United States Government Accountability Office

GAO Testimony 

Before the Committee on Budget, 

U.S. Senate

TAX GAP

Making Significant Progress 

in Improving Tax 

Compliance Rests on 

Enhancing Current IRS 

Techniques and Adopting 

New Legislative Actions 

Statement of David M. Walker 

Comptroller General of the United States 

For Release on Delivery

Expected at 10:00 a.m. EST 

Wednesday, February 15, 2006 

 

GAO-06-453T 
What GAO Found

United States Government Accountability Office

Why GAO Did This Study

Highlights

Accountability Integrity Reliability

February 15, 2006

TAX GAP

Making Significant Progress in Improving 

Tax Compliance Rests on Enhancing 

Current IRS Techniques and Adopting 

New Legislative Actions 

Highlights of GAO-06-453T, a testimony 

before the Committee on the Budget, U.S. 

Senate 

The Internal Revenue Service’s 

(IRS) most recent estimate of the 

difference between what taxpayers 

timely and accurately paid in taxes 

and what they owed was 

$345 billion. IRS estimates it will 

eventually recover some of this tax

gap, resulting in an estimated net 

tax gap of $290 billion. The tax gap 

arises when taxpayers fail to 

comply with the tax laws by

underreporting tax liabilities on tax 

returns; underpaying taxes due 

from filed returns; or nonfiling, 

which refers to the failure to file a 

required tax return altogether or in 

a timely manner. 

The Chairman and Ranking

Minority Member of the Senate 

Committee on the Budget asked 

GAO to present information on the 

causes of and possible solutions to 

the tax gap. This testimony 

addresses the nature and extent of

the tax gap and the significance of

reducing the tax gap, including

some steps that may assist with 

this challenging task. For context, 

this testimony also addressed 

GAO’s most recent simulations of

the long-term fiscal outlook and the 

need for a fundamental

reexamination of major spending

and tax policies and priorities. 

What GAO Recommends

GAO is not making any new 

recommendations but discusses 

some past recommendations and 

highlights some new areas for

possible attention. 

Our nation’s fiscal policy is on an imprudent and unsustainable course. As 

long-term budget simulations by GAO show, over the long term we face a 

large and growing structural deficit due primarily to known demographic 

trends, rising health care costs, and lower federal revenues as a percentage 

of the economy. GAO’s simulations indicate that the long-term fiscal 

challenge is too big to be solved by economic growth alone or by making 

modest changes to existing spending and tax policies. Rather, a fundamental 

reexamination of major policies and priorities will be important to recapture

our future fiscal flexibility. 

Underreporting of income by businesses and individuals accounted for most 

of the estimated $345 billion tax gap for 2001, with individual income tax 

underreporting alone accounting for $197 billion, or over half of the total 

gap. Corporate income tax and employment tax underreporting accounted 

for an additional $84 billion of the gap. 

Reducing the tax gap would help improve fiscal sustainability. Given the tax 

gap’s persistence and size, it will require considering not only options that 

have been previously proposed but also new administrative and legislative 

actions. Even modest progress would yield significant revenue; each 1 

percent reduction would likely yield nearly $3 billion annually. Reducing the 

tax gap will be a challenging long-term task, and progress will require 

attacking the gap with multiple strategies over a sustained period. These 

strategies could include efforts to regularly obtain data on the extent of, and 

reasons for, noncompliance; simplify the tax code; provide quality service to 

taxpayers; enhance enforcement of tax laws by utilizing enforcement tools 

such as tax withholding, information reporting, and penalties; leverage 

technology; and optimize resource allocation. 

IRS’s Tax Year 2001 Gross Tax Gap Estimates by Type of Noncompliance and Type of Tax 

Dollars in billions

Type of tax 

Type of 

noncompliance

Individual 

income

Corporate 

income Employment Estate Excise Total

Underreporting $197 $30 $54 $4 No estimate $285

Underpayment 23 2 5 2 $1 $34

Nonfiling 25 No estimate No estimate 2 No estimate $27

Total $244 $32 $59 $8 $1 $345

Source: IRS. 

Note: Figures may not sum to totals due to rounding. 

www.gao.gov/cgi-bin/getrpt?GAO-06-453T.

To view the full product, including the scope 

and methodology, click on the link above. 

For more information, contact Michael 

Brostek at (202) 512-9110 or 

brostekm@gao.gov. 
Chairman Gregg, Senator Conrad, and Members of the Committee: 

I appreciate this opportunity to discuss the annual tax gap—the difference 

between what taxpayers timely and accurately pay in taxes and what they

should pay under the law—and how reducing that gap can help the nation 

cope with its large and growing long-term fiscal challenges. The Internal 

Revenue Service (IRS) most recently estimated a gross tax gap that 

reached $345 billion for tax year 2001. IRS estimated that it would recover 

around $55 billion through late payments and IRS enforcement actions, 

resulting in a net tax gap of around $290 billion.1

 The tax gap arises when 

taxpayers intentionally or unintentionally fail to comply with the tax laws. 

Their failure to pay taxes increases the burden of funding the nation’s 

commitments for those taxpayers who voluntarily pay their taxes. 

For context in considering the tax gap, I will first provide the committee 

with an overview of the federal government’s fiscal condition and the 

challenges we will face in funding our nation’s commitments. Next, I will 

discuss the size and components of the tax gap. Finally, I will discuss the 

significance of reducing the tax gap and various means to achieve that 

goal, including measuring the extent of, and reasons for, noncompliance; 

simplifying the tax code; improving taxpayer service; enhancing IRS 

enforcement through the use of tools such as withholding, information 

reporting, and penalties; leveraging technology; and optimizing resource 

allocation. 

My remarks are based on our previous work on a variety of issues, in 

particular, recent testimonies and a report on reducing the tax gap.2

 These 

efforts were conducted in accordance with generally accepted government 

auditing standards. 

 1

Throughout this statement, references to the tax gap refer to the gross tax gap unless 

otherwise noted. 

2

GAO, Tax Compliance: Reducing the Tax Gap Can Contribute to Fiscal Sustainability

but Will Require a Variety of Strategies, GAO-05-527T (Washington, D.C.: Apr. 14, 2005); 

Tax Gap: Multiple Strategies, Better Compliance Data, and Long-Term Goals Are Needed

to Improve Taxpayer Compliance, GAO-06-208T (Washington, D.C.: Oct. 26, 2005); and

Tax Compliance: Better Compliance Data and Long-term Goals Would Support a More 

Strategic IRS Approach to Reducing the Tax Gap, GAO-05-753 (Washington, D.C.: July 18,

2005). 

Page 1 GAO-06-453T 
Let me begin by highlighting three major points: 

• GAO’s long-term budget simulations show that over the long term we face 

large and growing structural deficits due primarily to known demographic 

trends, rising health care costs, and lower federal revenues as a 

percentage of the economy. Continuing on this unsustainable fiscal path 

will gradually erode, if not suddenly damage, our economy, our standard 

of living, and ultimately our national security. Our current path also will 

increasingly constrain our ability to address emerging and unexpected 

budgetary needs and increase the burdens that will be faced by our 

children, grandchildren, and future generations. Reducing the current tax 

gap would contribute to our fiscal sustainability while simultaneously 

improving fairness for those citizens who fully and timely meet their tax 

obligations.

• Underreporting of income by businesses and individuals accounted for 

most of the estimated $345 billion tax gap for 2001, with individual income 

tax underreporting alone accounting for $197 billion, or over half of the 

total gap. Corporate income tax and employment tax underreporting 

accounted for an additional $84 billion. 

• Given the persistence and size of the tax gap, we need not only to consider

options that have been previously proposed but also explore new 

administrative and legislative approaches to reducing the tax gap. Even

modest progress would yield significant revenue; each 1 percent reduction

would likely yield nearly $3 billion annually. Reducing the tax gap will be a 

challenging, long-term task and progress will require attacking the gap on 

multiple fronts and with multiple strategies over a sustained period. These 

strategies could include efforts to regularly obtain data on the extent of, 

and reasons for, noncompliance; simplify the tax code; provide quality 

services to taxpayers; enhance enforcement of the tax laws by utilizing 

enforcement tools such as tax withholding, information reporting, and 

penalties; leverage technology; and maximize resource allocation. 

The federal government’s financial condition and long-term fiscal outlook

present enormous challenges to the nation’s ability to respond to emerging

forces reshaping American society, the United States’ place in the world, 

and the future role of the federal government. Over the next few decades

as the baby boom generation retires and health care costs continue to rise, 

federal spending on retirement and health programs—Social Security, 

Medicare, Medicaid, and other federal pension, health, and disability 

programs—will grow dramatically. Absent policy changes on the spending 

and/or revenue sides of the budget, a growing imbalance between 

Long-term Fiscal 

Challenge Provides 

Impetus to 

Reexamine Tax 

Policies and 

Compliance 

Page 2 GAO-06-453T 
expected federal spending and tax revenues will mean escalating and

eventually unsustainable federal deficits and debt that will threaten our 

future economy, standard of living, and, ultimately, our national security. 

Ultimately, the nation will have to decide what level of federal benefits and 

spending it wants and how it will pay for these benefits. 

GAO’s long-term simulations illustrate the magnitude of the fiscal 

challenges associated with an aging society and the significance of the

related challenges the government will be called upon to address. Indeed, 

the nation’s long-term fiscal outlook is daunting under many different 

policy scenarios and assumptions. For instance, under a fiscally restrained 

scenario, if discretionary spending grew only with inflation over the next 

10 years and all existing tax cuts expire when scheduled under current 

law, spending for Social Security and health care programs would grow to 

consume over 80 percent of federal revenue by 2040. (See fig. 1.) On the 

other hand, if discretionary spending grew at the same rate as the 

economy in the near term and if all tax cuts were extended, by 2040 

federal revenues may just be adequate to pay only some Social Security 

benefits and interest on the growing federal debt. (See fig. 2.) 

Page 3 GAO-06-453T 
Figure 1: Composition of Spending as a Share of GDP Under Baseline Extended

Note: In addition to the expiration of tax cuts, revenue as a share of GDP increases through 2016 due

to (1) real bracket creep, (2) more taxpayers becoming subject to the AMT, and (3) increased

revenue from tax-deferred retirement accounts. After 2016, revenue as a share of GDP is held 

constant. 

Percent of GDP

Fiscal year

All other spending Medicare & Medicaid Social Security Net interest

Source: GAO’s January 2006 analysis.

0

10

20

30

40

50

2005 2015 2040 2030

Revenue

Page 4 GAO-06-453T 
Figure 2: Composition of Spending as a Share of GDP Assuming Discretionary 

Spending Grows with GDP After 2006 and All Expiring Tax Provisions are Extended

Note: This includes certain tax provisions that expired at the end of 2005, such as the increased AMT

exemption amount. 

Addressing the projected fiscal gaps shown here will require policymakers 

to examine the advisability, affordability, and sustainability of existing 

programs, policies, functions, and activities throughout the entire federal

budget—spanning discretionary spending, mandatory spending, including

entitlements, and tax policies and programs. Neither slowing the growth of 

discretionary spending nor allowing tax cuts to expire—nor both options 

combined—would by themselves eliminate our long-term fiscal imbalance. 

Additional economic growth is critical and will help to ease the burden, 

but the projected fiscal gap is so great that it is wholly unrealistic to 

expect that we will grow our way out of the problem. The President’s 2007 

budget released last week included some proposals to reduce the growth

in Medicare spending. Whether or not these proposals are adopted, they 

should serve to raise public awareness of the importance of health care 

costs to both today’s budget and tomorrow’s. This could also serve to 

jump start discussion about appropriate ways to control a major driver of 

our long-term fiscal outlook—health care spending. Clearly, tough choices 

will be required. Changes in existing budget processes and financial, fiscal, 

and performance metrics will be necessary to facilitate these choices. 

Early action to change existing programs and policies would yield the 

highest fiscal dividends and provide a longer period for prospective 

Percent of GDP

Fiscal year

All other spending Medicare & Medicaid Social Security Net interest

Source: GAO’s January 2006 analysis.

0

10

20

30

40

50

2005 2015 2040 2030

Revenue

● ● ● ●

Page 5 GAO-06-453T 
beneficiaries to make adjustments in their own planning. The longer we 

wait, the more painful and difficult the choices will become and the less 

transition time we will have. By waiting, an important window is lost 

during which today’s relatively large workforce can increase saving and

begin preparing for the necessary changes in fiscal policy, Social Security, 

and health care as well as other reforms that may be necessary parts of the 

solution to this coming fiscal crunch. However, the long-term challenge is

fast becoming a short-term one as the retirement of the baby boomers’ 

generation will begin as early as 2008 and since overall workforce growth 

has already begun to slow. While our long-term fiscal imbalance cannot be 

eliminated with a single strategy, reducing the tax gap is one approach that 

could help address the looming fiscal challenges facing the nation. 

The tax gap is an estimate of the difference between the taxes—including 

individual income, corporate income, employment, estate, and excise 

taxes—that should have been timely and accurately paid and what was 

actually paid for a specific year. The estimate is an aggregate of estimates 

for the three primary types of noncompliance: (1) underreporting of tax 

liabilities on tax returns; (2) underpayment of taxes due from filed returns; 

and (3) nonfiling, which refers to the failure to file a required tax return 

altogether or timely.3

 Estimates for each type of noncompliance include 

estimates for some or all of the five types of taxes that IRS administers. 

IRS develops its tax gap estimates by measuring the rate of taxpayer 

compliance—the degree to which taxpayers fully and timely complied 

with their tax obligations. That rate is then used, along with other data and 

assumptions, to estimate the dollar amount of taxes not timely and 

accurately paid. For instance, IRS most recently estimated that for tax 

year 2001, 83.7 percent of owed taxes were paid voluntarily and timely, 

which translated into an estimated gross tax gap of $345 billion. IRS 

Underreporting 

Accounted for Most of 

the Tax Gap Estimate 

 3

 Taxpayers who receive filing extensions, pay their full tax liability by payment due dates, 

and file returns prior to extension deadlines are considered to have filed timely. 

Page 6 GAO-06-453T 
developed these estimates using compliance data collected through the 

National Research Program (NRP).4

Using its recently collected compliance data, IRS has estimated that 

underreporting of income represented over 80 percent of the tax gap for 

2001 (an estimated $285 billion out of a gross tax gap estimate of $345 

billion), as indicated in table 1. 

Table 1: IRS’s Tax Year 2001 Gross Tax Gap Estimates by Type of Noncompliance and Type of Tax 

Dollars in billions 

Type of tax

Type of noncompliance

Individual 

income tax 

Corporate 

income tax Employment tax Estate tax Excise tax Total

Underreporting $197 $30 $54 $4 No estimate $285

Underpayment 23 2 5 2 1 $34

Nonfiling 25 No estimate No estimate 2 No estimate $27

Total $244 $32 $59 $8 $1 $345

Source: IRS. 

Note: Figures may not sum to totals due to rounding. 

Within the underreporting estimate, IRS attributed about $197 billion, or 

about 57 percent of the total tax gap, to individual income tax

underreporting, including underreporting of business income, such as sole 

proprietor,5

 informal supplier,6 and farm income (about $109 billion); 

nonbusiness income, such as wages, interest, and capital gains (about $56 

 4

NRP replaced the Taxpayer Compliance Measurement Program, which last measured 

compliance for individuals for 1988 but then was canceled because of concerns about costs

and burdens on taxpayers. GAO, Tax Administration: New Compliance Research Effort Is

on Track, but Important Work Remains, GAO-02-769 (Washington, D.C.: June 27, 2002);

and GAO, Tax Administration: Status of IRS’ Efforts to Develop Measures of Voluntary 

Compliance, GAO-01-535 (Washington, D.C.: June 18, 2001) discuss the development of the 

NRP study. 

5

 Sole proprietors are self-employed individuals who should file a Schedule C with their

individual tax return to report profits and losses from their business. Sole proprietors

include those who provide services, such as doctors or accountants; produce goods, such

as manufacturers; and sell goods at fixed locations, such as car dealers and grocers. 

6

 Informal suppliers are sole proprietors who work alone or with few workers and, by 

definition, operate in an “informal” manner. Informal suppliers include those who make

home repairs, provide child care, or sell goods at roadside stands. These taxpayers should 

report business profits or losses on a Schedule C. 

Page 7 GAO-06-453T 
billion); overstated credits (about $17 billion); and overstated income 

adjustments, deductions, and exemptions (about $15 billion). 

Underreporting of corporate income tax contributed an estimated $30 

billion, or about 10 percent, to the 2001 tax gap, which included both small 

corporations (those reporting assets of $10 million or less) and large 

corporations (those reporting assets of over $10 million). 

Employment tax underreporting accounted for an estimated $54 billion, or 

about 16 percent, of the 2001 tax gap and included several taxes that must 

be paid by self-employed individuals and employers. Self-employed 

individuals are generally required to calculate and remit Social Security 

and Medicare taxes to the U.S. Treasury each quarter. Employers are 

required to withhold these taxes from their employees’ wages, match these 

amounts, and remit withholdings to Treasury at least quarterly. 

Underreported self-employment7

 and employer-withheld employment 

taxes, respectively, contributed an estimated $39 billion and $14 billion to

IRS’s tax gap estimate. The employment tax underreporting estimate also 

includes underreporting of federal unemployment taxes (about $1 billion). 

Taxpayers who do not file their tax returns on time or at all and otherwise 

do not pay their tax liabilities accounted for the remainder of the 2001 tax

gap—around $61 billion. For example, nonfiling and underpayment 

noncompliance by individual taxpayers alone contributed an estimated 

$48 billion to this portion of the tax gap. 

IRS has concerns with the certainty of the overall tax gap estimate in part 

because some areas of the estimate rely on old data and IRS has no 

estimates for other areas of the tax gap. For example, IRS used data from 

the 1970s and 1980s to estimate underreporting of corporate income taxes

and employer-withheld employment taxes. For large corporate income tax 

underreporting, IRS based its estimate on the amount of tax recommended 

from operational examinations rather than the tax ultimately assessed as 

part of the total tax liability.8

 According to IRS officials, IRS relies on the 

amount of tax recommended because it is difficult to determine the true 

 7

As employment taxes and income taxes for self-employed taxpayers are largely assessed 

on the same income, self-employed individuals who underreport their income consequently 

underreport the employment tax due on that income. 

8

IRS continually examines tax returns from about 1,100 of the nation’s largest corporations,

all of which have assets of more than $250 million. For fiscal year 2002, IRS examined 

around 7 percent of all large corporations. 

Page 8 GAO-06-453T 
tax liability of large corporations due to complex and ambiguous tax laws 

that create opportunities for differing interpretations and that complicate 

the determination. These officials further stated that because these 

examinations are not randomly selected and are not focused on identifying

all tax noncompliance, the estimate produced from the examination data 

is not representative of the tax gap for all large corporations. They also 

explained that due to these complexities and the costs and burdens of 

collecting complete and accurate data, IRS has not systematically 

measured large corporation tax compliance through statistically valid 

studies, even though the officials acknowledged that such studies would 

be useful in estimating the related tax gap.9

IRS has no estimates for corporate income, employment, and excise tax

nonfiling or for excise tax underreporting. For these types of 

noncompliance, IRS maintains that the data are either difficult to collect, 

imprecise, or unavailable. In addition, it is inherently difficult for IRS to 

observe and measure some types of underreporting or nonfiling, such as 

tracking cash payments that businesses make to their employees, as 

businesses and employees may not report these payments to IRS in order 

to avoid paying employment and income taxes, respectively.

10

IRS’s overall approach to reducing the tax gap consists of improving 

service to taxpayers and enhancing enforcement of the tax laws. Recently, 

IRS has taken a number of steps that may improve its ability to reduce the 

tax gap. Favorable trends in staffing of IRS enforcement personnel; 

examinations performed through correspondence, as opposed to more 

complex face-to-face examinations; and the use of some enforcement 

sanctions such as liens and levies are encouraging. Also, IRS has made 

progress with respect to abusive tax shelters through a number of 

initiatives and recent settlement offers that have resulted in billions of 

dollars in collected taxes, interest, and penalties. In addition, IRS has 

successfully prosecuted a number of taxpayers who have committed 

criminal violations of the tax laws. 

 9

GAO, Tax Administration: Compliance Measures and Audits of Large Corporations 

Need Improvement, GAO/GGD-94-70 (Washington, D.C.: Sept. 1, 1994); Tax

Administration: Factors Affecting Results from Audits of Large Corporations, 

GAO/GGD-97-62 (Washington, D.C.: Apr. 17, 1997); and Tax Administration: IRS Measures 

Could Provide a More Balanced Picture of Audit Results and Costs, GAO/GGD-98-128 

(Washington, D.C.: June 23, 1998). 

10For a more detailed discussion about data sources and methodologies used in estimating 

the tax gap, see GAO-05-753. 

Page 9 GAO-06-453T 
Given its persistence and size, we need not only to consider expanding 

current approaches but also explore new legislation to help IRS in 

reducing the tax gap.

11 Although IRS has made a number of changes in its 

methodologies for measuring the tax gap over the past three decades, 

which makes comparisons difficult, regardless of methodology the 

voluntary compliance rate that underpins the gap has tended to range from

around 81 percent to around 84 percent. Thus, although the dollar 

amounts of the tax gap have changed, IRS has consistently reported a 

persistent, relatively stable portion of the taxes that should have been 

timely and accurately paid were not paid. 

Reducing the Tax Gap 

Will Require 

Expanding Existing 

Approaches and 

Considering New 

Legislative Actions 

As we have reported in the past,12 closing the entire tax gap may not be 

feasible nor desirable, as it could entail more intrusive recordkeeping or 

reporting than the public is willing to accept or more resources than IRS is 

able to commit. However, given its size, even small or moderate reductions 

in the net tax gap could yield substantial returns, which could improve the 

government’s fiscal position. For example, based on IRS’s most recent 

estimate, each 1 percent reduction in the net tax gap would likely yield 

nearly $3 billion annually. Thus, a 10 percent to 20 percent reduction of the 

net tax gap would translate into from roughly $30 billion to $60 billion in

additional revenue annually.13

 11We have suggested similar steps for the entire tax system as well as all major spending

programs in order to confront the nation’s fiscal challenge through a fundamental review, 

reexamination, and reprioritization of government’s capacity to align itself with the needs 

and demands of the 21st century. See GAO, 21st Century Challenges: Reexamining the 

Base of the Federal Government, GAO-05-325SP (Washington, D.C.: February 2005). 

12GAO, Taxpayer Compliance: Analyzing the Nature of the Income Tax Gap, 

GAO/T-GGD-97-35 (Washington, D.C.: Jan. 9, 1997). 

13Any significant reduction of the tax gap would likely depend on an improvement in the 

level of taxpayer compliance. In some instances, the amount of the tax gap can change 

without a corresponding change in the level of compliance. For example, a reduction in

marginal tax rates could result in a smaller tax gap simply because the amount of tax that

should be paid has been reduced, even if the level of compliance remains unchanged.

Page 10 GAO-06-453T 
However, reducing the tax gap will be challenging14 and it must be 

attacked on multiple fronts and with multiple strategies, some of which 

follow. 

Regularly Measure 

Compliance and Set 

Compliance Goals 

A critical step toward reducing the tax gap is to understand the sources 

and nature of taxpayer noncompliance. Regularly measuring compliance, 

including the reasons why taxpayers are not compliant, can offer many 

benefits, including helping IRS identify new or growing types of 

noncompliance, identify changes in tax laws and regulations that may 

improve compliance, understand the effectiveness of its programs to 

promote and enforce compliance, more effectively target examinations of 

tax returns, and determine its resource needs and allocations. Likewise, 

regularly measuring compliance can provide IRS with information against 

which to set goals for improving compliance and measure progress in 

achieving such goals. 

In our July 2005 report on reducing the tax gap, we made 

recommendations to IRS to develop plans to periodically measure tax 

compliance; take steps to improve its data on the reasons why taxpayers 

do not comply; and establish long-term, quantitative goals for voluntary 

compliance levels with an initial focus on individual income tax 

underreporting and total tax underpayment. Taken together, these steps 

can help IRS build a foundation to understand how its taxpayer service 

and enforcement efforts affect compliance and make progress on reducing 

the tax gap. The Commissioner of Internal Revenue agreed with our 

recommendations, highlighted challenges associated with them, and 

commented on various steps IRS would take to implement each 

recommendation. We are encouraged that according to IRS’s Fiscal Year 

2007 Congressional Budget Justification, IRS has recently established a 

voluntary compliance goal, with a target of 85 percent voluntary 

compliance by 2009, and plans to periodically measure progress against 

this goal. 

 14Recognizing these challenges, we have long been concerned about tax noncompliance 

and IRS’s efforts to address it. Since 1990, we have had various aspects of tax 

noncompliance on our high-risk list, and last year we have affirmed our broad concern by

consolidating two prior high-risk areas into one—Enforcement of Tax Laws. See GAO,

High-Risk Series: An Update, GAO-05-207 (Washington, D.C.: January 2005). 

Page 11 GAO-06-453T 
Efforts to simplify the tax code and otherwise alter current tax policies 

may help reduce the tax gap by making it easier for individuals and 

businesses to understand and voluntarily comply with their tax 

obligations. Among the many causes of tax code complexity is the growing 

number of preferential provisions in the tax code, such as exemptions and 

exclusions from taxation, deductions, credits, deferral of tax liability, and 

preferential tax rates.15 Tax expenditures—as they are known by 

statute16—can be a tool to further some federal goals and objectives, such 

as financing higher education or funding research and development. 

However, their aggregate number contributes to the complexity that 

taxpayers face in doing their taxes and planning their financial decisions.

As figure 3 shows, the number of tax expenditures reported by the 

Department of the Treasury has more than doubled since 1974. Figure 4 

shows the Revenue Loss Estimates for the Five Largest Tax Expenditures 

Reported for Fiscal Year 2005. 

Simplify the Tax Code 

 15GAO, Government Performance and Accountability: Tax Expenditures Represent a

Substantial Federal Commitment and Need to be Reexamined, GAO-05-690 (Washington,

D.C.: Sept. 23, 2005). 

16The Congressional Budget and Impoundment Control Act of 1974, Pub. L. No. 93-344, Sec.

3, 88 Stat. 299 (July 12, 1974) (codified at 2 U.S.C. sec. 622(3)). 

Page 12 GAO-06-453T 
Figure 3: Number of Tax Expenditures Reported by Treasury, 1974-2005 

Note: The number of tax expenditures reflects all provisions reported by Treasury, including those 

enacted but effective for future fiscal years. For example, Treasury’s last list included tax 

expenditures enacted in 2005 that will be effective in fiscal years 2006 and later. The trend also

reflects changes in Treasury’s income tax baseline that defines a tax expenditure. 

Page 13 GAO-06-453T 
Figure 4: Revenue Loss Estimates for the Five Largest Tax Expenditures Reported

for Fiscal Year 2005 

0

20

40

60

80

100

120

140

Estimated dollars in billions

Source: Office of Management and Budget (OMB), Analytical Perspectives, Budget of the United States Government,

Fiscal Year 2007.

Exclusion of employer contributions for insurance premiums and medical care

Deductibility of mortgage interest on owner-occupied dwellings

Exclusion of pension contributions and earnings: employer-sponsored defined benefit plans

Child tax credit

Exclusion of pension contributions and earnings: employer-sponsored 401(K) plans

118.4a

62.2

50.6

41.8b

37.4

Note: “Tax expenditures” refers to the special tax provisions that are contained in the federal income 

taxes on individuals and corporations. OMB does not include forgone revenue from other federal 

taxes such as Social Security and Medicare payroll taxes. 

a

If the payroll tax exclusion were also counted here, the total tax expenditure for employer 

contributions for health insurance premiums would be about 50 percent higher or $177.6 billion. 

b

This is the revenue loss and does not include associated outlays of $14.6 billion. 

The multiple tax preferences for education assistance illustrate the 

consequences of the proliferation of tax expenditures. In our July 2005 

report17 on postsecondary tax preferences, we found that hundreds of 

thousands of taxpayers do not appear to make optimal decisions when 

 17GAO, Student Aid and Postsecondary Tax Preferences: Limited Research Exists on the

Effectiveness of Tools to Assist Students and Families through Title IV Student Aid and

Tax Preferences, GAO-05-684 (Washington, D.C.: July 29, 2005). 

Page 14 GAO-06-453T 
selecting education-related tax preferences. One explanation of these 

taxpayers’ choices may be the complexity of postsecondary tax 

preferences, which experts have commonly identified as difficult for tax

filers to use. Also, many argue that complexity creates opportunities for 

tax evasion, through vehicles such as tax shelters. Simplification may 

reduce opportunities for taxpayers to avoid taxes through the creation of 

complex and abusive tax shelters. 

Another area of the tax system that may deserve additional exploration, 

although not directly related to the tax gap, is whether the federal incomebased tax system is sustainable and administrable in a global economy and 

how we should tax the income of U.S. multinational corporations that is 

earned outside of the United States.18 Every year, U.S.-based multinational 

corporations transfer hundreds of billions of dollars of goods and services 

between their affiliates in the United States and their foreign subsidiaries.19

Such transactions may be a part of normal business operations for 

corporations with foreign subsidiaries. However, it is generally recognized

that given the variation in corporate tax rates across countries, an 

incentive exists for corporations with foreign subsidiaries to reduce their 

overall tax burden by maximizing the income they report in countries with 

low income tax rates, and minimizing the income they report in or 

repatriate to countries with high income tax rates. Various studies have 

suggested that U.S.-based multinational corporations appear to engage in 

transactions such as these that shift income from their affiliates in high-tax 

countries to subsidiaries in low-tax countries to take advantage of the 

differences in tax rates in foreign countries.20

The growth in multinational corporate transactions and structures has also 

introduced increasing complexity in administering the tax code. The loss 

of highly skilled technical employees at IRS who can examine compliance 

 18Although not necessarily a solution to the tax gap, given the challenges facing our incomebased tax system, some have suggested moving more towards a consumption-based tax 

system. Our recent report on understanding the tax reform debate discusses a number of 

topics that tax experts have identified as those that should be considered when evaluating

tax policy. See GAO, Understanding the Tax Reform Debate: Background, Criteria, & 

Questions, GAO-05-1009SP (Washington, D.C.: September 2005). 

19GAO, International Taxation: Information on Federal Contractors with Foreign 

Subsidiaries, GAO-04-293 (Washington, D.C.: Feb. 2, 2004).

20A survey of studies that examine income shifting by multinational corporations appears in 

Department of the Treasury, Office of Tax Policy, The Deferral of Income Earned Through

U.S. Controlled Foreign Corporations (Washington, D.C.: December 2000), 197-213. 

Page 15 GAO-06-453T 
issues arising from globalization, such as transfer pricing, underscores the 

challenge that IRS faces in ensuring it has sufficient staff with adequate 

skills to address these complex issues. 

Providing quality services to taxpayers is an important part of any overall

strategy to improve compliance and thereby reduce the tax gap. One 

method of improving compliance through service is to educate taxpayers 

about confusing or commonly misunderstood tax requirements.21 For 

example, if the forms and instructions taxpayers use to prepare their taxes 

are not clear, taxpayers may be confused and make unintentional errors. 

One method to ensure that forms and instructions are sufficiently clear is 

to test them before use. However, we reported in 2003 that IRS had tested

revisions to only five individual forms and instructions from July 1997 

through June 2002, although hundreds of forms and instructions had been 

revised in 2001 alone.22

Enhance Services to 

Taxpayers 

Enhance Enforcement 

Tools Available to IRS 

In terms of enforcement, IRS will need to use multiple strategies and 

techniques to identify and deter noncompliance. As figure 5 shows, one 

pair of tools have been shown to lower levels of noncompliance—

withholding tax from payments to taxpayers and having third parties 

report information to IRS and the taxpayers on income paid to taxpayers. 

For example, banks and other financial institutions provide information 

returns (Forms 1099) to account holders and IRS showing the taxpayers’ 

annual income from some types of investments. Similarly, most wages, 

salaries, and tip compensation are reported by employers to employees 

and IRS through Form W-2. Findings from NRP indicate that around 98.8 

percent of these types of income are accurately reported on individual 

returns. 

 21GAO/T-GGD-97-35. 

22GAO, Tax Administration: IRS Should Reassess the Level of Resources for Testing

Forms and Instructions, GAO-03-486 (Washington, D.C.: Apr. 11, 2003). 

Page 16 GAO-06-453T 
Figure 5: Individual Income Tax Underreporting Categorized by Amount Subject to Withholding and Information Reporting, 

2001 

In the past, we have identified a few specific areas where additional 

withholding or information reporting requirements could serve to improve 

compliance:23

• Requiring tax withholding and more or better information return 

reporting on payments made to independent contractors. Past IRS 

data have shown that independent contractors report 97 percent of the 

income that appears on information returns, while contractors that do not

receive these returns report only 83 percent of income. We have also 

identified other options for improving information reporting for 

 23GAO, Tax Gap: Many Actions Taken, but a Cohesive Compliance Strategy Needed, 

GAO/GGD-94-123 (Washington, D.C.: May 11, 1994). 

Page 17 GAO-06-453T 
independent contractors, including increasing penalties for failing to file 

required information returns, lowering the $600 threshold for requiring 

such returns, and requiring businesses to separately report on their tax 

returns the total amount of payments to independent contractors.24 IRS’s 

Taxpayer Advocate Service recently recommended allowing independent 

contractors to enter into voluntary withholding agreements.25

• Requiring information return reporting on payments made to 

corporations. Unlike payments made to sole proprietors, payments made 

to corporations for services are generally not required to be reported on 

information returns. IRS and GAO have contended that the lack of such a

requirement leads to lower levels of compliance for small corporations. 

Although Congress has required federal agencies to provide information 

returns on payments made to contractors since 1997,26 payments made by 

others to corporations are generally not covered by information returns. 

The Taxpayer Advocate Service has recommended requiring information 

reporting on payments made to corporations,27 and the Administration, in 

its fiscal year 2007 budget, has proposed requiring additional information 

reporting on certain goods and service payments by federal, state, and

local governments.28

• Requiring more data on information returns dealing with capital

gain income. Past IRS studies have indicated that much of the 

noncompliance associated with capital gains is a result of taxpayers 

overstating an asset’s “basis,” the amount of money originally paid for the 

asset. Currently, financial institutions are required to report the sales 

prices, but not the purchase prices, of stocks and bonds on information 

returns. Without information on purchase prices, IRS cannot use efficient

and effective computer-matching programs to check for compliance and 

must use much more costly means to examine taxpayer returns in order to 

verify capital gain income. The Taxpayer Advocate Service has 

 24GAO, Tax Administration: Approaches for Improving Independent Contractor 

Compliance, GAO/GGD-92-108 (Washington, D.C.: July 23, 1992). 

25Internal Revenue Service, Taxpayer Advocate Service, National Taxpayer Advocate 2005 

Annual Report to Congress (Washington, D.C. Dec. 31, 2005). 

26Taxpayer Relief Act of 1997, Pub. L. No. 105-34 (1997). 

27National Taxpayer Advocate 2005 Annual Report to Congress.

28Executive Office of the President, Office of Management and Budget, Budget of the 

United States Government, Fiscal Year 2007. 

Page 18 GAO-06-453T 
recommended requiring financial institutions to track cost basis 

information and report it to IRS and taxpayers.29

Although withholding and information reporting are highly effective in 

encouraging compliance, such additional requirements generally impose 

costs and burdens on the businesses that must implement them. However, 

continued reexamination of opportunities to expand information reporting 

and tax withholding could increase the transparency of the tax system. 

Opportunities to expand information reporting and tax withholding could

be especially relevant toward improving compliance in areas that are 

particularly complex or challenging to administer, such as with net income

and losses passed through from “flow-through” entities such as S 

corporations and partnerships to their shareholders and partners.30

Another enforcement tool that can potentially deter noncompliance is the 

use of penalties for filing inaccurate or late tax and information returns. 

Congress has placed a number of civil penalty provisions in the tax code. 

However, as with civil penalties related to other federal agencies, inflation 

may have weakened the deterrent effect of IRS penalties. For example, the 

Treasury Inspector General for Tax Administration has noted that the $50 

per partner per month penalty for a late-filed partnership tax return, 

established by Congress in 1978, would equate to $17.22 in 2004 dollars. In 

its fiscal year 2007 budget, the administration has proposed expanding 

penalty provisions applicable to paid tax return preparers to include nonincome tax returns and related documents. In addition, Congress recently

increased certain penalties related to tax shelters and other tax evasion 

techniques.31 Given Congress’s recent judgment that some tax penalties 

were too low and concerns that inflation may have weakened the 

effectiveness of the civil penalty provisions in the tax code, additional 

increases may need to be considered to ensure that all penalties are of 

sufficient magnitude to deter tax noncompliance. 

Leveraging technology to improve IRS’s capacity to receive, process, and

utilize taxpayer returns could help IRS better determine how to allocate its 

Leverage Technology 

 29National Taxpayer Advocate 2005 Annual Report to Congress.

30Partnerships and S corporations are businesses commonly referred to as flow-through 

entities, as they do not generally pay taxes on income. Instead, they distribute net income 

and losses to partners, shareholders, and beneficiaries, who are subsequently required to

report net income or losses on their individual tax returns and pay any applicable taxes. 

31American Jobs Creation Act of 2004, Pub. L. No. 108-357 (2004). 

Page 19 GAO-06-453T 
resources to reduce the tax gap and would seem to be a prudent 

investment. IRS has invested heavily in modernizing its technology and 

those investments have paid off. Telephone service has improved and

taxpayers are much more likely to get through to IRS and obtain 

assistance from IRS than before IRS upgraded its technology. Further, 

electronic filing has grown substantially. Tax information submitted to IRS 

electronically enables faster, more accurate processing and quicker 

interactions between IRS and taxpayers. Electronically filed returns are 

processed as they are received, therefore giving IRS access to more timely 

and accurate tax information, which can be used for better data analysis 

capability and quicker focus on issues that need resolution. IRS estimates 

it saves $2.15 on every individual tax return that is processed 

electronically. According to IRS data, electronic filing has allowed IRS to 

use more than a 1,000 fewer staff years to process paper returns, resources 

that can then be dedicated to other service or enforcement work.32

However, IRS’s Business Systems Modernization project, through which 

the agency is modernizing its outdated technology, is far from complete. 

IRS needs to continue to strengthen management of this effort and make 

prudent technology investments to maximize the efficiencies that can be

gained in IRS operations and services to taxpayers. 

Sound resource allocation is another tool for addressing the tax gap. The 

more effectively IRS can allocate its resources, the more progress should 

result. The new NRP data, for example, are to be used to better identify 

which tax returns to examine so that fewer compliant taxpayers are 

burdened by unnecessary audits and IRS can increase the amount of 

noncompliance that is addressed through its enforcement activities. As 

part of its attempt to make the best use of its enforcement resources, given 

budget constraints, IRS has developed rough measures of return on 

investment in terms of tax revenue that is directly assessed from 

uncovering noncompliance. Developing such measures is difficult because 

of incomplete information on all the costs and all the tax revenue 

ultimately collected from specific enforcement efforts, as well as on the

indirect tax revenues generated when current enforcement actions prompt 

voluntary compliance improvements in the future. Continuing to develop 

Optimize Resource 

Allocation 

 32Some state and federal tax experts have recognized that mandatory electronic filing for 

certain categories of tax practitioners is one remaining option with the potential to 

significantly increase electronic filing. However, mandatory electronic filing would likely 

impose some costs and burdens on tax practitioners. 

Page 20 GAO-06-453T 
the return on investment measures could help officials make more 

informed decisions about allocating resources, particularly during periods 

of budget constraints. Even with better data, however, officials will need 

to make judgments that take into account intangibles, such as how to 

achieve an equitable enforcement presence across the various taxpayer 

groups. 

Our nation’s fiscal imbalance and challenges have created an imprudent 

and unsustainable path that needs to be addressed. While our long-term 

fiscal imbalance is too large to be corrected by one strategy, reducing the 

tax gap can help address the looming fiscal challenges. Collecting the 

billions of dollars that already should be paid, for example, would help 

ease the many difficult decisions that need to be made about our spending 

programs as well as the rest of the tax system. However, the tax gap itself

has been large and pervasive over the years and therefore, reducing the

gap will not only require expansions of current efforts, but also new and 

innovative solutions. While IRS takes the lead in continuing to find ways to 

significantly reduce the tax gap, support from Congress will be essential 

since legislation will likely be needed to implement many of the tax gap 

reduction ideas offered today. We look forward to continuing to work with 

Congress and IRS on these issues. 

Chairman Gregg, Senator Conrad and members of the committee, this 

concludes my testimony. I would be happy to answer any questions you 

may have at this time. 

Contact points for our Offices of Congressional Relations and Public 

Affairs may be found on the last page of this testimony. For further 

information on this testimony, please contact Michael Brostek on (202) 

512-9110 or brostekm@gao.gov. Individuals making key contributions to 

this testimony include Tom Short, Assistant Director; Jeff Arkin; Elizabeth 

Fan; and Cheryl Peterson. 

Concluding 

Observations 

Contact and 

Acknowledgments 

Page 21 GAO-06-453T (450475) 
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