S. HRG. 109–496

THE $350 BILLION QUESTION:

HOW TO SOLVE THE TAX GAP

HEARING

BEFORE THE

COMMITTEE ON FINANCE

UNITED STATES SENATE

ONE HUNDRED NINTH CONGRESS

FIRST SESSION

APRIL 14, 2005

(

Printed for the use of the Committee on Finance

THE $350 BILLION QUESTION: HOW TO SOLVE THE TAX GAP

U.S. GOVERNMENT PRINTING OFFICE

WASHINGTON : 

For sale by the Superintendent of Documents, U.S. Government Printing Office

Internet: bookstore.gpo.gov Phone: toll free (866) 512–1800; DC area (202) 512–1800

Fax: (202) 512–2250 Mail: Stop SSOP, Washington, DC 20402–0001

26–535—PDF 2005

S. HRG. 109–496

THE $350 BILLION QUESTION:

HOW TO SOLVE THE TAX GAP

HEARING

BEFORE THE

COMMITTEE ON FINANCE

UNITED STATES SENATE

ONE HUNDRED NINTH CONGRESS

FIRST SESSION

APRIL 14, 2005

(

Printed for the use of the Committee on Finance

COMMITTEE ON FINANCE

CHARLES E. GRASSLEY, Iowa, Chairman

ORRIN G. HATCH, Utah

TRENT LOTT, Mississippi

OLYMPIA J. SNOWE, Maine

JON KYL, Arizona

CRAIG THOMAS, Wyoming

RICK SANTORUM, Pennsylvania

BILL FRIST, Tennessee

GORDON SMITH, Oregon

JIM BUNNING, Kentucky

MIKE CRAPO, Idaho

MAX BAUCUS, Montana

JOHN D. ROCKEFELLER IV, West Virginia

KENT CONRAD, North Dakota

JAMES M. JEFFORDS (I), Vermont

JEFF BINGAMAN, New Mexico

JOHN F. KERRY, Massachusetts

BLANCHE L. LINCOLN, Arkansas

RON WYDEN, Oregon

CHARLES E. SCHUMER, New York

KOLAN DAVIS, Staff Director and Chief Counsel

RUSSELL SULLIVAN, Democratic Staff Director

(II)

(III)

C O N T E N T S

OPENING STATEMENTS

Page

Grassley, Hon. Charles E., a U.S. Senator from Iowa, chairman, Committee

on Finance ............................................................................................................ 1

Baucus, Hon. Max, a U.S. Senator from Montana ................................................ 3

WITNESSES

Walker, Hon. David, Comptroller General, U.S. Government Accountability

Office, Washington, DC ....................................................................................... 5

Everson, Hon. Mark, Commissioner, Internal Revenue Service, Washington,

DC .......................................................................................................................... 22

Yin, George K., Chief of Staff, Joint Committee on Taxation, Washington,

DC .......................................................................................................................... 25

O’Connor, Hon. Eileen J., Assistant Attorney General, U.S. Department of

Justice, Washington, DC ..................................................................................... 26

George, Hon. Russell, Inspector General for Tax Administration, U.S. Department of the Treasury, Washington, DC ............................................................. 28

Olson, Nina E., National Taxpayer Advocate, Taxpayer Advocate Service,

Washington, DC ................................................................................................... 30

Brown, Kevin M., Commissioner, Small Business/Self-Employed Division, Internal Revenue Service, Washington, DC .......................................................... 47

Jardini, Nancy J., Chief, Criminal Investigation, Internal Revenue Service,

Washington, DC ................................................................................................... 49

ALPHABETICAL LISTING AND APPENDIX MATERIAL

Baucus, Hon. Max:

Opening statement ........................................................................................... 3

Brown, Kevin M.:

Testimony .......................................................................................................... 47

Prepared statement .......................................................................................... 55

Everson, Hon. Mark:

Testimony .......................................................................................................... 22

Prepared statement .......................................................................................... 62

Responses to questions from committee members ......................................... 73

George, Hon. Russell:

Testimony .......................................................................................................... 28

Prepared statement .......................................................................................... 280

Grassley, Hon. Charles E.:

Opening statement ........................................................................................... 1

Prepared statement .......................................................................................... 301

Jardini, Nancy J.:

Testimony .......................................................................................................... 49

Prepared statement .......................................................................................... 303

O’Connor, Hon. Eileen J.:

Testimony .......................................................................................................... 26

Prepared statement .......................................................................................... 310

Responses to questions from committee members ......................................... 321

Olson, Nina E.:

Testimony .......................................................................................................... 30

Prepared statement .......................................................................................... 325

Responses to questions from committee members ......................................... 357

Page

IV

Walker, Hon. David:

Testimony .......................................................................................................... 5

Prepared statement .......................................................................................... 363

Responses to questions from committee members ......................................... 392

Yin, George K.:

Testimony .......................................................................................................... 25

Prepared statement with attachment ............................................................. 397

COMMUNICATION

The National Treasury Employees Union ............................................................. 443

(1)

THE $350 BILLION QUESTION:

HOW TO SOLVE THE TAX GAP

THURSDAY, APRIL 14, 2005

U.S. SENATE, COMMITTEE ON FINANCE, Washington, DC.

The hearing was convened, pursuant to notice, at 10:10 a.m., in

room G–50, Dirksen Senate Office Building, Hon. Charles E. Grassley (chairman of the committee) presiding.

Also present: Senators Thomas, Crapo, Baucus, Conrad, Lincoln,

and Wyden.

OPENING STATEMENT OF HON. CHARLES E. GRASSLEY, A U.S.

SENATOR FROM IOWA, CHAIRMAN, COMMITTEE ON FINANCE

The CHAIRMAN. Thank you all very much for coming to a very

important hearing on a very important day of April 14, the day just

before tax day, which we all know for decades as being April 15.

The eve before tax day is different than Christmas Eve because

taxpayers obviously have no choice on whether they want to give

or receive, because at this particular time, we are all giving.

The eve before tax day is also different than New Year’s Eve because taxpayers are spending it with pencils and calculators instead of champagne and noisemakers, although I suspect some people will be making a lot of noise in frustration as they try to figure

out their tax return and as they try to navigate the Earned Income

Tax Credit and the Alternative Minimum Tax.

People know how I have spoken out about the Alternative Minimum Tax. I want to give you an example. I do not think I am violating 6203 if I talk about my own tax return.

But I read in the Wall Street Journal that it takes 4 hours to

figure the Alternative Minimum Tax. Now, I do not know whether

it does or not. But about 3 weeks ago, my wife and I went to the

little town of Allison, Iowa to do our income tax and I had to pay

$75 Alternative Minimum Tax. Now, does that not seem a little bit

ridiculous and that we ought to be doing something about this?

Now, I am Chairman of the Senate Finance Committee. I have

not gotten anybody interested in doing anything about it unless

you’ve got some doggone big offset. It seems to me to be ridiculous

to have a tax policy to offset a tax that we never intended to collect

in the first place. I hope we can do something about that.

Now, continuing—and pardon me for digressing—unfortunately,

while a strong majority of Americans seek to honestly pay the

amount of tax that they owe and not one penny more, there are

many who are playing fast and loose.

2

The problem of the tax gap is costing the Nation over $300 billion a year in taxes that are not voluntarily paid. I say to my colleagues that there are no easy solutions or answers here.

I am worried that too often Senators and Representatives feel

just a wave of the hand somehow can solve this problem, and just

magically put these billions of dollars into the Nation’s coffers. If

it were that easy, we would have had this job done a long time ago.

So, we are fortunate to have the Comptroller General of the

United States, Mr. Walker, here today, whose statement says, and

says it very effectively, that ending the tax gap will be a ‘‘challenging task,’’ and that there is no single solution. It will take multiple efforts on different fronts to address this issue.

As I said in last week’s hearing involving charities and charitable

giving, the tax gap, somewhat like a loaf of bread, is made up of

many different slices. We need to understand each one better and

look for several ways to address them.

But let me make it clear. We will work to address the tax gap.

We owe nothing less to the millions of honest working families who

find tax day the toughest day of the year. It is absolutely wrong

that families have to tighten their belts and find new ways to keep

the family budget balanced because others are not paying their fair

share.

Today, our witnesses will talk about under-reporting, talk about

under-payment, talk about non-filing of taxes. But we will also

hear about cases of outright fraud. This is not a matter of taking

advantage of complexities in the code or exploiting gray areas, but

open, intentional evasion of fuel excise taxes or totally false claims

for refunds of fuel taxes never paid on fuel that was not even purchased.

This type of fraud probably affects every American, because this

is dedicated tax money that builds America’s highways in every

State of the Nation. For every dollar these bad guys steal, it is a

dollar that does not make your bridges safe or fix potholes on your

highways.

Last fall, as part of the American Jobs Creation Act, we were

able to enact an anti-fuel fraud package estimated to raise $9.3 billion by shutting down many of the schemes involved in fuel tax

fraud. But criminals are creative, and we continue to investigate

schemes that range from large-scale rings all the way down to

mom-and-pop operations.

Unfortunately, the higher the price of gasoline, the more that

they are motivated to do this by blending everything from used

motor oil to discarded paint thinner and cleaning products by the

billions of gallons to otherwise hide the true nature of gasoline that

they may or may not get at the pump.

Unfortunately, they not only steal from the U.S. Government,

but they are stealing from all of us as well. The tax gap is a $350

billion problem, and we are working very hard, slice by slice, to

find solutions for the American taxpayer.

Senator Baucus?

3

OPENING STATEMENT OF HON. MAX BAUCUS,

A U.S. SENATOR FROM MONTANA

Senator BAUCUS. Thank you, Mr. Chairman.

If everyone fully obeyed the law, our current tax code would

bring in as much as $353 billion each year. That is about $1 billion

a day in debt that the government would not be piling up, $1 billion a day less borrowing, if collected.

Mr. Chairman, in just the time since you announced this hearing

last Thursday, $7 billion in taxes that are lawfully owed have gone

uncollected. That number does not represent a new estimate based

on the latest research. I suspect that the actual number may be

significantly higher.

We all remember Everett Dirksen, an oil leader from Illinois who

once said: ‘‘A million here and a million there, and pretty soon you

are talking about real money.’’ Well, the $353 billion tax gap is certainly real money.

Most Americans would find that amount of money hard to visualize. I know I do. How much is $353 billion? That is pretty hard

to visualize. How high would a stack of $100 bills—not $1 bills, but

$100 bills—have to be to reach $350 billion? The answer is astonishing: 334 miles high.

I have a stack here, a brick of $100,000. It is not actually

$100,000. [Laughter.] The front end is $100 bills and the back end

is $100 bills, but in the middle are $1 bills. [Laughter.] But this

represents $100,000. That is what a stack of $100,000 would look

like.

In my home State, a stack of $100,000 would stretch from Billings, MT to Missoula, MT—here is a map. This is Billings here—

all the way to Missoula, MT. That is about 330 some miles. We

have a big State in Montana. If this was stacked one by one right

next to each other all the way, that is the distance it would take,

a stack of not $100, but of $100,000 bills, this stack representing

100,000 bills.

Now, that is the same distance from Hartford, CT to Washington,

DC. That is about 350 miles. Or a stack from Los Angeles, CA to

San Jose, CA. That is about 342 miles. Or from Jackson, MS to Atlanta, GA. That is about 380 miles.

Now, what does that mean for the average school teacher in my

State of Montana, or the waitress in Iowa, or the farmer in North

Dakota? What does that mean? It means you are paying more

taxes on your wages than you should because you are not collecting

the taxes from those who are evading the law. It means that the

value of the dollar in your pocket is actually less because our Nation has been piling up debts and owes more money to foreign governments.

It means we could reduce the deficit by three-fourths. Now, just

look at this. This is pretty instructive, I think. The green bar on

the left is essentially the tax gap, $353 billion. That is based on

the old data of several years ago. If we had current data, my guess

is it would be higher.

But that would pay for roughly three-fourths of the deficit right

there, just the tax gap, if people paid the money that they should

pay, and if Uncle Sam collected the money that is legally owed.

4

It could pay for a large portion of annual Social Security outlays.

Again, about two-thirds to three-fourths of annual Social Security

outlays. It could pay for all of the annual Medicare outlays. All of

it. The tax gap covers all of the annual Medicare outlays. It is incredible. It is astounding, when you stop to think about it. It would

pay for it all.

We have a Social Security insolvency problem facing the Nation.

Just think, on an equivalent basis, how much of Social Security solvency could be solved if general revenues were fully collected and

used to fund the Social Security trust fund, as opposed to payroll

taxes. Perhaps it could lower the payroll tax. Who knows? But the

point is, this is not just some academic concept. This is real money.

This is real.

I hope that finally, after all the talking we have had about the

tax gap over the years, that we can finally do something about it.

I think the American people, if they stopped and thought about it

a little more, would be pretty outraged. It is our responsibility to

actually do something about it.

Now, I am not going to speak at great length. We have great witnesses here. But if we fail to collect the taxes that are lawfully

owed, what is the additional effect? It undermines people’s confidence, not only in the tax system, but in our government. It just

undermines confidence.

People want to pay their taxes. Most people see it as their obligation, their civic obligation, their American obligation to pay their

taxes. But they also suspect that a lot of other people are not paying their taxes.

When they learn the amount that people are not paying, it really

starts to undermine people’s confidence in the tax system, in the

government, and they are going to begin to think, well, gee, why

should I pay? Others are not paying; why should I?

In addition, it starts to undermine our standard of living. It automatically undermines Americans’ standard of living when taxes

that are legally owed are not collected. Again, it is worth repeating,

this is not about raising taxes. It is simply about making sure that

what is owed is paid. That is all this is about.

There is another part to this, and that is uncollected payroll

taxes, employment taxes. The annual tax gap for the under-reporting of payroll taxes is estimated at about $71 billion. That is on top

of the $353 billion.

About $71 billion there is under-reported. About $60 billion of

this is for under-reported Social Security employment taxes. So, we

can eliminate one-fourth or one-half of the Social Security tax gap

if we could collect payroll taxes that are legally owed.

I appreciate the witnesses we have here. I do hope that this is

the beginning of the end of the gap. We have talked about it a lot.

Let us start doing something about it. Let us really start doing

something about it.

I think we are only going to be able to do something about it if

we give ourselves deadlines, as metrics, the amount by which we

are going to reduce that gap over what period of time so we can

report progress or report lack of progress to see where we are and

give some actual accountability to the American people.

5

It is an outrage. This is absolutely outrageous. So I hope, Mr.

Chairman, we finally do begin to get this solved. Thank you very

much.

Senator CONRAD. Mr. Chairman?

The CHAIRMAN. Yes?

Senator CONRAD. Might members of the committee have a chance

to study the display? [Laughter.] I have never had my hands on $100,000.

Senator BAUCUS. Well, as a former tax commissioner of North

Dakota——

The CHAIRMAN. I guess, better yet, those of us from Iowa or

North Dakota do not even know there are denominations that big.

[Laughter.]

I just wanted to remind people, and I know you know this be- cause you helped us accomplish it, but we did have about $24 billion worth of effort of tax shelter closing in the FSC-ETI bill last

year.

Senator BAUCUS. That is right.

The CHAIRMAN. Now we have an opportunity to turn to the seventh Comptroller General of the United States, David Walker.

Since assuming his position November 9, 1998, he has been effectively doing what Comptroller Generals are supposed to be doing,

improving the performance of the Federal Government. We all benefit from that, but we in Congress see his agency as one of the

main helping hands that we have to do our oversight work.

General Walker?

STATEMENT OF HON. DAVID WALKER, COMPTROLLER GENERAL, U.S. GOVERNMENT ACCOUNTABILITY OFFICE, WASHINGTON, DC

Mr. WALKER. Mr. Chairman, Senator Baucus, Senator Conrad, it

is a pleasure to be before the Senate Finance Committee to talk

about this important topic of the annual tax gap.

With your permission, Mr. Chairman, I would respectfully request that my entire statement be included in the record so I can

move to summarize.

The CHAIRMAN. Yes. Let me say, so everybody else who is a witness will not have to go through the same process, your statement

will just be automatically included in the record, and we would like

to have you summarize according to the time that the staff has

warned you about. Thank you very much.

Go ahead.

[The prepared statement of Mr. Walker appears in the appendix.]

Mr. WALKER. Thank you, Mr. Chairman. I will summarize using

three slides that are also in my testimony.

Let me say at the outset, with your comment, Mr. Chairman,

about this being April 14. For the record, I will file a timely extension tomorrow. I have paid AMT at least once already, so I share

your pain with regard to that issue, although my AMT number was

a little bit higher than your number.

The CHAIRMAN. You are not a farmer, that is why. [Laughter.]

Mr. WALKER. I am a public servant, like you are.

But let me also say for the record, while it may be somewhat

masochistic and it is not intended this way, I actually fill out my

6

return by hand every year just to be able to go through the exercise

and experience the complexity, the confusion, and the type of pains

people go through, although I will file electronically this year, for

a number of different reasons.

I appreciate this opportunity to be before you. I think this is a

very important topic. What I would like to do is start with the first

slide which is in my testimony, to note that, as has been mentioned, it is important that we focus on this actual annual tax gap,

because it is the difference between what taxpayers timely and accurately pay in taxes and what they should pay under the law.

Reducing this tax gap can help the Nation cope with its large

and growing fiscal challenges. I think it is important to note, as

Senator Baucus said, this is very important given the size of our

large and growing deficit. It is very important to note, as shown

in the far right-hand bottom corner, that the total estimate is $312

to $353 billion.

Senator BAUCUS. Excuse me, General.

Mr. WALKER. Yes, sir?

Senator BAUCUS. Frankly, I cannot read that. It is too far away.

Do you know where it is in your testimony?

Mr. WALKER. Yes, sir. I do know where it is in my testimony. It

is page 21, Senator.

Senator BAUCUS. Twenty-one.

Mr. WALKER. Page 21. Thank you so much.

But as Senator Baucus mentioned, the unified budget deficit last

year was $412 billion, the on-budget deficit was $567 billion, and

so this is a big chunk of that money.

The IRS estimates that through its own enforcement efforts that

$312 to $353 billion will actually be about $257 to $298 billion, but

it is still a large and unacceptable number.

I think we must recognize that, in today’s times of large current

and projected deficits, that people have a patriotic duty to pay their

taxes. If they do not pay their taxes, they, in effect, among other

things, are not only taking from their country, they are taking from

their children and their grandchildren. It is very clear that, based

upon the current fiscal path that we are on, that a failure to pay

your tax dollar today means your children and grandchildren are

going to pay higher taxes in the future.

So, it is important that we focus on the fact that there is a patriotic duty and that you have to put a face on the failure of individuals to properly pay their taxes.

In this regard, as you know, this tax gap estimate is based upon

2001 data and it did not represent an update of all the different

forms of taxation. It was primarily individual taxation and related

types of activities. Now, that is the biggest chunk of the money.

This committee has been concerned with tax-exempt entities.

There have been concerns with regard to corporations that are not

subchapter S corporations. So, clearly, more efforts need to be

taken in order to update data with regard to other aspects of noncompliance.

But I think it was prudent and appropriate that the IRS start

off with the biggest number, which is the individual taxation, although it did deal with somewhat dated information. This estimate

7

is up from the last time the IRS undertook this effort for tax year

1988.

I think it is important to put this in context. Next, please. Each

of you Senators should have received a copy of the report that was

published on February 14, 2005 by GAO entitled, ‘‘Twenty-first

Century Challenges: Reexamining the Base of the Federal Government.’’ (http://www.gao.gov/new.items/d05325sp.pdf)

Senator BAUCUS. Mr. General, again, we are looking for where it

is in your testimony.

Mr. WALKER. This, you do not have. It is just in my hands, Senator. I am just trying to bring it to your attention. Your staff has

this. If I can get you an additional copy, I will be happy to do that.

It is really important, in the little, spare time that you have,

which is basically zero, that you take an opportunity to look at this,

because it paints a very clear and compelling picture about where

we are and where we are headed from a fiscal standpoint.

This is one of the charts in my testimony. This chart is on page

8 of my testimony. There are two simulations shown in my testimony to show where we are and where we are headed with regard

to our fiscal future. This is one of them. This is not a pretty picture.

The fact of the matter is that, based upon CBO’s long-range economic growth assumptions, if you assume that discretionary spending grows by the rate of the economy, if you assume that the Social

Security and Medicare trustees’ best estimates of cost for those programs are accurate, and if you assume that all of the tax cuts are

extended and made permanent, this is our fiscal future. It means

that the Federal Government could be doing little more than paying interest on the massive Federal debt around 2040.

Social Security, frankly, is a small part of our challenge. It is less

than 10 percent of our fiscal imbalance. We could be facing much

greater problems, all the more reason why this committee is holding a hearing on the tax gap. Because if we can make progress on

the tax gap, it can make a major contribution to try to deal with

our imbalance.

But as Chairman Grassley properly said, we should have zero

tolerance for a tax gap. But it will never be zero. Just like fraud,

waste, abuse, and mismanagement in the Federal Government.

We are constantly trying to fight, along with the Inspectors General and others, including the Congress, fraud, waste, abuse, and

mismanagement in the Federal Government. It will never be zero,

so therefore we need to end up using other tools in order to accomplish the overall objective.

Clearly, I think it is important to note the next one, that the IRS

has started to allocate additional resources to tax enforcement-related activities. This chart on page 14 of my testimony shows that,

within the last several years, the IRS has started to increase its

examination rate for individual income taxes.

As you know, Senators, it is important to provide taxpayer assistance in order to help people who want to comply with the law

be able to effectively comply with the law. The IRS has done a lot

over the last several years to try to improve assistance and responsiveness to taxpayers.

8

At the same point in time, one has to recognize that not everybody is intent on voluntarily complying and that some individuals,

even if they do file a tax return, do not necessarily include all their

income or do not necessarily properly state all their deductions, et

cetera.

As a result, it is very, very important to have a strong, effective,

and credible enforcement presence in order to employ the carrotand-stick approach. The carrot is, we are going to help you comply.

The stick is, if you do not comply, there could be significant adverse consequences. So, it is important that continued progress be

able to be made here through a variety of different mechanisms.

But as the Chairman and the Ranking Member mentioned, we

are going to have to attack this on multiple fronts using multiple

strategies over a sustained period of time in order to be able to be

successful. That is going to include not just beefing up enforcement,

it is going to include simplifying the tax code.

It is also going to potentially include additional information returns and additional withholding mechanisms with regard to certain segments of the population where the tax compliance rate is

lower.

Finally, I might note, as has been mentioned by Senator Baucus,

it is important that we have some metrics here. It is important

that we have goals, objectives and strategies with appropriate responsibility and accountability mechanisms as to what can be done

to try to close this tax gap.

I would respectfully suggest, Senators, that one of the other

things that you may want to consider is, I understand that, under

current law, that individual Revenue agents cannot be held accountable for particular goals with regard to tax collections.

But I would respectfully suggest that one of the things you may

want to consider, as part of a comprehensive plan by the Agency,

is whether or not there could be a balanced scorecard approach

where at least Senior Executive Service members who are not dealing directly with the taxpayers might be able to be held accountable for providing quality service within their units, as well as trying to make progress with regard to key enforcement goals.

Congress has enacted a number of pieces of important legislation

within the past few years to try to deal with taxpayer abuse, including the creation of the Taxpayers’ Advocate Office. There are

certain checks and balances that exist in the system now that I

think can help to minimize the possibility of taxpayer abuse.

At the same time, becoming a high-performing organization and

making progress on goals require that there be some transparency

and accountability for achieving real results, while having checks

and balances to make sure that there are not abuses in doing so.

So, Senators, thank you very much for your time. I would be

happy to answer any questions that you may have.

The CHAIRMAN. All right. We will take 5-minute rounds. The

members who have come are in the order of: Grassley, Baucus,

Thomas, and Conrad.

I am interested, General Walker, in your comments about dealing with the tax gap, the part that the taxpayers’ service might

play in that. I have always been of the view that most taxpayers

9

want to comply, and if they can receive good information, will act

on it and comply.

Your views, then, on the importance of providing services, specifically what kind of services that can address the tax gap. In addition, while enforcement is easier to measure, how can we best

measure the impact of improved services? To what extent do you

find the IRS doing that?

Mr. WALKER. Well, clearly, Mr. Chairman, the IRS has placed a

considerable amount of time and attention and allocated additional

resources to increase taxpayer services in a variety of different

ways, including having the toll-free number capabilities where individuals can call in and ask questions.

I myself, quite frankly, have taken advantage of that on more

than one occasion. While sometimes the waits can be longer than

you would like, I have found in using these services over the last

several years, that the quality and the responsiveness has improved. Some of the work that we have done at GAO was focused

on trying to make sure that that continues to occur.

So, yes, I believe that that is an important element and that we

need to try to use survey mechanisms, et cetera, to try to ascertain

whether, and to what extent, that is making a difference based

upon the persons who are being aided.

At the same point in time, I think it is fair to say that our tax

laws are incredibly complex. There is absolutely no question that

there needs to be simplification of our tax laws.

I am a certified public accountant and I do my own taxes, and

I can get it done. However, it is hard to imagine an individual who

in good faith is trying to comply facing this Herculean task, if you

are filing anything other than a short form. It is unbelievable. So,

I think simplification has to be part of it, too.

The CHAIRMAN. I would focus on the point that you make in your

testimony where you state that closing the tax gap, in some cases,

may not be feasible or desirable. Expand on that point. Because,

as I mentioned in my opening statement, too many members think

the tax gap is something that is just out there, ripe fruit to pluck.

I think we all understand it is complicated, but would you respond

to that?

Mr. WALKER. Yes, Mr. Chairman. You are exactly right. It is

kind of like the issue that I touched on in my opening statement.

There are many people who believe that we can eliminate fraud,

waste, abuse, and mismanagement, and there are many people who

believe that, if all we did was have zero fraud, waste, abuse, and

mismanagement in the Federal Government, that would take care

of our deficit problems and our long-range fiscal imbalances. It is

just not feasible to do that.

The same thing applies with regard to the tax gap. It would be

overly intrusive with regard to many Americans if we were to require the detailed amount of information that would be reported to

the IRS. We have to balance enforcement with privacy and other

types of considerations.

I do, however, believe that additional progress can be made, but

I think a lot of that progress is going to require selected additional

information returns. For example, the cost basis associated with

capital gains.

10

Right now, people have to report the amount of proceeds, but you

do not know what the cost basis is. Obviously, the gain or loss is

based upon the difference, and therefore that is an issue.

In addition, with regard to income that is received by individuals

through pass-through vehicles such as partnerships, such as subchapter S corporations, whether or not there is a way, in addition

to the information that is being provided to the IRS, to have some

type of withholding for individuals that are receiving income on a

recurring basis through those entities. I, myself, used to be a partner with a global firm that operated in partnership form. I would

end up filing my estimated on a quarterly basis.

I think there are many situations where there is a pass-through

vehicle where you might be able to have an entity, a corporate entity or a partnership, be able to do some things on behalf of those

partners or subchapter S shareholders that could help in this regard.

The CHAIRMAN. My last question is, in regard to your study, it

is my understanding that you are looking into various tax reform

proposals. I would ask you to talk about tax reform and how it may

or may not help with the tax gap.

Mr. WALKER. Mr. Chairman, as I mentioned, I think tax reform,

clearly, has to be part of a comprehensive, long-term strategy to

maximize compliance and to minimize the tax gap. We have a tax

code today that is way overly complex.

When I fill out my own tax return, I am left with the feeling, not

only that it is overly complex, but that it is, to a certain extent,

a bait-and-switch system. I sit and I fill it out. I claim all of my

income and then certain of my deductions are limited and my exemptions get phased out. Then all of a sudden, after I fill out all

of this, then oops, there is this surtax called AMT that comes up.

So, clearly, I think we need to try to do what we can to streamline and simplify it. That is easier said than done, but I think it

has to be part of our longer-term strategy.

The CHAIRMAN. Senator Baucus?

Senator BAUCUS. Thank you, Mr. Chairman.

General Walker, where do you think we should begin to simplify?

I think you are right. We all know intuitively, the code is way, way

too complex. So some of the questions that come to my mind are,

how do we get at this?

Targeting our efforts here, there is an opportunity for the President’s Commission on Tax Reform that is meeting right now to

tackle simplification. I am just curious about what advice you

might have that we could give them.

Mr. WALKER. Well, Senator Baucus, I will say that the Chairman

and Ranking Member of the Tax Reform group are your former colleagues, and also that I know them as well. I have had conversations with them, and we have also let them know that we would

be more than happy to share GAO’s work over the years in this

area.

I think you have to look at tax incentives and what can be done

to re-look at a lot of our existing tax incentives, whether they be

exclusions or whether they be deductions.

Candidly, one of the things that is noted in this booklet is that,

when you consider the total value of tax incentives each year,

11

many years they exceed the total cost of discretionary spending, yet

they are off the radar screen. You do not see them.

We also have to take a look at not just how they might contribute to simplification, but also, what type of results are these tax

incentives having? For example, the health care exclusion. Is that

helping to control health care costs or is it exacerbating the problem?

So, I would be happy to provide more information, if you would

like. We are sharing our knowledge and experience with the commission that the President has appointed, and I look forward to

seeing what they come up with.

Senator BAUCUS. I appreciate that. I suppose one example would

be all the various education accounts. There are lots of different

credits and deductions for education. Frankly, I cannot keep them

all straight, there are so many of them.

The same is true in personal savings. There are a lot of personal

savings vehicles. To me, that is one area that can be simplified, too.

Let us get rid of a few of them, maybe package it in a way that

is more simple.

Mr. WALKER. With regard to those savings vehicles, Senator, as

you know, not only are there a lot of them, but in many cases you

do not have to preserve the income to retirement in order to be

able to use those vehicles and benefit from them.

Senator BAUCUS. That is true.

If you could address, too, as near as you can tell, the degree to

which we have to give resources to the IRS so they can figure out

what the problem is. We hear lots of complaints that the computer

system is antiquated. They are making efforts to try to address

that.

But I am a bit disturbed that the latest data that we have from

the IRS—I think it is 2001 data—is for under-reporting on the individual side. We do not yet know what the tax gap is on the corporate side, or other pass-throughs. We just know under-reporting

so far on individual income taxes, and that is just 2001. Heck, this

is 2005 already.

I would think that the Service would be able to tell us. I am surprised at how long it has taken the Service to try to figure out the

answer to this question. If you could just comment a little on that,

please.

Mr. WALKER. Senator Baucus, you are correct that they use 2001

data in order to estimate the individual under-reporting gap. But

as you also understand, it took them a considerable amount of time

to do it. So, therefore, they have more timely data available to

them now, but clearly that is something that you may want to ask

the Commissioner about: what can be done to try to expedite the

availability of data? We have this problem in many areas of government, including, most acutely, I might add—no pun intended—

in the health care area.

With regard to resources, there is no question that there is a resource issue here. As you know, the President has proposed additional resources targeted for enforcement in his budget proposal for

the Congress’s consideration in that regard.

There is no question also that our study shows—and our work

over the years, as well as the IRS’s—that there can be a good reVerDate 11-MAY-2000 10:48 Jul 28, 2006 Jkt 095484 PO 00000 Frm 00019 Fmt 6633 Sfmt 6633 26535.000 SFIN1 PsN: SFIN1
12

turn on investment for targeted investment in enforcement activities, although I think we have to keep in mind that in the first

year there is not likely to be much of a return on investment because you are hiring the people in. You have to train them and

equip them. You have to do all these things where you are incurring the costs, but you are not necessarily going to get the benefit

in year one.

I believe, over time, there has been a return of about 4:1 with

regard to IRS’s total budget, but there is a limit as to how far you

can carry that concept. We are doing work for the Congress, based

upon existing law, to monitor more closely the efforts that the IRS

is doing in the area of information technology upgrades. In fact, before additional funds flow to the IRS, GAO is required to provide

certain information to the Congress as a pre-condition.

So, clearly, some additional resources are necessary, but my view

is, as in all cases—even for GAO—to the extent that somebody

wants incremental resources, there should be a business case.

What do you want the resources for? What type of return on investment are we going to get? What are the metrics that we can use,

meaning the Congress can use, to ascertain whether or not people

are delivering on the promises over a period of time?

Senator BAUCUS. Well, my time has expired. But, for the record,

if you could, or maybe at some point, tell this committee, metrics

that you might suggest. You have been in the business a long time.

Your agency is well geared for this. But if you could give us some

ideas of what the metrics should be, that would be a real service.

Mr. WALKER. I would be happy to, Senator.

[The information appears in the appendix on p. 396.]

Senator BAUCUS. Thank you. I might add, too, I think you are

doing a great service, General. I mean, I think of people I know in

the government who are really trying hard, a lot of value added in

terms of service, and you are one of them. I want to thank you for

your service.

Mr. WALKER. Well, thank you, Senator. I have 3,214 people backing me up, and they are great people, too. Thank you, Senator.

The CHAIRMAN. Thank you.

Senator Thomas?

Senator THOMAS. Thank you, Mr. Chairman.

Obviously, we are all aware of a number of problems here. By

the way, there is a package of savings arrangements out there now

that we introduced about a month ago, in a roll-out with Secretary

Snow and others, to simplify these savings vehicles.

How would you, in a fairly brief response, see the role of the

Comptroller in terms of this issue?

Mr. WALKER. The Comptroller General, myself?

Senator THOMAS. Yes. And your agency. You have 3,000 people

and we have all these problems, so what are you doing?

Mr. WALKER. Well, Senator, that is a good question. It is a fulltime job, trying to maximize the performance and assure the accountability of the Federal Government. Over 90 percent of our resources are geared towards working on issues that the Congress either instructs us to do or asks us to do.

13

In fact, we do quite a bit of work for this committee, the Senate

Finance Committee, with the areas under its jurisdiction, not only

the tax area, but also health care and other issues.

What is important is, we measure success by the results that are

achieved based upon our work. Take last year, as an example. We

issued over 1,000 reports and recommendations on a variety of

issues dealing with the Federal Government. Eighty-three percent

of our recommendations were adopted. The result of adopting those

recommendations was $44 billion in financial benefits—namely either savings or money freed up for re-deployment to higher priority. That is a $95 return for every dollar invested.

We do three kinds of work: oversight work, insight work, and

foresight work. Oversight is the money being expended for the intended purpose of compliance with the laws and regulations. That

is most of our work.

Insight work. What is working and what is not working with regard to policies and programs?

Foresight work. What are some of the trends and challenges facing the country and the Congress, and how can we help you get

facts to make more timely and informed judgments? That is what

this book is about.

Senator THOMAS. Yes.

Mr. WALKER. So the answer is, we can do work in all three of

those areas geared towards trying to help improve performance, assure accountability, and to close the fiscal gap over time.

Senator THOMAS. Well, that is great. I know it is a tough job. But

we are here looking at numbers back in 2000, where more money

is lost than you have talked about saving in these 4 years. Is it

that you do not know what to do? I mean, do you not know how

to solve the issue? You do not, or we do not? Is it that you do not

have the mechanism to do it? Why has there not been a move here

on $300 billion a year?

Mr. WALKER. In fairness, Senator, I think what is important is,

we have had areas of the IRS dealing with enforcement and dealing with these issues on our high-risk list, which, as you know, is

published every 2 years, for a number of years.

As you know, we work for the Congress. We are auditors, investigators, evaluators, attorneys, et cetera. The primary responsibility for administering the tax laws and for closing the tax gap,

really, is with the executive branch. The executive branch is responsible for managing the tax administration program.

Senator THOMAS. But you are a part of it.

Mr. WALKER. We are not. No, no, no. We work for the Congress.

We are in the legislative branch. We are the third largest agency

in the legislative branch.

Our job is to work with the Congress to try to help you exercise

your oversight responsibilities, your authorization responsibilities,

and your appropriations responsibilities. So what we try to do is do

work to point out to you and the executive branch agencies areas

for improvement and how to move forward.

Senator THOMAS. And the executive branch.

Mr. WALKER. Correct.

14

Senator THOMAS. But certainly there is some coordination between you and the executive branch, or if there is not, there certainly ought to be.

Mr. WALKER. There is, absolutely.

Senator THOMAS. Yes.

Mr. WALKER. In fact, the President’s Management Agenda, which

I am sure you are familiar with, is based primarily on GAO’s highrisk list. Commissioner Everson, who was Deputy Director of OMB

when that was created, directly contributed to its creation. I think

he could tell you how much interaction we have with the IRS in

order to try to help them see the way forward.

Senator THOMAS. Well, I want to be clear, I am not trying to be

critical. I am trying to say, where is the problem? Is it a matter

of not having the ideas yet as to what to do, or is it a problem of

knowing that there ought to be some things done but we are not

able to do them? Maybe it is all legislative. If it is legislative, then

you ought to be giving us specific advice on what we ought to be

doing.

Mr. WALKER. Senator, there are several specific suggestions that

we have in our testimony. I think it is a combination. I think, number one, there are additional actions that need to be taken by the

Internal Revenue Service that do not require legislation.

Number two, there are some resource needs that the Congress is

going to have to decide on. Number three, I think you may well

have to do some things that are going to require legislation.

For example, to the extent that you are going to allow them to

use metrics to try to be able to balance not only service, but results

and enforcement, you may have to re-look at some of the restrictions that are currently placed on the IRS on the ability to consider

enforcement goals for senior executives for their evaluations.

Obviously, to the extent that there is tax simplification, that is

something that the Congress is going to have to do. That is not

something the IRS can do. So, we are going to have to act on multiple fronts over an extended period of time, and I would be more

than happy to meet with you, Senator, if you want to talk in more

detail about it.

Senator THOMAS. All right. Thank you very much.

Mr. WALKER. Thank you, Senator.

The CHAIRMAN. Senator Conrad?

Senator CONRAD. Thank you, Mr. Chairman. I thank the Chairman and the Ranking Member for holding this hearing. I think this

is very important.

As somebody who has a budget responsibility for our colleagues,

I have long been persuaded that the tax gap is one of the opportunities to close the deficit without cutting spending, without raising

taxes. I think this is an opportunity for us to make real progress

on the deficit.

Obviously, we also have to restrain spending. We have also got

to find other ways to close this tremendous gap that we have, a

budget deficit that is advertised at $400 billion. But really what is

being added to the debt is not $400 billion. I think a lot of people see the deficit and say, it is $400 billion,

that is what is being added to the debt. No. What is being added

to the debt is closer to $600 billion. The difference is the money

15

that is being taken from various trust funds that have to be repaid

and that do not get included in the calculation of the deficit.

So, turning to the tax gap, this estimate of $312 to $353 billion,

which is an initial re-estimate, is still leaving out lots of things. As

I understand it, this is still based on the corporate side on data

from 1988, updated to 2001.

Based on my contacts with the accounting community, they believe the environment has changed substantially in that period and

that, in fact, the tax gap in the corporate area is probably much

larger than these estimates.

In addition, as I understand it, this does not include illegal activity. This is what is owed by people not being paid. Although I see

some indication that this includes over-stated deductions or credits,

tax shelter investors, skimmers, moonlighters. I am not sure what

‘‘skimmers’’ refers to. I would be interested to hear from the Commissioner what all these terms relate to.

I heard on Tuesday of this week a former Commissioner of the

IRS, Donald Alexander, estimated the tax gap is more likely in the

$400 billion range because current estimates do not fully account

for non-filers, the underground economy, and certain other illegal

activity.

My own belief is, that is probably a greater likelihood. I think

the greater likelihood is that this estimate understates the tax gap.

As we get more refined data, we will find it is even larger, which

makes the imperative of moving forward even greater.

With that, Mr. Comptroller General, I want to thank you for the

energy and effort you have put into alerting the American people

of the fiscal imbalances facing the country, not only in the immediate term, but in the longer term, the demographic tsunami that

is coming at us, a doubling of the people eligible for Social Security

and Medicare combined with our budget deficits, combined with

our trade deficits that mean we as a Nation are borrowing more

and more money, not only from ourselves, but borrowing it from

abroad as well, and that makes us increasingly vulnerable.

I want to salute you for really taking a leadership role. It is not

your responsibility to close the tax gap. Your responsibility is to

alert us and to alert the Nation about the nature of the tax gap,

and to make recommendations on how we can take action to close

it. So, I very much appreciate what you are doing in that regard.

Let me ask you this. I have become more and more convinced as

I look at this that we will never make dramatic progress in closing

the tax gap absent serious systemic tax reform. Can you give us

some idea—you have spent hundreds of hours on this subject—

what your conclusions are with respect to the need for tax reform

as a means of making substantial progress?

Mr. WALKER. I think one of the questions you are going to have

to deal with is how to streamline and simplify the tax code as it

relates to individual income taxes—I will start off with that—to

where you may end up having a flatter—not a flat—income tax,

but also less tax preferences.

I think, also, you are going to have to consider, in time, given the

change in the nature of the economy, given the change in the distribution of wealth and income in this country, at some point in

16

time enacting some consumption-based taxes, while dealing with

the regressivity issue.

The fact of the matter is, the world has changed dramatically

since 1988, especially on the corporate side. We are truly in a global economy. We are competing on a global basis. We are not an island. We may be the world’s only super-power, but we cannot go

it alone, and there are other countries coming up.

So the fact is, I think we are going to have to look outside the

box, not just try to tinker around the edges, but maybe reconsider

on what basis we are taxing and what we are giving preferences

to at the same point in time.

Senator CONRAD. I notice my time has expired. Thank you, Mr.

Chairman.

The CHAIRMAN. Now, Senator Crapo. Then after Senator Crapo,

Senator Lincoln.

Senator CRAPO. Thank you very much, Mr. Chairman.

Mr. Walker, I, too, appreciate you coming here and the important

work that you do.

I was interested in noting in your materials that the largest portion of the tax gap is in the area of individual income tax returns.

In fact, according to the chart that I saw, somewhere between $198

and $234 billion worth of the gap is attributable to personal income

tax returns.

In that context, have you had a chance to read the letter that

was put out yesterday by the President’s Advisory Panel on Tax

Reform?

Mr. WALKER. No, Senator, I have not. But I will do it when I get

back.

Senator CRAPO. All right. I will just summarize one portion of it

to you, because it was interesting to me. They came out with six

themes that they are going to use to guide their further deliberations. Throughout it was a concern that has been raised about the

complexity of the tax code.

It is interesting that you just commented on that in your response to the previous question. One of their points was that the

complexity of our code breeds a perception of unfairness and creates opportunities for manipulation of the rules to reduce tax.

The profound lack of transparency that they noted means that

individuals and businesses cannot easily understand their own tax

obligations or be confident that their neighbors or competitors are

paying their fair share.

I recall back, oh, it has been 8 or 9 years ago now, I think, that

one of the magazines in this country created a typical situation for

a family of four, I think, and sent it out to a number of different

tax preparing groups, like accountants, or whatever it may be, and

asked them to prepare the tax return for this situation they had

created.

And I do not remember the number they sent it out to, but whatever it was, they got that number of answers back. From professionals, they got different answers to the same set of facts under

the tax code as to what the tax liability for this family would be.

With all of this kind of thing in mind, the question I have, coming back to the fact that you have identified by far the largest part

of the problem being the individual income tax return arena, have

17

there been any studies done to demonstrate a relationship between

the increasing complexity of the tax code and the increasing size

of the tax gap?

Mr. WALKER. I am not aware of any that are directly focused on

that, Senator. But you also may want to ask the Commissioner as

well. He might be aware of some.

Senator CRAPO. We will do that. It just seems to me that one of

the big problems that we face is the fact of the complexity. And I

have noted previously, if we could send out a basic set of tax information to six different experts, or whatever the number was, and

get six different answers back, then how can the Internal Revenue

Service claim that they know the right answer when they audit a

tax return?

Now, obviously they get to say what the right answer is, which

is another part of the unfairness perceived by the American public.

But the fact is, here, in addition to the fairness issues that we are

addressing, it seems to me that one of the things that we could possibly do to improve the tax code dramatically in a number of ways,

which would also address the tax gap, is to reduce the complexity.

Could you comment on that?

Mr. WALKER. No doubt about that. But as you can see, Senator,

with regard to the summary of the results from the latest estimate,

the biggest problem is believed to be with under-reporting of income, where individuals, whether they be individuals, subchapter

S corporation shareholders, partners or whatever, and whether it

be due to sales of stock or other types of investments, or whether

it be through interest income or other things, where income is not

being reported.

I think there is a lot that has been done over the last few years

to try to enhance reporting to the IRS so they can do matching. In

fact, they have done a lot on that. I have seen and experienced

some of that myself.

But I do believe, as I touched on before, if you really want to get

at this over the longer term, it is more than enforcement. It is also

having additional transparency, potential additional withholding,

and simplification so that people who, in good faith, want to comply, can comply.

Senator CRAPO. When you talk about under-reporting, which I

did note was the lion’s share of the issue with regard to individual

tax returns, I assumed when I read that that there were ways to

under-report because of the complexity of the code. Is that correct?

Mr. WALKER. You may want to ask the Commissioner, but I believe a lot of that has to do with not as much complexity as it does

with the fact that there is income that is being earned that has not

been reported to the IRS, and the IRS does not have information

where it can match what the individual did as compared to what

they should have reported.

Senator CRAPO. In other words, just blatant refusal to report

transactions.

Mr. WALKER. Part of that number is represented by that. I think

the Commissioner could probably tell you more.

Senator CRAPO. All right. Thank you. Thank you very much.

The CHAIRMAN. Senator Lincoln, then Senator Wyden.

18

Senator LINCOLN. Thank you, Mr. Chairman. Thank you for

bringing us together on such an important issue.

I am sorry I was late. I noticed in my office that there was a lot

of fun being had down here, so I thought I had better come down

here and check out what you guys were doing. A lot of laughter

going on.

The CHAIRMAN. Well, we try to earn our money, but we will be

corrected, if not, by you.

Senator LINCOLN. All right.

Mr. WALKER. The hundred thousand dollar stack may be gone

now, Senator. I am not sure. [Laughter.]

Senator LINCOLN. Well, thank you, too, Mr. Walker, for being

here. I would like to echo the sentiments from Senator Conrad

about how much we appreciate this.

We realize that we have a responsibility here to make the necessary corrections and changes, simplifications, as you have mentioned, and we appreciate the way in which you have provided us

the information in a good, sound way to be able to make those decisions.

I do think that the simplification that you have echoed is very

important. Senator Hatch and I have worked hard. Having recognized that there were multiple different definitions of a child was

one of the very first steps, I guess, that we began to take up last

year, which was very helpful.

Just a couple of questions. I think one of the reasons that this

issue has become even more important has been the record deficits,

the historic deficits, that we are seeing in our Nation right now and

the need for us to look for places of how we can correct that.

I guess a very simple question would be if you think we are living beyond our means. Even if we collected all of the taxes that

were owed, would we still be living beyond our means?

Mr. WALKER. Yes. We are on an imprudent and unsustainable

fiscal path. Last year, we had a unified deficit of $412 billion and

an on-budget deficit of $567 billion. Of the $412 billion number,

less than 25 percent related to Iraq, Afghanistan, and incremental

homeland security costs, and we had the strongest economic growth

of any industrialized nation. We are not on a prudent, nor are we

on a sustainable, path.

Senator LINCOLN. Well, I agree with you on that. I think that

that is why it is ever more responsible for us to look at this as an

issue that we should be able to deal with and improve upon.

One of the things that I have become concerned about, if we are

talking about dealing with the tax gap by cutting back taxpayers’

assistance, which is what is apparent in this budget, I suppose—

the budget request included a decrease in funding of the taxpayer

services to offset some of the increase in enforcement—what does

that do? I mean, I just put my taxes in the mail this morning. They

were enormously complicated, and I am probably the least complicated of the 100 members up here.

Mr. WALKER. Well, it depends on how you cut back on it. I imagine that might be a question you may want to ask the Commissioner. Basically, it depends upon how those funds are being expended.

19

Let me give an example I can relate to when I became Comptroller General in November of 1998. After studying our situation,

I ended up closing 5 of 16 field offices because I did not believe we

could justify maintaining the additional infrastructure costs associated with those.

We took a number of other actions that in some cases reduced

head count, and yet our results actually increased. Even though we

ended up closing certain offices, we increased automation, and we

ended up doing a number of other things designed to enhance our

overall productivity and effectiveness.

So, I think the key is not just whether or not the money is coming out of that area or whether or not certain facilities may be

closed, but what are the likely implications of those actions given

other possible compensating actions? And there can be offsets because of process improvements, because of technological enhancements, and other areas.

Senator LINCOLN. Well, the technological advancements, to a certain degree, though, do they not require a great deal of assistance

in coming up to speed?

Mr. WALKER. Yes, to the extent that you have technological enhancements, there is absolutely no question that there is a training

element of that. You end up having to train people on these new

technologies. They have to become familiar with these new technologies.

In the end, you have to have a human being there available to

be able to deal with people if the automated menus do not get the

job done. As you know, there are a lot of automated menus when

you call the IRS. Sometimes it takes you a while to get through

them.

Senator LINCOLN. Well, I guess my concern has stemmed from,

particularly in some of our more rural areas, some of the problems

we have seen with EITC could really have been prevented, or we

could correct them, if we were able to have better assistance early

on in transferring or translating to a more technological solution.

But it seems to go backwards. It seems to me that we get the technology without the assistance to be able to implement it, particularly in rural areas.

We have been trying to correct some of that, because there are

those who really have seen some of the problems we have had with

the ITC and have genuinely wanted to try to correct some of that

but really have not been able to get the assistance out to particularly the smaller areas, the rural areas where we see a lot of those

EITC problems and claims existing.

Mr. WALKER. Well, a couple of thoughts off the top of my head.

We are becoming an increasingly wired society. More and more

people are using the Internet, and if one has access to the Internet,

irrespective of where you live, it is a universal communication

mechanism.

What has the IRS done and what else can the IRS do to provide

more information with regard to this and other areas of complexity

up front before people file their tax returns? Then, second, what,

if anything, might be able to be done to provide targeted information to individuals who are claiming EITC such that they have certain information to be able to consider in future filings?

20

Senator LINCOLN. Right. Progressivity.

The CHAIRMAN. Your time is up.

Senator Wyden, Senator Baucus has one more question. He has

to leave the room just for a minute. Could he ask a question ahead

of you?

Senator WYDEN. Of course.

Senator BAUCUS. I thank both of you very much. Just very briefly.

Mr. Walker, on page 22 of your report, it is basically pointed out

that the IRS has only looked at certain data. Given its current research priorities, it will not begin another NRP—that is, another

study—of individual returns before 2008, if at all, and would not

complete such study until 2010.

It is my understanding that there is no effort to look at other sectors, corporate returns, excise tax returns, et cetera, by the IRS.

You go on to say that, ‘‘Although the costs and burdens of compliance measurement are legitimate concerns, we believe compliance

studies to be good investments.’’

Could you just elaborate on that basic point? It looks like this is

not a comprehensive examination of data to determine whether or

not there is compliance. There is a concern because of the cost of

trying to determine whether there is compliance. As you point out,

in some cases that is a good investment.

Mr. WALKER. Right.

Senator BAUCUS. Could you just comment on that a little bit,

please?

Mr. WALKER. Well, Senator, as you know, the last time the IRS

did the estimate for the individual side was 1988, and this new estimate is focused on the individual side and it is based on 2001

data.

We think it is important to update it more frequently than every

13 years. We need to have metrics. We need to understand how we

are doing. In addition to that, we also need to make sure that we

do not leave segments of the taxpayer population off the radar

screen.

It is important that, periodically, we take a look at the corporate

side, that we look at the other elements that have not been looked

at, although it is fair to say, a vast majority, at least historically,

of the estimated tax gap has been associated with individuals, although some of those could be partners in partnerships, or subchapter S shareholders operating in corporate form. So, we believe

it is important to have a comprehensive plan to periodically update

all aspects of this to develop the metrics.

I will also say this, that there is no question you need to streamline and simplify the code. There is also a need to stabilize the

code, because one of the difficulties that the IRS will have is when

the law keeps on changing, it makes it that much more difficult,

not just for taxpayers to comply and those who assist to try to get

the job done, but also to come up with apples to apples comparisons

of how we are really doing on a trend line with regard to the tax

gap, because it is a moving target, if you will.

So, we do believe there needs to be a plan that provides more frequent updates, and also a broader cross-section of the taxpayer reporting information.

21

Senator BAUCUS. Thank you very, very much. I thank my colleague.

The CHAIRMAN. Thank you.

Now, Senator Wyden?

Senator WYDEN. Thank you, Mr. Chairman.

Mr. Walker, let me commend you for all of the excellent work

that you do for the Congress. Probably no one avails themselves

more of your office than me, and I am very appreciative.

My concern, and the area I want to examine first with you, is

I am not convinced that the IRS is looking at the right places. I

am constantly being told, for example, that law-abiding citizens are

being hassled and that opportunities to collect more revenue are

being overlooked.

So my question to you is, based on what you know, do you think

the IRS is looking at the right places?

Mr. WALKER. I think within the last several years the IRS has

started to allocate additional resources to enforcement. It has focused those resources on the areas that historically have been a

problem. The results of this new study are preliminary. There are

more detailed results that will be forthcoming. I would hope and

expect that the IRS would be informed by those results in determining how they are going to allocate their future resources. I do

note that there are some aspects of the taxpayer universe that

have not been updated as a result of this. For example, the corporate side. The world has changed dramatically on the corporate

side since 1988.

At the same point in time, it is my understanding that while

there is, I think, significant additional opportunity for abuse on the

corporate side because of some of those changes, it is my understanding the IRS is allocating additional resources there as well.

This is something you may want to pursue with the Commissioner as to what degree of resource allocation and how that is

being targeted. For example, transfer pricing, I know, is a huge

issue in today’s global economy.

Senator WYDEN. I intend to pursue this, not just today, but in

the future. You all audit programs. You audit agencies. If you tell

us at some point that the IRS is not looking at the right places,

that is an argument for having you audit the auditors to make sure

that the enforcement efforts really go to the right place.

Now, you said earlier that you did not think closing the entire

tax gap was practical. But could you attach a figure on how much

you think the tax gap could actually be closed? This is, I think, especially relevant given the deficit. So, take a crack, if you would,

at trying to give us a number and your best and most realistic assessment of how much of the tax gap could be closed.

Mr. WALKER. As you know, Senator Wyden, GAO prides itself on

having generally accepted methodologies, reasonable assumptions,

and fact-based inputs in order to be able to come to those conclusions, so it is virtually impossible for me to give you a number.

I will tell you this: to a great extent it depends upon a variety

of factors. It depends upon whether or not you take steps to

streamline and simplify the code. It depends upon whether and to

what extent the IRS is given authority to be able to receive additional information returns.

22

It depends upon whether and to what extent additional steps are

taken to try to increase withholding opportunities for certain types

of taxpayers. It depends upon whether and to what extent the Congress ends up allocating targeted resource enhancements for enforcement where a business case can be made, that they can be a

good return on investment.

Ultimately, I think it depends upon whether or not the Congress

considers alternative means of raising revenue, such as consumption-based taxes while dealing with the regressivity problem that

could be associated with that. You have to do that. Most major industrialized countries have moved more towards a consumption tax

base where you collect it differently.

Senator WYDEN. Let us say that is not done.

Mr. WALKER. All right.

Senator WYDEN. I would like to see some of that done.

Mr. WALKER. Sure.

Senator WYDEN. But if it is not done—and I will only ask once

more and not persist—can you give us some sense of what you

think might be realistic?

Mr. WALKER. You can raise tens of billions of dollars. How much

you can raise depends upon a variety of factors, but there is no

doubt in my mind that you can raise tens of billions of dollars.

Senator WYDEN. Well, I thank you. I thank you for your professionalism. I look forward to working closely with you.

Thank you, Mr. Chairman.

The CHAIRMAN. Yes. Thank you, General Walker.

Mr. WALKER. Thank you, Mr. Chairman. Thank you.

The CHAIRMAN. I would call our second panel, Mark Everson,

Commissioner of IRS, the person that is right in the middle of estimating the size of the tax gap and currently doing a lot to address

it, but telling us how we can do more; and Mr. George Yin, Staff

Director, Joint Committee on Taxation, to discuss general principles as identified by the Joint Committee staff that should influence any new tax legislation when we seek to enhance compliance;

Eileen O’Connor, Assistant Attorney General, Tax Division, Department of Justice, telling us of progress already made in bridging

the tax gap, and particularly of tax-avoiding schemes that are

thwarted as a result of the work of her agency; Treasury Inspector

General of Tax Administration, Russell George, providing us additional information on the tax gap and possible solutions, telling us

also how the IRS can protect taxpayers’ rights and improve customer service, all a concern to us, but something that needs to be

done as we look at the aggressive administration that it takes to

close the tax gap; and finally, Nina Olson, with the title of National

Taxpayer Advocate, who will discuss how both enforcement and

high-quality customer service does increase compliance.

We will proceed in the way you were introduced. So, Mr.

Everson?

STATEMENT OF HON. MARK EVERSON, COMMISSIONER,

INTERNAL REVENUE SERVICE, WASHINGTON, DC

Mr. EVERSON. Thank you, Mr. Chairman, Senator Crapo. I am

pleased to be here. I want to start out by saying, we do recognize

that it is not Christmas Eve, Senator, on April 14th.

23

In fact, I will just tell you one story. This morning I got up, and

my dog, who usually gives me a pretty good welcoming—he is a

pug—he just sort of ignored me. My wife said to me, ‘‘See? This

time of year, nobody loves you.’’ [Laughter.]

I appreciate your continued interest in and support for our efforts to increase compliance with the tax laws. Simply put, the tax

gap is the difference between the tax that taxpayers should pay

and what they actually pay on a timely basis.

Our research confirms that the vast majority of Americans pay

their taxes honestly and accurately, but the findings also show

that, even after IRS enforcement efforts and late payments, the

government is being short-changed by over a quarter trillion dollars each year because some pay less than their fair share. People

who are not paying their taxes shift their burden to the rest of us.

In this time of budget deficits, a dollar not received by the government becomes debt, the burden of which will be felt by future

generations. Moreover, as President Kennedy stated in 1961, large,

continued avoidance of tax on the part of some has a steadily demoralizing effect on the compliance of others.

Our research shows the gross tax gap to be between $312 billion

and $353 billion. The old tax gap estimate for 2001 was $311 billion, a figure based on studies conducted in 1988 and earlier, so

there has been what I would term a modest deterioration in tax

compliance among individual taxpayers since the last study was

conducted in 1988.

IRS enforcement actions, coupled with late payments, recover

about $55 billion of the total tax gap, leaving a net annual tax gap

of between $257 billion and $298 billion.

Current data are preliminary, so our tax gap estimates are

shown as ranges. As refinements are made to the analyses, some

estimates may change. It is unlikely, but possible, that the final estimates of the total tax gap will fall outside the established range.

There are two views of the tax gap: by type of noncompliance—

that is to say, non-filing, under-reporting, and under-payment—and

by type of tax. The new research for 2001 addresses the under-reporting of income and self-employment taxes by individual taxpayers. It is based on audits of 46,000 individuals. The study did

not address corporate compliance.

Preliminary findings include under-reporting noncompliance is

the largest component of the tax gap. Preliminary estimates show

under-reporting accounts for more than 80 percent of the total tax

gap, with non-filing and under-payment at about 10 percent each.

Individual income tax is the single largest source of the annual

tax gap, accounting for about two-thirds of the total. For individual

under-reporting, more than 80 percent comes from under-stated income, not over-stated deductions.

Most of the under-stated income comes from business activities,

not wages or investment income. Finally, compliance rates are

highest where there is third party reporting or withholding. Preliminary findings show less than 1.5 percent of wages and salaries

are misreported.

The next stage of our research will be to finish the data analysis

and refine the tax gap data by late this year. The IRS will use the

24

data to update its statistical tools for selecting individual returns

for audit.

An understanding of the tax gap and its components will allow

the legislative and executive branches of government to make better decisions about tax policy and the allocation of resources for tax

administration.

The study confirms two key points involving tax enforcement and

simplification. The IRS needs to enforce the laws, so that when

Americans pay their taxes they are confident that neighbors and

business competitors are doing the same.

At the same time, this research underscores the President’s call

for tax reform. Complexity obscures understanding. Complexity in

the tax code compromises both the service and enforcement missions of the IRS.

Those who try to follow the law but cannot understand their tax

obligations may make inadvertent errors or ultimately throw up

their hands and say, why bother? Meanwhile, individuals who seek

to pay less than what they owe often hide behind the tax code’s

complexity in order to escape detection by the IRS and pay less.

Since 2001, we have taken a number of steps to bolster enforcement. These charts show you the story. We have increased total individual audits to more than 1 million; they were just over 600,000

4 years ago. We have also more than doubled high-income audits.

We have brought up recommended criminal prosecutions. That is

what we refer over to the Department of Justice.

Between fiscal year 2001 and 2004, the IRS increased its enforcement revenues from $33.8 billion to $43.1 billion. Enforcement revenues are the monies that result from IRS collection, audit, and

document matching activities.

Enforcement revenues directly reduce the tax gap and the Nation’s budget deficit. They exclude the positive impact on compliance that occurs when someone learns, in a casual conversation,

that their neighbor has been audited and then thinks twice about

fudging his or her own return.

The President has called for a nearly 8-percent increase for enforcement activities in the administration’s 2006 IRS budget request. These investments will pay for themselves several times

over and help reduce the tax gap. I thank the members of this committee for the efforts you have made to get more resources for the

IRS. Please keep it up.

Finally, I would like to point out that our system of tax administration is fundamentally one of self-assessment and enjoys a high

compliance rate. The IRS is moving aggressively to reduce the tax

gap. With proper funding, over a number of years we will be able

to close a significant portion of the gap. But no one should think

we can totally eliminate the gap. That would take draconian measures and make the government too intrusive. We have to strike the

right balance.

Thank you.

The CHAIRMAN. Thank you, Mr. Everson.

[The prepared statement of Mr. Everson appears in the appendix.]

The CHAIRMAN. Now, Mr. Yin?

25

STATEMENT OF GEORGE K. YIN, CHIEF OF STAFF, JOINT

COMMITTEE ON TAXATION, WASHINGTON, DC

Mr. YIN. Thank you, Mr. Chairman, Senator Baucus, and members of the committee. I am pleased to testify today about the tax

gap and ways to reduce it.

As you know, the Joint Committee staff recently completed a report on options to improve tax compliance and reform tax expenditures in response to a request of the Chairman and Ranking Member. The report provides about 70 specific tax legislative options to

address one or more of the many contributing factors to the tax gap

and noncompliance.

In my brief time, I will describe some tax legislative principles

to enhance compliance. The staff report contains a number of items

that illustrate these principles. I have appended to my testimony

summaries of each option in the report, and am happy to respond

to any questions about them.

First, as has already been discussed, the most important way to

reduce the tax gap is to simplify the law. Complex laws spawn inadvertent errors, as well as opportunities for intentional noncompliance, and contribute to taxpayer confusion and real or perceived unfairness in the tax system.

Studies have shown that taxpayers are less likely to be compliant

if they perceive the tax system to be inequitable.

Now, I recognize that simplification is often in conflict with other

policy objectives. But if a tax system fails to collect from taxpayers

the proper amount of tax due, every other policy objective, whether

it be efficiency, horizontal equity, redistribution, providing social or

economic incentives, or simply financing the government’s needs, is

undermined. Thus, effective tax compliance and enforcement are

core objectives, and simplification is the most important way to

achieve them.

The current and earlier Joint Committee work has provided over

100 specific suggestions on simplification. Let me just say that, in

addition to addressing issues like the AMT and certain larger areas

like education and some of the benefit areas on which we have

made suggestions, I would support the Chairman’s initial point,

which is that, in large part, it is just taking one step at a time.

These are hard issues. Individual provisions should be examined

to see whether they are vulnerable to noncompliance, and if so,

whether the policy objective that was designed for the provision

would justify the level of exposure that the provision provides.

The second principle is to increase the visibility of transactions

by, for example, requiring information reporting and tax withholding whenever administratively feasible. Withholding is the

more effective technique and can be expected to help stimulate improved voluntary reporting and payment of tax apart from any

amounts actually withheld.

To begin to address the problem of income under-reporting by

sole proprietors, which is consistently the single largest contributor

to the tax gap, the staff report proposes requiring withholding on

certain government payments for goods and services.

The proposal can be expected to improve compliance to an important extent without burdening any private sector payors. The proVerDate 11-MAY-2000 10:48 Jul 28, 2006 Jkt 095484 PO 00000 Frm 00033 Fmt 6633 Sfmt 6633 26535.000 SFIN1 PsN: SFIN1
26

posal, thus, attempts to balance the goals of improving compliance,

while not creating undue administrative burdens.

Third, where possible, avoid having tax outcomes depend upon

difficult factual determinations. Such rules present compliance burdens, noncompliance opportunities, and enforcement difficulties.

The report contains proposals to avoid having tax consequences depend upon such determinations such as valuation issues.

In cases where a factual inquiry is unavoidable, the report offers

several rough, more administrable rules of thumb that attempt to

approximate the result that would arise if facts were fully known

and undisputed.

Fourth, treat the taxation of income and deductions consistently.

The mismatched treatment of income and related deductions is a

common sheltering technique. The report contains several proposals to prevent this type of inconsistency.

Finally, as appropriate, supplement technical rules with standards. A strictly rule-based tax system cannot prescribe the appropriate outcome of every conceivable transaction that might be devised by taxpayers. Thus, to improve compliance, technical tax

rules should be supplemented with anti-tax avoidance standards to

ensure that the Congressional purpose is achieved.

The staff report contains a proposal to apply a higher level of judicial scrutiny only to the relatively uncommon transactions bearing the characteristics of tax shelters. In developing this proposal,

the staff examined the characteristics of each listed transaction

and a number of others, including transactions described in the

Joint Committee report on Enron.

By signaling to tax advisors and courts that tax rules should be

interpreted in a manner consistent with Congressional objectives,

the proposal may be expected to reduce tax shelter activity and the

size of the tax gap.

Mr. Chairman, the Joint Committee staff looks forward to continue working with the committee on the proposals contained in

the report, as well as in developing additional proposals to improve

taxpayer compliance and reduce the tax gap.

The CHAIRMAN. Thank you.

[The prepared statement of Mr. Yin appears in the appendix.]

The CHAIRMAN. Now, Ms. O’Connor?

STATEMENT OF HON. EILEEN J. O’CONNOR, ASSISTANT ATTORNEY GENERAL, U.S. DEPARTMENT OF JUSTICE, WASHINGTON, DC

Ms. O’CONNOR. Good morning, Mr. Chairman, Ranking Member.

Thank you very much for inviting me to speak with you this morning about the progress that the Tax Division of the Department of

Justice has made in contributing to closing the tax gap.

While the tax gap remains a significant challenge, it is important

to recognize the dramatic improvements in tax enforcement since

2001, the most recent year for which we have a reliable estimate

of it.

Since then, the 500-plus men and women of the Department of

Justice’s Tax Division, including our 300 attorneys, have, among

other things, brought civil injunction suits to stop tax scams early

27

and at their source, the promoters, even though criminal prosecution might be developed down the road.

We have brought suit against people and firms the IRS suspects

of promoting tax shelters to obtain information about those shelters, including the names of those who engaged in them.

Through our civil litigation, we have also helped the IRS to identify those who have stashed money offshore to avoid reporting their

full income for tax purposes. Through our criminal prosecution programs, we have ensured that, consistent with Department of Justice policy, the most serious provable charges are brought.

The results have been dramatic. Since we began our injunction

program in 2001, we have obtained court orders enjoining more

than 100 tax scam promoters and preparers of fraudulent returns.

When we get these court orders, we also ask the court to order

the promoter to provide the IRS and the Department of Justice

with customer lists. Although total numbers are yet to be determined, it is estimated that these cases involved as many or more

than half a million participants, and attempted to cheat the United

States’ Treasury of nearly $2 billion.

In the sophisticated tax shelter arena, we have proven wrong two

assumptions that permitted this scourge on the tax system to flourish. We have proven that tax shelter promoters and participants

will get caught, and when they do, their opinion letters will not

necessarily get them out of penalties.

Without meaningful penalties, there is no down side to participating in an abusive tax shelter. During the last 4 years, by obtaining authoritative appellate decisions on tax shelters’ lack of merit,

the Tax Division has closed down tax shelters estimated to be

worth over $11 billion nationwide.

The shelter cases that the Division is currently handling impli- cate over $20 billion in taxes, interest, and penalties payable to the

Federal Treasury. The return on investment of dollars spent in the

Tax Division of the Justice Department, depending on who, when,

and what you count, is in the range of 10 to 20 to 1.

The prospect of civil enforcement alone will not convince everyone to comply with the tax laws, so the law provides criminal sanctions as well. Criminal prosecutions deter tax fraud and reassure

honest taxpayers that the law is being enforced fairly and uniformly.

What effect the revival of tax enforcement will have on the tax

gap cannot be measured immediately, but we can already see the

impact on the behavior of tax scam promoters, on taxpayers, and

on tax advisors.

In addition to this anecdotal evidence, a poll the IRS Oversight

Board conducted last July and released last week provides concrete

evidence of our progress. For the first time since the poll began in

1999, the 2004 results showed a positive trend in public confidence

in tax enforcement. The poll results are consistent with our success

in demonstrating our commitment to detect, pursue, and punish

tax offenders.

But that is only part of the Tax Division’s contribution. The Tax

Division is important to the administration of the tax system precisely because it is not the Internal Revenue Service. Rather, it is

part of the Department of Justice, whose name describes its misVerDate 11-MAY-2000 10:48 Jul 28, 2006 Jkt 095484 PO 00000 Frm 00035 Fmt 6633 Sfmt 6633 26535.000 SFIN1 PsN: SFIN1
28

sion. Justice requires that the laws be enforced uniformly and fairly.

The Tax Division can sometimes help lead the IRS into new

areas of tax enforcement, such as our initiative to expand the use

of civil injunctions to stop tax scam promoters.

But for the most part, the input of the Division’s work flow is

driven by the IRS’s output, because only after IRS administrative

tools fail to resolve the matter must the Tax Division come to bat.

Tax Division activity, therefore, is a lagging indicator of the level

of IRS enforcement activity.

The IRS’s recent Son of Boss initiative is a good example of this.

The IRS’s recent announcement concerning the number of taxpayers who participated in the Service’s Son of Boss settlement initiative was striking, not only because of the $3.5 billion the Service

has received through this initiative, but also because, out of nearly

1,800 Son of Boss participants that were identified through Tax Division litigation, one-third of those are not going to participate in

the IRS settlement initiative. That is going to create a litigation

tsunami which is going to be hitting the Tax Division, and is already beginning to hit.

The Tax Division is proud of the role that we have played in providing the enforcement stick that makes the IRS’s carrot of settlement initiatives effective. It is essential that the Tax Division be

able to continue providing the support that is so critical to the

IRS’s success in promoting voluntary tax compliance.

By closing down tax shelters, enjoining tax scams, and appropriately prosecuting criminal activity, we are promoting justice.

There is much left to do, and we in the Tax Division look forward

to continuing to undertake these challenges.

I look forward to answering your questions. Thank you, Mr.

Chairman.

The CHAIRMAN. Thank you.

[The prepared statement of Ms. O’Connor appears in the appendix.].

The CHAIRMAN. Now, Mr. George?

STATEMENT OF HON. RUSSELL GEORGE, INSPECTOR GENERAL FOR TAX ADMINISTRATION, U.S. DEPARTMENT OF THE

TREASURY, WASHINGTON, DC

Mr. GEORGE. Thank you, Chairman Grassley. Chairman Grassley, Senator Baucus, thank you for the opportunity to present testimony on the subjects of the tax gap and the balance that the Internal Revenue Service is attempting to strike among enforcing the

tax code, providing customer service, and protecting taxpayers’

rights.

Mr. Chairman, I believe the importance of these issues cannot be

overstated. Our Nation’s duty to provide for the general welfare

and protect its citizens is based on the ability to raise and collect

revenue on a timely basis through taxes.

Because the tax gap poses such a significant threat to the integrity and administration of our system of voluntary compliance, one

of the top priorities I have set for TIGTA is to identify ways the

IRS can close the tax gap.

29

As you know, the tax gap is not new. In testimony before this

committee in 1982, then-IRS Commissioner Roscoe Egger declared

that the tax gap had been a problem for years, but had reached

alarming levels by rising from $29 billion in 1973 to $87 billion in

1981. While $87 billion was then, and still is, quite a bit of money,

it is dwarfed by the latest IRS estimate that the tax gap now

stands between $312 and $353 billion each year.

Recommendations have been circulating for years on how to close

the tax gap. Some of those made 10 to 15 years ago are still relevant. I have discussed them in significant detail in my written

testimony, Mr. Chairman, and will just touch on three briefly in

my oral comments.

The first recommendation is to simplify the tax code. As you have

heard repeatedly during this hearing, the complex tax code causes

taxpayers to struggle to comply with their tax obligations and the

IRS to struggle to apply the tax law. The Taxpayer Advocate identified the complexity of the tax code as the most serious problem

facing taxpayers.

TIGTA audit work supports her conclusion. We have performed

numerous audits testing the ability of the IRS’s employees to respond accurately to tax questions. We have found that some IRS

employees—whose job it is to help taxpayers with tax questions—

cannot correctly apply the tax code.

Our most recent audit of the accuracy of responses provided by

IRS employees to taxpayers over the telephone found that only 62

percent of the answers given were correct. Much of this inaccuracy

is due to the complexity of the tax code.

The second recommendation that I will touch on this morning to

reduce the tax gap is that the IRS should work with Congress to

develop legislation requiring withholding on non-employee compensation.

Non-employee compensation is money paid to independent contractors who sell goods or perform services, such as sales representatives, painters, landscapers, and the like. According to IRS estimates, $130 billion, or approximately 40 percent of the tax gap, is

attributable to individuals who under-report their business income.

TIGTA maintains that requiring withholding on non-employee

compensation could reduce the tax gap by billions of dollars. GAO

and the Taxpayer Advocate have made similar recommendations in

the past.

The third recommendation I will mention is that the IRS must

continue to address the cost increases and schedule delays that

have plagued efforts to modernize its computer systems.

Modernized systems will provide IRS employees with timely and

accurate information on the status of tax accounts, allowing for improved customer service. Modernized systems will also dramatically

improve the ability of the IRS to collect delinquent taxes, thereby

reducing the tax gap.

Mr. Chairman, you also requested that I address the issue of the

IRS reaching the appropriate balance among enforcement, customer service, and taxpayer rights.

Again, I have touched on this in some detail in my written testimony, but I will say that since the passage of the Restructuring

30

and Reform Act in 1998, the IRS has focused on customer service,

and as a result, customer service has improved.

However, the progress the IRS has made in this area is counterbalanced by the fact that enforcement actions have dropped dramatically. Liens, levies and seizures against noncompliant taxpayers are all down significantly from their totals in the 1990s.

For example, in 1997, the IRS issued over 3.5 million levies; in

2004, just over 2 million levies were issued. The drop in seizures

is even more striking, declining from over 10,000 in 1997 to just

440 in 2004.

Recently, however, enforcement actions have begun to increase.

I believe the recent increase in IRS enforcement actions is a move

in the right direction.

With that said, the IRS must exercise great care not to emphasize enforcement at the expense of taxpayer rights and customer

service. I believe that steps to reduce the current level of customer

service should be taken only with the greatest thought and consideration of their impact, and only with all the necessary data to support their actions.

Mr. Chairman, Senator Baucus, I appreciate the opportunity to

share my views this morning, and I look forward to taking whatever questions you may have at the appropriate time.

The CHAIRMAN. Thank you.

[The prepared statement of Mr. George appears in the appendix.]

The CHAIRMAN. Now, Ms. Olson?

STATEMENT OF NINA E. OLSON, NATIONAL TAXPAYER

ADVOCATE, TAXPAYER ADVOCATE SERVICE, WASHINGTON, DC

Ms. OLSON. Thank you, Mr. Chairman, Senator Baucus, and

members of the committee.

Tax evasion and tax cheating are serious problems for the tax

system and have real victims. The complexity of the tax code also

contributes to the tax gap by causing inadvertent errors and by creating loopholes ripe for exploitation.

If you divide the $256 billion-plus net tax gap by the roughly 130

million individual taxpayers, each individual taxpayer pays, on average, about $2,000 extra in taxes each year to subsidize noncompliance. As the National Taxpayer Advocate, I view this as a

serious violation of the rights of compliant taxpayers.

The IRS is to be commended for aggressively attacking corporate

tax shelters and tax cheating by wealthy individuals. As we move

forward, however, we must address the fact that an estimated twothirds of the tax gap is attributable to noncompliance by self-employed individuals, not corporate tax shelters.

I am concerned that the IRS has not conducted enough research

to design a comprehensive and long-term strategy to increase compliance in that sector.

The IRS’s current guiding principle is: service plus enforcement

equals compliance. Taxpayer service makes it possible, and even

easy, for taxpayers to comply with their tax obligations by providing forms and tax preparation, answers to tax law and procedural questions, and the ability to resolve account problems.

Enforcement is designed to impose consequences on the relatively

few taxpayers who do not comply, and thereby deter noncompliance

31

in general. Unfortunately, the IRS’s equation does not tell us what

is the optimal mix between service and enforcement, because each

of the equation’s elements is a variable.

For example, if we reduce service, there is no guarantee, no matter how much we increase our enforcement efforts, that compliance

will increase overall. Indeed, it is entirely possible that an increase

in enforcement initiatives, offset by a decrease in taxpayer service,

would result in less compliance.

The IRS’s current approach reflects the view that enforcement

activity should be increased while taxpayer service is reduced. Is

that the right answer? Within enforcement, where are our dollars

best targeted?

The truth is, we have no idea. The IRS is able to track revenue

collected as a direct result of its enforcement activities. While that

is useful information, it is the indirect effect of IRS’s activities on

both the taxpayer service side and the enforcement side that generates a far greater amount of revenue.

Even if the IRS only audits about 1 percent of tax returns, for

example, much larger numbers of taxpayers will choose to comply

because of the possibility that they could be audited. Thus, a single

audit has a ripple effect, or in economic terms, a multiplier effect.

But not all audits are created equal. One dollar spent on auditing industries with historically high rates of noncompliance, such

as construction, may have a very different multiplier than an audit

of a corporate tax shelter.

Similarly, 1 dollar spent on making it easier for taxpayers to

comply with their tax obligations—for example, publishing forms,

advertising e-file, answering tax law questions—almost certainly

has a multiplier effect as well. We simply do not have adequate research to show where the next dollar is best spent.

Moreover, in terms of improving overall tax compliance, we do

not have data that show whether the multiplier effect is generally

greater at this time for enforcement or for taxpayer service. Thus,

a decision to increase enforcement and reduce taxpayer service is,

to a large degree, based more on instinct than solid research.

To be sure, this is not easy research to do, and it is a long-term

project. But in the absence of better research, it is important to emphasize that the decision about how much to increase or decrease

certain activities, such as the taxpayer assistance centers, represents merely a policy call based on educated guessing.

In my written testimony and in my most recent report to Congress, I discuss 24 options to address the tax gap. Some of these

recommendations attempt to reduce opportunities for noncompliance, are relatively inexpensive, and can be implemented immediately.

Other recommendations require either legislative action or

longer-term planning and some we may not want to implement for

policy reasons, but many of my recommendations are actionable

and all will have an impact on closing the tax gap.

As the IRS ramps up its enforcement programs, it must ensure

that aggressive enforcement of the laws is balanced by aggressive

protection of taxpayer rights. We must avoid the IRS’s pre-1998

systemic failure to listen to taxpayers’ concerns.

32

Toward that end, an effective IRS enforcement strategy must recognize that Congress established the Taxpayer Advocate Service as

a safety valve against potential IRS enforcement excesses, and for

TAS to accomplish its mission of protecting taxpayer rights, it must

be adequately funded and be a key participant in all program planning.

In sum, I give the IRS high marks for its activities to combat corporate tax shelters and abusive schemes, but I believe the IRS

needs to do much more, and better, research to help it map its future compliance initiatives.

In developing these initiatives, the IRS should keep in mind that

both taxpayer service and enforcement, not enforcement alone, are

responsible for our overall 85-percent compliance rate.

If we erode service to pay for enforcement, I suspect we will end

up not only with a country full of unhappy taxpayers, but with a

lower overall compliance rate as well.

Thank you.

The CHAIRMAN. Thank you very much.

[The prepared statement of Ms. Olson appears in the appendix.]

The CHAIRMAN. Senator Baucus intends to be here to ask questions as well, so, if I get done before he gets here, I will have to

maintain the panel at the table.

First, to Mr. Yin. As you know, over the past 2 years I have

pushed the Senate—and this committee, for the most part, has

agreed with this action—toward what we call the codification of the

economic substance measure. We have done that in several different bills.

This has been very controversial. We have had commentary on

what we tried to do. Quite frankly, the commentary has been almost 100 to 1 against our codification.

I noted with interest that your staff of the Joint Committee has,

for the first time, I believe, taken a position recommending codification of economic substance. The version you recommend in the tax

gap report seems to be very targeted and limited somewhat compared to what the Senate did.

I would like to have you compare our proposal with your proposal

and explain why you think your version might be the better of the

two.

Mr. YIN. I would be happy to do that, Mr. Chairman. As you

know, many of the concerns that have been expressed about the

version that was previously supported in the Senate are simply

variations of one common theme, which is that, if this step were

taken by the Congress and passed into law, it would unnecessarily

create uncertainty as to the tax consequences of many ordinary

business transactions that have nothing to do with tax sheltering

activity.

What we and the staff tried to do is, we tried to take those concerns to heart. We tried to craft a solution which would take the

substance of what the Senate and your committee have previously

advocated, but target it in a way to demonstrate that the focus of

your committee’s recommendation would be on transactions that

have the characteristics of tax shelters.

33

By doing that, we were trying to find some middle ground between a rule that would be too widely applicable and one that

would be insufficiently broad.

We did examine every tax shelter transaction that we were

aware of, including a number of ones that were studied in the

Enron report, to try to develop the appropriate characteristics.

I would say, it is not an easy task. I would not begin to suggest

that we have found the perfect solution, but we were confident

enough to put it out for your committee’s consideration and Congress’ consideration in this important question.

The CHAIRMAN. Ms. O’Connor, again, on economic substance, we

have noted that most of the cases in which economic substance has

produced an inconsistent or questionable policy, results have occurred in the Federal District Court or the Federal Appeals Court,

or also in the Courts of Claims. This generally has not occurred,

in my judgment, in the U.S. Tax Court, I suppose mostly because

of more expertise in deciding taxation questions.

I note with particular concern the recent Coltec case before the

Court of Claims in which the judge declined to apply the economic

substance doctrine because Congress has not acted to codify the

doctrine.

My question is, do you think the Court of Claims and the Federal

District and Appeals Court possess the technical competency to interpret the intent of increasingly complex tax law? Do you think

this is what lays at the base of the problem then on the economic

substance doctrine?

Ms. O’CONNOR. The importance of the economic substance doctrine is directly related to a point that many people have already

discussed this morning, and that is the complexity of the Internal

Revenue Code, and the fact that that complexity permits people

who put together tax sheltering transactions to provide for them a

veneer of legitimacy.

It is penetrating that veneer of legitimacy and explaining to a

court what is actually at the heart of a transaction that does create

some complications for the attorneys who are presenting the case.

I am not sure I understand exactly what your question is with

regard to economic substance. And as to the abilities of judges who

are not tax specialists to entertain tax cases, I probably would be

well advised to say as little as possible. [Laughter.]

The CHAIRMAN. Not being a lawyer, maybe I ought to accept your

judgment on that, because I do not want to get you in trouble. But

I could point out—and I will not ask you to comment further, but

just so you know the basis of my question—there have been a lot

of different opinions on this issue.

I am going to ask Director Everson to speak to the same question

that I asked you.

Mr. EVERSON. We are concerned, Senator, with what can be

forum-shopping by taxpayers based on perceptions of getting a better deal in one court as opposed to another. We do have a uniquely

complex sort of back-end in this system where you can go, just as

you indicated, to any one of the three different judicial review

mechanisms. Perhaps this should be looked at as we look at tax reform.

34

The CHAIRMAN. You can probably comment, because we have had

these different court cases looking at economic substance, to a different point, with the idea that we wanted to leave some flexibility.

But that flexibility has turned into opposite opinions in some cases

of what should be done about the courts at the District Claims and

Appeals Court level.

Mr. EVERSON. I think that is just what I said. It should be looked

at. It is the back-end of the system. I am concerned that there is

forum-shopping that takes place out there.

The CHAIRMAN. So then it seems to me your statement then is

in support of Congress doing some codification.

Mr. EVERSON. I am not addressing economic substance, sir. I am

getting to that broader question you asked about District Courts

versus, say, the Tax Court.

The CHAIRMAN. Yes. That is fine.

Now I want to follow up with another question. Last fall, we enacted the American Jobs Creation Act, shutting down LILOS and

SILOS, but not without substantial concessions to shelter promoters that were in the process of setting up these abusive

schemes.

The Senate-passed version would have shut down this abuse as

of November 17, 2003, which was a year before our enactment.

This tough deadline was watered down to March 13, 2004, 4

months later.

Then even worse, the enacted bill grandfathered in LILOS and

SILOS if the schemes had been submitted for approval by the Federal Transit Administration after June 30, 2003, but before March

13, 2004.

It gives the Federal Transit Agency more time to approve the

schemes until January 1 of next year, 2006. Incredibly, this provides shelter promoters another full year to get their deals approved by the Federal Transit Authority.

Treasury has been forced to grandfather in these rotten deals because of the bill’s effective dates. I understand a special footnote

had to be added to the IRS guidance on this abuse just to carve

out these grandfathered sheltered deals.

Will it help your enforcement effort if Congress goes back and

shuts down this give-away to tax shelter promoters? I want you to

know that I intend to monitor which deals are trying to slip

through the give-away. There is no way these deals deserve another year, but answer my question about the ease of administration, or if that is a concern of yours.

Mr. EVERSON. Senator, I appreciate your concern here. My concern is, this afternoon, I will be over at Ways and Means, and they

did take a different view of this, as you just indicated. Obviously,

I very much appreciate what you did in the JOBS act on shelters

in general.

As you have stated, that was the toughest anti-shelter legislation

since 1986. I agree with that. I appreciate your support. We are

going forward, as you know, aggressively, to work on SILOS and

LILOS on a continuing basis.

The CHAIRMAN. All right.

Before I turn to Senator Baucus, I have a question for Ms. Olson

and Mr. George dealing with the issue of whistle-blowers.

35

I have seen first-hand the enormous benefit that whistle-blowers

can bring to the table in helping all of government, but particularly

those of us in Congress, in fighting fraud. The False Claims Act has brought in over $10 billion in the last

10 years that has been recovered from fraud, particularly in Health

and Human Services, Department of Defense, but also other departments of government. While taxes are not covered by the False

Claims Act, the Congress did give the IRS very far-reaching authority to encourage and reward whistle-blowers.

However, in my view of the whistle-blower program at IRS, it

has been clear that the opportunities of encouraging and rewarding

whistle-blowers have not been realized. I would ask you two your

general views about this matter of encouraging whistle-blowers at

the IRS.

Then I would ask Commissioner Everson to comment on the

steps that the IRS and Treasury have taken to respond to my November letter to Secretary Snow on this matter of very strong importance to me personally, and to this committee.

Ms. OLSON. Mr. Chairman, I looked into this issue last summer,

following your original hearing on the tax gap and listening to the

gentleman who was testifying as the whistle-blower. I have several

folks on my staff who have been very involved in this program in

the past. What we gathered is some information that I found very

interesting.

First, whistle-blowers only cost 4 cents on the dollar—the whole

administration of the program—which is essentially the same cost

of any enforcement program that the IRS runs.

What we also found was that there was really only a single program analyst in the IRS in the Small Business/Self Employment

Division that issues guidance on this program, and that the rest of

the authority over the program is spread out through the whole

IRS.

Individual Revenue agents and Revenue officers make the recommendations about what rewards should be given, and essentially

individually evaluate whether a lead is of any value whatsoever.

There is virtually no involvement or no one in authority in the

Large and Mid-sized Business Division involved in this program,

which is surprising, since so many of the leads involve corporate

tax shelters or issues in that area. It seems like that would be an

area of great impact.

We did make some recommendations including, at the very least,

that the IRS should create a joint task force involving LMSB,

Small Business, Criminal Investigation, and probably TEGE to

really look at the administration of this program and try to get

some coordination across divisions.

We also recommend that they look at the cycle time that it takes

from the point where leads are processed, and then once it is determined that a lead is good, that a payment goes out to the whistleblower. We have other issues that we will be glad to submit to you.

The CHAIRMAN. All right. Thank you.

Mr. George?

Mr. GEORGE. Thank you, Mr. Chairman. Many of the points that

Ms. Olson raised are concerns of the Inspector General’s Office. We

have actually recently begun to plan for, and audit, this issue

36

based on your expression of interest. We would hope to have that

completed in the not-too-distant future. We will definitely keep the

committee staff informed.

I would note, also, I was at an event with former Commissioner

Sheldon Cohen just last week where he raised this very issue. And

while there are positive aspects to it in terms of increasing revenue

and closing the tax gap, he noted that it has been used as an abusive tool in the past, too, and that is something that we want to

certainly take into consideration when we consider this program.

The CHAIRMAN. We were talking about this being more used at

the corporate level than at the individual level. Was that clear to

you?

Mr. GEORGE. Well, I will make sure that we take up that point.

The CHAIRMAN. All right.

Now, Commissioner Everson, I ask you to comment just on a little different variety of my question about the response of your

agency and Treasury.

Mr. EVERSON. Yes. We are looking at this. You and I have had

conversations in the past. I know you had it in legislation and it

got stripped out. We want to do more here. As you know, we have

no shortage of leads on problems within the code. We would like

to do more here.

We want to make sure that anything that does happen here

statutorily has the right context to it, so that people who have been

involved in promotions, as an example, cannot take advantage of

this. It would have to be very carefully crafted to make sure that

the right people who truly are independent of the conduct do not

benefit from participating in this.

The CHAIRMAN. Could I ask you to comment on the fact that you

have fairly broad authority in this area already, and the extent to

which there is, in my judgment, not sufficient use of that broad authority?

Mr. EVERSON. Yes. I think we probably can do more in this area.

I will be anxious to see what the Inspector General comes up with

in terms of specific recommendations. I think that will be a useful

exercise for us.

The CHAIRMAN. Thank you. I thank you all for your answers to

the questions.

Senator Baucus?

Senator BAUCUS. Thank you, Mr. Chairman.

Just kind of a question, a clarification here, Commissioner. In

the GAO report, on pages 13 through 15, essentially it points out

that there is an increase of examination rates of individual filers,

but that has been driven mostly by correspondence examinations,

while more complex field examinations have continued to decline.

In fact, there is a chart in here which basically makes that point

clear on how the correspondence is going up, but actually the field

examinations—that is, audits—is declining. Is that accurate? Just,

your comment about that.

Mr. EVERSON. I make it a practice not to question GAO facts, but

that is substantially correct. I think that is a good thing. Correspondence audits are a very effective tool. If you look at what we

are doing, it enables us to make selected inquiries on particular

matters.

37

For high-income individuals, my recollection is—and I will confirm this figure for the record—that when we did correspondence

audits in the last year, we were getting something like $16,000, on

average, for the audit in terms of the monies that would be assessed and coming in. Highly effective. You target one or two areas

and go forward.

Now, we are trying to bring up the field audit rates, too. I think

they are starting to edge up, particularly on the high-income folks

as well. But we are not abandoning field audits, not at all, but we

are trying to target where we do our work.

Senator BAUCUS. I would like whomever can answer this and has

a strong view to address this: where do we get the greatest bang

for our buck? I ask that question because of that, and I looked at

your charts, Commissioner. Here is one. This is in no order. It says,

‘‘Criminal prosecutions recommended.’’

Mr. EVERSON. Right.

Senator BAUCUS. It is a big increase. Well, a percentage increase.

On an absolute basis, an increase, too, but not nearly as high as

it was back in the late 1990s.

Mr. EVERSON. That is correct.

Senator BAUCUS. This has, for fiscal year 2004, 3,000, roughly,

pursued, that is, criminal prosecutions recommended. So my question really is, what was the result of all that? How many were actually followed up? How many reached settlement? How many were

prosecuted? What is the result, also in terms of revenue?

Mr. EVERSON. Sure. Let me make the first point, and then, of

course, defer to Attorney General O’Connor.

That is the front end in the sense of, those are what we send

over from our Criminal Investigations Division as recommendations. Justice has to go through their own process.

Senator BAUCUS. I understand. That is my question.

Mr. EVERSON. Then there is a lag time here, as she indicated.

Senator BAUCUS. I understand that. I am asking about the result.

Ms. O’CONNOR. The results are excellent.

Senator BAUCUS. Quantify the results, please.

Ms. O’CONNOR. There are some results that are not quantifiable.

In the last 4 years, we have increased the number of prosecutions

we have authorized per year by 60 percent. Last year, we authorized nearly 1,400 criminal tax prosecutions.

What is difficult to quantify is the deterrent value of that. Now,

when we prosecute a tax criminal, we are after not only the deterrent effect that the publicity that we are doing that is going to

gain, but we also want to collect the tax.

The Tax Division, in the last few years, has instituted a program

of working with U.S. Attorney’s Offices and the Internal Revenue

Service to make sure that, when someone is convicted of a tax

crime, they not only go away to prison for a few years, but they

also pay the taxes.

Senator BAUCUS. All right.

If I might, again, 3,000 pursued. How many actually prosecuted?

Ms. O’CONNOR. Three thousand is the number in the IRS

records. That is not all tax crimes. That 1,359, those are prosecutions that we authorize. More often than not, those do go all the

38

way to prosecution. Those are not already prosecuted. We will authorize an investigation or a prosecution. It takes time, then, for

the prosecution to go forward, so I do not have a final number for

you on the number of people we convicted.

Senator BAUCUS. I understand that. Well, let us go back to 2002,

in the last 3 years, 2002, 2003, and 2004. For the record, what is

the number of criminal prosecutions recommended by IRS? Of

those, how many were prosecuted? Of those, how many resulted in

settlement? Of those, how many judgments did you get favorable

to the IRS, and the amounts? If you could do that, please.

Ms. O’CONNOR. We would be happy to provide that for the

record.

[The information appears in the appendix on p. 275.]

Ms. O’CONNOR. Let me just say, generally, though, with our prosecutions, they are either going to be prosecuted or they are going

to plead.

Senator BAUCUS. I understand. That is why I broke it down. I

understand that. The same is true, if I might, for the high-income

audits. That is, how much? There is significant increase, as you

pointed out, Commissioner, from fiscal 2001 to fiscal 2004?

Mr. EVERSON. Yes.

Senator BAUCUS. Again, on an absolute and a proportionate

basis, how much was recovered from those audits?

Mr. EVERSON. Sure. If you go back to the chart on the enforcement revenues, this shows the progress we have made. When you

get into a discussion of the overall tax gap, just between 2001 and

2004 there, it has gone from 33.8, I believe it is, to 43.1. That includes a bump-up in collections, but a very big bump-up in examinations that includes just these kinds of results as we get more

money. I will be happy to provide you the background.

Senator BAUCUS. I am just curious.

Mr. EVERSON. Also, so you can see the correspondence audits.

Those are a good deal for the taxpayer.

Senator BAUCUS. That would be good. That would be good.

And you have one chart on high-income audits.

Mr. EVERSON. Yes.

Senator BAUCUS. You have another one on individual audits. I

assume that high-income is a subset of the individual ones.

Mr. EVERSON. Yes, it is, sir. Yes, sir.

Senator BAUCUS. All right.

I am just concerned, frankly, about the data we have, or do not

have, to tell us the size of the tax gap, where it is, and that kind

of a thing. I think this is your study. I am not sure which study

this is.

Your research program which you just concluded states that

under-reporters make up about 80 percent of the tax gap.

Mr. EVERSON. Yes.

Senator BAUCUS. I am a little concerned that you have not updated, though, the non-filer figures since 1988.

Mr. EVERSON. Right.

Senator BAUCUS. That is about 13 years ago. I have a hunch our

society has changed a little bit. You say that is about 10 percent

of the gap, non-filers, as I recall.

Mr. EVERSON. Yes.

39

Senator BAUCUS. I am just curious why you are not looking at

non-filers.

Mr. EVERSON. I want to make one clarification, too. I think

maybe our report has been a little misleading. I have never said

that that whole tax gap was in the State of Montana, as you have

it on that map. [Laughter.]

Senator BAUCUS. I appreciate that.

Mr. EVERSON. Can we go back to the tax gap map itself? You can

see that we have color-coded this. You should, I think, have a copy

of it in your materials.

Senator BAUCUS. I do.

Mr. EVERSON. Where we have said, green is where we feel the

numbers are good, blue is where we feel the numbers are all right,

and yellow is where they are suspect, let us say.

To get to the non-filing, the reason we have estimated that as

blue, as good, is because what we can do is we can take a look at

census data and use that census data in conjunction with what we

get about individuals to do a reasonable estimate of the size of the

non-filing gap.

I am not worried that the non-filing gap that is out there at the

left is improperly sized in terms of an order of magnitude. The

number that I think that is a potential problem out there, just as

your colleague Senator Conrad and others have said, is the corporate area, because we have not updated those numbers. That is

based on compliance behaviors, if you will, from 1988 taken forward into 2001, the old model.

Now, let us go to our pie chart, if we could, on the allocation of

the resources. I think that the decision that was taken a couple of

years ago to do the individuals first was the right one.

Senator BAUCUS. I am sorry, Commissioner. I was distracted. Go

ahead. I am sorry.

Mr. EVERSON. Yes. All right.

I want to emphasize that the decision that was taken a couple

of years ago to do individuals first, that was the right one, because

it is such a preponderant part.

Senator BAUCUS. It sounds like it.

Mr. EVERSON. But going beyond this, the other thing is, as you

know, and Senator Grassley knows, our budget request and our

whole efforts have been geared in the last several years to highincome individuals and corporations, the work we have been doing

in those areas. So, I am comfortable that we have waited to get

after this piece.

We do need to, as you have said, as the GAO has said, in the

coming months, to make sure we look at what our long-term research program will be and fit this in. The next thing we are going

to do is flow-throughs. That is a very important piece of this. But

I think the sequencing we have done here is right.

Senator BAUCUS. Right. Now, if you could just help me understand. Are you going to go back and look at non-filers?

Mr. EVERSON. I think we are going to be doing more work in refining the non-filer work over the next year. My research director

is confirming that to me. Yes.

Senator BAUCUS. All right.

What percent of individual taxpayers are non-filers?

40

Mr. EVERSON. About 10 percent.

Senator BAUCUS. Ten percent of all individual taxpayers are nonfilers?

Mr. EVERSON. Well, that is the figure you see. If you go back to

that figure, the non-filing gap, it is about 10 percent of the total.

The under-payment gap is about 10 percent as well. That is the

balance where someone recognizes that they have got a balance

due to us and then does not pay it.

Senator BAUCUS. Now, the yellow boxes here.

Mr. EVERSON. Yes.

Senator BAUCUS. When are we going to get to those?

Mr. EVERSON. I think we will reach those judgments over the

coming months, and when we present the President’s budget next

year we will have finalized what the sequencing and the fund investment is on this. It costs about $100 million to do this work on

individuals over a couple of year period. I will be honest with you.

When I got on the job—it is about 2 years now—the first thing

I was asked, the head of the Small Business Division said to me,

can we not cut out doing this national research program, because

it took so many auditors off-line. But we said, no, even though you

in the Congress did not give us as much money as the President

requested. So, there is a squeeze here and we are trying to balance.

Senator BAUCUS. Not us. Others.

Mr. EVERSON. Well, you are doing your best for us, and I appreciate that.

Senator BAUCUS. It kind of raises another question. Let me back

up. Last July, Senator Grassley and I sent you a letter asking you

to recommend certain procedures, actions that should be taken to

get at the gap.

Mr. EVERSON. Right.

Senator BAUCUS. Especially with respect to, I think it was the

cash economy, independent contractors, the self-employed. I think

that is what it was. I asked you to rank solutions according to burden on a taxpayer so we could get some sense of how to resolve all

these, not keeping you totally blind of the politics of this, because

obviously you have to do what is right here.

Mr. EVERSON. Right.

Senator BAUCUS. Actually, it was not a letter I sent you, it was

at a hearing.

Mr. EVERSON. It was an exchange somewhat like this.

Senator BAUCUS. That is what it was, somewhat like this.

Mr. EVERSON. Yes.

Senator BAUCUS. And you said you would get back by March 31.

Can you give me an idea of when we are going to get that?

Mr. EVERSON. Let me make a broad comment about attacking

the tax gap. As others have indicated, I look at this, as there are

two sides of this. The first side is improving the enforcement. That

is a big block of it.

The second side of this is statutory reform. We have been improving enforcement. We are doing two things. We are improving

our internal processes and we are also trying to augment our resources.

Within reform, we have to consider issues like reducing complexity, just what you talked about this morning. I have testified

41

to the Tax Panel about reducing the number of education credits.

People will be better able to understand what they are doing and

avoid inadvertent errors.

Senator BAUCUS. Right.

Mr. EVERSON. We have to look at increased reporting. This is an

example. There is a continuum here between increased reporting,

which is somewhat burdensome. The example that is always cited

here is that, in 1986, the Congress took its decision to request that

you put down a Social Security number on dependents. Before that,

you did not have to do that. The next year, 5 million dependents

vanished.

So even though there is not necessarily a change in enforcement,

just reporting itself has a positive effect. So, you can move, as

many have suggested and has been discussed this morning, to requiring reporting for payments to businesses or to other unincorporated service providers. Then you can go all the way up to withholding.

You asked what the dollar value of that would be. I cannot tell

you that right now until we refine our estimates. That does not

sound like you got much out of your inquiry last year. I want to

assure you, you really did. Mr. Mazor, behind me, did not want to

give me the ranges we have given you on March 31.

Senator BAUCUS. He works for whom?

Mr. EVERSON. He works for me. But we are quite sensitive about

telling our career people to come up with the numbers in any way

that might imply that they are being rushed in their work.

So what we have done here is we have bracketed these estimates

right now, as I said in my opening statement, and we will refine

them over time. Then we will be able to better answer the question

you asked, sir, as we get a little more detail on this.

Senator BAUCUS. All right. So, again, when? When will we get

what?

Mr. EVERSON. At the end of the year, what we will have is the

refinements of these estimates that will say how much. Let us go

to the individual line items. We need copies of this, I think, for the

members.

Senator BAUCUS. What I am really getting at is, when will we

get a response to the interchange that we had last July?

Mr. EVERSON. Well, when the research is completed. I indicated,

if you go back and look at that record, that this would be dependent on the research. We now have ranges established in these

areas. We are going to tighten these ranges up on each of these

line items.

As has been indicated, a lot of this is in the business income

under-reporting by individuals, so you cannot say how much are

you going to get until you know how big the problem is.

We will have that refined by the end of the year. Then what you

have to do, sir, is you have to marry up that increased reporting

and the other things that should be considered in the tax reform

initiative as well.

Senator BAUCUS. So what kind of metrics make sense? If we

want to find out how we are progressing here or not progressing,

what kind of metrics make sense?

42

Mr. EVERSON. Obviously, that enforcement revenue metric is a

key one. I am concerned. The Comptroller General and I had a conversation last evening—we were talking about today’s testimony—

just on this point that was raised, Section 1204.

It is a little tough, I think, for you to hold the IRS accountable

to get metrics results here if, as 1204 says, I cannot hold individuals accountable for getting results. So, that is a dynamic we need

to talk about as we establish the metrics here, because a lot of this

does tie to enforcement.

Senator BAUCUS. What about his suggestion about being more

creative with SES employees?

Mr. EVERSON. That is impossible under the law right now. The

law says the Internal Revenue Service shall not use records of tax

enforcement results to evaluate employees, and then it goes on

about quotas. Senator Grassley and I have had a conversation on

that.

I do not want any quotas for my people, but it is kind of crazy

if I have Revenue agents out there and they are complying with

every procedure that RA has that protects taxpayers, every procedure, they are doing it right, they are following all the processes,

but Chuck Grassley is taking in half as much money as Max Baucus.

Now, I use that example only because Senator Baucus is asking

the question. [Laughter.] Even though you are both following all

the procedures in the law, you are doing twice as well, we cannot

recognize the differentials.

Senator BAUCUS. All right.

What about you?

Mr. EVERSON. Well, I do not know.

Senator BAUCUS. We can hold you accountable.

Mr. EVERSON. I think you are doing a good job of that. [Laughter.]

Senator BAUCUS. But, I mean, whatever way you think works

best for you. I think you are doing a good job.

Mr. EVERSON. Thank you.

Senator BAUCUS. If we asked the Commissioner of the IRS to

come up with certain data by certain dates, can we not leave it up

to you to figure out how to do that?

Mr. EVERSON. Yes, we can, and we are doing it on things like

this.

The other point I want to make, though, is going back to what

David Walker said. You are not helping us because of the instability in the system. As the code keeps changing as we try to deliver metrics, it is tough.

Let me give you the simplest example here. Since 2001, you have

said the gap is higher. Well, that may or may not be true.

The individual piece where the noncompliance rate is relatively

high, those receipts have declined since 2001 from about $994 billion to, projected, under $900 billion this year. So, the impact of

noncompliance in the individual sector is actually lower in terms

of lost money.

On the other hand, you had an increase in the receipts that have

come in from corporations and from employment taxes since that

43

time, so there is a mixed question here, independent of other

changes that are taking place.

Senator BAUCUS. Maybe we should ask you to give us recommendations to simplify the code.

Mr. EVERSON. Well, I can only suggest to you that I have testified before the Tax Panel. I have had conversations with the Secretary. I had one with him just last week. He is very cognizant of

the compliance issues. If I can take just 1 more minute, with the

indulgence of the Chairman, I will tell you the five points of reference that I have indicated that I think are important for tax reform.

The first is that we have to build a system that is for the 21st

century, and not for the 1960s, that recognizes just these kinds of

changes where before people worked for AT&T, or the post office,

or the IRS. As I indicated, we get a lot of good information on that.

But the world has changed. There are many more self-employed

people, people who are independent contractors. It is against the

law for us to look at the issue of who an employee is. That has

been frozen since 1969. We need to look at the changes in the system there.

Senator BAUCUS. Other areas?

Mr. EVERSON. The second point. We need to look at the effect the

attitudes towards compliance will be. The President has talked

about that, in saying that appropriate progressivity must be retained. Obviously we cannot be perceived as harming one element

or another.

A third area is administrability. You are not going to do us any

favor if you bolt on new taxes, like the VAT, without simplifying

other areas. That will make it harder.

The fourth point is a very simple one: do an apples to apples

comparison. There are compliance problems in all systems. Do not

compare a suboptimized system today with a perfect, theoretical

system.

Then the last point, sir, is just pay attention to the transition.

We cannot afford to just slap this together and have a rocky start.

If we have a rocky start, it will take us decades to recover.

Senator BAUCUS. I appreciate that.

This is my last point, or question. Who is in charge in the administration? Is there a sense of urgency in the administration? Has

Karl Rove talked to you about this, for example?

Mr. EVERSON. On tax reform or the tax gap?

Senator BAUCUS. Well, reform, gap. They are part of the same

problem. As every panelist has said, part of the gap solution is reform.

Mr. EVERSON. Yes.

Senator BAUCUS. So I am just asking, who is in charge of trying

to close the gap? Is it the Secretary? Is it the President? I mean,

there are a lot of disparate parts here. You have the Service, you

have the Tax Division, you have the Taxpayer Bill of Rights, you

have the IG, and who knows who else.

We have these kinds of hearings often. But my belief is, we are

more likely to get it if somebody really cares at the top in the administration and cracks the whip a little bit if it gets people working together to address the gap.

44

Mr. EVERSON. I think the President has very much indicated his

support for addressing this, through the budget request he has

made for the IRS. As you are well aware, the average non-homeland, non-DoD domestic discretionary program is down 1 percent in

the budget. We are getting a 4-percent increase.

Second, he has introduced reform. Those are the twin elements

that have to take place, as everybody has said this morning, for us

to get this job done.

Senator BAUCUS. Well, you are a good soldier, Commissioner, and

I appreciate that. But I, frankly, do not see it yet, and I hope to

see it.

Mr. EVERSON. Well, I will share your concern, sir.

Senator BAUCUS. Thank you very much.

Thank you.

The CHAIRMAN. Thank you. I have four questions. I hope all of

you do not have to go to the bathroom yet. [Laughter.]

Commissioner Everson, I would like to follow up on my program

where we were talking about whistle-blowers, but now I want to

turn to an area where, by contrast, the administration has shown

tremendous zeal for involving the private sector. That would be in

the area of private debt collection that Congress authorized last

year in the JOBS bill.

However, it is my understanding that this program still has not

gotten off the ground. I would ask you for its status, and also ask

any other panelist for their comments on this program, that is, how

much tax gap is represented by uncollected taxes.

Mr. EVERSON. Yes, Senator. I am happy to do that. This is an

important new tool for us. As you have indicated, over 40 States

already use private collection agencies to supplement their own efforts. We have to do this right, though, because of the very real

concerns that people have about privacy, about debt collection in

general.

So we are working now to let initial contracts on this, and they

will be let in about 2 or 3 months. We will begin collecting the

monies, I would suggest to you, in January of next year.

The reason for the lag here is that it is the interaction of the systems. We have to do a lot of work in our computer systems because, if Mark Everson has a balance due, you cannot have somebody calling from a private collection agency if I have just sent the

check in last week.

So, you have got to make sure that we interact correctly with

these folks, but they cannot have broad access to our system. We

have to set up a new, very protected system that both gives them

the current information they need, but no more than they need to

do this work. So, that is going to take us a little time.

The other thing we are very cognizant of is, we are only going

to get one chance to do this. This was, as you know, a closely debated question. We are very appreciative of the additional authority, and I think it is going to make a real difference, though.

The CHAIRMAN. All right.

Mr. George?

Mr. GEORGE. Thank you, Mr. Chairman. The Inspector General’s

Office supports the Commissioner’s deliberate approach to this,

given the high stakes involved. If this thing, as the Commissioner

45

noted, is done incorrectly, it could truly adversely impact the people who are least in need of the harmful effects of this.

My office has developed an audit plan. We will closely monitor

this matter and we will assess its effectiveness as soon as it is up

and running. We hope to do that as soon as the announcement is

made as to who the PCAs are.

Ms. OLSON. Mr. Chairman, my office is working closely with the

team in the IRS that is trying to design this. Our particular focus

is ensuring that the collectors are trained on taxpayer rights.

We are actively monitoring a referral program so that cases

where taxpayers are concerned come to my office to have their

cases worked, working with the IRS, so that we can monitor what

is going on with this program to make sure that it does not have

an impact on taxpayer compliance and that it does not cause any

of the violations that the Commissioner has talked about.

The CHAIRMAN. Yes. All right.

Mr. Commissioner, there is this recent study by TRACK, the research organization at Syracuse that released a report that states

that, while big corporations involved in agriculture and manufacturing are nearly always audited by the IRS, that big banks and

insurance companies are only audited 20 percent of the time. With

the involvement of the farmers, it causes me to ask whether you

agree with the analysis of TRACK. This study raises serious questions about the need for full answers.

First, I would ask that the IRS clarify this issue for the committee by providing industry-by-industry audit rates and by size of

firm for large- and mid-sized corporations.

I would also like the IRS to provide the amount of tax voluntarily

paid by each sector, as well as the amount assessed and ultimately

paid by the sector in response to IRS audits.

Second, a senior IRS official was quoted, in response to TRACK,

as saying that the IRS allocates corporate auditors based on areas

with high risk of tax evasion, so then I ask the IRS to provide the

committee the analysis it used to make that determination.

Finally, the committee benefits from outside analysis of the work

of the IRS, such as performed by TRACK. And while I do not want

the IRS unduly burdened with complying with FOIA requests, I

also expect the IRS to make available to analysts audit and exam

information. The public benefits from openness in this area, and we

should be able to have an honest discussion based on those facts.

So, those are just requests, now.

Mr. EVERSON. I would be happy to comply with those requests,

sir.

The CHAIRMAN. All right.

[The information appears in the appendix on p. 276.]

The CHAIRMAN. Question. We recently developed testimony regarding the abuse of the research and development credit. We have

learned from conversation with the IRS that there are enforcement

problems regarding the definition of ‘‘qualified research,’’ the proper treatment of allocated expenses, and abuse of the reduced credit

election.

Last year, we learned that, after the credit was claimed, the

technology was unsuccessful. The patents were donated to charity

46

in exchange for an inflated deduction. We shut down that abuse,

as you know.

This year, we are learning that intangibles are migrating offshore to avoid tax through abuses of the transfer pricing rules and

cross-sharing agreements. We are also reviewing what role the advance pricing agreements may play in this area.

Is there a bigger problem with intangibles that Congress should

be focusing on? Is it time for Congress to step into the fray with

legislation?

Mr. EVERSON. Senator, this is an area of concern. You have covered a lot of ground in laying out that problem. As I have indicated, issues relating to corporations are very significant for us.

Your committee has been very helpful in terms of highlighting the

APA.

In particular, our Chief Counsel, Donald Korb, has had a series

of public hearings on this. I think we will be able to share with you

some initial conclusions quite soon about where we need to go in

this area. So, we do need to look at this. Intangibles are important

and are a focus for us.

The CHAIRMAN. All right.

To Ms. O’Connor and you, Commissioner, your testimony noted

that you have had considerable success in obtaining shelter promoter information, notwithstanding attempts by promoters to hide

behind Section 7525, the accountant-client privilege section.

It would seem to me that you have been dealt a significant blow

in your war on shelters by a ruling of Judge Holderman of U.S.

District Court for the Northern District of Illinois in the BDO

Seidman issue, where the judge held all but one of the 267 documents for which the accounting firm asserted privilege from IRS

scrutiny.

Would you comment on the impact of that ruling and whether

you need additional support from Congress in overcoming these

types of procedural road blocks to anti-shelter enforcement?

Ms. O’CONNOR. I think to call the recent decision by Judge

Holderman in the BDO Seidman case a significant blow in our efforts is a vast overstatement. I prefer not to comment on particular

litigation, particularly since this is a recent decision, and decisions

about whether to take an appeal are still under consideration.

I will note, however, that in this case this is one in a series of

rulings in the government’s efforts to get information from this

firm, and we have been largely successful. These particular documents were a small subset, a vast majority of which we have already obtained, and which the IRS is already putting to good use.

As for your offer of additional support, I am always happy to

have the Senators’ support for additional enforcement.

The CHAIRMAN. I must ask, is there any reservation in the response you just gave to me, a la your reluctance to make a point

of view to our committee on whether District Judges, Circuit

Judges, and Courts of Claims are competent to issue on tax decisions?

Ms. O’CONNOR. You can ask very difficult questions. The Commissioner properly noted that taxpayers have a choice of forum.

They can ask the Tax Court to redetermine the Commissioner’s deVerDate 11-MAY-2000 10:48 Jul 28, 2006 Jkt 095484 PO 00000 Frm 00054 Fmt 6633 Sfmt 6633 26535.000 SFIN1 PsN: SFIN1
47

termination that they owe additional taxes, or they can go to a District Court or the Court of Federal Claims.

Certainly, when a taxpayer takes a case to the District Court of

Federal Claims, they are going to find a judge who is not a tax specialist. That is true of any particular technically complex area of

law. Part of the duty of the advocate is to explain everything that

is necessary, sometimes within page limits.

And with the schedules that the judges set, sometimes perhaps

it is not always possible to explain everything that one needs to in

order for the court to see things that would support the government’s position.

I point out, however, that some of the recent setbacks you mentioned are also just at the trial level. And again, we have as an option to have a Court of Appeals take a look at those decisions.

The CHAIRMAN. All right.

Now, Commissioner Everson, and then we will dismiss the panel.

Mr. EVERSON. One of the singular achievements of the last several years has been in this area in terms of the professionals who

this country entrusts to give advice to taxpayers to pay, as you say,

no more than what they owe, but what they owe.

Too many of them, through these abusive shelters, were doing

just the opposite. They were into value creation and risk management and they tried to obscure the facts from the IRS by saying

that it was traditional privilege. That has been, I believe, substantially rebutted.

This is further strengthened by the good work you have done in

the JOBS Act. Because of the penalties that are in there for nondisclosure or list maintenance problems, we have got a lot of tools

here. I think we have turned the corner here.

We encourage the Justice Department to be aggressive in supporting our positions here. We are not going to win every case

every time, but we want people to know that when they say ‘‘no

dice,’’ we are going to continue to pursue it. We respect the courts.

When they tell us we are wrong, obviously we abide by that. But

we count on the Justice Department. They have done a great job

on this privilege litigation.

The CHAIRMAN. All right. I thank you all very much for your patience.

Now I call the third panel, two people. Kevin Brown, Commissioner of the Small Business/Self-Employed Division of IRS, testifying about four major areas of continued compliance problems in

the fuel distribution system.

Then we will hear from Ms. Nancy Jardini, Chief of Criminal Investigation, overseeing IRS investigations of criminal violations of

the tax code. She will discuss IRS efforts to combat fuel tax credit

and fuel excise tax evasion.

I am going to ask Mr. Brown to go first, then Ms. Jardini.

STATEMENT OF KEVIN M. BROWN, COMMISSIONER, SMALL

BUSINESS/SELF-EMPLOYED DIVISION, INTERNAL REVENUE

SERVICE, WASHINGTON, DC

Mr. BROWN. Good morning, Mr. Chairman. I appreciate the opportunity to be here today to describe recent compliance trends and

48

issues in highway-related excise taxes, and to highlight Internal

Revenue Service activities to address them.

I would also like to thank your committee staff members who assisted us during the preparation for this hearing.

Fuel excise taxes are an important source of Federal and State

revenues and finance a large share of improvements to the Nation’s

transportation system. The excise taxes imposed on gasoline, diesel

fuel, and kerosene account for more than 90 percent of Federal

Highway Trust Fund receipts. For fiscal year 2004, the fuel tax receipts deposited into the trust fund totaled $35.7 billion.

Maintaining the flow of receipts into the trust fund requires vigorous compliance activity. Federal and State excise tax rate increases over the years have increased incentives for tax evasion.

The ongoing revenue losses are a significant problem for tax administrators and for honest business taxpayers facing competition

from tax evaders.

The IRS has identified multiple points within the fuel distribution system that facilitate fuel tax noncompliance. First, the misuse

of dyed diesel fuel for tax evasion purposes persists, despite the numerous legislative and regulatory steps taken by Federal and State

governments. During fiscal year 2004, the IRS conducted more

than 120,000 fuel inspections and assessed over $4.6 million in

penalties for misuse of dyed fuel.

Fuel ‘‘bootlegging’’ is a second significant problem. Taxpayers

evade payment of taxes to a high rate jurisdiction by bootlegging

the fuel from a jurisdiction with a lower rate. This activity occurs

between States frequently, costing the States tax revenues and

their share of the Federal Highway Trust Fund.

A third critical compliance problem is associated with improper

declarations of motor fuel on import/export documents. This activity, which involves bringing taxable fuel into the United States in

a manner that evades payment of any and all excise taxes, occurs

at border crossing points and points of entry for ocean-going vessels.

Finally, the creation and use of adulterated fuel through

‘‘cocktailing’’ (or blending) the product is a significant compliance

problem. This technique generates higher profits by increasing the

volume of diesel fuel with used motor oil and other distillates, including pollutants, cleaning agents, and unfinished refinery products. This activity not only results in an ongoing revenue loss, but

also may be dangerous to the public when hazardous waste is

blended with taxable fuels.

In the last decade, there have been four major excise tax compliance success stories, all of which reduce significantly the opportunities for tax evasion. First, moving the point of taxation for motor

fuels from the distributor back to the terminal. Second, requiring

home heating oil and other diesel products to be dyed red if sold

tax-free. Third, taxing undyed kerosene on the same basis as the

regular diesel fuel. Finally, implementing the Excise Summary Terminal Activity Reporting System, also known as ExSTARS.

ExSTARS enables the IRS to track all fuel transactions that

occur within the fuel industry’s bulk shipping and storage system

and provides the capability to track fuel from the pipeline system

49

to the point of taxation for the Federal excise tax at the terminal

rack.

Through ExSTARS, we receive information on six to nine million

fuel transactions monthly, from over 96 percent of registered terminals. The fact that 30 percent of these reports come to the IRS on

paper has hampered our efforts to use the data to detect under-reported tax on individual excise tax returns.

However, this will be changing in January of 2006, and I want

to acknowledge this committee for its lead role in including mandated electronic filing of information reports in the recently passed

American Jobs Creation Act.

Mandated electronic filing, coupled with recently enacted legislation for increased penalties, will enable us to close the gaps in information reporting for ExSTARS.

In conclusion, while many challenges remain, I believe that we

are making progress in our goals to ensure that Federal motor

fuels taxes dedicated to the Federal Highway Trust Fund are reported and paid.

This progress is due in no small measure to the continued leadership, guidance, and active support of our excise tax programs from

this committee and the Congress.

Mr. Chairman, I thank you for this opportunity to appear before

this distinguished committee, and I would be happy to answer any

questions you and the other members of the committee may have.

The CHAIRMAN. Thank you.

[The prepared statement of Mr. Brown appears in the appendix.]

The CHAIRMAN. Now, Ms. Jardini?

STATEMENT OF NANCY J. JARDINI, CHIEF, CRIMINAL INVESTIGATION, INTERNAL REVENUE SERVICE, WASHINGTON, DC

Ms. JARDINI. Good afternoon, Mr. Chairman. It is a privilege to

testify here today with my colleague, Mr. Brown. I want to echo his

comments of thanks to your staffs for working with us to prepare

testimony on these important issues.

The Internal Revenue Service’s Criminal Investigation Division

works to detect, halt, and investigate tax fraud and to protect the

revenue. Our testimony today will focus on our very limited, but

important, role in the overall IRS efforts involving compliance in

the areas of fuel tax credits.

Fraud related to fuel tax credits is definitely on the rise. CI addresses this on several fronts. We halt fraudulent refunds from

being released; we criminally investigate fuel tax credit claims that

are fraudulent; we refer questionable claims for civil examination;

and we accept referrals of developed criminal conduct from the

Small Business/Self-Employed Division.

From 1999 until today, CI’s overall efforts to detect and deter refund crimes have resulted in stopping nearly $4 billion in false refund claims associated with a broad variety of schemes, including

the fuel tax credit.

CI employs a highly sophisticated data mining system, known as

the Electronic Fraud Detection System, which houses more data

than any other computer system at the IRS, with the exception of

the master file, and has the capability to combine refund returns

with other IRS files into one centralized system. This enables us

50

to quickly detect suspicious activity and identify anomalous patterns.

During the 2003 filing season, we identified the fraudulent use

of the fuel tax credit as an area of emerging concern, identified

over $19 million in suspicious fuel tax credit claims, and initiated

22 criminal investigations.

Nonetheless, the number of schemes continued to rise in 2004,

with a total of over $30 million in suspicious claims identified. In

response, CI almost doubled the number of criminal investigations

in this area.

Some of the characteristics of these schemes include stolen taxpayer identities, the use of Schedule Cs, multiple years of returns

filed concurrently, and returns filed in different IRS processing centers.

I would like to point out that just yesterday an indictment was

handed up in the District of Minnesota involving almost $2 million

in fraudulent fuel tax claims claimed in 978 Federal income tax returns during 2004.

After the original scheme perpetrated by a return preparer was

discovered, IRS data mining tools allowed us to trace other returns

originating from the same source. Of those returns, 99 percent contained false fuel tax credits.

In January of this year, an individual was sentenced to Federal

prison for submitting false claims for refund of the fuel tax credit

in the District of Wisconsin.

In that case, the IRS processing center noticed a number of returns claiming the fuel tax credits for individuals who, due to their

occupation, would not be expected to be able to claim that credit.

The defendant was part of a scheme with others who filed claims

totaling over $90,000 in fraudulent fuel tax credits.

In another recent scheme, we have identified over 4,200 tax returns claiming more than $6 million in fuel tax credits utilizing

paper returns and Schedule Cs, and that investigation is currently

ongoing.

Based upon the emerging fraudulent conduct identified in this

area, we have several initiatives under way. We are continually improving our electronic fraud detection system by adding new information about schemes to the fraud criteria.

In the President’s 2006 budget request, $10.7 million is requested to be used to curtail refund crimes which would be used

to support efforts in detecting fraudulent fuel tax refund claims

and other types of similar schemes.

The IRS is aggressively focusing on fraud referrals, ensuring that

Revenue agents, Revenue officers, and Special Agents know and

understand the badges of fraud and work together to ensure that

fraudulent activity is criminally investigated.

Finally, we continually improve our fraud scheme alerts to ensure that all employees of the IRS who are associated with returns

processing are aware of the emerging schemes, including the fuel

tax credit schemes.

Mr. Chairman, I thank you for this opportunity to appear before

your distinguished committee, and I welcome your questions.

[The prepared statement of Ms. Jardini appears in the appendix.]

51

The CHAIRMAN. I am going to start with you, since you just finished, and it follows on to something you said.

Ms. JARDINI. All right.

The CHAIRMAN. Your testimony reflects increased criminal referrals and paid taxpayer fraud. Have you seen significant growth in

the filing of fraudulent fuel tax refunds or of new and different

schemes that maybe you have not seen before?

Ms. JARDINI. We certainly have, Mr. Chairman. To put it in context for you, 3 years ago, in 2002, we identified $2 million in fraudulent fuel tax credit schemes. In 2004, we identified $21 million.

So, we are seeing significant growth in this area. We are seeing

these returns being submitted by promoters and preparers.

However, in the case that I referenced in my oral testimony that

was a plea agreement in January, it was a nurse who was completing returns for a number of associates, all fraudulently claiming the fuel tax credit claim. So, this is not necessarily traditional

preparers or promoters who are engaging in this type of activity.

As I pointed out, we are seeing some trends in this area. We are

seeing the fuel tax credit being claimed largely in returns that

have Schedule C income. We are seeing multiple returns filed in

multiple different types, in multiple different campuses, and we are

looking at all of that conduct.

The CHAIRMAN. Yes. Following up on your comment about paid

preparers, how often do they participate in the refund schemes that

you detect, not only in fuel fraud, but you might say in all types

of fraudulent refund claims? Would additional preparer penalties in

this area be helpful in the administration of the claims?

Ms. JARDINI. Overall, in all of the refund claims that we detect

and identify, over half of those schemes utilize a paid preparer.

However, more than that utilize some type of preparer or promoter

who would not be covered by the regulations around Circular 230

and the traditional enrolled agents, or certified public accountants,

or professional tax preparers.

Within Criminal Investigation, we devote about 15 percent of our

direct investigative time, of our agents’ time in the field, to these

types of investigations.

In our estimation, support for the data mining and intelligence

analyst type of activity that we are pursuing to detect these types

of returns and stop them would be enormously useful.

The CHAIRMAN. Thank you.

Mr. Brown, it is my understanding that the IRS already receives

information reports on fuel transactions from registered terminals.

Would additional reporting requirements help the IRS to combat

additional fuel tax noncompliance?

Mr. BROWN. Yes. On the individual income tax side, as Commissioner Everson just testified, we find that where we have information reporting, coupled with document matching on the part of the

Internal Revenue Service—the type of thing you see with interest

and dividends in your personal situation—we have enormously

high compliance rates. So the more information reporting we have,

we absolutely believe that does increase compliance.

There are many places in this chain, as the fuel passes through

the chain. Fuel is imported into this country. It comes ashore in

52

barges. It leaves domestic refineries. It travels through pipelines,

it travels on barges, it travels on trucks.

Our information reporting system, right now, picks up when the

fuel is delivered to a terminal. That is where we have information

reporting. As you can see, there are gaps in other places in the

process where information reporting would prove quite beneficial.

The CHAIRMAN. I want to continue with you. You have outlined

four areas of significant noncompliance. Would further changes to

the penalty structure deter additional noncompliance?

Mr. BROWN. One of the common schemes that I have referenced

in my written testimony is what they call ‘‘cocktailing,’’ or blending.

There is a chart that shows this, actually.

The CHAIRMAN. Yes. I have a picture of that here. It is difficult

to read, but I did see a picture of that right here.

Mr. BROWN. It is a handwritten sheet there that talks about how

people are blending. The reason they do this, I have learned over

the course of overseeing this excise tax area, is that diesel engines

will fire off of almost anything, so we put in legal taxable fuel, fuel

that has been taxed.

But if you mix it with all kinds of other products, it can be industrial waste of different types, used dry cleaning fluids, used motor

oils, you mix those with the taxed fuels, and suddenly you have

more volume. You have a gallon that is half taxed and half not

taxed, and there is a tremendous incentive for profit.

As you can see from this, it does not require an advanced degree

in chemistry to figure out how to make something run in a diesel

engine. Rather, this is fairly rudimentary when you look at it.

The penalty structure, as it is right now, is if one of our fuel compliance officers happens to detect a cocktailed fuel, one that is

mixed with inappropriate substances and taxable fuel, there is no

penalty.

The sanction is that you have to pay tax on what you have

added. That is it. The fuel with used dry cleaning fluids, whatever

it might be that you have added, you now have to pay tax on that

as if that is proper fuel. There is no penalty.

I would liken it to the tax shelter arena. The calculation on the

part of many sophisticated people in this country over the past several years was that, if I get caught, all I have to do is pay tax and

interest. I might as well roll the dice and see what happens, because there is no real penalty here.

The CHAIRMAN. Last question to Mr. Brown. We continue to have

concerns over tax preparers and taxpayer participation in fraudulent refund claims. Could you describe why fuel fraud claims have

become an enticing target for tax fraud schemes?

Mr. BROWN. Yes, sir. When you look at page 2 of the 1040, on

line 43, which is highlighted there, that is sort of the ‘‘eureka’’ moment for taxpayers. That is when they discover how much tax they

owe and they can compare it to what has been withheld or what

they have paid in estimated taxes so far during the year.

And right below there is the opportunity to claim credits. I think

our experience leads us to believe that taxpayers see the tax they

owe, skip down a few lines—as you can see on the chart, they are

down to line 69—and suddenly there is an opportunity to wipe the

tax out.

53

One possible solution to that would be to not allow someone to

claim this credit on the income tax return, but rather to claim it

on an excise tax claims form.

We have a specific form, an 8849. And there, that would also

guarantee that it is reviewed by an excise tax reviewer as opposed

to just being reviewed in a service center by someone who is used

to reviewing all kinds of returns.

The CHAIRMAN. Yes. I said that was the last question, but let me

ask one more.

I understand that an unscrupulous fuel dealer can avoid penalties for not paying tax on fuel by claiming the fuel ‘‘is not suitable for use,’’ even though the diesel engine could run on the fuel

without a problem.

Can you please explain in more detail how someone can avoid enforcement action by gaming the ‘‘suitable for use’’ rule?

Mr. BROWN. Certainly. Actually, in California we lost a criminal

case partially due to this very argument. We were unable to convince a jury that a refiner’s product was suitable for use, even

though we were able to demonstrate that the product ultimately

ended up in a diesel-powered highway motor vehicle.

What is suitable for use is obviously a subjective determination

in the eyes of some judges in this country. I would urge you to take

a look at a standard that many States have employed successfully.

They have changed their definition to ‘‘fuel offered for sale.’’

That, then, triggers the taxation if it is merely offered for sale as

opposed to getting into some heated debate about, actually, is it

suitable for use in an engine.

The CHAIRMAN. And that has been very successful in those

States?

Mr. BROWN. In those four States, they have reported success

with that standard, yes.

The CHAIRMAN. And so out of 50 States, 4 use that standard.

Mr. BROWN. There are four that I am aware of right now that

recently changed to that standard.

The CHAIRMAN. Well, obviously, I thank you very much for your

testimony. We started out with all panels today opening this hearing with the question about how we close the $350 billion tax gap.

We have heard many good suggestions and comments today in response to that question. These will help inform the committee and

help us in our work that is always ongoing to close the tax gap.

But we have also faced some cold reality, particularly from the

first two panels. Closing the gap will be a very hard and difficult

journey.

Now, of course, it is easy for any of us in Congress to give

speeches, on the eve of the day, decrying the tax gap. The hard

part is doing something about it.

I think we made a good start last year in the JOBS bill, and I

hope to continue that good work in cooperation, as I always do,

with Senator Baucus, during this Congress. I thank all of the panels for working with us to help solve some of these problems of the

tax gap.

Thank you very much. There may be questions. I should have announced this to the other panelists as well. There may be some

members who could not come here, or even members who were

54

here, that have additional questions for response in writing. We

would give 2 weeks for the response, please. Thank you all very

much.

The hearing is adjourned.

[Whereupon, at 1:06 p.m., the hearing was concluded.]

(55)

A P P E N D I X

ADDITIONAL MATERIAL SUBMITTED FOR THE RECORD

56

57

58

59

60

61

62

63

64

65

66

67

68

69

70

71

72

73

74

75

76

77

78

79

80

81

82

83

84

85

86

87

88

89

90

91

92

93

94

95

96

97

98

99

100

101

102

103

104

105

106

107

108

109

110

111

112

113

114

115

116

117

118

119

120

121

122

123

124

125

126

127

128

129

130

131

132

133

134

135

136

137

138

139

140

141

142

143

144

145

146

147

148

149

150

151

152

153

154

155

156

157

158

159

160

161

162

163

164

165

166

167

168

169

170

171

172

173

174

175

176

177

178

179

180

181

182

183

184

185

186

187

188

189

190

191

192

193

194

195

196

197

198

199

200

201

202

203

204

205

206

207

208

209

210

211

212

213

214

215

216

217

218

219

220

221

222

223

224

225

226

227

228

229

230

231

232

233

234

235

236

237

238

239

240

241

242

243

244

245

246

247

248

249

250

251

252

253

254

255

256

257

258

259

260

261

262

263

264

265

266

267

268

269

270

271

272

273

274

275

276

ADDITIONAL RESPONSES TO SENATOR GRASSLEY TO

QUESTIONS POSED DURING THE HEARING

277

278

279

280

281

282

283

284

285

286

287

288

289

290

291

292

293

294

295

296

297

298

299

300

301

302

303

304

305

306

307

308

309

310

311

312

313

314

315

316

317

318

319

320

321

322

323

324

325

326

327

328

329

330

331

332

333

334

335

336

337

338

339

340

341

342

343

344

345

346

347

348

349

350

351

352

353

354

355

356

357

358

359

360

361

362

363

364

365

366

367

368

369

370

371

372

373

374

375

376

377

378

379

380

381

382

383

384

385

386

387

388

389

390

391

392

393

394

395

396

397

398

399

400

401

402

403

404

405

406

407

408

409

410

411

412

413

414

415

416

417

418

419

420

421

422

423

424

425

426

427

428

429

430

431

432

433

434

435

436

437

438

439

440

441

442

(443)

COMMUNICATION

444

445

446

447

448

Æ