Tax Administration: Information on IRS' Taxpayer Compliance Measurement
Program (Letter Report, 10/06/95, GAO/GGD-96-21).
Pursuant to a congressional request, GAO provided information on the
Internal Revenue Service's (IRS) Taxpayer Compliance Measurement Program
(TCMP) for tax year 1994, focusing on: (1) how IRS addressed the
problems identified in a previous GAO report; (2) how persistent
problems affect final TCMP results; (3) other informational sources that
IRS could use to target its audits more effectively; and (4) the
relevancy of TCMP data for alternative tax system proposals.
GAO found that: (1) IRS has taken appropriate actions to correct the
previously identified problems in the implementation of TCMP; (2) due to
uncertainties about its fiscal year 1996 budget, IRS has delayed TCMP
audits until December 1, 1995; (3) the audit delay will allow IRS to
complete testing of TCMP database components and data collections
systems; (4) the audits could be further delayed if the tests reveal
additional problems; (5) IRS plans to collect data on partners,
shareholders, and misclassified workers which should allow it to better
measure compliance levels and TCMP audit results; (6) computerized
auditor comments should make it easier for researchers to analyze TCMP
results and allow IRS to collect data on other tax issues that are not a
part of TCMP; (7) IRS still needs to develop a research plan that would
allow it to more timely analyze TCMP data; (8) no alternative
information sources exist that could help IRS better target its audits;
(9) IRS is developing a new identification system for tax return audits,
but it will not be available until after year 2000; and (10) TCMP could
be useful in designing and administering a new tax system and
identifying compliance trends.
--------------------------- Indexing Terms -----------------------------
REPORTNUM: GGD-96-21
TITLE: Tax Administration: Information on IRS' Taxpayer Compliance
Measurement Program
DATE: 10/06/95
SUBJECT: Tax administration systems
Tax return audits
Voluntary compliance
Statistical methods
Data collection operations
Proposed legislation
Computerized information systems
Income taxes
Auditing standards
Information systems analysis
IDENTIFIER: IRS Taxpayer Compliance Measurement Program
IRS Automated Issue Identification System
IRS Totally Integrated Examination System
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Cover
================================================================ COVER
Report to the Honorable
Joseph K. Knollenberg, House of Representatives
October 1995
TAX ADMINISTRATION - INFORMATION
ON IRS' TAXPAYER COMPLIANCE
MEASUREMENT PROGRAM
GAO/GGD-96-21
Taxpayer Compliance Measurement
(268710)
Abbreviations
=============================================================== ABBREV
IRS - Internal Revenue Service
TCMP - Taxpayer Compliance Measurement Program
TIES - Totally Integrated Examination System
Letter
=============================================================== LETTER
B-266278
October 6, 1995
The Honorable Joseph K. Knollenberg
House of Representatives
Dear Mr. Knollenberg:
This report responds to your September 12, 1995, request to provide
information on the Internal Revenue Service's (IRS) Taxpayer
Compliance Measurement Program (TCMP) for tax year 1994.\1 You
specifically asked us for information on (1) how IRS addressed the
problems discussed in our December 1994 report on the status of the
program and, if the problems persist, how they would affect final
TCMP results;\2 (2) informational sources other than TCMP that IRS
could use to target its audits more effectively; and (3) the
relevancy of TCMP data for alternative tax system proposals.
--------------------
\1 IRS collects TCMP data by auditing every line on tax returns for a
random sample of taxpayers.
\2 Tax Compliance: Status of the Tax Year 1994 Compliance
Measurement Program (GAO/GGD-95-39, Dec. 30, 1994).
RESULTS IN BRIEF
------------------------------------------------------------ Letter :1
IRS has generally taken appropriate action on the concerns we raised
in our 1994 report that dealt with meeting milestones for starting
TCMP audits, testing TCMP database components, developing data
collection systems, and collecting and analyzing data. However, due
to uncertainties about its fiscal year 1996 budget, IRS has delayed
the start of its TCMP audits from October 1 to December 1, 1995. The
delay is fortuitous because it could allow IRS to finish testing TCMP
database components and data collection systems before audits begin.
The date to start the audits could be further delayed if test results
show that major modifications need to be made to the database or data
collection systems.
IRS plans to collect the data on partners, shareholders, and
misclassified workers as we suggested in our 1994 report. These
additional data should allow IRS to better measure compliance levels,
which could increase the value of TCMP audit results. Also, IRS
plans to have auditors computerize some of their comments on audit
findings, which should make it easier for researchers to analyze TCMP
results. The automated comment feature could also provide IRS an
opportunity to collect data on taxpayer burden and other issues that
are not part of the TCMP database. We still are concerned that IRS
has not developed a research plan that could be used to analyze final
TCMP results. IRS could use preliminary TCMP data to help it
formulate research questions.
We are not aware of any other available IRS or third-party data that
could be used to develop return selection formulas that would allow
IRS to target its audits as effectively as TCMP data. IRS is
attempting to develop an Automated Issue Identification System that
has the potential of selecting returns that should be audited.
However, IRS does not expect to have the technological capabilities
to fully develop and implement the system until after the turn of the
century.
TCMP could be very useful not only for improving compliance in the
existing tax system, but also as a tool for designing and
administering a new system. While types of income and deductions
included in each new proposed tax system vary, TCMP could still
provide data on compliance issues that would have to be addressed in
any of the new system proposals that we reviewed. To the extent that
elements of the existing tax system are retained, TCMP could continue
to fulfill its traditional role of providing data needed for
selecting returns for audit, identifying sources of noncompliance,
and identifying potential tax law changes. To the extent that new
tax systems are proposed and adopted, TCMP data could alert tax
system designers and administrators to potential areas of
noncompliance and provide data on which to base rules and
regulations. The longer it takes to implement a new tax system, the
more useful TCMP data could be for helping design and administer the
new system.
BACKGROUND
------------------------------------------------------------ Letter :2
For about 30 years, TCMP has been IRS' primary program for gathering
comprehensive and reliable taxpayer compliance data. It is IRS' only
program to measure noncompliance on a random basis, allowing IRS to
make statistically reliable estimates of compliance nationwide.
IRS uses the data for measuring compliance levels, estimating the tax
gap, identifying compliance issues, developing formulas for
objectively selecting returns for audit, and allocating audit
resources. Congress and federal and state agencies have used TCMP
data for policy analysis, revenue estimating, and research.
The 1994 TCMP survey is planned to be the most comprehensive TCMP
effort ever undertaken. That is because IRS is undertaking four
surveys at once to collect comparable information on businesses
organized in different ways. Currently planned to include about
153,000 tax returns, this TCMP was designed to obtain compliance
information for individuals (including sole proprietors); small
corporations (i.e., those with assets of $10 million or less); S
corporations; and partnerships.\3 This TCMP was also designed to
obtain information at the national level as well as for smaller
geographical areas across the country. About 120,000 of the sample
returns are to cover businesses; about 33,000 are to cover
individuals. This is to be the first time that IRS will conduct a
TCMP audit for all four types of taxpayers at the same time.
The 1994 TCMP sample is stratified by market segments, as opposed to
type of return, income amount, and asset size, which were the
characteristics used to stratify samples in prior surveys. A market
segment represents a group of taxpayers with similar characteristics,
such as taxpayers engaged in manufacturing. IRS plans to stratify
taxpayers into 23 business and 4 nonbusiness (individual) market
segments. IRS will also have one market segment for
foreign-controlled corporations. IRS believes that stratifying in
this manner would allow it to more effectively use TCMP data for
identifying noncompliance trends and selecting cases for audit. To
assure comparability with previous TCMP surveys, the sample can also
be stratified into the traditional groupings (i.e., type of return).
As planned, in the 1994 TCMP, IRS would audit about 40,000 more
returns than the aggregate for all entity types from the latest TCMP
surveys conducted on these entities. IRS' primary reasons for this
increase are the use of market segments and ensuring statistical
validity for IRS' 31 District Office Research and Analysis sites,
which are located throughout the country.
IRS considers the 1994 TCMP effort to be particularly important
because it would be the first comprehensive effort to validate its
current market segment compliance strategy for identifying and
correcting noncompliance, and also because existing compliance data
are getting old.\4 IRS expects to have completed audits on about 30
percent of the sample returns by October 1996 and to have final TCMP
data in late 1998. IRS plans to collect data on the reasons for
noncompliance and the specific tax issues associated with the
noncompliance. IRS also plans to place greater emphasis on quality
audits to ensure that accurate data are collected. Finally, in its
TCMP training for auditors, IRS plans to emphasize the need to make
effective use of internal data to reduce the amount of information
requested from taxpayers, thus reducing the burden imposed on those
taxpayers.
--------------------
\3 An S corporation is one taxed similarly to a partnership. A
qualifying corporation may choose to be generally exempt from federal
income tax. Its shareholders then include in their income their
share of the corporation's separately stated items of income,
deduction, loss, and credit.
\4 The latest TCMP surveys were made of 1988 individual returns, 1987
small corporation returns, 1984 S corporation returns, and 1981
partnership returns.
OBJECTIVES, SCOPE, AND
METHODOLOGY
------------------------------------------------------------ Letter :3
Our objectives were to (1) determine how IRS addressed the problems
discussed in our 1994 TCMP status report and, if the problems
persist, how they will affect final TCMP results; (2) identify
informational resources other than TCMP that IRS could use to target
its audits more effectively; and (3) assess the value of TCMP data
for alternative tax system proposals.
To determine the actions IRS took on the concerns we raised in our
1994 report, we reviewed TCMP documents and discussed the actions
taken with IRS officials responsible for designing and implementing
the program. To determine whether other information sources could be
used to replace TCMP, we relied on work we had done on TCMP and we
discussed with IRS officials how IRS could use other potential data
sources, including state and nongovernment sources. To determine the
relevancy of TCMP data for new tax system proposals, we reviewed
various published documents on these systems and compared them to the
current income tax system.\5
Our observations in this report are based in large part on the work
we have done over the years on IRS' compliance programs in general as
well as specific work on TCMP. We issued a report in May 1994 on all
such work.\6
We did our work in September 1995 in accordance with generally
accepted government auditing standards. On September 29, 1995, we
obtained oral comments on a draft of this report from officials
responsible for planning and implementing TCMP in IRS' Compliance
Research Division, including the National Director of Compliance
Research. We have incorporated their comments where appropriate.
--------------------
\5 The documents we reviewed include: Joint Committee on Taxation,
Description and Analysis of Proposals to Replace the Federal Income
Tax (JCT-18-95), June 5, 1995; Robert E. Hall and Alvin Rabushka,
The Flat Tax (Second Edition, 1995); H.R. 2060, which deals with a
flat tax and was introduced in July 1995 by Representative Dick
Armey; S. 722, which deals with the Unlimited Savings Allowance and
was introduced in April 1995 by Senators Pete Domenici and Sam Nunn;
and documents on a simplified income tax, which we obtained from the
office of Representative Richard Gephardt.
\6 Tax Gap: Many Actions Taken, But a Cohesive Compliance Strategy
Needed (GAO/GGD-94-123, May 11, 1994). This report has a
bibliography of tax compliance-related reports that we have completed
since 1982.
OUR CONCERNS WITH IRS' PLANS
FOR THE UPCOMING TCMP
------------------------------------------------------------ Letter :4
Our 1994 TCMP report discussed concerns dealing with various aspects
of IRS' plans for the upcoming TCMP. Basically, these concerns
centered on IRS being able to (1) meet major milestones for starting
audits, (2) collect audit adjustment data on partners and S
corporation shareholders, (3) collect data on potentially
misclassified workers,\7 (4) develop data collection systems, (5)
make it easier for researchers to access TCMP audit workpapers, and
(6) develop a TCMP research plan.
--------------------
\7 Workers can be classified as either "employees" or "independent
contractors" (self-employed individuals who provide services). Under
common law, the degree of control, or right to control, that a
business has over a worker governs the classification. If a worker
must follow instructions on when, where, and how to do the work, he
or she is more likely to be an employee. It is important for IRS to
know whether a worker is correctly classified because employees who
have their taxes withheld are generally more compliant than
independent contractors.
MEETING MILESTONES
---------------------------------------------------------- Letter :4.1
In our 1994 report, we raised a concern about IRS' ability to meet
its October 1, 1995, milestone for starting the TCMP audits. Our
concern was based on the amount of work that had to be done to design
and test the TCMP data collection system, develop training material,
train auditors, and produce case file information.
In early September 1995, IRS postponed the start of its TCMP audits
from October 1, 1995, to December 1, 1995. IRS attributed the delay
to the uncertainties about its fiscal year 1996 budget. IRS does not
expect the delay in starting the audits to affect the March 31, 1998,
date for completing all 153,000 TCMP audits.
The delay in the start of the audits could allow IRS to complete
various TCMP database testing, which has not been completed as
originally scheduled. For example, IRS has not completed all its
tests of the consistency of reported business return data, which were
scheduled to be completed by August 31, 1995. The tests are designed
to identify and eliminate inconsistencies in the data and need to be
completed before audit cases can be sent to the field. According to
IRS officials, the tests associated with reported return data on
individual taxpayers (i.e., Form 1040 information) have been
completed and returns are ready to be sent to field offices for
audit. IRS expects to complete all tests of the business portion
(i.e., corporations and partnerships) of the database by November 30,
1995. We are concerned that if major modifications have to be made
to the data, the December 1, 1995, date to start audits of business
taxpayers could be delayed.
DATA ON PARTNERS AND
SHAREHOLDERS
---------------------------------------------------------- Letter :4.2
In our 1994 report, we raised concern about whether the amount of
information IRS would be collecting on partnerships and S
corporations would be adequate to measure the compliance levels for
these two entities.\8 In response to the report, IRS officials said
they would collect more data on partnerships and S corporations but
would not collect data on partners and shareholders. IRS has since
decided that it would capture data on partners and shareholders.
This additional data could increase the value of TCMP data for
determining tax impacts of partnership and S corporation audits and
measuring the tax gap associated with these entities.
--------------------
\8 These two entities each report income on two tax documents.
Partnerships report on Form 1065, "U.S. Partnership Return of
Income" and Schedule K, "Partners' Shares of Income, Credits,
Deductions, etc.;" while S corporations use two similar forms, Form
1120S "U.S. Income Tax Return for an S Corporation" and Schedule K,
"Shareholders' Shares of Income, Credits, Deductions, etc."
DATA ON MISCLASSIFIED
WORKERS
---------------------------------------------------------- Letter :4.3
In our 1994 report, we were concerned that IRS would not be
collecting sufficient information on businesses that misclassified
their workers as independent contractors instead of as employees. We
were also concerned that IRS would not be gathering data on taxpayers
who file returns as sole proprietors, but who potentially may be
employees and not independent contractors. According to IRS
officials, IRS will be capturing tax data on referrals made to
employment tax specialists on classification cases. Also, IRS has
developed a detailed employment tax data collection instrument to
gather in-depth data on the results of those employment tax issues
that are identified in the TCMP audits.
DATA COLLECTION SYSTEMS
---------------------------------------------------------- Letter :4.4
In our 1994 report, we commented on IRS' concurrent development of
two data collection systems for use by auditors to directly enter
their audit results onto computers. We were concerned that IRS had
not made a decision on which of these two systems to use. Our
concern related to the time IRS would need to test the selected
system, develop training materials, and train auditors on how to use
it. IRS stated that it needed a back-up system to the primary
system, which is the Totally Integrated Examination System (TIES), as
an insurance plan in case TIES proves less than satisfactory. TIES
was being developed for use in IRS' regular audit program and is
being modified to meet TCMP specifications.
According to IRS officials, complete system acceptability tests will
be done on both data collection systems. IRS officials said that
they expect the tests to be done by November 22, 1995, and that TIES
will be available for use by the time audits are scheduled to start.
If major modifications need to be made to the systems as a result of
the tests, we are concerned that IRS may not meet its December 1,
1995, revised milestone for starting audits.
TCMP WORKPAPERS
---------------------------------------------------------- Letter :4.5
In our 1994 report, we suggested that IRS find ways to make TCMP
audit workpapers available through electronic media so that the
workpapers would be readily available for compliance research. In
commenting on our report, IRS agreed to explore the feasibility of
retaining the computer disks for those cases where the workpapers are
generated by computer. IRS officials subsequently informed us that
it is not technically feasible to automate all audit workpapers.
However, IRS has included a 100-line comment section in the TCMP data
collection systems and in the TCMP database to capture clarifying
information on complicated cases, which could provide researchers
with some of the additional information found in the audit
workpapers.
Adding the comment section to the TCMP database could enhance the
overall value of the TCMP data and may be a good substitute, in some
cases, for the audit workpapers. Therefore, it is important that
auditors be instructed in the types of information to include in the
comment section. The automated comment feature also provides IRS
with an opportunity to collect information on issues that cannot be
analyzed using the data elements currently planned to be on the TCMP
database. For example, one criticism of TCMP audits has been that
the audits are burdensome or overly intrusive for taxpayers.\9 IRS
could use the automated comment section to gather information on
taxpayer burden, such as the time taxpayers estimate they spent
preparing for the audit and the types of documents auditors had to
get from taxpayers in order to verify tax return data.
--------------------
\9 See Tax Administration: IRS' Plans to Measure Tax Compliance Can
Be Improved (GAO/GGD-93-52, Apr. 5, 1993). In this report we
discussed the criticisms that had been directed to TCMP audits.
These criticisms dealt with the audits being too costly and intrusive
on taxpayers and the untimely production of data.
TCMP RESEARCH PLAN
---------------------------------------------------------- Letter :4.6
In our 1994 report, we pointed out that IRS did not have a research
plan that defines the research questions and the data to be collected
that would answer the questions. IRS still does not have a research
plan. In response to our 1994 report, IRS officials stated that from
past TCMP surveys they know what elements are needed to do compliance
estimation, measure the tax gap, and develop return selection
formulas. They said that since virtually all the data from sampled
returns are collected, IRS will have appropriate and comprehensive
information to meet its research needs.
While the lack of a research plan may not directly lessen the value
of final TCMP results, such a plan could put IRS in a better position
to quickly analyze final TCMP data. One criticism of prior TCMP
surveys has been that useable TCMP data were not produced in a timely
fashion.
To help formulate research questions, IRS could analyze preliminary
TCMP results. For example, IRS expects to complete about 46,000 TCMP
audits by the end of fiscal year 1996, which could be enough cases to
formulate research questions. IRS is reluctant to use preliminary
unweighted or partially weighted TCMP data because the data are not
statistically valid. Even though preliminary data may not be
statistically valid, these data could provide early information on
possible noncompliance trends and other problems, such as complexity
issues, which could be useful to both IRS and Congress when they are
examining potential modifications to the tax system.
OTHER DATA SOURCES FOR
TARGETING AUDITS
------------------------------------------------------------ Letter :5
IRS uses TCMP data to develop objective, mathematical formulas, which
it uses to score returns for audit selection. As a result, IRS can
make more efficient use of its audit resources and avoid
unnecessarily burdening compliant taxpayers. For example, in 1969,
the year before IRS started using this scoring system, about 46
percent of IRS' audits resulted in no change to an individual's tax
liability. By using TCMP-based formulas, IRS has been able to more
accurately select tax returns requiring changes, thus reducing the
no-change rate to less than 15 percent in 1994.
We are not aware of any other available data that can be used to
develop return selection formulas that would allow IRS to target its
audits as effectively as TCMP data. IRS is attempting to develop an
Automated Issue Identification System that has the potential of
selecting returns that should be audited. The system is being tested
on individual tax returns in two IRS locations, and, according to IRS
officials, the preliminary results are promising. However, this
system would be dependent in part on the TCMP-developed return
selection formula to identify the returns that should be audited.
Also, this system would require that almost all tax return data be
transcribed onto computers similar to the amount of data transcribed
from returns that are selected for TCMP audits. IRS does not expect
to have the technological capability to have all return information
on computer until after the turn of the century.
There are third-party databases that potentially could be used to
supplement the compliance data that IRS obtains from its TCMP
surveys. However, these databases cannot be used to develop return
selection formulas because they either contain just aggregate data on
businesses and individuals or have information just on specific tax
issues. For example, Bureau of Labor Statistics and U.S. Census
data can be used to make aggregate profiles of the population based
on various income characteristics, such as average household
earnings. Some states have databases that IRS could use to
supplement its audit and other compliance activities, such as state
sales tax data. Commercial sources for information on industry norms
are also available to supplement IRS compliance activities. IRS
currently uses these data sources in some of its compliance research
projects.
TCMP AND ALTERNATIVE TAX SYSTEM
PROPOSALS
------------------------------------------------------------ Letter :6
There are a number of proposals to change the current tax system.
The proposals are as follows:
A Flat Tax would levy a single-rate wage tax on individuals and a
single-rate cash-flow tax on businesses.
An Unlimited Savings Allowance (USA) Tax would provide for a
three-bracket individual income tax, with a full deduction for
income saved rather than consumed. On the business side, a
single rate would apply to income from both corporate and
noncorporate businesses, with an immediate deduction for capital
investment and purchases of inventory.
A Simplified Income Tax would broaden the tax base, lower the tax
rate, and eliminate most current deductions and credits.
A Value Added Tax (VAT), a consumption tax, would be collected at
each stage of the production process.
A Retail Sales Tax, a consumption tax, would be collected at the
retail level in the form of a sales tax.
To determine the relevancy of TCMP data to these alternative tax
systems, we analyzed the tax return elements IRS plans to examine in
its tax year 1994 TCMP and published documents on the systems. (See
app. I for the results of this analysis.) In doing our analysis, we
did not consider the TCMP costs and benefits or taxpayer burden for
each of the proposals. Generally, we found that TCMP data could have
some relevancy for each alternative tax system. The degree of
relevancy depended on the number of current tax elements that would
be retained under an alternative tax system--the more elements that
are retained, the more relevant the TCMP data would be.
RELEVANCY OF TCMP RESULTS
FOR DESIGNING AND
ADMINISTERING ALTERNATIVE
TAX SYSTEM PROPOSALS
---------------------------------------------------------- Letter :6.1
Potentially, data obtained from TCMP audits could be used to guide
both the final design and administration of a new tax system. While
complete 1994 TCMP data would not be available until late in 1998,
data on about 46,000 sample cases should be available by the end of
fiscal year 1996. As questions arise during the process of drafting
new tax laws, data from some of the 46,000 cases, while not
statistically valid at the district level, may indicate obvious
trends in nationwide data that could be used in making decisions on
changes to tax law.
With respect to the administration of tax laws, each of the current
proposals would require that tax administrators implement some form
of compliance strategy. Any such strategy would likely be dependent
on compliance data. The 1994 TCMP should be able to provide much of
the information necessary for implementing such a compliance
strategy. For example, any new tax system would likely continue to
rely on audits to ensure compliance. Accordingly, auditors would
continue to need compliance information on business income and
expenses and, for some of the proposals, compliance information on
individual income and deductions. For the most part, this data could
be provided by the 1994 TCMP.
Some TCMP data would be useful in the design of all the proposed tax
systems. For example, gross receipts, a key area of noncompliance in
past TCMP audits, would be important in each of the new tax
proposals. For this potential problem area, TCMP should show the
compliance levels, provide specific tax issues associated with the
identified noncompliance, and provide reasons for the noncompliance.
The compliance data should help Congress to determine the potential
extent of noncompliance that could be expected under the new tax
system proposals. This would be important in setting tax rates.
Similarly, data on the reasons why the noncompliance occurred and the
specific tax issue involved could provide clues to legislative
actions that may be needed to help prevent noncompliance under the
new system or to help tax administrators identify noncompliant
taxpayers more readily. Knowing these weak spots would be useful so
that Congress could attempt to overcome these problems as it
considers designs for new tax systems.
To the extent that the proposals for tax reform retain elements of
the current system, such as properly determining business receipts
and expenses, TCMP data could play a prominent role in helping to
evaluate and design those parts of the proposed new tax system.
To the extent that a new tax system is adopted that differs radically
from the existing system, TCMP data would still be useful. For
example, TCMP information on gross receipts of retail businesses
would be useful for designing and administering a retail sales tax
system. Under this system, information on all business income and
expenses could be relevant for profiling those retailers who would be
more likely to underreport their gross receipts. Also, if a federal
retail sales tax included consumer services not now covered by state
sales taxes, TCMP could be the only source of information on
underreporting of gross receipts by the sellers of these services.
It must be recognized that the results from TCMP would reflect
noncompliance under the income tax law and the administrative
practices in place today. Incentives or opportunities to evade tax
on certain transactions may increase or decrease under a new system.
For example, if a business taxpayer fails to report a sale of an
asset under the current income tax, the business might avoid paying
tax on a capital gain, a fraction of the selling price. Under many
consumption tax proposals, all the proceeds of an asset sale are
taxable, but at a lower rate. The incentive to not report the sale
may increase or decrease relative to the current system, depending on
the circumstances. In addition, opportunities to not comply in some
areas may change significantly depending on whether administrative
tools such as withholding and information reporting were included as
part of the system.
In order to effectively select returns for audit under a new tax
system, tax administrators may be able to use 1994 TCMP results in
combination with information on the relative incentives and
opportunities to avoid tax under that system, until direct measures
of noncompliance under the new system became available.
THE USE OF TCMP DATA IN THE
INTERIM
---------------------------------------------------------- Letter :6.2
The preceding discussion dealt only with the usefulness of TCMP
results for administering each of the proposed tax systems once the
new system had been fully implemented. The results of the planned
TCMP would also be of use in administering the current income taxes
in the interim period before a new system would be completely phased
in and the old system completely phased out. The 1994 TCMP data
would become increasingly important if it proves impossible to fully
implement a new tax system until after the turn of the century. This
is because IRS would need to continue to audit returns under the
current tax law, and existing return selection criteria are based on
past TCMP survey data, which are growing older every year.
The usefulness of the forthcoming TCMP during the interim would
depend on the effective date of the replacement system and on the
extent to which the enacting legislation would include transition
provisions. The 1994 TCMP data used to develop audit selection
formulas for the current tax system are not scheduled to be developed
before late 1998. However, if a new tax system became effective
before that time and had few transition provisions, IRS could still
use interim TCMP data on noncompliance issues to direct audits of tax
returns filed under current rules.
If tax reform legislation were to take longer to pass, if the
legislation provided for a significant period of time between the
date of enactment and the effective date of the new system, or if the
legislation contained numerous transition provisions, then the value
of the planned TCMP would be greater. Items such as unused tax
credits and deductions for depreciation, depletion, and net operating
losses might be subject to transition rules. For example, it has
been suggested that if a flat tax were enacted, businesses might be
allowed to claim depreciation deductions during a transition period
of several years for assets they purchased under the old system.\10
Others have suggested that taxpayers could be subject to both the
current income tax and a new consumption tax for a period of years,
with the income tax rate declining as the consumption tax rate
increases.\11
If the planned TCMP were cancelled and the current income taxes were
not completely phased out before the next century, then IRS would be
compelled to select income tax returns for audit on the basis of
compliance information that was over 10 years old. Administrators of
the new tax system also would have only this same dated compliance
information to guide their enforcement efforts for several years
before data from any future TCMP became available.
--------------------
\10 See Hall and Rabushka, The Flat Tax, second edition, 1995.
\11 See Department of the Treasury, Blueprints for Basic Tax Reform,
1977.
CONCLUSIONS
------------------------------------------------------------ Letter :7
IRS has taken action on most of the concerns we raised in our
December 1994 report. The delay in starting the TCMP audits because
of budgetary concerns is fortuitous because IRS had not completed
testing all the tax return database or data collection systems for
the TCMP. These tests have to be completed before audits can start.
If the tests show that major modifications have to be made to the
database or data collection systems, then IRS may not meet its
December 1, 1995, revised date for starting audits.
There is still time for IRS to develop a research plan so that it
could analyze final TCMP results more quickly. IRS could begin now
to formulate research questions and could also use preliminary TCMP
data as they become available to develop other questions.
It is important that there are no further delays because the existing
TCMP data are old, and, to our knowledge, there are no other data
sources that IRS could use to develop formulas for selecting returns
for audit. IRS is attempting to develop a system that could be used
for selecting returns, but this system would not be operational until
after the turn of the century.
TCMP data could also be of value for helping with the design and
administration of alternative tax systems. The value of the data
would depend on how much of the current tax system would be retained
under the new system.
AGENCY COMMENTS AND OUR
EVALUATION
------------------------------------------------------------ Letter :8
On September 29, 1995, we discussed a draft of this report with IRS
Compliance Research Division representatives, including the National
Director of Compliance Research. They generally agreed with our
assessment of the actions taken on the concerns we raised in our 1994
report, the availability of other information sources to replace
TCMP, and the relevancy of TCMP data for new tax system proposals.
---------------------------------------------------------- Letter :8.1
Copies of this report are being sent to various interested
congressional committees, the Director of the Office of Management
and Budget, the Secretary of the Treasury, the Commissioner of
Internal Revenue, and other interested parties. It will also be made
available to others upon request.
Major contributors to this report are listed in appendix II. Please
contact me on (202) 512-9044 if you or your staff have any questions
about the report.
Sincerely yours,
Natwar Gandhi
Associate Director, Tax Policy and
Administration Issues
TCMP AND ALTERNATIVE TAX SYSTEM
PROPOSALS
=========================================================== Appendix I
This appendix discusses some ways the individual and business
segments of the 1994 TCMP could be used to evaluate the design and
administration of the five alternative tax system proposals. The
proposals are described below.
A Flat Tax would levy a single-rate wage tax on individuals and a
single-rate cash-flow tax on businesses.
An Unlimited Savings Allowance (USA) Tax would provide for a
three-bracket individual income tax, with a full deduction for
income saved rather than consumed. On the business side, a
single rate would apply to income from both corporate and non-
corporate businesses, with an immediate deduction for capital
investment and purchases of inventory.
A Simplified Income Tax would broaden the tax base, lower the tax
rate, and eliminate most current deductions and credits.
A Value Added Tax (VAT), a consumption tax, would be collected at
each stage of the production process.
A Retail Sales Tax, a consumption tax, would be collected at the
retail level in the form of a sales tax.
INDIVIDUAL TAXPAYERS
--------------------------------------------------------- Appendix I:1
Under the VAT and Retail Sales Tax proposals, individuals would bear
taxes as they consume goods and services, but, unless they were sole
proprietors, they would not file tax returns. Therefore, the
nonbusiness (e.g., individuals who are not sole proprietors) portion
of the TCMP (about 18 percent of the sample) has no relevancy for
these two types of taxes. The flat tax, the USA tax, and the
simplified income tax would require returns for individual taxpayers
who do not own businesses. Thus, TCMP data should have some
relevancy in evaluating these alternative tax systems.
Table I.1 shows the TCMP data elements for individuals that could be
relevant to policymakers and tax administrators in developing and
administering the flat tax, USA tax, and simplified tax systems. The
TCMP data elements are essentially the same as the line items found
on the Form 1040, Individual Income Tax Return. The "yes" in the
columns in table I.1 indicates that the TCMP element would be
relevant for evaluating the proposals. Those columns in table I.1
that do not contain "yes" indicate that TCMP data collected for these
elements would not be relevant for that particular tax system. The
sample sizes shown in table I.1 are the number of individual returns
IRS plans to audit in the TCMP.
Table I.1
Relevant Individual TCMP Data Elements
For Developing and Administering
Alternative Tax Systems
Simplified
TCMP data element Flat tax USA income tax
---------------------------------- ---------- ---------- ----------
TCMP sample size\a 92,185 92,185 92,185
Filing status Yes Yes Yes
Exemptions Yes Yes Yes
Blind and/over 65 exemptions Yes
Income types
----------------------------------------------------------------------
Wages, salaries, and tips Yes Yes Yes
Taxable interest income Yes Yes
Nontaxable interest income Yes Yes
Dividend income Yes Yes
Taxable refunds or credits of
state and local income taxes
Nonfarm business income\b Yes Yes Yes
Alimony received Yes Yes
Capital gain or (loss)\c Yes Yes
IRA distributions\d Yes Yes Yes
Pensions and annuities Yes Yes Yes
Income from rental real estate, Yes Yes
partnerships, S corporations\e
Farm income\f Yes Yes Yes
Unemployment income Yes Yes Yes
Social Security benefits Yes Yes
Other income Yes Yes
Adjustments to income
----------------------------------------------------------------------
IRA deductions for self and spouse Yes
Moving expenses Yes Yes
One-half of self employment tax\g Yes Yes
Self-employed health insurance
deduction
Keogh retirement plan and SEP Yes Yes
deduction\g
Penalty on early withdrawal of Yes Yes
savings
Alimony Yes Yes
Schedule A deductions
----------------------------------------------------------------------
Medical and dental expenses
State and local income taxes
Mortgage interest\h Yes Yes Yes
Charitable contributions\h Yes Yes
Casualty and theft losses
Other miscellaneous deductions\i Yes
Credits
----------------------------------------------------------------------
Child and dependent care expenses
Credit for the elderly or disabled
Foreign tax credit Yes Yes
Other credits\j
Other taxes
----------------------------------------------------------------------
Self-employment tax\k Yes Yes Yes
Alternative minimum tax
Recapture taxes
Social Security tax on tip income Yes Yes Yes
Tax on qualified retirement plans
Advanced earned income payments Yes Yes
Payments
----------------------------------------------------------------------
Tax withheld Yes Yes Yes
Earned income credit Yes Yes
Excess Social Security Tax Yes Yes Yes
Other payments Yes Yes Yes
----------------------------------------------------------------------
\a 64,010 of these returns are sole proprietors and are also included
in the analysis of businesses.
\b Under flat tax and USA proposals, this income would be reported on
a separate business income form. Distributed business income would
be taxed under the individual tax in the USA system.
\c While gains and losses as such would not be computed under the
flat tax and the USA tax, data from this line would provide
information about the proceeds from capital transactions, which are
part of the tax base.
\d Information from this line would be useful for administration
purposes because some of this income might still be taxable.
\e Under the USA tax, income reported on this line from partnerships
and S corporations would be part of the tax base. Rental income
would be useful for business returns.
\f Farm income would be considered business income under flat tax and
USA proposals. However, distributed income would be taxable to the
individual in the USA proposal.
\g These deductions would become part of business tax returns under a
flat tax.
\h Under Senator Spector's flat tax proposal, all mortgage interest
and charitable contributions could be deducted. Hall and Rabushka
have suggested that 90 percent of mortgage interest on existing loans
might be deductible during the flat tax transition phase.
\i Investment interest expense and job-related expenses shown on this
line were moved to adjustments to income under the Simplified Income
Tax proposal.
\j Other credits are (1) jobs credit, (2) credit for alcohol used as
a fuel, (3) credit for increasing research activities, (4) low-income
housing credit, (5) disabled access credit, (6) enhanced oil recovery
credit, (7) renewable electricity production credit, (8) credit for
employer Social Security and medicare taxes paid on certain employee
tips, and (9) credit for contributions to selected community
development corporations.
\k Because employment taxes apparently would remain largely
unchanged, this data element would be useful for all the alternative
tax proposals. Additionally, it would be useful under the USA
proposal for analysis of the employment tax credit being offered.
Source: Developed by GAO from summaries of the new tax proposals and
analysis of TCMP coverage.
FLAT TAX PROPOSAL
------------------------------------------------------- Appendix I:1.1
As indicated in table I.1, some of the TCMP individual tax elements
should be relevant for evaluating the flat tax proposal. However,
there would be no need to evaluate the compliance associated with
investment-type income or deductions, such as charitable
contributions or state and local taxes, because these elements are
not part of the proposal. The relevant individual tax elements are
filing status, exemptions, wages and salaries, pension income, and
unemployment compensation. TCMP data could be used to determine how
accurately taxpayers have reported these elements and the reasons why
taxpayers have failed to comply under the current tax system. For
example, the TCMP data may indicate that even under a flat tax,
current requirements are too complex for many taxpayers to determine
their proper filing status. The TCMP data could provide information
on ways current law could be simplified to reduce complexity and
improve compliance.
USA TAX PROPOSAL
------------------------------------------------------- Appendix I:1.2
As indicated in table I.1, almost all TCMP income elements for
individuals would be included in the USA tax system and, thus, should
be useful for evaluating this system. Under the USA system,
taxpayers would be allowed unlimited deductions for net increases to
savings; however, except for IRA deductions, taxpayers are not
currently required to report these data. Therefore, TCMP data would
not be useful for determining whether taxpayers would accurately
report all investment deposits. On the other hand, TCMP data should
be useful for determining the reporting accuracy of investment
proceeds.
Under the USA system, all deductions under the current income tax,
except for mortgage interest and charitable contributions, would be
eliminated. TCMP data should be useful in developing compliance
statistics and programs for these two items. However, TCMP could not
be used to evaluate the postsecondary education deduction allowed
under the USA proposal. Similarly, TCMP data could not be used to
evaluate the fringe benefits that would be taxable under the USA
proposal because these benefits, such as employer paid medical
insurance, are currently not taxable and would not be studied in the
TCMP survey of individuals. However, data on fringe benefits would
be gathered on the business portion of the TCMP.
SIMPLIFIED INCOME TAX SYSTEM
------------------------------------------------------- Appendix I:1.3
As indicated in table I.1, almost all of the TCMP elements should be
relevant for evaluating compliance with income reporting
requirements. On the deduction side, only TCMP data on mortgage
interest would be relevant for evaluating this system. Like the USA
tax system, fringe benefits would be taxed; thus, the individual
portion of the TCMP would not be useful for evaluating this type of
income.
BUSINESS TAXPAYERS
--------------------------------------------------------- Appendix I:2
All five alternative tax systems cover businesses, which include sole
proprietorships, corporations, S corporations, and partnerships.
About 82 percent of the TCMP sample covers businesses. Table I.2
indicates the TCMP data elements that should be useful for developing
and administrating the flat tax, USA, VAT, and retail sales tax
systems. Table I.2 does not contain information on the simplified
income tax system because we were not able to obtain any information
on the business portion of this tax system. However, on the basis of
information available on the individual portion, it would appear that
almost all business income and deduction items in the current system
would be relevant under the simplified income tax system.
Table I.2
Relevant Business TCMP Data Elements For
Developing and Administering Alternative
Tax Systems\a
Value
added Sales
TCMP data element Flat tax USA tax tax
------------------------------ -------- -------- -------- --------
TCMP sample size 124,981 124,981 124,981 35,672
Income and cost of goods sold
----------------------------------------------------------------------
Gross receipts or sales Yes Yes Yes Yes
Cost of goods sold
----------------------------------------------------------------------
Inventory
Purchases Yes Yes Yes
Cost of labor Yes
Other costs Yes Yes Yes
Gross profit
Dividends
Interest
Gross rents\b Yes Yes Yes
Gross royalties\b Yes Yes Yes
Capital gain net income
Net gain or (loss) from sale Yes Yes Yes
of business property\c
Other income\d
Business deductions
----------------------------------------------------------------------
Compensation of officers Yes
Salaries and wages Yes
Repairs and maintenance Yes Yes Yes
Bad debts Yes
Rents Yes Yes Yes
Taxes and licenses Yes
Interest
Charitable contributions
Depreciation\e Yes Yes Yes
Depletion\e Yes Yes Yes
Advertising Yes Yes Yes
Pension and profit-sharing Yes
plans
Employee benefit programs\f Yes
Other deductions Yes Yes Yes
Net operating loss Yes Yes Yes
deductions\g
Tax credits\h
----------------------------------------------------------------------
\a Information gathered on businesses includes small corporations, S
corporations, partnerships, and sole proprietorships.
\b To the extent that tax law characterizes rents, royalties, and
payments for the right to use property as income, as opposed to a
return on investment, these amounts would be included in a VAT tax
base.
\c While gains and losses as such would not be computed under these
proposals, data from this line would provide information about the
proceeds from sales of business property, which would be part of the
tax base. Also, sales tax might be applicable if the sale were made
to a final consumer.
\d Selected items of other income such as recovery of previously
deducted bad debts may be included in the tax base for the flat tax,
USA, and VAT proposals. However, most kinds of other income would
probably not be included.
\e Depreciation and depletion information would be useful for
obtaining data on the purchase price of assets that would be
deductible under the proposed flat tax and USA tax systems.
\f While these benefits would not be deductible by businesses, the
information should be useful under the USA tax proposal because the
benefits would be taxable to individuals.
\g Although these deductions would not be carried over in the USA tax
proposal, this data could be used in the design phase to correct
problems that may arise as operating losses begin to occur under the
new tax.
\h Tax credits include (1) foreign tax credit, (2) possessions tax
credit, (3) orphan drug tax credit, (4) nonconventional fuels tax
credit, (5) general business tax credit, and (6) prior year
alternative minimum tax credit.
Source: Developed by GAO from summaries of the new tax proposals and
analysis of TCMP coverage.
FLAT TAX
------------------------------------------------------- Appendix I:2.1
Under the flat tax proposal, businesses would be assessed a tax on
gross receipts less the costs of providing the goods or services.
Therefore, as indicated in table I.2, almost all of the TCMP tax
elements dealing with business gross receipts and deductions should
be relevant for administering a flat tax, such as designing
compliance strategies, identifying returns for audit, and estimating
the tax gap. If this proposal were implemented, TCMP data on
business investment income and interest expenses would not be
relevant.
USA TAX
------------------------------------------------------- Appendix I:2.2
As indicated in table I.2, many of the income and deduction items
currently reported on business returns would still be reported on
returns under the USA tax proposal. Thus, the TCMP data would be
relevant for developing compliance programs, selecting returns for
audit, and estimating the tax gap. Items that would not be relevant
include investment type income (e.g., interest and dividends); and
deductions for wages and salaries, interest payments, and
contributions to employee pension programs.
VAT
------------------------------------------------------- Appendix I:2.3
As indicated in table I.2, if a VAT were adopted as a replacement for
the existing income tax, TCMP data on business gross receipts and
purchases would be relevant for looking at potential compliance
problems with VAT reporting. Thus, TCMP information would continue
to be useful in developing compliance programs, selecting returns for
audit, and estimating the tax gap.
RETAIL SALES TAX
------------------------------------------------------- Appendix I:2.4
As indicated in table I.2, return information on gross receipts
should be relevant for evaluating compliance problems under a retail
sales tax system. A retail sales tax would generally apply only to
businesses in the retail trade market segments. This group comprises
about 24 percent of the planned 1994 TCMP sample.
MAJOR CONTRIBUTORS TO THIS REPORT
========================================================== Appendix II
GENERAL GOVERNMENT DIVISION,
WASHINGTON, D.C.
Ralph Block, Assistant Director, Tax Policy and
Administrative Issues
James Wozny, Chief Tax Economist, Tax Policy and
Administrative Issues
Ed Nannenhorn, Economist
SAN FRANCISCO REGIONAL OFFICE
Lou Roberts, Evaluator-in-Charge