Background

Individual federal taxpayers have several options for preparing and filing  their returns as shown in figure 1.
Using the traditional method, taxpayers or their preparers prepare paper  returns and then file the returns by mailing them to one of IRS’s  submission processing centers. At the submission processing centers,  paper returns are opened and sorted, checked for completeness,  numbered with an identifying code, manually transcribed into IRS’s  computerized databases, and checked for accuracy. Transcribing paper  returns inevitably introduces errors that then must be resolved by IRS and  taxpayers. IRS devoted 2,798 staff years to paper processing in 2006. About  58 million taxpayers submitted their returns on paper in 2006.
For a number of years, some taxpayers or preparers have used tax  preparation software to prepare returns electronically. However, after  returns have been electronically prepared taxpayers cannot transmit them  directly to IRS in order to electronically file them. Instead, only paid tax  preparers and tax preparation software companies that IRS has designated  as electronic return originators (ERO) can transmit tax returns  electronically to IRS. These companies may charge taxpayers for the  services they provide, including electronic filing. Taxpayers who prepare  their returns on their home computer and then use the electronic filing  option are actually sending their returns electronically to an ERO. The  EROs typically bundle returns from many taxpayers and then  electronically forwards them to IRS. IRS conducts suitability checks of  applicants who are applying to become EROs. These checks may include  checking the applicants’ criminal background, credit history, and tax  compliance. In 2006, approximately 72 million returns were submitted  electronically. As shown in figure 1, electronic filing eliminates a number  of steps necessary for processing paper returns.
In 2002, IRS entered into an agreement with the Free File Alliance, a  consortium of tax preparation companies, to provide on-line electronic  preparation and filing to eligible taxpayers at no charge. Taxpayers can  access Free File on IRS’s Web site, which provides links to the Web sites  of the Free File Alliance companies. Taxpayers prepare their returns  using free software on the companies’ Web sites and then electronically  file their returns from the Web sites. In 2005, eligibility was restricted to  taxpayers with incomes of $50,000 or less. The number of tax returns filed  through Free File for filing season 2006 was about 4 million. As part of the  Free File agreement, IRS agreed not to compete with the Alliance  members by providing free, on-line tax return preparation and filing  services to taxpayers on its Web site.
Some taxpayers electronically prepare their returns but they choose to  print and mail the tax return to IRS. These taxpayers are known as “v- coders” because IRS codes these returns with a “v” for processing  purposes and to track separately from other paper filers. As shown in table  1, out of the 58.3 million paper returns submitted last year, approximately  42 million were v-coded returns. V-coders are an attractive target for  conversion to e-filing because these taxpayers already have access to  computers and electronically prepare their returns, both prerequisites for  electronic filing.
Until 2005, federal taxpayers had the option to Telefile. Telefile allowed  taxpayers with simple returns to file electronically via telephone. This  service was discontinued in 2005 because of declining usage and relatively  high costs.
Very generally, I-file is a Web site application that allows users to prepare  and submit information to an agency electronically. Since the late 1990s,  almost half of the states have offered an I-file service to taxpayers.  Currently, 20 states and the District of Columbia currently offer this  service to taxpayers. Three states have discontinued an I-file service for  taxpayers. In addition, several foreign tax agencies offer I-file services.  Also, some federal agencies offer nontax I-file services that, for example,  allow users to apply for benefits on-line. Individuals applying for federal  student aid, agricultural grants and loans, and veterans’ benefits may  choose to use the agencies’ Web sites to prepare and submit applications  rather than using paper to prepare forms and the mail to submit forms. For  example, since 1997, the Department of Education has offered individuals  an I-file service for preparing and submitting the Free Application for  Federal Student Aid.
Figure 2 shows the growth of federal electronic filing since 1997.  According to IRS officials, it is getting harder to convert taxpayers to  electronic tax return filing since those who might convert most readily  have already done so.
Electronic filing has also grown at the state level, as shown in figure 3.  Several states imposed electronic filing mandates on tax preparers who  meet certain criteria, such as filing 100 state tax returns or more, which  contributed to increased electronic filing. Moreover, state taxing  authorities are using technologies such as I-file and 2-D barcode to enable  more efficient processing of returns.
Within IRS, the Wage and Investment Division (W&I) and Modernization  and Information Technology Services (MITS) have a role in electronic  filing. W&I’s Electronic Tax Administration (ETA) administers IRS’s  electronic filing programs and is responsible for receiving and processing  tax returns electronically filed through EROs by taxpayers and preparers.  MITS has the information technology (IT) and programming staff that  develops and maintains IRS’s electronic filing systems, including hardware  and software.
IRS currently has a project underway, Modernized e-File (MeF), to replace  its current electronic filing technology with a modernized, Internet-based  electronic filing application. Successful implementation of the MeF system  will give IRS increased capability to accept electronically filed returns  (including individual returns) from EROs. Neither the current e-filing  technology nor MeF does allow direct electronic filing by individuals.

	I-file Systems Use Two Main Technologies and Offer a Range of Features and Taxpayer Eligibility Requirements

I-file systems have a range of design options. Two main technologies used  to collect data from taxpayers exist: PDF fillable form technology often  looks like the paper version of a form and Web page technology is  interactive and prompts the user to respond to preformatted questions.  Figure 4 illustrates the variety of features available with either technology.  Tax agencies that have I-file systems also established a variety of eligibility  requirements for taxpayers.

		PDF Fillable Forms

PDF fillable form technology can closely resemble or reproduce the paper  version of the form. This is one technology often used when agencies want  to show users the paper version of a form. The PDF fillable forms are  accessed through the agencies’ Web site, but users need additional  software (PDF readers are available for free on the Internet) to view and  fill in the fields.
The U.S. Department of Agriculture (USDA) has offered PDF fillable forms  with direct submission to support USDA’s Rural Development eForms  System since 2002. USDA initially offered 200–300 on-line forms but later  expanded the system to about 1,500 eForms for the public and USDA  employees to prepare and submit forms directly on USDA’s Web site.  Individuals may use the agency’s Web site to apply for a number of  programs such as agriculture conservation, crop disaster, rural water, and  farm loans. Users of USDA’s eForms can access the system with and  without a user account. If a user creates an account with USDA, the user  may save forms on USDA’s Web space and electronically submit the forms  to the agency via the agency Web site. With an account, users may also  bundle several forms together for submission. Once the forms are  submitted electronically, the user receives an instant confirmation code,  which users may reference if any questions arise. Additionally, users may  use the account to view the status of the forms, and resubmit any form  that may need corrections. Figure 5 shows a USDA fillable form with save  and submission features.
Without an account, users can search and download forms from the Web  site, fill the forms in, and print the forms. However, users cannot submit  forms electronically. USDA’s eForms provide basic instructions, like the  paper version, and more detailed instructions are provided in separate  PDF documents. After the user completes the form, it may be saved on a  personal computer or printed and mailed to the agency.
IRS currently provides PDF fillable form versions of some tax return forms  and schedules. These forms can be downloaded to a home computer, filled  in, printed, and mailed back to IRS. They cannot be filed electronically  with IRS and, therefore, are not an I-file option.

		Web Pages That Allow Data Entry

Another technology uses Web pages (HMTL),an interactive, ease-of-use  Web site feature, containing checkboxes, option lists, text boxes, and  buttons that allow users to respond to preformatted questions. Web pages  do not always resemble the paper version of the form but collect similar  information. Because these Web pages can be viewed using a regular Web  browser, users usually do not need additional software.
Similar to the PDF fillable forms, Web pages allow the agency to choose  the features offered to the user. Some agencies offer fewer features to  users. For example, both Utah’s TaxExpress and California’s CalFile  systems allow users to log-in/create an account, perform calculations, link  to other forms and publications, and submit directly to the agency. Other  agencies have more sophisticated systems which offer more features. For  example, United Kingdom’s Self Assessment system allows users to save  their partially completed forms and return to the system at a later time,  edit the forms, and view any changes made.
Another example of a more sophisticated system with multiple features is  Maryland’s I-file. Maryland offers features such as account access,  calculations, and hyperlinks to other forms and publications. It also allows  users to save work and return later and view prior years’ returns. The  Maryland system also prepopulates some of the taxpayer’s biographic  information and allows users to check the status of their current return.  Figure 6 shows a computer screen picture/image of Web page technology  with calculations and hyperlinks to help features from Maryland’s I-file  system.

		Eight States We Profiled Offer I-file Systems with a Variety of Features and Taxpayer Eligibility Requirements

Table 2 describes the I-file systems we profiled in eight states. As  mentioned, state tax agencies offered a range of features such as  calculations and save and return. Some states restricted eligibility by  income, residency requirements, or number of itemized deductions.
Appendix I provides additional information about each state’s I-file system  such as the extent to which the state used contractors to develop and  operate the system. Some systems do not operate on computer hardware  owned by the states, but instead operate on hardware owned by  contractors.

	State Agencies’ I-file Benefits and Costs Have Been Relatively Modest

Both the benefits states received from their I-file systems and costs of  developing and operating them have been relatively modest. Based on the  available information, it is unclear whether the benefits to the states were  greater than their costs.

		State I-file Systems Reduced Paper Filing, but the Magnitude of the Benefits Was Limited by Low Usage

According to officials in five of the eight states we profiled, state I-file  systems generated benefits (before subtracting the costs of system  development and operation) by increasing e-filing and reducing paper  filing. However, the benefits were limited by the low usage. As shown in  table 3, I-file users as a percentage of total filers ranged from less than 1  percent to just over 5 percent. Only three states gave us estimates of the  number of taxpayers eligible to I-file. Pennsylvania had 20 percent of  eligible taxpayers I-filing in 2006 while California and South Carolina both  had less than 2 percent. While Pennsylvania had 20 percent of eligible  taxpayers using I-file, GAO is interpreting this as a low usage rate since the  state instituted the system in 2000.
The benefits to state tax agencies included reducing the costs of  processing paper returns plus related costs due to correcting math and  transcription errors and contacting taxpayers about such errors. The  magnitude of the benefits to tax agencies depends on the savings per  return and the number of taxpayers converted from paper to electronic  filing. Returns prepared and filed through I-file that would have otherwise  been electronically filed do not generate significant benefits in the form of  reduced costs for the tax agencies. Only returns converted from paper to  electronic filing generate benefits in terms of cost savings for the tax  agency.
Three of the tax agencies we profiled gave us estimates of how much  converting a return from paper to electronic filing saved them in  processing costs. California estimated that each taxpayer converted from  paper to e-filing saved the state about $1.00 in processing costs per return.  Pennsylvania officials reported it costs about $4.72 to process paper  returns, while electronically filed returns costs them only $1.25—a cost  savings of $3.47 per return. One of the largest cost savings on a per return  basis was reported by Kansas where agency officials reported saving $11  per electronic return filed. These savings reflect operations in each state  and may not indicate savings that other states or IRS might achieve.
State agency officials provided some information about savings beyond  reduced processing costs but could not provide dollar estimates of the  savings. Kansas officials said the state had less than a 1 percent math error  rate for I-filed returns compared to a 17 percent rate for paper returns.  California officials reported a decrease in math and transcription errors.  The state agency reported that fewer contacts with taxpayers can benefit  the agency and yield a savings from fewer notices. Maryland officials said  they have less need to contact taxpayers who I-file.
The number of taxpayers converted from paper filing to electronic filing  due to state I-file systems is relatively modest. In an evaluation conducted  3 years after CalFile was implemented, California estimated that as many  as 67,000 I-filers were new e-filers in 2004. That number is less than 1  percent of eligible filers in California the same year. The other tax  agencies we profiled could not document how many returns were  converted from paper to electronic filing as a result of I-file, but the  number has to be relatively small because the total number of I-file users  is relatively small.
Low usage may be due to a number of reasons, including little marketing  and the lack of integration with the federal tax system. Officials in five  states said the amount budgeted for marketing was minimal. Pennsylvania  reported allocating $20,000 to $40,000 for marketing during calendar years  2000 to 2002. The other tax agencies did not provide dollar amounts. Using  different methods to prepare and file state and federal returns can be an  inconvenience to taxpayers. Many tax preparation software packages offer  the convenience of integrating federal and state tax return preparation.  Much of the required data has to be entered only one time and is  automatically transferred from the federal to the state tax return. Users of  state I-file systems would have to prepare their federal tax return using  one preparation method and then learn a second, to prepare their state  return.
Foreign tax agencies with I-file systems and federal agencies with on-line  application systems reported higher usage rates than the state agencies we  profiled, as shown in table 4. Reasons differed for the higher usage rates  among foreign tax agencies and federal agencies. French officials offered a  financial incentive of 20 euros (approximately $26) in 2005 to French  taxpayers who filed tax returns on-line and paid taxes electronically. An  official with France’s General Tax Directorate said the rebate increased  usage to such a degree the system was overloaded and officials needed to  extend the filing deadline. One federal agency attributed high usage to the  type of user the agency serves. An official with the Department of  Education said usage of the on-line financial aid system was high, due in  part, to the target population of students who are Internet-savvy.
In addition to the benefits to the tax agencies, state I-file systems also  generated benefits for users. Taxpayers who convert from paper to  electronic filing because of the availability of I-file received the benefits of  electronic filing, such as faster refunds. Compared to paper filing, Utah’s  TaxExpress I-file system reduced return processing time to 4-5 days from  8-10 days and generated faster refunds. South Carolina’s SCnetFile! users  received direct deposit of refunds within 9-10 days, paper checks were  processed within about 3 weeks, according to agency officials. Some  taxpayers who convert from paper may benefit by not having to respond  to notices for math errors, by having lower compliance burdens, and by  preferring electronic confirmation that the tax agency received their  return. A benefit to some taxpayers using I-file is saving on electronic  filing fees. Taxpayers who were charged electronic filing fees and convert  to I-file would save. Taxpayers, who electronically file for free, such as  users of the Free File program, would not save on fees. Another benefit to  some taxpayers using state I-file systems is the security of not having to  file through a third party such as an ERO. However, as was noted earlier  and shown in appendix I, some state I-file systems are operated by  contractors on the contractors’ computer hardware.
Table 5 compares some of the advantages and disadvantages of the  various methods of preparing and filing federal tax returns from a  taxpayer’s perspective.

		Available Information Indicates That I-file Costs Were Relatively Modest Because States Limited Features, Eligibility, and Capacity Needs

The cost data we were able to gather from the state tax and federal  agencies we profiled, while incomplete, implies that costs were relatively  modest. No state tax agency had complete, documented data on the costs  of developing their I-file systems. In many cases, I-file costs were not  tracked separately from department-wide activities. No state tax agency  had available data on costs such as management planning and  conceptualization or contractor oversight. However, some state tax  agencies did have estimates for large portions of their I-file costs, such as  systems development or operating costs, as shown in table 6.
As already noted, state tax agencies varied in the extent to which they  used contractors or in-house staff to develop or operate I-file systems.  Three states profiled-Indiana, Kansas, and Utah-used a contractor and  relied almost wholly on the contractor to provide I-file services. The  software and servers (computer hardware) are owned and operated by the  contractors. Some taxpayer support for individuals, including technical  help desk assistance, is provided by the contractor as well. Other states  used a contractor to develop the system, but the state owned and operated  the server. Some states, such as California and Maryland, primarily used  in-house staff to develop and operate their systems. In these states,  taxpayers prepared returns on state-owned servers.
Available data on total I-file costs show costs are a small percentage of  state tax agencies’ budgets. For example, California spent just over  $700,000 to develop and operate CalFile from 2003 to 2005—less than 0.1  percent of the tax agency’s annual budget. Pennsylvania’s pa.direct.file  annual operating cost of $125,000 is less than 0.1 percent of the Revenue  Department’s 2006 budget of $176 million. For states that primarily used  contractors, data on specific types of costs are not available because many  types of costs are covered by the fee per return charged by contractors.  We did not verify cost information provided by state agencies or  contractors. While the state cost data are incomplete, the data are  consistent with what we learned about development and operating costs  at USDA and the Department of Veterans Affairs.
The available data also show costs are relatively modest when calculated  per tax return. Three states that relied heavily on a contractor were  charged $0.75 per return or $1.00 per return to develop and operate I-file  systems, as shown in table 6. Based on the data provided, we calculated  Pennsylvania’s I-file average costs per return as $0.94 for 2000 to 2006, and  California’s average costs per return as $2.30 for 2003 to 2005. These costs  per return are relatively modest compared to what the states told us about  their costs for processing paper returns. For example, Pennsylvania  officials said it cost $4.72 per return to process a paper return.
Several factors contributed to keeping I-file costs relatively modest. Six of  the eight state agencies we profiled limited eligibility. Three states  developed their system incrementally and increased eligibility over time.  As shown in table 2, some states restricted eligibility by income, residency  requirements, or number of itemized deductions. States also varied on the  extent to which they offered system features, such as the ability to save a  partially completed return and the extent to which certain information can  be automatically filled in on the form using previous years’ returns. By  limiting eligibility and features, agencies can limit certain costs, such as  software development and testing, that do not change as the number of  users changes (fixed costs). Restricting the eligibility and features also has  some effect on costs that do depend on the number of system users  (variable costs), such as computer hardware and help desk assistance.  Variable costs for purchases of hardware and telecommunications to  support the system can also increase if system features become more  sophisticated and if the system allows users to file more complex returns.
Another factor that contributed to modest costs was that contracts  between states and contractors covered the development and operation of  computer systems that provided multiple services, not just tax services.  For example, a contractor’s representative told us the contractor may not  recoup all its costs for I-file with the fees charged per tax return. Instead,  the costs may be recouped from other services provided to the state.
One other factor keeping costs modest was the limited number of  anticipated users. As discussed previously, the number of users in all eight  states we profiled was less than 6 percent of all taxpayers. Low usage also  affects variable costs for purchases of system hardware and  telecommunication services. Several states told us that they were able to  mitigate additional capacity costs by building upon existing systems  hardware. As reported in their feasibility report, California officials  planned to build the CalFile system using the existing technical  environment and noted that no additional software, hardware, or licenses  would need to be procured. It was expected that all project expenditures  would be for staff costs only. One contractor indicated that additional  capacity was available to support increased usage, if needed, from other  existing servers. Some states we profiled did not make significant changes  to their current levels of taxpayer support because of the low usage rates.  For instance, Maryland’s taxpayer service group provided I-file training to  the current staff but did not have any need to hire additional staff.

		Whether States Realize Benefits Greater Than Costs from Their I-file Systems Is Unclear

In all states profiled, whether benefits are greater than costs is unclear for  two reasons. As previously noted (1) data on benefits and costs was  incomplete and (2) based on available data, both benefits and costs were  modest.
Although incomplete, the available data combined with the decision by  three states to discontinue their systems raise the possibility that in at  least some states the benefits were less than costs. According to officials  in two of the three states that discontinued their I-file systems, the benefits  did not appear greater than costs and the system was not providing a good  return on their investment. One agency official reported experiencing low  usage and high costs. Officials with Iowa’s Department of Revenue said  the state had hoped to see major growth in electronic filing usage by  introducing an I-file system, yet the system use peaked at 22,815 I-filed  returns in 2004. Iowa officials estimated the system was costing about  $7.00 per return. Like Iowa, Arkansas discontinued its I-file services.  According to a state official, Arkansas’s I-file system operated for 5 years  beginning in tax year 2000 and processed a total of 5,149 returns. The  highest usage was in 2005, with only 1,382 returns processed.
Another example of a state in which the benefits may be less than the  costs, based on reported information, is California. A study of the CalFile  system revealed California overestimated benefits, expecting 400,000 users  in 2004 but getting 110,000. Further, the study highlighted that California  underestimated costs with development costs expected to be $304,538 but  coming in at $511,797. California officials estimated the agency saves  approximately $1.00 per return in processing costs by converting paper  returns to electronic returns. In 2004, California estimated 67,000 filers  converted to electronic filing, which would have saved the agency $67,000.  In the same year, California reported spending $256,362 on CalFile for  development and operating costs. Consequently, based on reported  information, benefits appear less than costs. However, additional benefits  could have been realized from decreased math errors, for example, but the  amount of such benefits is not known. California officials told us that  CalFile may still be beneficial to the state because it provided another  method of filing.
Pennsylvania estimates show the benefits of its I-file system could exceed  costs. Pennsylvania estimated $3.47 per return in cost savings for  processing and administrative costs associated with converting paper to  electronic filing. Between tax year 1999 and 2005, a total of 1,362,867  taxpayers used the I-file system. Pennsylvania did not provide an estimate  of the number of I-file users that converted from paper. However, if 28  percent of users converted from paper to e-filing, Pennsylvania would  break even. If more than 28 percent converted, Pennsylvania could realize  a net benefit.

	Achieving a Net Cost Savings for IRS Depends on the Cost of Developing the System and the Number of Paper Filers Converted

Providing federal taxpayers with an I-file system would be a new service  for which IRS would incur new costs. Whether the additional costs of the  new program could be offset by reduced costs from processing fewer  paper returns depends on a number of factors, such as the costs of  developing and operating the system and number of taxpayers converted  from paper to I-file.

		Providing I-file Would Be a New Service with New Costs for IRS That Could Be Higher Than States’ Costs

I-file would be a new service that IRS would provide for taxpayers. To  develop the new service, IRS would have to (1) create or procure return  preparation software for IRS’s Web site and (2) extend direct e-filing to  individuals, in which the return would be routed into the current stream of  electronically filed returns coming in from EROs.
IRS’s fixed costs for I-file could be higher than the fixed costs of the states  we profiled for several reasons. Currently, IRS’s Web site is mostly  informational, meaning taxpayers can obtain information from IRS but  they cannot submit information to IRS’s tax return databases. The  information that taxpayers can obtain includes instructions, downloadable  forms, and refund status. Developing an I-file system would require IRS to  develop a transactional Web site, where taxpayers could enter information  that would be submitted to IRS’s tax return databases. Transactional Web  sites require more security and other features not necessary for an  informational Web site.
Some of the states we profiled had transactional Web sites in place before  they developed their I-file systems.  Those states included Kansas,  California, Indiana, and Utah. To provide I-file, IRS would need to incur  the costs of developing a transactional capability.
Other factors that could cause IRS’s fixed costs to differ from the states’  fixed costs include the relative complexity of the federal tax system, the  types of taxpayers who are eligible, and the features of the I-file system,  such as memory. The federal income tax system is more complex than  states’ tax systems, which generally piggyback on the federal return. For  example, the federal Form1040 for tax year 2006 contains 77 lines and can  require up to 41 other forms, schedules, or worksheets to complete, while  Maryland’s Form 502 contains 52 lines (starting with federal adjusted gross  income) and can require only 7 other forms, schedules, or worksheets to  complete. IRS could limit fixed costs by limiting taxpayer eligibility the  way some states did. Limiting eligibility to more simple forms, such as the  federal Form1040 EZ, would reduce the complexity of I-file software.  Similarly, the features offered on an I-file system would affect the  complexity of the software. Features such as save and return and auto- populating can require additional memory and potentially increase costs.
IRS’s variable costs for an I-file system could also be higher than the  states’. As previously noted, many of the states we profiled had low  variable costs for computer hardware and taxpayer support because they  were able to make use of existing capacity, either inside the tax agency or  at other state agencies. Several states we profiled said that if their usage  rates were significantly higher than current rates, they would incur  additional costs to increase capacity. According to IRS officials, IRS does  not have excess capacity that could be used to provide I-file services to  taxpayers. As a consequence, IRS’s variable costs per return for I-file  services could be higher than the states’.

		Net Cost Savings Depends on the Number of Paper Filers Converted

The number of paper filers who convert to electronic filing can have a  significant impact on the overall cost savings IRS could achieve by  operating I-file. IRS data show, each paper return that is processed cost an  estimated $2.65 per return in 2003, while each electronic return cost an  estimated $0.29, resulting in an estimated cost savings of $2.36 per return  processed electronically. However, we cannot independently verify this  estimate and its basis is unclear because IRS’s cost accounting system is  not yet able to support preparation of such cost estimates.Additionally,  other costs may be reduced by electronic filing including costs associated  with math errors. Math errors on paper returns may be due to taxpayer  error or IRS transcription errors. Both can result in notices being sent to  taxpayers and phone contacts with taxpayers. Both types of errors are  reduced by electronic filing.
IRS could achieve a net cost savings if the costs saved by reduced paper  processing were greater than the costs incurred from developing and  operating an I-file system. The key to IRS achieving a net cost savings  depends on the number of individuals converted from paper to electronic  filing and the savings per return (estimated to be $2.36 per return by IRS).  I-file users who previously electronically filed do not generate such  savings. In 2006, 58.3 million tax returns (45 percent of all tax returns)  were filed on paper. Any savings from reduced paper processing would  have to be netted against the cost of the I-file system to determine whether  cost savings were realized.
The extent to which federal paper filers would convert to an I-file system  is uncertain. According to respondents of an IRS Oversight Board survey,  some taxpayers reported not feeling comfortable filing taxes  electronically. These taxpayers reported not having confidence that the  Internet is secure or that their privacy is protected. These taxpayers also  cited other reasons including: the Internet was too complicated, or the  taxpayer liked to use paper method or they didn’t want to pay the  electronic filing fee. An I-file system would address some of these taxpayer  concerns but not all of them. For example, if taxpayers’ security and  privacy concerns are focused on third party transmitters, then an I-file  system might mitigate the concerns.If the concerns are more general and  apply to the Internet as a whole, then an I-file system (only accessible over  the Internet) may not mitigate the concerns. Additionally, IRS’s Free File  service, which may be the existing service most similar to I-file had 4.0  million users (about 3 percent of total taxpayers and 4 percent of eligible  taxpayers) in 2006. This usage rate is an indication of the challenge of  converting some taxpayers to electronic filing.
The 13.6 million v-coders who self-prepared are an attractive target for an  I-file program. Because v-coders prepare their return on a computer, they  are presumably more comfortable with computers and may be more  willing to try I-file than taxpayers who did not use a computer to prepare  their returns. Because they file on paper, converting them to I-file results  in reduced paper processing costs. V-coded returns prepared by paid  preparers may be less susceptible to convert to I-file because these paid  preparers have concerns about existing e-file options. Several of the states  we profiled emphasized the importance of defining the target population  when designing an I-file system. Whether such a narrowly defined  population, as v-coders who self prepare, could be successfully targeted at  the federal level is unclear.
In addition to the net savings that could be realized from I-file, another  factor that should be considered is whether IRS has the systems  management capability needed to develop such a program. For well over a  decade, IRS has been involved in a multibillion dollar effort to modernize  its information systems. While IRS has made noteworthy progress  improving its systems management capability, it has had a history of cost  increases and schedule delays that led us to designate systems  modernization as a high-risk area in 1995. Those cost increases and  schedule delays were due, at least in part, to deficiencies in various  management controls and capabilities that have not yet been fully  corrected. In 2003, we noted that IRS had made significant progress in  establishing management controls and foundational systems architecture.However, systems modernization remained at risk because the scope and  complexity of modernization activities was increasing. In 2005, we  reported that balancing the scope and pace of modernization activities  with IRS’s ability to manage them remained a challenge. IRS has made  further progress since 2005 addressing concerns about systems  management. However, critical management controls and capabilities  have still not yet been fully implemented or institutionalized. Before  proceeding with I-file, IRS would need to consider the impact of the  program on its existing portfolio of systems development projects and the  impact of the program on its current modernization vision and strategy.  This would entail IRS determining whether it has the management  capabilities to take on this new project and what, if any, ongoing and  planned programs would need to be deferred.

	Agency Comments

In written comments on a draft of this report, the Commissioner of  Internal Revenue said he appreciated our observations on the states’  experiences with I-file systems. He summarized the facts presented in the  report. He then went beyond our description of the facts to reach the  conclusion that the facts support IRS’s current strategy for growing  electronic filing.
The full text of the Commissioner’s comments is reprinted in appendix IV.
As agreed with your offices, unless you publicly announce its contents  earlier, we plan no further distribution of this report until 30 days after its  date. At that time, we will send copies to other appropriate congressional  committees and the Commissioner of Internal Revenue. The report is  available at no charge on GAO’s Web site at http://www.gao.gov.
If you or your staff have any questions about this report, please contact me  at (202) 512-9110 or whitej@gao.gov. Contact points for our Offices of  Congressional Relations and Public Affairs may be found on the last page  of this report.  Key contributors to this report are listed in appendix V.

Appendix I: Individual Profiles

We profiled eight state tax agencies, two foreign tax agencies, and three  federal agencies with I-file systems. The tables below (tables 7-19) contain  information on the characteristics of individual agencies, taxpayer  eligibility requirement for 2006, and the costs, benefits, and challenges  associated with developing and operating I-file systems. Information on  benefits and challenges was collected via structured interviews with open- ended questions. We are reporting information on eligibility found on  agencies’ Web sites.
Total costs were $717,000 over 3 years. For years 2003-2005, one-time  development costs were $512,000 and ongoing costs for operations were  $205,000.
Reported benefits to the agency:    Fewer processing errors   Increase in taxpayers paying via e-pay    Faster payment processing    Cost savings per I-filed return    Reported benefits to the taxpayers:    Direct submission to tax agency/no third party involvement    Faster refunds    Tax preparation industry objections    Ensuring security of the system    Updates to system based on late tax law changes   Total costs for development of the system were approximately $1 million  to $2 million with an annual maintenance fee of $480,000 for individual and  business users.
Reported benefits to the agency:    Reduced paper processing and reduced paper processing staff    Reported benefits to the taxpayers:    Confirmation of return receipt    Ability to print a PDF copy of the return    Direct deposit for refund    Attracting taxpayers to use the system   Total costs were not available. Contractors charged $1 per return for  developing and operating the system, along with some marketing and  technical taxpayer support.
Officials with the Indiana Department of Revenue declined several  requests for interviews to discuss benefits and challenges associated with  developing the I-file system.
Total costs were not available. Contractors charged $1 per return for  developing and operating the system, along with some marketing and  technical taxpayer support. In 2006 and 2007, Kansas also received a  marketing budget of $100,000 for marketing of Webfile and electronic  filing.
Reported benefits to the agency:  Increase in electronically filed returns    Fewer paper returns    Fewer processing errors    Cost savings    Reported benefit to the taxpayers:    Less incidence of lost documentation    Authentication of taxpayers   Maryland did not track any of its costs separate from the operating budget  for the Information Technology Division and Revenue Administration  Division. They noted that most of their costs would be incurred in staff  hours; however, none of their staff is specifically dedicated to the I-file  system.
Reported benefits to the agency:    Reduced paper processing staff    Less contact with taxpayers via telephone or notices    Fewer processing errors    Reported benefits to taxpayers:    Faster refunds    Auto-population of W-2 information (state employees only)    Quicker preparation of return    Compatibility of system with all user browsers    Addressing taxpayers concerns about the security of their information    Development and maintenance of the security platforms   State officials estimated the system cost $400,000 to develop, $125,000 per  year to operate, and $40,000 in improvements for the system. Officials also  received between $20,000 – $40,000 to market the system for the first few  years.
Reported benefits to the agency:    Reduced paper processing    Faster return processing  Improving customer service and satisfaction    Reported benefits to the taxpayers:    Faster refunds    Confirmation of return receipt    Less incidence of lost documents    Agreement among stakeholders    Designing a user friendly, intuitive system    Capacity needs during peak filing   Total costs were not documented; however, officials believed the  development of the system cost several hundred thousand dollars, while  maintenance of the system is expensed to the information technology  department.
South Carolina officials did not report any specific benefits for the agency  or taxpayers.
Attracting users to the system    Maintaining current users to the system    Total costs were not captured. Contractors charged the state of Utah $0.75  per return to develop and operate the system along with some marketing  and technical taxpayer support.
Reported benefits to the agency:  Increase in electronically filed returns    Reduced paper processing    Reduced paper processing staff    Reported benefits to the taxpayers:    Faster refunds    Ensuring the stability of system during the first year roll-out    Authentication of taxpayers   Total costs for development was $600,000, with $350,000 for a special  license from Adobe, $50,000 for maintenance and $200,000 for forms  technology, research, and piloting the initial system.
Reported benefits to agency:    Higher than anticipated electronically filed applications    Transmission of forms internally (USDA employees only)
Reported benefits to applicants:    User authentication    Total costs not reported.    Reported benefit to agency:    High percentage of electronic applications    Reported benefits to applicant:    Helped users avoid errors    Provided quicker application processing    Stakeholder agreement    System stability and capacity during peak filing   Total costs of developing this system was $355,000 with additional  associated costs of about $3,500. The annual maintenance contract is  $40,000.

Appendix II: One-time, Ongoing, Variable, and Fixed Costs

The costs of developing and operating an I-file system can characterized in  several ways. Some types of costs are incurred one-time; other types of  costs will recur consistently over time (ongoing). In addition, some costs  can be considered to be variable in that they depend on the number of  users of the system, while other types of costs can be considered to be  fixed—independent of the number of users of the system. Table 20 shows  the types of one-time/ongoing and fixed/variable costs that may be  incurred to develop and operate an I-file system.

Appendix III: Objectives, Scope, and Methodology

To identify the options available to IRS for developing an I-file system, we  conducted literature searches and examined Web sites for all states, 75  executive and independent branch agencies, and two studies listing  foreign countries with e-filing services. We also interviewed  representatives from the IRS Oversight Board, Federation of Tax  Administrators (FTA),four government contractors (Adobe, EZGov, NIC  Inc., and Pearson Government Solutions), and the Electronic Tax  Administration Advisory Committee (ETAAC).
To identify the universe of states with I-file systems, we reviewed the Web  sites of all 50 states and the District of Columbia. We found 20 states and  the District of Columbia provided I-file services. Of the remaining 30  states, we found 3 discontinued their I-file program, 9 had no state income  tax, and 18 relied on other technologies, such as 2-D barcode.
For data on I-file usage rates, we used data from FTA’s annual state  individual income tax filings reports for 1998-2006. FTA annually surveys  states on their paper and electronic filing figures. We reviewed FTA’s  methodology for collecting the data but did not verify all the numbers  reported by states to FTA. However, we corroborated some of FTA’s data  with our data on six of the eight states we profiled. We found one  discrepancy with the state of Utah due to a definitional misunderstanding.  We corrected the inaccuracy using the state’s data. We used this data as  background for reporting and determined that the data were sufficiently  reliable for this report.
To determine the benefits and costs of I-file systems, we developed in- depth profiles of eight state tax agencies (California, District of Columbia,  Indiana, Kansas, Maryland, Pennsylvania, South Carolina, and Utah) to  illustrate the range of Internet filing systems, types of features, and level of  usage. In less depth, we collected information about two foreign tax  agencies and three federal agencies with I-file systems. We used the  following criteria to select our eight state tax agencies to profile:   (1) number of I-file users (based on data from the Federation of Tax  Administrators), (2) year I-file system implemented, (3) contractor or in- house developed, and (4) types of features offered. We selected the states  to have a range for each one of our criteria. We selected tax agencies in  two foreign countries (United Kingdom and France) based primarily on  their having a large volume of users. We selected three federal agencies  (Department of Agriculture, Department of Education, and Department of  Veterans Affairs) that allow individuals to prepare and submit forms on  agencies’ Web sites and have a range of features, users, and technologies.
We developed a data collection instrument and conducted structured  interviews to collect information on agency benefits and costs associated  with developing and operating I-file systems. We asked open-ended  questions about usage rates, system features, eligibility requirements,  benefits to agencies and taxpayers, and system costs. We interviewed state  tax, foreign tax, and federal agency officials and contractors with the  California Franchise Board, District of Columbia Office of Tax and  Revenue, Indiana Department of Revenue, Kansas Department of Revenue,  Comptroller of Maryland, Pennsylvania Department of Revenue, South  Carolina Department of Revenue, Utah State Tax Commission, the United  Kingdom Her Majesty’s Revenue and Customs, and the France General  Tax Directorate. We talked to contractors, program directors, program  staff, IT staff for the Department of Agriculture’s Rural Development  office, the Department of Education, and the Department of Veterans  Affairs’ Office of Compensation and Pension Service. We analyzed and  summarized our information and confirmed the accuracy of our analysis  and summaries with the appropriate state tax, foreign tax, and federal  agency officials.
We used widely accepted economic definitions of benefits and costs and  corroborated these definitions with state officials, IRS officials, the IRS  Oversight Board, ETAAC, and FTA.
To determine benefits, we asked for information on savings from reduced  paper processing, reduced error rates, improvements in processing time  and refund issuance, the number of I-file users, and the number of  taxpayers converted from paper filing to I-file. When benefit information  was not measured in dollars, we asked for other available quantitative  measures, such as time saved. In cases where tangible measures of  benefits were not available, we asked for qualitative descriptions. We  corroborated benefit information reported by the contractors, the IRS  Oversight Board, and FTA with information provided by the states  profiled. By profiling eight states, we saw consistency in the types of  benefits reported. However, we did not verify the amount of cost savings  reported by state agencies, but based on previous GAO work and  discussions with state agency and IRS officials for this engagement, we  understand that electronic filing reduces the number of processing staff  needed, for example, and generates dollar savings. We determined that  state estimates of savings per return are sufficiently reliable as a general  indicator, but not necessarily as a precise indicator, of savings.
To determine costs, we summarized costs on a total cost basis and per  return basis. We distinguished between fixed and variable costs and  summarized the factors influencing each. We asked for information on  development costs, operating costs, marketing costs, and taxpayer support  (help desk) costs. No state could give us complete information on costs.  For example, no state had information on planning costs, or where  applicable, contract management costs. However, the cost information we  were able to gather covered large elements of total costs, such as  development and operating costs. In such cases, we asked for definitions  of terms, dates covered, and other available information about the  estimates. Seven of the eight state tax agencies could not provide  supporting documentation. California was the one state with extensive  documentation on its system’s benefits and costs including a feasibility  study, a post-implementation evaluation, and a project overview.
For states that relied on contractors, we asked state officials for  information about contract costs. We corroborated information provided  on contractor fees per return by interviewing contractors and reviewing  contracts. We obtained copies of the contracts for Kansas, Indiana, and  Utah from state agency Web sites and publicly available documents. The  contracts documented the fee per tax return paid by those states to the  contractor for I-file services.
Because the available state data were incomplete and not always  documented, the total costs that we calculated can only be interpreted as  rough orders of magnitude. Based on the consistency in what was  reported from the eight states, we determined that the data were reliable  for estimating the rough magnitude of total costs.
To determine the reliability of IRS’s processing cost estimates for paper  and electronic filing, we reviewed agency spreadsheets that support the  estimates and interviewed knowledgeable officials. We spoke with IRS  officials in the Electronic Tax Administration and W&I’s Strategy and  Finance about costs included in paper processing and electronic filing  costs. These costs include pipeline processing costs, labor, oversight with  management and supervision, and non-pipeline processing activities  including quality assurance. Because of long standing limitations in IRS’s  cost accounting capability, cost data at this detailed level has not been  audited. Based on prior reports about staff savings from electronic filing,  we determined that IRS’s estimate of savings per return is sufficiently  reliable as a general indicator, but not necessarily as a precise indicator, of  savings.
To describe the potential for IRS to realize cost savings from providing an  I-file service, we compared the types of costs states incurred with the  types of costs IRS would likely face in developing and operating an I-file  system. We identified (1) the segments of the taxpayer population who  may be potential I-file users, (2) the potential for net cost savings, and   (3) the likelihood federal paper filers would convert to an I-file system. We  reviewed the IRS Oversight Board’s Taxpayer Customer Service and  Channel Preference Survey, November 2006, to determine why federal  taxpayers do not file returns electronically. Because of the low response  rate to this survey, the survey results we report cannot be used to make  inferences about the views of all U.S. taxpayers. Instead, the results we  present should be interpreted as representing the 1,101 taxpayers who  responded to the survey. GAO did not assess the extent to which these  respondents over- or under-represent certain segments of the U.S.  taxpayer population in terms of such characteristics as age, income,  education level, race, or Hispanic origin. We reviewed agency  documentation on cost savings associated with reduced paper processing.  We reviewed prior GAO reports to determine management capacity for  overseeing previous IT projects and IRS’s history of management  challenges.
We performed our work from May 2006 through March 2007 in accordance  with generally accepted government auditing standards.

Appendix IV: Comments from the Internal Revenue Service

Appendix V: GAO Contact and Staff Acknowledgments

	Acknowledgments

In addition to the person named above, Signora J. May, Assistant Director;  Michele Fejfar; Evan Gilman; Robyn Howard; Rich Hung; Veronica  Mayhand; Donna Miller; Ed Nannenhorn; Cheryl Peterson; Gabriele Tonsil;  and Tina L. Younger made key contributions to this report.

Summary:
Why GAO Did This Study

Some states and countries allow taxpayers to prepare and file tax returns on their Internet Web sites at no charge, an option not available to federal taxpayers. Such a service might mitigate the concerns taxpayers have about current electronic filing options, which require filing through a third party and may involve fees. Increased electronic filing would reduce IRS's paper processing costs, reduce transcription errors, and speed up refunds. However, the idea is controversial. IRS already has a Free File program which offers free return preparation and filing by private companies for some people via IRS's Web site. Some are opposed to IRS competing with tax preparation software companies. GAO was asked to (1) describe IRS's options for on-line preparation and filing (I-file) based on states' experiences; (2) determine the benefits and costs of I-file based on the experiences of the states; and (3) describe the potential for IRS to realize cost savings from I-file. GAO profiled 7 states and the District of Columbia, 2 foreign countries and 3 federal agencies to describe I-file options and determine their benefits and costs.

What GAO Found

The options available to IRS for implementing I-file system vary in technology, features, and eligibility. The states profiled all employed an interactive format on their Web sites for tax return preparation. The systems varied in whether they included features such as the ability to save and return. Systems also varied in eligibility, i.e. limiting income or residency. For the systems profiled, both reported benefits and costs were relatively modest and it is unclear whether benefits were greater than costs. I-file systems may generate benefits by increasing electronic filing and reducing filing fees for taxpayers. California and Pennsylvania estimated savings of $1.00 per return and $3.47 respectively per return converted from paper. However, the benefits were limited by low usage. I-file usage rates were less than 6 percent. Available data on I-file costs, while limited, shows costs are a very small percentage of state tax agencies' budgets. For example, California reported spending $700,000 to develop and operate CalFile from 2003 to 2005--less than 0.1 percent of the tax agency's annual budget. States kept I-file costs relatively modest by restricting eligibility and features. Several states used contractors to develop and operate their I-file system as well as provide the computer hardware. Low usage also contributed to modest costs. For example, some states said low usage meant they could use existing computer equipment. IRS's potential to realize net cost savings from an I-file system depends on the costs of developing the system and the number of taxpayers converted from paper to electronic filing. IRS's costs could be higher than the states'. First, the federal tax system is more complex. Second, unlike states which already had Web sites with Internet transaction capabilities, IRS would have to significantly upgrade its Web site and incur new security costs. Finally, developing an I-file system would further stretch IRS's capability to manage systems development, a GAO high risk area since 1995. Converting paper filers to electronic filing generates savings of $2.36 per return, according to IRS estimates. However, the number of paper filers who would convert is uncertain. The 13 million individual taxpayers who prepared their returns on a computer but then printed and mailed them to IRS are one target for conversion to I-file.