Taxpayer Compliance: Analyzing the Nature of the Income Tax Gap
(Testimony, 01/09/97, GAO/T-GGD-97-35).
GAO discussed the income tax gap, the difference between income taxes
owed and those voluntarily paid. GAO noted that: (1) the Internal
Revenue Service's (IRS) data suggest that U.S. taxpayers voluntarily pay
about 83 percent of the income taxes they owe and ultimately pay about
87 percent after IRS enforcement programs; (2) this compliance level, in
combination with economic growth, translates into billions of tax gap
dollars; (3) IRS estimates show that voluntary compliance in reporting
income varies across groups of individuals; (4) IRS data show that
compliance is highest under tax withholding, a little lower without
withholding but with information reporting to IRS, and much lower when
neither system is in place; (5) in addition to the relative visibility
of the income to tax administrators, other factors also influence the
level of compliance; (6) IRS faces many challenges in reducing the
income tax gap; (7) collection of some of the tax gap might require
either more intrusive record keeping or reporting than the public is
willing to accept or more resources than IRS can commit; and (8) it is
important that IRS know as much as possible about current compliance
with the tax laws and use that knowledge to focus its resources in a
cost-effective way.
--------------------------- Indexing Terms -----------------------------
REPORTNUM: T-GGD-97-35
TITLE: Taxpayer Compliance: Analyzing the Nature of the Income Tax
Gap
DATE: 01/09/97
SUBJECT: Tax administration
Tax administration systems
Taxpayers
Tax nonpayment
Voluntary compliance
Income taxes
Tax return audits
Tax returns
Noncompliance
Tax law
IDENTIFIER: IRS Taxpayer Compliance Measurement Program
TCMP
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Cover
================================================================ COVER
Before the National Commission on Restructuring the Internal Revenue
Service
For Release
on Delivery
Expected at
11:00 a.m. EST
Thursday
January 9, 1997
TAXPAYER COMPLIANCE - ANALYZING
THE NATURE OF THE INCOME TAX GAP
Statement of Lynda D. Willis, Director, Tax Policy and
Administration Issues, General Government Division
GAO/T-GGD-97-35
GAO/GGD-97-35T
(268778)
Abbreviations
=============================================================== ABBREV
IRS - x
TCMP - x
TAXPAYER COMPLIANCE: ANALYZING
THE NATURE OF THE INCOME TAX GAP
==================================================== Chapter STATEMENT
Messrs. Chairmen and Members of the Commission:
We are pleased to be invited by you to discuss the income tax
gap--the difference between income taxes owed and those voluntarily
paid. The Internal Revenue Service (IRS) has estimated that
taxpayers do not voluntarily pay more than $100 billion annually of
taxes due on income from legal sources.\1
While such "tax gap" estimate is necessarily imprecise, it indicates
significant noncompliance and the challenge that IRS faces in finding
ways to reduce the tax gap.
When some taxpayers do not pay all the taxes they owe, that part of
the burden of funding approved government programs shifts to
taxpayers who fully comply. Thus, maintaining high levels of
compliance and reducing the tax gap are important for equity reasons.
However, it would be unrealistic to assume that our tax system, or
any tax system, can achieve 100-percent compliance and thus eliminate
the tax gap.
My statement covers four points which are based on our previous
reports and ongoing work. These points are:
-- First, IRS' data suggest that U.S. taxpayers voluntarily pay
about 83 percent of the income taxes they owe and ultimately pay
about 87 percent after IRS enforcement programs. This
compliance level, in combination with economic growth,
translates into billions of "tax gap" dollars.
-- Second, IRS' estimates show that voluntary compliance in
reporting income varies across groups of individuals. Among
those filing income tax returns, wage earners report 99 percent
of their wages; self-employed individuals who operate formally
report 68 percent of their business income; and "informal
suppliers," self-employed individuals who operate informally on
a cash basis, report just 19 percent of such income on their tax
returns.
-- Third, IRS data show that compliance is highest under tax
withholding, a little lower without withholding but with
information reporting to IRS, and much lower when neither system
is in place. In addition to the relative visibility of the
income to tax administrators, other factors also influence the
level of compliance. For example, complex tax laws can lead to
more noncompliance.
-- Fourth, IRS faces many challenges in reducing the income tax
gap. For example, some of the "tax gap" may not be collectible
at an acceptable cost. Such collection might require either
more intrusive record keeping or reporting than the public is
willing to accept or more resources than IRS can commit. Thus,
it is important that IRS know as much as possible about current
compliance with the tax laws and use that knowledge to focus its
resources in a cost-effective way.
Successfully reducing the tax gap may depend on several systematic
factors in addition to overcoming the challenges faced by tax
administrators. Before discussing these points, I would like to
discuss the "tax gap" estimates and how they are derived.
--------------------
\1 Income tax gap estimates released in 1988 and 1996 have excluded
unpaid income taxes owed from illegal activities such as drug dealing
and prostitution. IRS' tax gap estimates in 1979 and 1983 included
such an estimate. Since then, IRS researchers have decided that the
data and methodology for reliably making this estimate are lacking.
TAX GAP ESTIMATES
-------------------------------------------------- Chapter STATEMENT:1
Tax gap estimates, for the most part, have traditionally begun with
IRS' Taxpayer Compliance Measurement Program (TCMP). Under this
program, IRS auditors did line-by-line audits of randomly selected
tax returns to identify under- and overreporting for a line item.
IRS used these results to estimate compliance for the taxpayers
included in the TCMP. TCMP has been used since 1963 to measure
compliance on income tax returns filed by individuals about every
third tax year. The last TCMP for such individual filers covered tax
year 1988. IRS also has done a few TCMPs for individual nonfilers
and for small corporations (those reporting less than $10 million in
assets). Other data from IRS enforcement programs and special
studies have been used to supplement TCMP results or to estimate the
tax gap for large corporations and informal suppliers.
IRS' most recent estimate (1996) projects tax gap numbers for
individuals in tax years 1985, 1988, and 1992. Previous IRS
estimates provided projections for other tax years as well as for
corporations.\2 IRS estimated that the income tax gap for individuals
reached as high as $95 billion for tax year 1992. IRS data show the
tax gap has grown over time even though the compliance rate has
remained roughly the same because the economy has grown and changes
in the tax laws have had the unintended effect of increasing
opportunities for noncompliance. After making adjustments for tax
law changes and shifts in types of income, IRS estimated that overall
individuals have been paying about 83 percent of the total income
taxes owed.
IRS has been able to recover a portion of the tax gap through its
enforcement programs, such as audits and document matching.\3 IRS
estimates that its enforcement programs have, on average, recovered
about 4 percent of all individual and corporate income taxes due in
any particular tax year. Thus, IRS estimates that overall compliance
reaches about 87 percent after IRS enforcement programs. However,
because of the time consumed by these programs and by any subsequent
appeals and litigation, the 87-percent compliance level cannot be
reached until a number of years after the taxes were due.
--------------------
\2 IRS last updated in 1990 an estimate of the corporate income tax
gap. That tax gap estimate was $33 billion for tax year 1992. It
did not include the most recent TCMP for small corporations, which
showed that their income tax compliance, dropped from 81 percent in
1980 to 61 percent in 1987. IRS Research Division did not know when
it would have the time and resources to finish updating the corporate
tax gap estimates.
\3 IRS' 1996 estimate for individuals noted that IRS enforcement
programs recovered about $15 billion of the $95 billion income tax
gap for 1992, leaving a net gap of $80 billion.
COMPONENTS OF THE TAX GAP
-------------------------------------------------- Chapter STATEMENT:2
As shown in table I.1, IRS' estimate attributes about three-fourths
of the gross income tax gap to individuals and one-fourth to
corporations. For tax year 1992, the individual tax gap primarily
arose from individuals not fully reporting their income on filed tax
returns ($59 billion of the $95 billion estimate). The most recent
estimate of the corporate tax gap projected it to be $33 billion for
tax year 1992. Noncompliance in reporting income, deductions, and
other offsets to income or tax comprised most of the total--$24
billion by large corporations and $7 billion by small corporations.
Within these overall tax gap estimates, compliance varied by type of
individual taxpayers filing the tax returns (see table I.2), as
follows:
-- Wage earners whose wages are subject to tax withholding (the
most systematic method for making income visible to IRS) are
estimated to report 99 percent of their wages.
-- Individuals are estimated to report 98 percent of their interest
income and 92 percent of their dividend income, most of which is
subject to tax-information reporting but not tax-withholding
requirements.
-- In contrast, IRS estimates that self-employed individuals who
formally operate businesses other than farms report about 68
percent of their business income, which is neither subject to
withholding nor necessarily covered by information reporting.
-- Finally, self-employed informal suppliers, who are even less
likely to have income reported to IRS on information returns,
report an estimated 19 percent of their business income.
The tax gap for individual taxpayers who did not file tax returns for
tax year 1992 was almost $14 billion. Other components of the
individual tax gap included overreported deductions, credits and
other offsets to income ($14 billion), and taxes not remitted along
with the filed return ($8 billion).
Similarly, variations in compliance exist in the corporate sector.
Small corporations tend to mirror the compliance patterns of
self-employed individuals. Unreported business income is the biggest
compliance problem, and sufficient documentation of income is often
lacking. In large corporations, by contrast, the tax gap typically
arises from different interpretations of an ambiguous and complex tax
code. Upon audit, IRS auditors may interpret the tax provisions
differently and, as a result, recommend adjustments to the
corporation's tax liability.\4
--------------------
\4 IRS' primary basis for estimates of the large corporation tax gap
arise from these recommended audit adjustments. When any taxpayer
appeals the recommendation, the appeal process may result in the
recommended tax liability being reduced in whole or in part.
SYSTEMATIC FACTORS THAT
INFLUENCE TAX COMPLIANCE
-------------------------------------------------- Chapter STATEMENT:3
Tax administrators around the globe have worked to promote compliance
with whatever tax system is in place. On the basis of our previous
work\5 , we have identified some common principles that have
influenced their success.
First: The simpler the rules, the better. This reflects the basic
principle that the simpler the tax code, the more certain the results
in applying it and the fewer the opportunities for disagreements over
the "fine points" of tax law. However, we have reported that the
existing U.S. system is neither simple nor certain. For example,
some paragraphs in the Internal Revenue Code have generated as many
as 250 pages of implementing regulations.
Second: Collecting from fewer sources is easier. Tax withholding
allows the tax collector to focus on the relatively small number of
employers rather than on all employees. For example, Congress
followed this reasoning in changing the collection point for diesel
fuel taxes to the smaller number of businesses earlier in the
production chain. Subsequent to this and other changes in the
taxation scheme for diesel fuel, collections have risen
significantly.
Third: More visible tax information promotes higher compliance. Tax
withholding and information reporting are two means of making income
and some deductions visible to both the taxpayer and the tax
administrator; this visibility leads to significantly higher
compliance rates. Good records and other types of paper trails also
lead to better results when the tax administrator audits a return or
takes some other enforcement action.
Fourth: Good information is critical to identifying compliance
problems. This principle recognizes the importance of systematically
estimating the extent of noncompliance and variations in taxpayer
behavior. In this way, the tax administrator can identify areas
warranting attention, tax returns to audit, and the results of any
efforts to improve compliance.
Fifth: Focus compliance efforts where they will do the most good.
Having information on the most significant compliance problems helps
the tax administrator to tailor its enforcement efforts accordingly.
At present, the largest component of the U.S. income tax gap arises
from individuals not fully reporting their income, particularly
income that is not subject to tax withholding. This knowledge has
helped IRS to train its auditors to better detect unreported income.
Sixth: Deal with compliance problems quickly. IRS has found that
the longer it takes to reach a taxpayer, whether through enforcement
or assistance, the less success in correcting the compliance problem.
--------------------
\5 Reducing the Tax Gap: Results of a GAO-Sponsored Symposium
(GAO/GGD-95-157, Jun. 2, 1995).
THE CHALLENGE FOR IRS
-------------------------------------------------- Chapter STATEMENT:4
IRS' goal has been to improve the compliance level from 87 percent to
90 percent by 2001. The tax gap estimates have provided ways for
determining whether compliance is improving. At the broadest level,
the estimates provide an indicator of the seriousness of the
compliance problems and any related inequities. To the extent that
sufficient details are known, the estimates also provide insights on
the types of tax issues or taxpayers associated with low and high
compliance.
One method by which IRS hopes to improve compliance is by increasing
its compliance presence. Over the last 30 years, the rates at which
IRS has audited income tax returns have declined over 75 percent.
While alternative mechanisms such as document matching reach many
types of income that may not be reported, IRS has no substitute for
auditing in the case of more complex tax issues. Another method of
improving compliance is to educate the taxpayer about confusing or
commonly misunderstood tax requirements. IRS has initiated efforts
to develop better information that should help IRS to improve its
compliance presence as well as to secure more opportunities for
outreach and education with taxpayer groups.
To support such efforts, IRS has been reorganizing its compliance
research function to push more research into field offices. IRS
hopes that systematic research, combined with detailed knowledge
about tax and enforcement issues, can provide a road map to
large-scale compliance gains. With this end in mind, IRS has been
scheduling various research projects and attempting to build new
databases to allow its researchers access to current data related to
the compliance of various taxpayer groups. Finally, IRS is
considering different ways to measure how well our voluntary tax
system is working.
The importance of these steps has increased with the demise of TCMP.
In October 1995, concerns about costs and burdens on taxpayers
prompted IRS to cancel a planned tax year 1994 TCMP for individuals,
small corporations, and other types of small businesses.\6 IRS has
not yet developed an alternative to the comprehensive, statistically
valid estimates on tax compliance that TCMP provided. Lacking such a
replacement to date, IRS hopes that its enhanced research activities
will provide a partial substitute.
It is not yet clear whether IRS will be able, absent TCMP data, to
continue to provide a comprehensive tax gap estimate with any
statistical precision at the national level. Without such an
estimate, IRS and Congress will not know how well our voluntary tax
system works overall and the extent that all types of taxpayers are
paying their fair share of taxes. Nor will IRS and Congress have a
broad context by which to judge the seriousness of the compliance
problems uncovered in field research of selected tax issues and
taxpayer groups.
One factor IRS must balance against its desire to increase voluntary
compliance is the additional costs and burdens that are incurred by
both IRS and the taxpayer. Depending on the actions taken, improving
the compliance rate could dramatically increase the costs to IRS and
the burdens on taxpayers. Reaching for a near-perfect compliance
rate very likely would mean imposing burdens and costs that our
society may not accept.
IRS is hoping that its enhanced research efforts will allow it to
target noncompliance in a systematic way and thus guide enforcement
and educational activities while minimizing costs and burdens. We
have reported\7 that IRS' approach of supplementing its enforcement
efforts with research into the causes of noncompliance strikes us as
being intuitively logical. However, we found mixed support among IRS
officials for this approach causing tensions that could have an
adverse impact on its success. Further, IRS had not completed the
infrastructure for planning and managing the research, although
progress has been made. If the research efforts fall short of
expectations, IRS may have to rely on other means, some possibly more
intrusive or more burdensome, to select taxpayers for enforcement
activities such as audits.
--------------------
\6 While TCMP audits would actually reduce the overall long-term
burden on taxpayers to the extent that fewer compliant taxpayers
would be selected for IRS audits in the future, the time and
documentation requirements for taxpayers selected for a TCMP audit
can be burdensome. For a discussion of the difficulties of measuring
tax system burden, see our prior testimony entitled Tax System
Burden: Tax Compliance Burden Faced by Business Taxpayers
(GAO/T-GGD-95-42, Dec. 9, 1994).
\7 Tax Research: IRS Has Made Progress but Major Challenges Remain
(GAO/GGD-96-109, Jun. 5, 1996).
------------------------------------------------ Chapter STATEMENT:4.1
In summary, I would like to reiterate how important it is for IRS (or
any other tax administrator) to invest resources in measuring
compliance. It is also important for IRS to use the results to
balance efforts among its competing goals of (1) maximizing
collection of taxes owed, (2) promoting uniform compliance, and (3)
minimizing taxpayer burden. I would welcome any questions.
SELECTED TAX GAP STATISTICS
=========================================================== Appendix I
Table I.1
Gross Tax Gap Estimates for Tax Year
1992 (Dollars in Billions)
Tax gap
Tax distributi
gap on
Source of tax gap amount (percent)
-------------------------------------------------- ------ ----------
Individual tax gap $95.3 74.3%
Unreported income on filed returns 58.6 45.6
Sole proprietors 29.2 22.7
All other income 29.4 22.9
Overstated deductions\a 14.4 11.2
Nonfiler 13.8 10.7
Individual remittance gap 8.4 6.5
Math errors 0.1 0.1
Corporate tax gap 33.1 25.8
Small corporations 7.0 5.5
Large corporations 23.7 18.5
Other\b 0.4 0.3
Corporate remittance gap 2.0 1.6
======================================================================
Total tax gap\c $128.4 100.0%
----------------------------------------------------------------------
\a Includes subtractions for erroneous deductions, exemptions,
credits, and other adjustments.
\b Includes unreported income and overstated deductions for exempt
organizations' unrelated business income and for fiduciaries.
\c Totals may not add due to rounding.
Source: Income Tax Compliance Research, IRS Publication 1415 (7-88);
Income Tax Compliance Research, IRS Publication 1415 (4-90); and
Federal Tax Compliance Research, IRS Publication 1415 (4-96).
Table I.2
1992 Underreporting--Individual Tax Gap
by Source (Dollars in billions)
1992
tax Net
gap reporting
Description amount percentage
------------------------------------------------- ------ -----------
Underreported income
Wages and salaries $3.2 99.1%
Interest 0.9 97.7
Dividends 1.3 92.2
State tax refund \a 99.2
Alimony 0.1 86.7
Capital gains 2.5 92.8
IRS Form 4797 0.7 72.0
Pensions and annuities 1.8 96.0
Taxable unemployment 0.3 93.1
Farm income 3.4 67.8
Partnership and small business corporation income 3.6 92.5
Rents and royalties 3.7 82.8
Informal suppliers 12.3 18.6
Other sole proprietors 16.9 67.7
Other income 7.6 75.1
Taxable Social Security 0.2 95.8
Overstated offsets
Adjustments to income 0.2 98.0
Deductions 5.1 95.6
Exemptions 2.9 95.5
Credits 6.2 59.8
======================================================================
Total underreporting tax gap\b $73.1
----------------------------------------------------------------------
\a Less than $0.1 billion dollars.
\b Totals may not add due to rounding.
Source: Federal Tax Compliance Research, IRS Publication 1415
(4-96).
Table I.3
Gross Income Tax Gap for Selected Tax
Years 1985, 1988, and 1992 (Dollars in
billions)
Gross income tax gap
------------------------------
Corporate
Individual income
Tax year Total income tax tax\a
-------------------------------------- ------ ---------- ----------
1985 $85.9 $70.4 $15.5
1988 105.2 80.9 24.3
1992 128.4 95.3 33.1
----------------------------------------------------------------------
\a Amount may be understated since the corporate income tax nonfiler
number is not available for inclusion in the total.
Source: Income Tax Compliance Research, IRS Publication 7285 (3-88);
Income Tax Compliance Research, IRS Publication 1415 (4-90); Federal
Tax Compliance Research, IRS Publication 1415 (4-96); and Information
from IRS' Research Division.
*** End of document. ***