, unless otherwise noted, returns
filed on magnetic media. 

\3 Tax Administration:  Opportunities to Increase the Use of
Electronic Filing (GAO/GGD-93-40, Jan.  22, 1993). 


   OBJECTIVES, SCOPE, AND
   METHODOLOGY
------------------------------------------------------------ Letter :3

Our objectives were to assess (1) IRS' progress in achieving its
electronic filing goal, (2) the availability of data needed to
develop an electronic filing strategy, and (3) the implications for
IRS if it does not reach its electronic filing goal and reduce its
reliance on paper. 

To accomplish our objectives, we did the following: 

  We analyzed IRS data for calendar years 1990 through 1994 on the
     number and composition of electronic filings.  For calendar year
     1995, we analyzed such data through May 1995. 

  We determined IRS' potential shortfall in meeting its 80-million
     goal for 2001 by using the annual growth rates for 1993 and
     1994.  We did not use the 1995 growth rate because IRS officials
     believe the 1995 rate is an aberration, and they expect the
     growth of electronic filing to resume in 1996. 

  We used IRS data on the average cost to process electronic returns
     and various types of paper returns in 1993 (the latest
     available)\4 , along with data on the number of returns filed in
     1994, to estimate (1) the potential savings if all forms 1040,
     1040A, and 1040EZ had been filed electronically in 1994 and (2)
     the portion of potential savings that IRS realized, given the
     number of returns that were actually filed electronically in
     1994.  We did not assess the reliability of IRS' data on average
     processing costs for paper and electronic returns. 

  We interviewed officials and staff who had electronic filing
     responsibilities in IRS' National Office; 2 of its 7 regional
     offices (Central and Mid-Atlantic); 5 of its 63 district offices
     (Baltimore, Cincinnati, Cleveland, Indianapolis, and Richmond);
     and 4 of its 10 service centers (Andover, Cincinnati, Memphis,
     and Philadelphia).  We judgmentally selected IRS field offices
     that were involved with unique electronic filing initiatives
     and/or were convenient to our audit staff. 

  We reviewed information related to the electronic filing program,
     including IRS' electronic filing strategy, related legislative
     proposals, and surveys of preparers and taxpayers done by the
     AICPA and other organizations. 

  We reviewed IRS' modernization plans, including documents on the
     sizing of submission processing centers and discussed with
     returns processing and information systems managers in IRS'
     National Office, IRS' plans in the event electronic filing falls
     short of expectations. 

We did our work between April 1994 and May 1995 in accordance with
generally accepted government auditing standards.  We requested
comments on a draft of this report from the Commissioner of Internal
Revenue or her designee.  On July 27, 1995, IRS' Executive for
Electronic Filing and the Site Executives for IRS' Computing Centers
and Submission Processing provided oral comments.  Those comments and
our evaluation are summarized on pages 17 to 20 and are incorporated
in this report where appropriate. 


--------------------
\4 As computed by IRS, processing costs for paper returns include the
costs incurred for such things as opening and sorting the mail,
preparing the returns for data transcription, keypunching data from
the returns into the computer, and correcting errors made by
taxpayers in preparing the returns and by IRS in processing them. 
Processing costs for electronic returns include those costs IRS
incurs after the return is received.  (Processing costs do not
include the telecommunications costs associated with receiving the
return because they are currently incurred by the taxpayer/preparer.)
These costs include upfront validity checks and other costs
associated with preparing return data so they can be merged with data
from paper returns on magnetic tape. 


   IRS' ELECTRONIC FILING STRATEGY
   HAS NOT PRODUCED THE KIND OF
   RESULTS NEEDED TO MEET IRS'
   GOAL
------------------------------------------------------------ Letter :4

Since the inception of electronic filing, IRS' marketing strategy has
been targeted primarily at professional tax return preparers.  That
strategy has not resulted in the level of electronic filing that will
bring IRS to its long-term goal nor has it attracted those taxpayers
who file the kinds of returns that contribute most to IRS'
paper-processing workload and costs.  One impediment to the growth of
electronic filing that IRS has yet to adequately address is its cost
to taxpayers and preparers. 


      FOCUS OF IRS' MARKETING
      EFFORTS HAS NOT CHANGED MUCH
      SINCE ELECTRONIC FILING
      BEGAN
---------------------------------------------------------- Letter :4.1

When electronic filing started in 1986, IRS' marketing approach was
to encourage tax return preparers to provide electronic filing in
hope that they would market the service to the general public.  IRS'
rationale for this approach was based primarily on the large number
of returns prepared by professional preparers--about 57 million for
tax year 1993. 

Because we saw the need for IRS to expand the appeal of electronic
filing, we recommended, in January 1993\5 , that IRS identify
additional market segments and specify national strategies for
attracting those market segments to electronic filing.  To that end,
an IRS task group, in May 1993, presented a strategy that encompassed
21 initiatives for increasing the number of electronically filed
returns. 

A few of the 21 initiatives have been implemented and have resulted
in modest increases in the number of electronic returns.  For
example, one initiative called for expanding TeleFile--a program that
allows taxpayers who meet certain criteria to file 1040EZ returns by
telephone.  About 680,000 taxpayers in 10 states filed returns using
this method in 1995 compared with 149,000 in 1 state in 1993, and IRS
plans to expand the program nationwide in 1996.  Another initiative
called for expanding cooperative arrangements with states that would
allow electronic filers to jointly file their federal and state tax
returns.  As of June 9, 1995, about 1.5 million taxpayers in 29
states had used this program compared with about 635,000 taxpayers in
15 states in 1993. 

However, other initiatives included in the 1993 strategy have been
delayed or dropped.  According to the IRS task group, several of
these initiatives required legislation.  For example, the task group
had estimated that IRS could obtain 37 million electronic returns by
legislatively mandating that tax return preparers who prepare a large
number of individual returns offer electronic filing.  That
initiative was dropped because, according to IRS and Treasury
officials, there was little chance that Congress would pass such
legislation.  Appendix I provides additional information on those
initiatives that the task group said would require legislation. 

Because several initiatives that were designed to attract large
numbers of taxpayers to electronic filing have not been implemented,
IRS' default strategy has been to continue marketing electronic
filing to tax preparers.  However, that strategy has resulted in a
program that primarily attracts individuals who file simple tax
returns, are due refunds, and are willing to pay the fees associated
with electronic filing to get those refunds sooner. 


--------------------
\5 GAO/GGD-93-40. 


      NUMBER OF TAXPAYERS USING
      ELECTRONIC FILING RELATIVELY
      LOW COMPARED WITH IRS' GOAL
---------------------------------------------------------- Letter :4.2

As shown in figure 1 on page 8, the number of electronic returns
increased from about 4.9 million returns in 1990, when electronic
filing became available nationwide, to a high of 16.4 million returns
in 1994, before dropping to an estimated 14.8 million returns in
1995. 

IRS attributes the decrease in electronic filing in 1995 to steps it
took to prevent refund fraud.  As a result of these steps, refunds
for millions of taxpayers were delayed, thereby reducing the major
appeal of electronic filing.  IRS officials believe that the decrease
is temporary. 

Even if electronic filing begins growing again, IRS will be hard
pressed to reach its electronic filing goal.  We estimate that
electronic filing, including returns filed on magnetic media, would
need to grow at an annual rate of about 32 percent to reach 80
million returns in 2001.  That rate contrasts with the 14 percent
annual growth rate IRS achieved in 1993 and 1994.  As shown in figure
1, if annual growth were to continue at 14 percent, we estimate that
only about 33 million returns would be filed electronically in 2001. 

   Figure 1:  Number of Returns
   Filed Electronically in
   Calendar Years 1990 Through
   1995 and Estimated Shortfall in
   Meeting 80-Million Goal for
   Calendar Year 2001

   (See figure in printed
   edition.)

Note 1:  The 1995 figure is an estimate. 

Note 2:  These data include business returns filed mostly on magnetic
media and, for 1994 and 1995, include an estimated 2.4 million and 3
million such returns, respectively. 

Source:  GAO computations using IRS data. 


      THE MORE COMPLEX TAX RETURNS
      ARE NOT BEING FILED
      ELECTRONICALLY
---------------------------------------------------------- Letter :4.3

Not only is the number of electronic returns relatively low, but the
returns being filed electronically are generally those that
contribute least to IRS' paper-processing workload and operating
costs.  Electronic filing has not yet attracted a representative
number of taxpayers who file individual income tax returns on the
more complex Form 1040 and business returns. 

Since electronic filing began, IRS has focused its marketing efforts
on individual income tax returns.  Accordingly, those returns, which
accounted for about 56 percent of all returns filed in 1994,
accounted for 86 percent of those filed electronically.  Despite the
focus on individual returns, electronic filing is not attracting
those taxpayers who represent the largest segment of individual
filers and those who file the most costly individual income tax form
to process on paper.  As a result, potentially significant cost
savings may be going unrealized. 

On the basis of IRS' 1993 service center processing cost estimates
(the latest available), it cost IRS $4.53 to process a paper Form
1040, $3.95 to process a paper Form 1040A, and $3.36 to process a
paper Form 1040EZ.\6 The most costly of the three (Form 1040)
accounted for about 59 percent of all individual returns (paper and
electronic) processed in 1994, yet Form 1040 accounted for only about
20 percent of the individual returns filed electronically. 

On the basis of IRS' processing cost estimates for paper returns and
its estimated average cost of $3.08 to process each electronic
individual return, we estimated (1) the total potential processing
savings that could have been achieved if all individual income tax
returns had been filed electronically in 1994 and (2) the portion of
those potential savings that went unrealized.\7 Figure 2 shows that
the greatest amount of unrealized savings, about $90 million, was for
returns filed on Form 1040. 

   Figure 2:  Estimated Savings
   That Could Have Been Realized
   if All Individual Income Tax
   Returns Were Filed
   Electronically in 1994 and
   Estimated Amount That Went
   Unrealized

   (See figure in printed
   edition.)

Source:  GAO computations using processing cost data in IRS' Service
Center Costing Handbook for 1993 and return filing data from IRS'
Management Information System for Top Level Executives. 

Because paper returns filed by businesses are more expensive to
process than paper returns filed by individuals, according to IRS
data, they would seem to represent a potential source of significant
savings if filed electronically.  IRS estimated, for example, that in
1993 it cost $6.97 to process each partnership return (Form 1065),
$6.95 to process each corporate income tax return (Form 1120), and
$6.19 to process each Employers Quarterly Federal Tax Return (Form
941). 

In 1994, about 6 percent of all business returns were filed
electronically (2.4 million out of 42 million), while the
participation rate for individual returns was about 12 percent (14
million out of 115 million).  Of the 2.4 million electronically filed
business returns, all but about 46,000 were filed on magnetic
media.\8

IRS officials said that the lower participation rate for business
returns reflects, in part, the priority IRS has attached to
increasing the number of electronically filed individual returns. 
That priority is reflected in IRS' May 1993 strategy.  The more
traditional marketing aspects of IRS' strategy were focused on
getting individual returns filed electronically.  For business
returns, IRS' strategy was to rely on legislative mandates.  More
specifically, the 1993 strategy included an initiative that called
for developing a legislative proposal that would (1) mandate
electronic filing of many business returns, including those filed by
fiduciaries (Form 1041), partnerships, and corporations and (2)
require the electronic transmission of Employers Quarterly Federal
Tax Returns by businesses with 10 or more employees.  IRS has since
decided to pursue mandates only as a last resort but has not
developed an alternative strategy for getting large numbers of
business returns filed electronically. 


--------------------
\6 The 1040A and 1040EZ are less costly to process because they
generally contain fewer pages than the 1040 and thus less data for
IRS to input and less opportunity for taxpayers or IRS to err.  The
1040EZ has one page with no supporting schedules.  The 1040A has two
pages, like the 1040, but generally has fewer supporting schedules
because of limitations as to who can file a 1040A.  A 1040A filer,
for example, cannot claim itemized deductions, self-employment
income, rents and royalties, or capital gains.  According to IRS
data, it takes an average of 89 and 159 keystrokes, respectively, to
enter data into the computer from a paper 1040EZ and 1040A compared
with 247 keystrokes for an average 1040. 

\7 The savings from electronic filing would be even more if IRS did
not have to process the paper signature document (Form 8453) that
electronic filers are required to send to IRS.  IRS data show that it
costs 30 cents to process each of those forms, or about $4.3 million
in 1994. 

\8 Although returns filed on magnetic media are less costly to
process than returns filed on paper, IRS does not achieve all the
benefits from magnetic media that it does from electronic filing. 
For example, errors on magnetic media returns are printed out on
paper and mailed back to the sender.  The electronic filing system,
however, includes filters that check for such errors as mathematical
mistakes and incorrect Social Security numbers.  If an error is
identified, the system is designed to reject the return and
electronically notify the sender of the problem. 


      COST IS A MAJOR IMPEDIMENT
      TO THE GROWTH OF ELECTRONIC
      FILING
---------------------------------------------------------- Letter :4.4

IRS has not been successful in dealing with a major impediment to
greater taxpayer and preparer participation in electronic filing,
i.e., its cost. 

For most taxpayers, the only way to file electronically is through a
tax return preparer or electronic filing transmitter at a cost of
from $15 to $40.  This cost is in addition to any costs associated
with preparing the return.  In January 1993, we reported that
electronic filing appealed primarily to taxpayers who most needed
their refunds and that other taxpayers due refunds were unwilling to
pay the going fees for that benefit.\9

Cost is even more of an impediment to taxpayers owing money because
those taxpayers see little, if any, benefit to filing electronically. 
We know of little that has changed since 1993 to alter that opinion. 
As a result, less than 2 percent of the individual income tax returns
filed electronically in 1995 were from taxpayers owing money. 

In response to a recommendation in our January 1993 report and one of
the initiatives in IRS' May 1993 strategy, IRS has (1) increased the
number of walk-in sites that offer free electronic return preparation
and transmission and (2) provided additional support for similar
services at sites staffed by volunteers.  As of April 29, 1995, about
246,000 taxpayers had availed themselves of these free services. 

The free electronic filing at IRS and volunteer sites is generally
available to low-income taxpayers who file less complex returns. 
Cost is at least one factor that deters electronic filing by a
potentially more lucrative market of individual taxpayers--those with
home computers.  Since 1992, taxpayers using tax preparation software
could file returns from home computers and transmit them from home
through an approved computer service.  However, these filers must pay
a fee of about $15 and must still send paper, including a signature
document (Form 8453) and wage and withholding statements (Forms W-2),
to IRS.  Only about 1,400 taxpayers had filed their returns through
this program as of May 5, 1995. 

For those taxpayers who prepare their returns on computers but are
unwilling to pay to transmit the returns electronically, the result
is inefficient and counterproductive.  The taxpayer prepares the
return on a computer and then converts it to paper for mailing to
IRS, which then employs a labor intensive, error prone process to
input that information back into a computer. 

IRS has completed a draft strategy for increasing the number of
taxpayers filing from home computers.  Part of the strategy focuses
on eliminating the fees these taxpayers incur for having a third
party transmit their returns to IRS. 

Cost also deters some preparers from participating in the electronic
filing program.  In September 1994, the Chairman of the AICPA's Tax
Practice and Procedures Committee provided us with summary
information on members' experiences with electronic filing.  He said
that some practitioners have been filing electronically for several
years with positive experiences, while others discontinued doing so
because IRS' current electronic filing program "did not fit into
their `office routine' or because they or their clients did not
receive any additional benefit from the program to offset the
additional cost." He said that many practitioners are concerned with
the additional input, transmitting, and monitoring time required with
the current electronic filing program and the fact that electronic
filing is not yet a paperless system.  Among the paper documents, the
most problematic, according to the AICPA, is the signature document. 
That document, which is used to affirm that the information on the
electronic return is accurate, must be signed by the taxpayer and
filed with IRS within 24 hours after IRS has acknowledged acceptance
of the electronic return.\10

IRS has recognized for years the potential benefit of paperless
electronic filing but thought that legislation was needed to
authorize an alternative to the paper signature document. 
Information on IRS' efforts to obtain such legislation is presented
in appendix I.  In April 1995, however, IRS' Office of Chief Counsel
concluded that IRS had regulatory authority to prescribe signature
alternatives.  An IRS official said that IRS plans to test signature
alternatives in 1996. 


--------------------
\9 GAO/GGD-93-40. 

\10 The AICPA mentioned that another big obstacle to practitioner
participation in electronic filing is that many of the returns
prepared by its members involve forms that cannot be filed
electronically.  Thus, a firm would have to incur the costs of two
processes--one for paper returns and one for electronic returns. 


   IRS DOES NOT HAVE ADEQUATE DATA
   TO FOCUS ITS ELECTRONIC FILING
   STRATEGY
------------------------------------------------------------ Letter :5

IRS recognizes that it needs to increase the appeal of electronic
filing to attract more taxpayers.  IRS also recognizes that it does
not have unlimited staff or funds to apply to that effort.  However,
IRS' ability to effectively target its limited resources is hampered
by inadequate data on the relative costs and benefits of processing
different types of returns electronically versus on paper.  Business
and complex individual returns would seem to offer opportunities for
significant cost reductions if filed electronically.  However, IRS
does not have sufficient data to determine (1) what it would cost to
get those returns filed electronically, including the costs of any
incentives that might be needed to prompt certain groups of taxpayers
to file electronically and (2) how that cost compares to the expected
benefits from electronic filing. 

As discussed earlier, IRS has data on some of the costs incurred in
processing returns.  However, IRS does not have data on other costs
that can vary depending on how a return is filed.  Those costs
include (1) costs to store and retrieve returns and to administer
certain fraud controls, such as those established to assess the
suitability of preparers and transmitters who apply to participate in
the electronic filing program and (2) certain nonservice center costs
incurred in resolving taxpayer account errors that are made during
IRS' manual processing of paper returns (such as the costs associated
with handling the extra telephone calls generated by those errors). 
Without better data on the relative costs and benefits of electronic
filing as well as data on why taxpayers do not file electronically
and what it would take to get them to do so, IRS cannot make sound
decisions on such things as the feasibility of offering incentives
(such as a tax credit) to encourage greater participation in the
program. 

IRS awarded a contract in May 1995 that may provide at least some of
the needed cost/benefit data.  Among other things, the contract calls
for a systematic analysis of the costs and benefits of each step in
the electronic filing process.  We believe this aspect of the
contract is critical to helping IRS focus its resources on those
taxpayers or returns that provide the greatest opportunity for
reducing overall operating costs.  Data on the cost and benefits of
electronic filing versus paper filing for various taxpayers or
returns, coupled with estimates of the number of electronic returns
IRS can expect to receive from these market segments, should provide
IRS with a foundation for focusing future electronic filing marketing
strategies. 

It is not clear whether the contractor will be doing any taxpayer
focus groups or surveys to determine what changes IRS needs to make
to better motivate taxpayers to participate in electronic filing. 
IRS' most recent taxpayer opinion data on electronic filing were
collected in 1991 and those did not include data from businesses. 
Unless IRS obtains more current information from taxpayers, it may
have difficulty reliably estimating the number of electronic returns
it can expect to receive from different market segments. 

A complicating factor in any cost/benefit analysis is IRS' plan to
change the way it processes paper returns in the future.  Instead of
the current manually intensive process by which tax return data are
keypunched into the computer, IRS plans to scan paper returns.  If
scanning reduces the cost of processing paper returns, as expected,
it could alter any analysis of the relative costs and benefits of
electronic filing. 


   IRS DOES NOT HAVE CONTINGENCY
   PLANS IN CASE ELECTRONIC FILING
   GOALS ARE NOT REACHED
------------------------------------------------------------ Letter :6

In deciding on 5 submission processing centers and 23 customer
service centers and in determining the number of persons needed to
staff those centers, IRS relied, in large part, on expectations that
it would be receiving a minimum of 61 million electronically filed
returns by 2001.  Using IRS' return filing projections for 2001, we
estimated that submission processing centers would thus be expected
to process about 163 million paper returns. 

If fewer returns are filed electronically or if the returns filed
electronically do not substantially decrease IRS' paper-processing
workload, IRS will have to process more paper, which would decrease
productivity and increase costs.  The need to process more paper
could also cause IRS to revise its plans for the submission
processing centers.  Staffing and equipment needs could be expected
to increase at the sites if more paper returns have to be processed. 
A National Office official told us that if another submission
processing site is needed, site preparation costs alone would amount
to more than $17 million. 

A substantial increase in the number of paper returns could also
affect IRS' plans for its 23 customer service centers and the
availability of staff to work in compliance positions.  The customer
service centers are responsible for handling taxpayer telephone and
correspondence contacts, many of which are a byproduct of questions
that arise from processing taxpayers' returns.  Because of the
substantially higher error rates associated with paper returns,
according to IRS data (23 percent versus 2 percent for electronic
returns), customer service centers would likely need to field more
questions if IRS receives more paper returns than it has projected. 
And, if IRS needs more staff to process paper returns and provide
customer service, it may have fewer staff to redeploy to compliance
positions, thus decreasing the amount of additional tax revenue
anticipated from such a redeployment. 

IRS National Office officials told us that they had not developed
contingency plans for the possibility that electronic filing will
fall short of expectations.  They believe that IRS will be successful
in achieving the level of electronic filing needed to support the
projected workloads for the submission processing and customer
service centers.  In the event of a shortfall, they believe IRS will
have time later to develop alternative plans.  IRS has developed a
contingency plan for the document imaging system that is to
eventually replace IRS' current paper-processing system.  The purpose
of that plan is to ensure that the project office overseeing
implementation of this automated system can help submission
processing centers process tax documents if the automated system does
not meet prescribed efficiency rates.  The plan does not indicate how
IRS' plans for the new imaging system would have to be revised if IRS
receives more paper returns than the system is being designed to
handle.  The plan, given its focus on submission processing, also
does not address the impact of a shortfall in electronic returns on
IRS' plans for customer service. 

We believe that contingency plans are needed now.  IRS is beginning
to implement its customer service vision and is preparing to pilot
the imaging system.  In conjunction with those efforts, IRS needs to
identify and take into account the impact of possible shortfalls in
electronic filing.  The longer IRS waits, the fewer its options
become and the less time it will have to fully consider alternatives. 


   CONCLUSIONS
------------------------------------------------------------ Letter :7

IRS' ability to effectively process tax returns and assist taxpayers
in the future largely depends on how successful IRS is in converting
to an electronic environment and reducing its reliance on paper. 
Electronic filing of tax returns is a critical part of that
conversion.  However, without some dramatic changes in IRS' current
electronic filing program over the next 6 years, many of the benefits
available from electronic filing could go unrealized. 

The number of electronic returns has been growing at a pace that will
leave IRS far short of its 80-million goal in 2001.  Even more
important to the ultimate success of electronic filing, in our
opinion, is the fact that the returns being filed electronically are
generally the less complex returns that are the least costly for IRS
to process when filed on paper. 

The heavy representation of less complex returns may be influenced,
at least in part, by IRS' goal of 80 million returns.  Focusing
solely on this goal could cause IRS to expend its limited resources
on initiatives that are directed toward groups of taxpayers or types
of returns that provide the greatest opportunity to increase the
number of electronic returns but not the greatest opportunity to
reduce IRS' paper-processing workload and operating costs.  Although
a marketing strategy that focuses on reducing paper and costs may
generate fewer than 80 million returns, it could have a more
significant impact on IRS' overall operations.  The contract IRS
awarded in May 1995 may provide cost/benefit data IRS can use to
reassess its strategy.  That information may help IRS identify
effective steps to make electronic filing more attractive to those
taxpayers and tax return preparers who are now put off by its cost. 

If the growth and impact of electronic filing fall short of
expectations, IRS' paper-processing workload will increase.  More
paper means more errors, which, in turn, would create a need for more
taxpayer contacts.  Depending on the extent of the electronic filing
shortfall, IRS may need to increase the number and/or size of
submission processing and customer service centers and adjust plans
for equipping and staffing the centers.  However, IRS is not prepared
to make those adjustments because it has no contingency plans. 


   RECOMMENDATIONS TO THE
   COMMISSIONER OF INTERNAL
   REVENUE
------------------------------------------------------------ Letter :8

To help better ensure the success of IRS' modernization, we recommend
that the Commissioner do the following: 

  Identify those groups of taxpayers who offer the greatest
     opportunity to reduce IRS' paper-processing workload and
     operating costs if they were to file electronically and develop
     strategies that focus IRS' resources on eliminating or
     alleviating impediments that inhibit those groups from
     participating in the program, including the impediment posed by
     the program's cost. 

  Adopt goals for electronic filing that focus on reducing IRS'
     paper-processing workload and operating costs.  These goals
     could be used in addition to the existing electronic filing goal
     to assess IRS' progress in achieving the intended benefits of
     electronic filing. 

  Prepare contingency plans for the possibility that the electronic
     filing program will fall short of expectations. 


   AGENCY COMMENTS AND OUR
   EVALUATION
------------------------------------------------------------ Letter :9

We requested comments on a draft of this report from the Commissioner
of Internal Revenue or her designated representative.  Responsible
IRS officials, including IRS' Electronic Filing Executive and Site
Executives for Computing Centers and Submission Processing, provided
IRS' comments in a July 27, 1995, meeting.  These officials provided
a few factual clarifications that we have incorporated in this report
where appropriate.  The officials also said that they generally
agreed with our report recommendations.  They stated that they
recognized that much work needed to be done to increase the number of
electronic returns and identified plans or actions that were under
way that they believe address the recommendations.  We agree that IRS
has developed plans and is taking action to increase the number of
electronic returns.  However, we remain concerned that unless those
actions or plans are supported by the type of analysis and goal
setting that we are recommending, IRS may not be effectively
targeting its limited resources for marketing the electronic filing
program. 

On our first recommendation on identifying taxpayers who offer the
greatest opportunity to reduce IRS' paper-processing workload and
costs, IRS officials said that (1) they strongly believe that the
electronic filing program already focuses on those taxpayers who
offer the greatest opportunity to reduce IRS' paper- processing
workload--essentially individual taxpayers--but had not yet prepared
a business case to support that belief, (2) they were expanding
TeleFile nationwide for the 1996 filing season to make electronic
filing available to more individual taxpayers, and (3) research was
under way to help make electronic filing more appealing to taxpayers
and to help IRS expand the program to more individual taxpayers.  In
addition, IRS believes its current focus on individual taxpayers is
appropriate because the bulk of its processing costs stem from having
to process large numbers of individual returns in a short time
period.  IRS officials also said they are working with some large
businesses on electronic filing of employment tax returns.  These
returns represent a large portion of all business returns filed. 

Although the actions IRS mentioned may help expand the electronic
program, we believe the second and third items discussed above will
most likely have an effect on those taxpayers that are already
attracted to IRS' electronic filing program--those individual
taxpayers who file relatively simple returns.  The expansion of
TeleFile in 1996, for example, will have no impact on those
individual taxpayers that file more complex tax returns.  As we
discuss on page 6, the expansion IRS refers to is a geographic
one--going from 10 states to all states in the 1996 filing season. 
The TeleFile program will continue to focus on those taxpayers who
file the simplest individual tax return (Form 1040EZ). 

IRS' comment regarding research to make electronic filing more
appealing refers to analysis being done to profile (1) those
taxpayers who currently file electronically and (2) those who could
file electronically, but currently do not.  IRS believes this
profiling will assist in marketing electronic filing to those
individual taxpayers who do not currently use electronic filing.  We
agree that such an analysis may be helpful as a marketing tool for
district offices.  However, it is uncertain how this analysis will
help alleviate some of the current impediments to electronic filing
for many individual taxpayers, such as the cost to the taxpayer. 

With respect to our second recommendation on adopting goals for
electronic filing that focus on reducing IRS' paper-processing
workload and costs, IRS officials provided several examples of
actions that they believed indicated that they have adopted such
goals.  These examples included (1) the contract to conduct cost and
marketing analyses that we discuss on page 14, (2) another contract
that was awarded to develop a strategy to reach taxpayers who could
file from home computers, and (3) IRS' plans to eliminate processing
of signature documents for electronic returns. 

We agree that some of the actions IRS mentioned may reduce paper-
processing workload and costs.  However, these actions are steps IRS
is taking to achieve its existing performance goal of 80 million
returns.  The intent of our recommendation is for IRS to develop
other performance goals based on the analysis done in response to the
first recommendation. 

IRS' current performance goal provides little incentive to identify
and pursue opportunities for reducing the paper-processing costs
associated with more complex returns that may not represent a large
number of returns.  The analysis called for in our first
recommendation would put IRS in a better position to develop specific
goals for receiving certain types of returns electronically based on
the their contribution to reducing overall paper-processing costs. 
For example, goals such as "receive 75 percent of all corporate
returns electronically by 2001" or "reduce the number of paper
returns processed (in terms of number of pages rather than number of
returns) by 50 percent," might result in different decisions on how
IRS should focus its limited marketing resources than those decisions
currently being made. 

On our third recommendation regarding contingency planning, IRS
agreed that it needed to prepare for the eventuality of receiving
fewer electronic returns in 2001.  However, IRS representatives said
that contingency planning is not the only way to prepare for this
eventuality.  IRS officials said IRS is using a program management
approach to phase in operations under its new business vision.  IRS
officials expected this approach to provide the flexibility for
adjusting program plans to address any significant shortfall in the
number of electronic returns received.  In addition, IRS officials
said that the contract for procuring new scanning equipment for paper
returns is flexible.  Therefore, IRS expects to have an option to buy
additional equipment if it needs to process more paper returns than
it originally estimated. 

We reviewed a November 29, 1994, memorandum from IRS' Modernization
Executive to the heads of offices that are involved in IRS'
modernization program.  That memorandum described the program
management approach that IRS refers to above and a program control
process for helping to ensure that IRS achieves its modernization
goals.  According to the memorandum, the program control process will
include risk assessments that are to (1) identify impediments to
delivering various aspects of IRS' business vision and (2) prompt the
development of mitigation strategies to address identified risks. 

IRS would be responsive to our recommendation if it succeeds through
its program management approach in (1) promptly developing mitigation
strategies if more paper tax returns have to be processed in future
years than IRS currently expects and (2) specifying alternative
actions for processing paper returns and implementing its customer
service vision. 


---------------------------------------------------------- Letter :9.1

As agreed with your staff, unless you publicly announce the contents
of this report earlier, we plan no further distribution for 30 days. 
At that time we will send copies to the Secretary of the Treasury,
the Commissioner of Internal Revenue, and other interested parties. 
We will also make copies available to others on request. 

The major contributors to this report are listed in appendix II.  If
you or your staff have any questions about this report, you can reach
me at (202) 512-8633. 

Sincerely yours,

Lynda Willis
Associate Director, Tax Policy and
 Administration Issues


LEGISLATIVE NEEDS CITED IN IRS'
MAY 1993 ELECTRONIC FILING
STRATEGY
=========================================================== Appendix I

In May 1993, the IRS Electronic Filing Strategy Task Group issued a
report that included 21 initiatives directed at increasing the use of
electronic filing.  Five of those initiatives cited the need for
legislation.  As discussed below, none of that legislation has been
enacted and, in some cases, IRS has decided not to seek legislation. 


   PERMIT PAYMENT OF TAXES BY
   CREDIT CARD
--------------------------------------------------------- Appendix I:1

One of the 21 initiatives was directed at increasing the number of
balance due returns filed electronically.  Critical to the success of
this initiative, according to the task group, was legislation that
would allow credit card payments of tax obligations.  Such a
provision was included in section 4122 of H.R.  11, the Revenue Act
of 1992, which was passed by both houses of Congress but vetoed by
the President.  A similar provision was included in other bills, none
of which were enacted.  Most recently, IRS included this proposal in
a package of legislative initiatives sent to the Assistant Secretary
of the Treasury for Tax Policy in January 1995.  In February 1995,
Treasury's Office of Fiscal Assistant Secretary raised several
questions about the potential costs associated with this proposal and
how those costs would be funded.  As of June 26, 1995, IRS and
Treasury had not resolved these cost issues. 


   MANDATE ELECTRONIC FILING BY
   CERTAIN TAX RETURN PREPARERS
   AND BUSINESSES
--------------------------------------------------------- Appendix I:2

The task group estimated that 46 million more electronic returns
would be received if (1) preparers of 100 or more individual returns
were required to offer electronic filing and (2) businesses with 10
or more employees were required to file their returns electronically. 
The business returns specifically identified by the task group were
Form 1041 (U.S.  Fiduciary Income Tax Return), Form 1065 (U.S. 
Partnership Return of Income), Form 1120 (U.S.  Corporation Income
Tax Return), Form 1120S (U.S.  Income Tax Return for an S
Corporation), forms 5500 and 5500 C/R (Annual Return/Report of
Employee Benefit Plan), and Form 941 (Employer's Quarterly Federal
Tax Return). 

In a November 1993 testimony before a subcommittee of the then House
Committee on Government Operations, the Assistant Secretary of the
Treasury for Tax Policy made the following comments: 

     "The Service has proposed that the Secretary be given regulatory
     authority to require that tax returns be filed other than in
     paper form, including electronically or by magnetic
     media.  .  .  .  Broad regulatory authority to require that
     returns be filed other than in paper form is appropriate and
     essential to the Service's ability to modernize its systems,
     streamline its operations and, in general, deliver quality
     services at the least cost.  However, in view of the potential
     burdens on taxpayers and preparers in complying with electronic
     or magnetic media filing requirements, we currently are
     considering whether legislative refinements to this proposal may
     be necessary to clarify the intended scope and timing of the
     conversion to a non-paper based system."

The proposal was eventually dropped because IRS and Treasury
officials believed that Congress would not pass legislation that
would enable IRS or Treasury to dictate who would have to file
electronically. 


   ELIMINATE REQUIREMENTS FOR
   PAPER SUBMISSIONS IN ELECTRONIC
   FILING
--------------------------------------------------------- Appendix I:3

The task group noted that "In virtually every study conducted on
electronic filing, the issue of processing paper documents has been
identified as impacting negatively upon IRS' ability to realize
electronic filing's full savings potential." The task group further
said that "Eliminating the requirement to prepare and submit paper
documents could have a significant impact on reducing the cost
electronic filers pass on to their customers."

This initiative called for eliminating the paper documents associated
with electronic filing by proposing legislation that would (1) allow
alternatives to the paper signature document and (2) eliminate the
submission of paper attachments to the electronic return.  H.R.  11,
referred to earlier, included a provision (section 4933) that would
have addressed the first of those two legislative needs by
authorizing the Secretary of the Treasury to prescribe alternative
methods of verifying returns on a trial basis.  IRS' latest proposal,
included in its January 1995 submission to the Assistant Secretary
for Tax Policy, was broader.  It would have authorized the Secretary
of the Treasury to permit alternative methods of (1) verifying,
signing, and subscribing returns and other statements and (2)
submitting written declarations, statements, or other documents
required by the Internal Revenue Code. 

In April 1995, IRS' Office of Chief Counsel concluded that IRS had
regulatory authority to prescribe alternative methods for signing and
submitting tax returns and other written documents.  An IRS official
said that IRS plans to test signature alternatives in 1996. 


   INSTITUTE A PROMOTIONAL
   CAMPAIGN
--------------------------------------------------------- Appendix I:4

The task group determined that "a full scale, high-powered
promotional campaign" was needed to "maximize the number of
electronic returns." Because of the anticipated scope of the
promotional campaign, the task group recommended that IRS obtain an
appropriations rider for paid advertising.  IRS has taken no action
to get such a rider because of concerns that a paid advertising
campaign might jeopardize current free public service advertising. 


   PROPOSE TAX INCENTIVES
--------------------------------------------------------- Appendix I:5

To encourage greater participation in electronic filing, the task
group proposed that IRS initiate legislative action to provide tax
incentives for businesses and preparers.  The group suggested
consideration of such incentives as a more accelerated depreciation
schedule for electronic filing equipment and a higher percentage of
investment tax credit.  IRS has decided not to pursue such
legislation.  As noted in this report, IRS does not have the data
needed to determine what kind of incentives would be most effective
and what level of incentives makes sense given the benefits of
electronic filing. 


MAJOR CONTRIBUTORS TO THIS REPORT
========================================================== Appendix II

GENERAL GOVERNMENT DIVISION,
WASHINGTON, D.C. 

David J.  Attianese, Assistant Director
Monika Gomez, Evaluator
John Lesser, Senior Evaluator
Sherrie Russ, Senior Evaluator

CINCINNATI REGIONAL OFFICE

Daniel J.  Meadows, Evaluator-in-Charge
Linda Standau, Senior Evaluator
Laurie Housemeyer, Evaluator
Robert I.  Lidman, Regional Assignment Manager