r Release 

Delivery 

petted at 

:OO a.m. EST 

uraday 

rch 31, 1988 

The Tax Gap 

Statement of 

Jennie S. Stathis, Associate Director 

General Government Division 

Before the 

Senate Budget Committee 
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THE TAX GAP 

SUMMARY STATEMENT OF 

JENNIE S. STATHIS 

ASSOCIATE DIRECTOR 

GENERAL GOVERNMENT DIVISION 

U.S. GENERAL ACCOUNTING OFFICE 

The Internal Revenue Service's (IRS) objective for developing tax 

gap estimates is to gain some perspective on the magnitude and 

types of taxpayer noncompliance. IRS defines the "tax gap" as 

the difference between the amount of income taxes voluntarily 

paid by individuals and businesses an-amount of income taxes 

that are owed. IRS estimates that taxpayers will notm84.9 

billion in income taxes that they owe on income derived from 

legal sources for tax year 1987. 

Tax gap estimates can always be debated because of data 

limitations and different assumptions used in developing them. 

It is difficult to develop the estimates; and IRS is to be 

commended for the effort it has made; 

IRS has not made public the complete details of the assumptions, 

methodolcgies, and data used in arriving at its latest estimates. 

However, by reviewing the current and previous IRS tax gap 

studies and by interviewing IRS officials, GAO identified some 

issues which can affect the size of the estimates. For example, 

(1) IRS based its estimates on existing data, but some of that 

data was old; and (2) some types of taxable income, such as 

income received on a cash basis through informal -arrangements-- 

informal supplier income-- are very difficult to estimate. Even 

SOI the tax gap estimates provide perspective on the size of the 

overall tax gap and identify pockets of noncompliance where IRS 

enforcement actions can be focused. 

GAO recognizes that income from some pockets of the gap are more 

difficult to identify than others. However, IRS should strive to 

develop methods to get at all pockets of the tax gap. Over the 

last few years, GAO has reviewed several IRS enforcement programs 

and made recommendations and suggestions for program 

improvements. For the most part, IRS officials have been 

receptive to GAO's recommendations. 

GAO's testimony illustrates how three of IRS' enforcemien.t 

programs can be more effective in reducing the tax gad without 

significantly increasing IRS' resources. This testimoiny 

discusses: (1) the merits of establishing a busine,ss iinformation 

returns program, (2) the adequacy of IRS' efforts to address tip 

income noncompliance, and (3) the effectiveness of IRS' primary 

enforcement program for illegal source income. 
Mr. Chairman and Members of the Committee: 

We are pleased to be here to discuss the tax gap and ouir efforts 

over the past several years to help the Internal Revenup Service 

(IRS) narrow the gap. We have been concerned about the! size of 

the tax gap and have reported and testified on the need for IRS 

to take actions to better identify unreported income and collect 

the taxes owed the federal government. In this time of difficult 

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choices in deliberations over the federal budget, closing the tax 

gap in a cost-effective manner is more important than ever. By 

collecting more taxes that are properly due, IRS can make 

contributions to lowering the federal budget deficit. 

Today, Mr. Chairman, I would like to make two major points: 

-- First, it is difficult to precisely measure the tax gap, but 

IRS' estimates show that the tax gap remains substantial. 

-- Second, IRS can do more to reduce some parts of the tax gap. 

Our recommended improvements to several IRS enforcement 

programs should enable IRS to better identify unreported 

income and collect more taxes. 

Mr. Chairman, I would now like to discuss these two poiints in 

greater detail. 

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THE TAX GAP ESTIMATES 

IRS' objective for developing tax gap estimates is to gain some 

perspective on the magnitude and types of taxpayer noncompliance. 

IRS has issued three studies, in 1979, 1983, and 1988, on tax gap 

estimates. The estimates in these studies can always be debated 

because of data limitations and the different assumptions used in 

developing them. However,, available evidence suggests a 

I noncompliance problem in the billions of dollars, underscoring 

I the need for effective IRS enforcement actions. 

In order to understand IRS' most recent estimate, which was 

released in March 1988, it is important to understand what the. 

estimate includes and excludes. IRS defines the "tax gap" as the 

difference between the amount of income taxes voluntarily paid by 

individuals and businesses and 'the amount of income taxes that 

are owed. IRS estimates that taxpayers will not pay $84.9 

billion in income taxes that they owe for tax year 1987. This 

amount is for income derived from legal sources because the 1988 

I study did not include an estimate for illegal source income, as l 

I did the 1983 study. 

IRS divides the legal source income tax gap into two parts: 

individuals and corporations. Th,e individual tax gap 'includes 

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sole proprietorships and partnerships. For 1987, the 'tax gap for 

individuals is estimated to be $63.5 billion, or about 75 percent 

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Of IRS' latest tax gap estimate. The tax gap for corporations is 

estimated to be $21.4 billion, or about 25 percent. In the 1983 

study, the individual gap was estimated to be 92 percent and the 

corporation gap 8 percent. 

The individual tax gap includes estimates for those who file 

incorrect tax returns as well as those who do not file at all. 

Of the tax gap for individuals who file returns', unreported 

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income at $48.3 billion is the largest single portion. 

Unreported income can come from many sources such as wages and 

salaries, interest and dividends, sole proprietorship.income, 

capital gains, and what IRS calls informal supplier income. 

Informal supplier income is cash income received by individuals 

through informal arrangements, such as those for some home 

repairs or day care. The largest portions of unreported income, 

according to IRS' study, are from sole proprietorships‘ informal ' 

suppliers, and capital gains, which are 34, 16 and 14 percent of 

the $48.3 billion total, respectively. 

The corporation tax gap, from underreporting income and 

overstating deductions and credits, includes an approx;imate $16 

billion tax gap for large and medium corporations--tho:se with $10 

million or more in assets --and about a $5 billion tax gap for 

small corporations-- those with less than $10 million in assets. 

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IRS has not made public the complete details of the ass,umptions, 

methodologies, and data used in arriving at its latest :estimates. 

However, by reviewing the current and previous IRS tax igap 

studies and by interviewing IRS officials, we identified some 

issues which could affect the size of the estimates. ' 

-- First, IRS based its estimates on existing data, but some of 

, / that data was old. IRS used 1972 and 1977 data to estimate 

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the amount of income that should have been reported by 

individual nonfilers. To estimate the amount of underreported 

/ income from taxpayers who filed, IRS relied on the results of 

its Taxpayer Compliance Measurement Program examinations of 

1982 individual returns. For small corporations, IRS used 

1981 program data. 

-- Second, IRS1 assumptions and methodologies could affect the 

size of the tax gap estimates. For example, IRS assumed in 

its latest study that overall compliance would remain constant 

through 1992. This assumption was based in part on the 

results of examinations and the potential impact of changes in 

the tax laws since 1982, including the significant changes 

from the Tsx Reform Act of 1986. In its 1983 study, IRS 

assumed that compliance would decline because voluntary 

compliance rates were down. IRS' current study is not clear 

on how much this change in assumption affects the tiax gap 

estimates or IRS' projections of those estimates. 

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-- Third, IRS' published estimates of the legal sector gap are on 

a recommended basis; that is, they include some taxes that 

would be recommended by IRS' examiners, but which would not be 

assessed if successfully appealed. As the IRS study explains, 

on an assessed basis, the tax gap estimates are lowe'r. 

-- Fourth, IRS has excluded items from its 1988 tax gap estimates 

that it previously included in its 1983 study. As previously 

stated, IRS excluded any estimate for illegal source income 

frcm the 1988 study. In the 1983 study, IRS estimated a $9.0 

billion tax gap for 1981 from 3 illegal activities--gambling, 

drug trafficking, and prostitution. 

-- Fifth, some types of taxable income are very difficult to 

estimate. The $7.7 billion estimate for informal supplier 

income is based on data gathered from individuals about the 

extent to which they purchased various items or services from 

street vendors or others on a cash basis. From this data, IRS 

attempted to estimate the amount of unreported informal 

supplier income, making various assumptions about applicable 

tax rates, deductions, etc. of the individuals receiving this 

income. 

Further, IRS is already collecting a portion of what if considers 

the overall tax gap. IRS' own definition of the tax gap includes 

all income taxes not voluntarily paid, but owed. Thus', all the 

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amounts IRS collects through enforcement programs, like the 

examination of tax returns, could be deducted from IRS': estimate 

to arrive at a net tax gap. For example, if IRS enforcement 

programs resulted in several billion dollars in additional taxes 

collected, and this amount were applied to the tax gap iestimate, 

the tax gap would be reduced by the taxes IRS collected'. 

The issues associated with developing tax gap estimates make it 

difficult for Congress to have a firm base from which to measure 

the overall impact of IRS' enforcement programs in reducing the 

gap. Developing these estimates is difficult, and IRS is to be 

commended for the effort it has made. The tax gap estimates 

provide perspective on the size of the overall tax gap 'and 

identify pockets of noncomplia,nce where IRS enforcement actions 

can be focused. 

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IRS CAN TAKE ADDITIONAL STEPS TO CLOSE THE TAX GAP 

Some types of unreported income, such as wages, interest, and 

dividends, can be more easily identified than others through IRS b 

enforcement actions. Other types of unreported income, such as 

informal supplier and sole proprietor income, as well as income 

illegally obtained, are more difficult to identify, an4 thus 

taxes are more difficult to collect. Even so, we believe that 

IRS should strive to develop methods to get at all pockets of the 

tax gap. 

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Over the last few years, we have reviewed several IRS enforcement 

programs that are designed, in part, to reduce the tax :gap. We 

have made various recommendations and suggestions for irogram 

improvements, some of which could be made without significantly 

increasing IRS' resources. For the most part, IRS has :been 

, I receptive to our recommendations and has either taken action or 

/ Attached to this statement is a 

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plans to take action on them. / 

I / list of reports and testimonies on selected reviews of IRS' 

enforcement programs. Three of those reviews illustrate how IRS' 

enforcement programs can be made more effective in reducing the 

tax gap. 

In 1987 we testified on the merits of establishing a business 

information returns program. This program would be similar to 

IRS' information returns program for individuals, which is 

designed to detect unreported'income. IRS.matches income, such 

as interest or dividends, reported on information returns it 

receives from banks and other payors against income reported by 

individual taxpayers on tax returns. IRS considers th!s matching 

program for individuals a successful enforcement program, and IRS 

officials said it yielded $17 in tax assessments for every $1 in 

cost to IRS in 1985. 

Although IRS received about 31 million information returns for 

businesses in calendar year 1986, it had not establishsed a 

matching program for businesses. We concluded in our testimony 

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that IRS could initiate a matching program to identify unreported 

income of sole proprietorships and to identify business 

nonfilers. We also suggested alternatives to IRS to help 

overcome impediments associated with establishing a full-scale 

matching program for partnerships and corporations. Not all 

proprietorship and business income is subject to information 

reporting. However, we believe that portions of the culrrently 

estimated tax gap of $16.6 billion for proprietorships and $21.4 

billion for corporations can be reduced through cost-effective 

matching programs. IRS is testing the feasibility of an 

information returns matching program for identifying unreported 

income of sole proprietorships and for identifying business 

nonfilers. IRS is also testing the use of information ~returns to 

detect unreported corporate income. _ 

In 1986, we reported that tip income reporting could be 

increased. For calendar year 1981 --the latest year for which 

information was available --IRS estimated that individuals did not 

report or pay taxes on over $8.5 billion in tip income,* This 

unreported income translated into an estimated tax loss of $2.3 

billion. IRS further estimated that the tip income noncompliance 

rate was about 84 percent, the highest noncompliance r$te among 

all legal source income areas. 

We identified tip income detection methods that were b/eing used 

in some IRS regions but not in others. We pointed'out this 

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inconsistency as well as the need for an overall strategy to 

reduce unreported tip income. IRS officials generally iagreed 

with our recommendations and identified activities that! IRS had I 

underway to aid in the formulation and implementation qf an I 

overall strategy. One of the activities included a i 

congressionally mandated study of tip income noncompliance that, 

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1 among other things, will provide information on the nature and I 

I level of tip noncompliance. This study is expected to be issued 

I * this summer. 

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. With respect to IRS' efforts to address the illegal source income 

I tax gap, we will soon issue a report on IRS' Special Etiforcement 

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I Program--its primary means of detecting illegal source income. 

This program seeks to prosecute major criminals for tad law 

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/ / violations and tax the proceeds of illegal activities, thus 

I making them-less profitable. Our work showed that for the 

program cases closed in 1982--the latest data available--IRS 

collected about $11 million, of which $2 million represented 

taxes on illegal income. While we agree with IRS that it is 

difficult to identify and tax illegal source income, we believe 

that IRS could do more to add'ress the tax aspects of criminal 

cases. IRS officials informed us that in order to ensure more 

effective tax assessment and collection, they plan to implement a 

district level program to monitor civil actions on closed 

criminal cases. 

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We are currently doing other work related to reducing the tax 

gap. At this committee's request, we are reviewing how much 

revenue IRS actually generates through examinations. We are also 

looking at the effectiveness of IRS' efforts with regarg to 

independent contractors' compliance with the tax laws, the 

adequacy of levies to promote better compliance, and the effect 

that past declining audit coverage may have had on the tax gap. 

We have recognized the importance of IRS having adequate 

resources to maintain effective enforcement programs. We have 

testified on IRS' budget requests and recommended that IRS be 

given additional resources, which Congress has provided. We also 

believe, however, it is incumbent upon IRS to continue to 

identify those opportunities and innovative techniques that will 

enhance the effectiveness of its enforcement programs in reducing 

the tax gap. 

This concludes my prepared statement. I would be happy to answer 

your questions. . 8 

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Attachment At;tachment 

SELECTED GAO REPORTS AND TESTIMONIES : 

SINCE 1981 ON IRS ENFORCEMENT PROGRAMS 

Investigating Illegal Income--Success Uncertain, Improvements 

Needed (GAO/GGD-88-6 1, issuance due in spring of 1:988) 

Gas Guzzler Tax Compliance Can Be Increased (GAO/GGD-87-85, 

7/16/87) 

Testimony Before the Subcommittee on Commerce, Consumer and 

Monetary Affairs, House Committee on Government Operations 

on The Merits of Establishing a Business Information Returns 

Program (GAO/T-GGD-87-4, 3/17/87) 

I Tip Income Reporting Can Be Increased (GAO/GGD-86-119, g/30/86) 

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Information Returns Should Increase Proper Reporting of Farm 

, / I Income (GAO/GGD-86-69, 7/22/86) 

Testimony Before the Subcommittee on Commerce, Consumer and 

Monetary Affairs, House Committee on Government Operations 

on IRS' Information Returns Matching Program, 4/29/86 

Protecting Tax Revenue When Businesses File for Bankruptcy 

(GAO/GGD-86-20, 2/21/86). 

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The Federal/State Tax Information Exchange Program (GAO/GGD-86-8, 

12/13/85) 

IRS' Examination Selection System for Exempt Organizations' 

Unrelated Business Income (GAO/GGD-85-64, 7/8/85) 

IRS is Taking Action to Improve the Quality of Its Small 

Corporation Audits (GAO/GGD-85-26, 6/12/85) 

Testimony Before the Subcommittee on Commerce, Consumer and 

Monetary Affairs, House Committee onGovernment Operations 

On U.S. Citizens Living in Foreign Countries and Not Filing 

Federal Income Tax Returns, 5/8/85 

Administrative Changes Could Strengthen IRS' Claims for Rewards 

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Program (GAO/GGD-85-11, 4/19/85) 

Further Research into Noncompliance is Needed to ReduOe Growing 

Tax Losses (GAO/GGD-82-34, 7/23/82) 

What IRS Can Do To Collect More Delinquent Taxes (GAOIGGD-82-4, 

11/5/81) 

IRS Could Better Protect U.S. Tax Interests in Determining the 

Income of Multinational Corporations (GAO/GGD-81+81, 

g/30/81) 

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