Long-term Fiscal Challenge Provides Impetus to Reexamine Tax Policies and Compliance

The federal government’s financial condition and long-term fiscal outlook  present enormous challenges to the nation’s ability to respond to emerging  forces reshaping American society, the United States’ place in the world,  and the future role of the federal government. Over the next few decades  as the baby boom generation retires and health care costs continue to rise,  federal spending on retirement and health programs—Social Security,  Medicare, Medicaid, and other federal pension, health, and disability  programs—will grow dramatically. Absent policy changes on the spending  and/or revenue sides of the budget, a growing imbalance between  expected federal spending and tax revenues will mean escalating and  eventually unsustainable federal deficits and debt that will threaten our  future economy, standard of living, and, ultimately, our national security.  Ultimately, the nation will have to decide what level of federal benefits and  spending it wants and how it will pay for these benefits.
GAO’s long-term simulations illustrate the magnitude of the fiscal  challenges associated with an aging society and the significance of the  related challenges the government will be called upon to address. Indeed,  the nation’s long-term fiscal outlook is daunting under many different  policy scenarios and assumptions. For instance, under a fiscally restrained  scenario, if discretionary spending grew only with inflation over the next  10 years and all existing tax cuts expire when scheduled under current  law, spending for Social Security and health care programs would grow to  consume over 80 percent of federal revenue by 2040. (See fig. 1.) On the  other hand, if discretionary spending grew at the same rate as the  economy in the near term and if all tax cuts were extended, by 2040  federal revenues may just be adequate to pay only some Social Security  benefits and interest on the growing federal debt. (See fig. 2.)
Addressing the projected fiscal gaps shown here will require policymakers  to examine the advisability, affordability, and sustainability of existing  programs, policies, functions, and activities throughout the entire federal  budget—spanning discretionary spending, mandatory spending, including  entitlements, and tax policies and programs. Neither slowing the growth of  discretionary spending nor allowing tax cuts to expire—nor both options  combined—would by themselves eliminate our long-term fiscal imbalance.  Additional economic growth is critical and will help to ease the burden,  but the projected fiscal gap is so great that it is wholly unrealistic to  expect that we will grow our way out of the problem. The President’s 2007  budget released last week included some proposals to reduce the growth  in Medicare spending. Whether or not these proposals are adopted, they  should serve to raise public awareness of the importance of health care  costs to both today’s budget and tomorrow’s. This could also serve to  jump start discussion about appropriate ways to control a major driver of  our long-term fiscal outlook—health care spending. Clearly, tough choices  will be required. Changes in existing budget processes and financial, fiscal,  and performance metrics will be necessary to facilitate these choices.
Early action to change existing programs and policies would yield the  highest fiscal dividends and provide a longer period for prospective  beneficiaries to make adjustments in their own planning. The longer we  wait, the more painful and difficult the choices will become and the less  transition time we will have. By waiting, an important window is lost  during which today’s relatively large workforce can increase saving and  begin preparing for the necessary changes in fiscal policy, Social Security,  and health care as well as other reforms that may be necessary parts of the  solution to this coming fiscal crunch. However, the long-term challenge is  fast becoming a short-term one as the retirement of the baby boomers’  generation will begin as early as 2008 and since overall workforce growth  has already begun to slow. While our long-term fiscal imbalance cannot be  eliminated with a single strategy, reducing the tax gap is one approach that  could help address the looming fiscal challenges facing the nation.

	Underreporting Accounted for Most of the Tax Gap Estimate

The tax gap is an estimate of the difference between the taxes—including  individual income, corporate income, employment, estate, and excise  taxes—that should have been timely and accurately paid and what was  actually paid for a specific year. The estimate is an aggregate of estimates  for the three primary types of noncompliance: (1) underreporting of tax  liabilities on tax returns; (2) underpayment of taxes due from filed returns;  and (3) nonfiling, which refers to the failure to file a required tax return  altogether or timely. Estimates for each type of noncompliance include  estimates for some or all of the five types of taxes that IRS administers.
IRS develops its tax gap estimates by measuring the rate of taxpayer  compliance—the degree to which taxpayers fully and timely complied  with their tax obligations. That rate is then used, along with other data and  assumptions, to estimate the dollar amount of taxes not timely and  accurately paid. For instance, IRS most recently estimated that for tax  year 2001, 83.7 percent of owed taxes were paid voluntarily and timely,  which translated into an estimated gross tax gap of $345 billion. IRS  developed these estimates using compliance data collected through the  National Research Program (NRP).
Using its recently collected compliance data, IRS has estimated that  underreporting of income represented over 80 percent of the tax gap for  2001 (an estimated $285 billion out of a gross tax gap estimate of $345  billion), as indicated in table 1.
Within the underreporting estimate, IRS attributed about $197 billion, or  about 57 percent of the total tax gap, to individual income tax  underreporting, including underreporting of business income, such as sole  proprietor, informal supplier, and farm income (about $109 billion);  nonbusiness income, such as wages, interest, and capital gains (about $56  billion); overstated credits (about $17 billion); and overstated income  adjustments, deductions, and exemptions (about $15 billion).  Underreporting of corporate income tax contributed an estimated $30  billion, or about 10 percent, to the 2001 tax gap, which included both small  corporations (those reporting assets of $10 million or less) and large  corporations (those reporting assets of over $10 million).
Employment tax underreporting accounted for an estimated $54 billion, or  about 16 percent, of the 2001 tax gap and included several taxes that must  be paid by self-employed individuals and employers. Self-employed  individuals are generally required to calculate and remit Social Security  and Medicare taxes to the U.S. Treasury each quarter. Employers are  required to withhold these taxes from their employees’ wages, match these  amounts, and remit withholdings to Treasury at least quarterly.  Underreported self-employment and employer-withheld employment  taxes, respectively, contributed an estimated $39 billion and $14 billion to  IRS’s tax gap estimate. The employment tax underreporting estimate also  includes underreporting of federal unemployment taxes (about $1 billion).
Taxpayers who do not file their tax returns on time or at all and otherwise  do not pay their tax liabilities accounted for the remainder of the 2001 tax  gap—around $61 billion. For example, nonfiling and underpayment  noncompliance by individual taxpayers alone contributed an estimated  $48 billion to this portion of the tax gap.
IRS has concerns with the certainty of the overall tax gap estimate in part  because some areas of the estimate rely on old data and IRS has no  estimates for other areas of the tax gap. For example, IRS used data from  the 1970s and 1980s to estimate underreporting of corporate income taxes  and employer-withheld employment taxes. For large corporate income tax  underreporting, IRS based its estimate on the amount of tax recommended  from operational examinations rather than the tax ultimately assessed as  part of the total tax liability. According to IRS officials, IRS relies on the  amount of tax recommended because it is difficult to determine the true  tax liability of large corporations due to complex and ambiguous tax laws  that create opportunities for differing interpretations and that complicate  the determination. These officials further stated that because these  examinations are not randomly selected and are not focused on identifying  all tax noncompliance, the estimate produced from the examination data  is not representative of the tax gap for all large corporations. They also  explained that due to these complexities and the costs and burdens of  collecting complete and accurate data, IRS has not systematically  measured large corporation tax compliance through statistically valid  studies, even though the officials acknowledged that such studies would  be useful in estimating the related tax gap.
IRS has no estimates for corporate income, employment, and excise tax  nonfiling or for excise tax underreporting. For these types of  noncompliance, IRS maintains that the data are either difficult to collect,  imprecise, or unavailable. In addition, it is inherently difficult for IRS to  observe and measure some types of underreporting or nonfiling, such as  tracking cash payments that businesses make to their employees, as  businesses and employees may not report these payments to IRS in order  to avoid paying employment and income taxes, respectively.
IRS’s overall approach to reducing the tax gap consists of improving  service to taxpayers and enhancing enforcement of the tax laws. Recently,  IRS has taken a number of steps that may improve its ability to reduce the  tax gap. Favorable trends in staffing of IRS enforcement personnel;  examinations performed through correspondence, as opposed to more  complex face-to-face examinations; and the use of some enforcement  sanctions such as liens and levies are encouraging. Also, IRS has made  progress with respect to abusive tax shelters through a number of  initiatives and recent settlement offers that have resulted in billions of  dollars in collected taxes, interest, and penalties. In addition, IRS has  successfully prosecuted a number of taxpayers who have committed  criminal violations of the tax laws.

	Reducing the Tax Gap Will Require Expanding Existing Approaches and Considering New Legislative Actions

Given its persistence and size, we need not only to consider expanding  current approaches but also explore new legislation to help IRS in  reducing the tax gap. Although IRS has made a number of changes in its  methodologies for measuring the tax gap over the past three decades,  which makes comparisons difficult, regardless of methodology the  voluntary compliance rate that underpins the gap has tended to range from  around 81 percent to around 84 percent. Thus, although the dollar  amounts of the tax gap have changed, IRS has consistently reported a  persistent, relatively stable portion of the taxes that should have been  timely and accurately paid were not paid.
As we have reported in the past, closing the entire tax gap may not be  feasible nor desirable, as it could entail more intrusive recordkeeping or  reporting than the public is willing to accept or more resources than IRS is  able to commit. However, given its size, even small or moderate reductions  in the net tax gap could yield substantial returns, which could improve the  government’s fiscal position. For example, based on IRS’s most recent  estimate, each 1 percent reduction in the net tax gap would likely yield  nearly $3 billion annually. Thus, a 10 percent to 20 percent reduction of the  net tax gap would translate into from roughly $30 billion to $60 billion in  additional revenue annually.
However, reducing the tax gap will be challenging and it must be  attacked on multiple fronts and with multiple strategies, some of which  follow.

		Regularly Measure Compliance and Set Compliance Goals

A critical step toward reducing the tax gap is to understand the sources  and nature of taxpayer noncompliance. Regularly measuring compliance,  including the reasons why taxpayers are not compliant, can offer many  benefits, including helping IRS identify new or growing types of  noncompliance, identify changes in tax laws and regulations that may  improve compliance, understand the effectiveness of its programs to  promote and enforce compliance, more effectively target examinations of  tax returns, and determine its resource needs and allocations. Likewise,  regularly measuring compliance can provide IRS with information against  which to set goals for improving compliance and measure progress in  achieving such goals.
In our July 2005 report on reducing the tax gap, we made  recommendations to IRS to develop plans to periodically measure tax  compliance; take steps to improve its data on the reasons why taxpayers  do not comply; and establish long-term, quantitative goals for voluntary  compliance levels with an initial focus on individual income tax  underreporting and total tax underpayment. Taken together, these steps  can help IRS build a foundation to understand how its taxpayer service  and enforcement efforts affect compliance and make progress on reducing  the tax gap. The Commissioner of Internal Revenue agreed with our  recommendations, highlighted challenges associated with them, and  commented on various steps IRS would take to implement each  recommendation. We are encouraged that according to IRS’s Fiscal Year  2007 Congressional Budget Justification, IRS has recently established a  voluntary compliance goal, with a target of 85 percent voluntary  compliance by 2009, and plans to periodically measure progress against  this goal.

		Simplify the Tax Code

Efforts to simplify the tax code and otherwise alter current tax policies  may help reduce the tax gap by making it easier for individuals and  businesses to understand and voluntarily comply with their tax  obligations. Among the many causes of tax code complexity is the growing  number of preferential provisions in the tax code, such as exemptions and  exclusions from taxation, deductions, credits, deferral of tax liability, and  preferential tax rates. Tax expenditures—as they are known by  statute—can be a tool to further some federal goals and objectives, such  as financing higher education or funding research and development.  However, their aggregate number contributes to the complexity that  taxpayers face in doing their taxes and planning their financial decisions.  As figure 3 shows, the number of tax expenditures reported by the  Department of the Treasury has more than doubled since 1974.  Figure 4  shows the Revenue Loss Estimates for the Five Largest Tax Expenditures  Reported for Fiscal Year 2005.
The multiple tax preferences for education assistance illustrate the  consequences of the proliferation of tax expenditures. In our July 2005  report on postsecondary tax preferences, we found that hundreds of  thousands of taxpayers do not appear to make optimal decisions when  selecting education-related tax preferences. One explanation of these  taxpayers’ choices may be the complexity of postsecondary tax  preferences, which experts have commonly identified as difficult for tax  filers to use. Also, many argue that complexity creates opportunities for  tax evasion, through vehicles such as tax shelters. Simplification may  reduce opportunities for taxpayers to avoid taxes through the creation of  complex and abusive tax shelters.
Another area of the tax system that may deserve additional exploration,  although not directly related to the tax gap, is whether the federal income- based tax system is sustainable and administrable in a global economy and  how we should tax the income of U.S. multinational corporations that is  earned outside of the United States. Every year, U.S.-based multinational  corporations transfer hundreds of billions of dollars of goods and services  between their affiliates in the United States and their foreign subsidiaries.  Such transactions may be a part of normal business operations for  corporations with foreign subsidiaries. However, it is generally recognized  that given the variation in corporate tax rates across countries, an  incentive exists for corporations with foreign subsidiaries to reduce their  overall tax burden by maximizing the income they report in countries with  low income tax rates, and minimizing the income they report in or  repatriate to countries with high income tax rates. Various studies have  suggested that U.S.-based multinational corporations appear to engage in  transactions such as these that shift income from their affiliates in high-tax  countries to subsidiaries in low-tax countries to take advantage of the  differences in tax rates in foreign countries.
The growth in multinational corporate transactions and structures has also  introduced increasing complexity in administering the tax code. The loss  of highly skilled technical employees at IRS who can examine compliance  issues arising from globalization, such as transfer pricing, underscores the  challenge that IRS faces in ensuring it has sufficient staff with adequate  skills to address these complex issues.

		Enhance Services to Taxpayers

Providing quality services to taxpayers is an important part of any overall  strategy to improve compliance and thereby reduce the tax gap. One  method of improving compliance through service is to educate taxpayers  about confusing or commonly misunderstood tax requirements. For  example, if the forms and instructions taxpayers use to prepare their taxes  are not clear, taxpayers may be confused and make unintentional errors.  One method to ensure that forms and instructions are sufficiently clear is  to test them before use. However, we reported in 2003 that IRS had tested  revisions to only five individual forms and instructions from July 1997  through June 2002, although hundreds of forms and instructions had been  revised in 2001 alone.

		Enhance Enforcement Tools Available to IRS

In terms of enforcement, IRS will need to use multiple strategies and  techniques to identify and deter noncompliance. As figure 5 shows, one  pair of tools have been shown to lower levels of noncompliance— withholding tax from payments to taxpayers and having third parties  report information to IRS and the taxpayers on income paid to taxpayers.  For example, banks and other financial institutions provide information  returns (Forms 1099) to account holders and IRS showing the taxpayers’  annual income from some types of investments. Similarly, most wages,  salaries, and tip compensation are reported by employers to employees  and IRS through Form W-2. Findings from NRP indicate that around 98.8  percent of these types of income are accurately reported on individual  returns.
In the past, we have identified a few specific areas where additional  withholding or information reporting requirements could serve to improve  compliance:    Requiring tax withholding and more or better information return  reporting on payments made to independent contractors. Past IRS  data have shown that independent contractors report 97 percent of the  income that appears on information returns, while contractors that do not  receive these returns report only 83 percent of income. We have also  identified other options for improving information reporting for  independent contractors, including increasing penalties for failing to file  required information returns, lowering the $600 threshold for requiring  such returns, and requiring businesses to separately report on their tax  returns the total amount of payments to independent contractors. IRS’s  Taxpayer Advocate Service recently recommended allowing independent  contractors to enter into voluntary withholding agreements.
Requiring information return reporting on payments made to  corporations. Unlike payments made to sole proprietors, payments made  to corporations for services are generally not required to be reported on  information returns. IRS and GAO have contended that the lack of such a  requirement leads to lower levels of compliance for small corporations.  Although Congress has required federal agencies to provide information  returns on payments made to contractors since 1997, payments made by  others to corporations are generally not covered by information returns.  The Taxpayer Advocate Service has recommended requiring information  reporting on payments made to corporations, and the Administration, in  its fiscal year 2007 budget, has proposed requiring additional information  reporting on certain goods and service payments by federal, state, and  local governments.
Requiring more data on information returns dealing with capital  gain income. Past IRS studies have indicated that much of the  noncompliance associated with capital gains is a result of taxpayers  overstating an asset’s “basis,” the amount of money originally paid for the  asset. Currently, financial institutions are required to report the sales  prices, but not the purchase prices, of stocks and bonds on information  returns. Without information on purchase prices, IRS cannot use efficient  and effective computer-matching programs to check for compliance and  must use much more costly means to examine taxpayer returns in order to  verify capital gain income. The Taxpayer Advocate Service has  recommended requiring financial institutions to track cost basis  information and report it to IRS and taxpayers.  Although withholding and information reporting are highly effective in  encouraging compliance, such additional requirements generally impose  costs and burdens on the businesses that must implement them. However,  continued reexamination of opportunities to expand information reporting  and tax withholding could increase the transparency of the tax system.  Opportunities to expand information reporting and tax withholding could  be especially relevant toward improving compliance in areas that are  particularly complex or challenging to administer, such as with net income  and losses passed through from “flow-through” entities such as S  corporations and partnerships to their shareholders and partners.
Another enforcement tool that can potentially deter noncompliance is the  use of penalties for filing inaccurate or late tax and information returns.  Congress has placed a number of civil penalty provisions in the tax code.  However, as with civil penalties related to other federal agencies, inflation  may have weakened the deterrent effect of IRS penalties. For example, the  Treasury Inspector General for Tax Administration has noted that the $50  per partner per month penalty for a late-filed partnership tax return,  established by Congress in 1978, would equate to $17.22 in 2004 dollars. In  its fiscal year 2007 budget, the administration has proposed expanding  penalty provisions applicable to paid tax return preparers to include non- income tax returns and related documents. In addition, Congress recently  increased certain penalties related to tax shelters and other tax evasion  techniques. Given Congress’s recent judgment that some tax penalties  were too low and concerns that inflation may have weakened the  effectiveness of the civil penalty provisions in the tax code, additional  increases may need to be considered to ensure that all penalties are of  sufficient magnitude to deter tax noncompliance.

		Leverage Technology

Leveraging technology to improve IRS’s capacity to receive, process, and  utilize taxpayer returns could help IRS better determine how to allocate its  resources to reduce the tax gap and would seem to be a prudent  investment. IRS has invested heavily in modernizing its technology and  those investments have paid off. Telephone service has improved and  taxpayers are much more likely to get through to IRS and obtain  assistance from IRS than before IRS upgraded its technology. Further,  electronic filing has grown substantially. Tax information submitted to IRS  electronically enables faster, more accurate processing and quicker  interactions between IRS and taxpayers. Electronically filed returns are  processed as they are received, therefore giving IRS access to more timely  and accurate tax information, which can be used for better data analysis  capability and quicker focus on issues that need resolution. IRS estimates  it saves $2.15 on every individual tax return that is processed  electronically. According to IRS data, electronic filing has allowed IRS to  use more than a 1,000 fewer staff years to process paper returns, resources  that can then be dedicated to other service or enforcement work.
However, IRS’s Business Systems Modernization project, through which  the agency is modernizing its outdated technology, is far from complete.  IRS needs to continue to strengthen management of this effort and make  prudent technology investments to maximize the efficiencies that can be  gained in IRS operations and services to taxpayers.

		Optimize Resource Allocation

Sound resource allocation is another tool for addressing the tax gap. The  more effectively IRS can allocate its resources, the more progress should  result. The new NRP data, for example, are to be used to better identify  which tax returns to examine so that fewer compliant taxpayers are  burdened by unnecessary audits and IRS can increase the amount of  noncompliance that is addressed through its enforcement activities. As  part of its attempt to make the best use of its enforcement resources, given  budget constraints, IRS has developed rough measures of return on  investment in terms of tax revenue that is directly assessed from  uncovering noncompliance. Developing such measures is difficult because  of incomplete information on all the costs and all the tax revenue  ultimately collected from specific enforcement efforts, as well as on the  indirect tax revenues generated when current enforcement actions prompt  voluntary compliance improvements in the future. Continuing to develop  the return on investment measures could help officials make more  informed decisions about allocating resources, particularly during periods  of budget constraints. Even with better data, however, officials will need  to make judgments that take into account intangibles, such as how to  achieve an equitable enforcement presence across the various taxpayer  groups.

	Concluding Observations

Our nation’s fiscal imbalance and challenges have created an imprudent  and unsustainable path that needs to be addressed. While our long-term  fiscal imbalance is too large to be corrected by one strategy, reducing the  tax gap can help address the looming fiscal challenges. Collecting the  billions of dollars that already should be paid, for example, would help  ease the many difficult decisions that need to be made about our spending  programs as well as the rest of the tax system. However, the tax gap itself  has been large and pervasive over the years and therefore, reducing the  gap will not only require expansions of current efforts, but also new and  innovative solutions. While IRS takes the lead in continuing to find ways to  significantly reduce the tax gap, support from Congress will be essential  since legislation will likely be needed to implement many of the tax gap  reduction ideas offered today. We look forward to continuing to work with  Congress and IRS on these issues.
Chairman Gregg, Senator Conrad and members of the committee, this  concludes my testimony. I would be happy to answer any questions you  may have at this time.

	Contact and Acknowledgments

Contact points for our Offices of Congressional Relations and Public  Affairs may be found on the last page of this testimony. For further  information on this testimony, please contact Michael Brostek on (202)  512-9110 or brostekm@gao.gov. Individuals making key contributions to  this testimony include Tom Short, Assistant Director; Jeff Arkin; Elizabeth  Fan; and Cheryl Peterson.
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Summary:
Why GAO Did This Study

The Internal Revenue Service's (IRS) most recent estimate of the difference between what taxpayers timely and accurately paid in taxes and what they owed was $345 billion. IRS estimates it will eventually recover some of this tax gap, resulting in an estimated net tax gap of $290 billion. The tax gap arises when taxpayers fail to comply with the tax laws by underreporting tax liabilities on tax returns; underpaying taxes due from filed returns; or nonfiling, which refers to the failure to file a required tax return altogether or in a timely manner. The Chairman and Ranking Minority Member of the Senate Committee on the Budget asked GAO to present information on the causes of and possible solutions to the tax gap. This testimony addresses the nature and extent of the tax gap and the significance of reducing the tax gap, including some steps that may assist with this challenging task. For context, this testimony also addressed GAO's most recent simulations of the long-term fiscal outlook and the need for a fundamental reexamination of major spending and tax policies and priorities.

What GAO Found

Our nation's fiscal policy is on an imprudent and unsustainable course. As long-term budget simulations by GAO show, over the long term we face a large and growing structural deficit due primarily to known demographic trends, rising health care costs, and lower federal revenues as a percentage of the economy. GAO's simulations indicate that the long-term fiscal challenge is too big to be solved by economic growth alone or by making modest changes to existing spending and tax policies. Rather, a fundamental reexamination of major policies and priorities will be important to recapture our future fiscal flexibility. Underreporting of income by businesses and individuals accounted for most of the estimated $345 billion tax gap for 2001, with individual income tax underreporting alone accounting for $197 billion, or over half of the total gap. Corporate income tax and employment tax underreporting accounted for an additional $84 billion of the gap. Reducing the tax gap would help improve fiscal sustainability. Given the tax gap's persistence and size, it will require considering not only options that have been previously proposed but also new administrative and legislative actions. Even modest progress would yield significant revenue; each 1 percent reduction would likely yield nearly $3 billion annually. Reducing the tax gap will be a challenging long-term task, and progress will require attacking the gap with multiple strategies over a sustained period. These strategies could include efforts to regularly obtain data on the extent of, and reasons for, noncompliance; simplify the tax code; provide quality service to taxpayers; enhance enforcement of tax laws by utilizing enforcement tools such as tax withholding, information reporting, and penalties; leverage technology; and optimize resource allocation.