TAX GAP

Sources of Noncompliance 

and Strategies to Reduce It

Statement of James R. White, Director 

Strategic Issues

Testimony before the Subcommittee on 

Government Organization, Efficiency, and 

Financial Management, Committee on 

Oversight and Government Reform, House 

of Representatives

For Release on Delivery 

Expected at 10:00 a.m. EDT

Thursday, April 19, 2012

GAO-12-651T

United States Government Accountability Office

GAO
United States Government Accountability Office

Highlights of GAO-12-651T, a testimony 

before the Subcommittee on Government 

Organization, Efficiency, and Financial 

Management, Committee on Oversight and 

Government Reform, House of 

Representatives

April 19, 2012

TAX GAP

Sources of Noncompliance and Strategies to Reduce 

It

Why GAO Did This Study

In January 2012, IRS estimated that 

the gross tax gap—the difference 

between taxes owed and taxes paid on 

time—was $450 billion for tax year 

2006. IRS estimated that it would 

collect $65 billion through enforcement 

actions and late payments, leaving a 

net tax gap of $385 billion. From 2001 

to 2006, IRS estimated that the gross 

tax gap increased by $105 billion. 

However, the percentage of taxes 

owed that were paid on time remained 

relatively constant at 83.1 percent in 

2006, compared to 83.7 percent in 

2001.

Given persistent levels of 

noncompliance and large and growing 

structural deficits, it will be important to 

understand the causes of tax 

noncompliance and develop new 

approaches to minimize it. 

This testimony addresses two 

questions: (1) What types of taxpayers 

are responsible for the tax gap, and 

what is the nature of their 

noncompliance? (2) What are 

strategies for reducing the tax gap? 

The statement also discusses potential 

long-term strategies to prevent refund 

fraud related to identity theft. This 

statement is based largely on GAO’s 

recent reports and recommendations 

on tax noncompliance and updates 

GAO’s 2011 testimony on the tax gap.

What GAO Recommends

GAO has made numerous prior 

recommendations regarding actions to 

close the tax gap. Congress and IRS 

have acted on some, while others are 

reflected in the strategies presented in 

this testimony.

What GAO Found

Noncompliance does not have a single source but occurs across different types 

of taxes and taxpayers. For example, individual income tax accounts for the 

largest portion of the tax gap, but corporate income tax and employment tax are 

also significant. Further, misreporting by individuals involves business income, 

non-business income, deductions, and credits. The extent of misreporting 

depends on the extent to which income tax is withheld or reported to the Internal 

Revenue Service (IRS) by third parties. For example, nearly 40 percent, or $179 

billion, of the 2006 gross tax gap is due to misreporting of non-corporate 

business income and related self-employment taxes. Much of this misreporting 

can be attributed to sole proprietors underreporting receipts or over-reporting

expenses. Unlike wage and some investment income, sole proprietors’ income is 

not subject to withholding and only a portion is reported to IRS by third parties.

Because noncompliance has multiple causes and spans different types of taxes 

and taxpayers, multiple approaches are needed to reduce the tax gap. The 

following strategies could help and will require actions by Congress or IRS.

Enhancing information reporting by third parties to IRS could reduce tax 

evasion and help taxpayers comply voluntarily. However, identifying additional 

reporting opportunities can be challenging because third parties may not have 

accurate information available in a timely manner. Also, adding reporting 

requirements creates burden for both third parties and IRS. 

Ensuring high-quality services to taxpayers, such as by telephone and

correspondence or online, can help taxpayers who wish to comply with tax laws 

but do not understand their obligations. However, tax law changes and funding 

priorities have recently affected IRS’s ability to provide quality taxpayer services.

Devoting additional resources to enforcement would enable IRS to contact 

millions of potentially noncompliant taxpayers it identifies but cannot contact. To 

determine the appropriate level of enforcement resources, policymakers would 

need to consider how to balance taxpayer service and enforcement activities and 

how effectively and efficiently IRS currently uses its resources.

Expanding compliance checks before IRS issues refunds would involve 

matching information returns to tax returns during, rather than after, the tax filing 

season. This approach would require a major reworking of some fundamental 

IRS computer systems but could help address identity theft-related fraud and 

allow IRS to use enforcement resources on other compliance problems. 

Leveraging external resources, such as paid tax return preparers and 

whistleblowers, can help improve tax compliance because paid preparers’ 

actions have an enormous impact on IRS’s ability to effectively administer tax 

laws, and whistleblowers provide IRS information on suspected noncompliance. 

Modernizing information systems would allow IRS to post more 

comprehensive tax return information to its computer systems, which could 

facilitate the examination process and expedite taxpayer contacts for faster 

resolution.

Simplifying the tax code could help taxpayers understand and voluntarily 

comply with their tax obligations and limit opportunities for tax evasion.

View GAO-12-651T. For more information, 

contact James R. White at (202) 512-9110 or 

whitej@gao.gov.
 

Page 1 GAO-12-651T 

Chairman Platts, Ranking Member Towns, and Members of the 

Subcommittee:

I am pleased to be here to discuss the tax gap and related fraud, such as 

identity theft based refund fraud, and how to reduce it. In January 2012, 

the Internal Revenue Service (IRS) estimated that the gross tax gap—the 

difference between taxes owed and taxes paid on time—was $450 billion 

in tax year 2006. IRS estimated that it would eventually recover about $65 

billion of this amount through late payments and enforcement actions, 

leaving a net tax gap of $385 billion.1

My testimony today will answer two questions: (1) What types of 

taxpayers are responsible for the tax gap, and what is the nature of their 

noncompliance? (2) What are strategies for reducing the tax gap? As 

requested, we will also provide information on potential long-term 

strategies to prevent refund fraud related to identity theft. My testimony is 

based largely on our recent reports on tax noncompliance and updates 

our 2011 testimonies on the tax gap and identity theft.

The tax gap has been a persistent 

problem in spite of a myriad of congressional and IRS efforts to reduce it, 

as the rate at which taxpayers voluntarily comply with United States tax 

laws has changed little over the past three decades. In past testimonies, 

we have said that there are no easy fixes to this problem, and given 

persistent levels of noncompliance, reducing the tax gap will not likely be 

achieved through a single solution. Rather, the tax gap must be attacked 

on multiple fronts and with multiple strategies over a sustained period of 

time. Whether mistakes are intentional or unintentional, misreporting is 

unfair to compliant taxpayers and undermines the equity of the tax 

system. Moreover, in the face of large and growing structural deficits, it 

will be especially important to understand the causes of tax 

noncompliance today and continue to develop new approaches to 

minimize it.

2

 

1

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

otherwise noted. 

Additional 

information on our scope and methodology is available in our published 

products.

2

GAO, Tax Gap: Complexity and Taxpayer Compliance, GAO-11-747T (Washington, 

D.C.: June 28, 2011), and Taxes and Identity Theft: Status of IRS Initiatives to Help 

Victimized Taxpayers, GAO-11-721T (Washington, D.C.: June 2, 2011).

 
 

Page 2 GAO-12-651T 

This testimony and the reports and testimonies upon which it is based 

were conducted in accordance with generally accepted government 

auditing standards. Those standards require that we plan and perform the 

audit to obtain sufficient, appropriate evidence to provide a reasonable 

basis for our findings and conclusions based on our audit objectives. We 

believe that the evidence obtained provides a reasonable basis for our 

findings and conclusions based on our audit objectives.

For this hearing, we updated prior reported information about the 

estimated amounts for various components of the 2006 tax gap, the data 

and methodology used to estimate the 2006 tax gap, and actions IRS has 

taken to address our recommendations to improve taxpayer compliance. 

We confirmed the new information with IRS officials.

The gross tax gap has grown in dollar terms since IRS’s previous 

estimate for tax year 2001, increasing from $345 billion to $450 billion for 

tax year 2006.3 However, given the growth of the economy and total 

federal tax liability over that period, the percentage of taxes owed that 

taxpayers paid voluntarily and on time, known as the voluntary 

compliance rate, has remained relatively constant—83.7 percent in 2001 

and 83.1 percent in 2006.4

 

3

These amounts have not been adjusted for inflation. 

4

This 30 percent increase in the size of the gross tax gap from 2001 to 2006 is similar to 

the increase in the size of the United States economy (gross domestic product) over the 

time period. Likewise, total tax liabilities increased nearly 26 percent, from about $2.1 

trillion to about $2.7 trillion, from tax years 2001 to 2006. (Dollar amounts for total tax 

liabilities do not match percentage increase because of rounding.) IRS also estimated that 

corporate income tax underreporting increased by $37 billion during this time. However, 

this growth may not indicate increased corporate noncompliance. According to IRS, the 

2001 estimate of this portion of the tax gap was estimated based on old empirical data 

and was likely understated. In addition, from 2001 to 2006, corporation income tax 

liabilities more than doubled, while individual income tax liabilities grew by 15 percent.

The Tax Gap Is 

Spread across Various 

Types of Taxpayers 

and Taxes

Characteristics of the Tax 

Gap
 

Page 3 GAO-12-651T 

The tax gap 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 on time.5

The tax gap includes unintentional errors as well as intentional evasion, 

such as intentionally underreporting income, intentionally over-reporting 

expenses, and engaging in abusive tax shelters or frivolous tax schemes. 

It does not include legal tax avoidance activities (legally lowering tax 

liability), taxes due from illegally derived income, or various forms of 

fraud. For example, in general, refund fraud related to identity theft would 

not be included in the tax gap estimate because it does not involve 

evading a tax liability. Nevertheless, as discussed later in the testimony, 

actions taken to improve overall compliance and reduce the tax gap could 

also potentially address identity theft related fraud.

The 

estimate also covers the five types of taxes that IRS administers—

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

taxes.

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

and nature of taxpayer noncompliance. As shown in table 1, 

noncompliance does not come from a single source but rather occurs 

across different types of taxes and taxpayers. For example, individual 

income tax accounted for most of the tax gap estimate for tax year 2006. 

However, corporate income tax and employment tax also contributed a 

significant portion.

 

5

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 on time.
 

Page 4 GAO-12-651T 

Table 1: IRS’s Tax Year 2006 Gross Tax Gap Estimates by Type of Noncompliance and Type of Tax

Dollars in billions

Type of noncompliance

Type of tax

Individual 

income tax

Corporate 

income tax

Employment

tax Estate tax Excise tax Total

Underreporting $235 $67 $72 $2 No estimate $376

Underpayment 36 4 4 2 0.1 46

Nonfiling 25 No estimate No estimate 3 No estimate 28

Total $296 $71 $76 $7 $0.1 $450

Source: IRS.

As shown in table 2, individual income tax underreporting includes both 

nonbusiness income tax and business income tax underreporting. 

Business income for individuals includes income from a variety of 

business types, including sole proprietors,6 partnerships, and S 

corporations,7 many of which are small businesses. Nearly 40 percent, or 

$179 billion, of the 2006 gross tax gap can be attributed to these types of 

business taxpayers who underreport their business income tax, and by 

extension their self-employment tax, on their individual income tax 

returns.8 Further, the misreporting of business income tax can take on a 

variety of forms. For example, misreporting of non-corporate business 

income tax can be largely attributed to sole proprietors who understated 

receipts or overstated expenses.9

 

6

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

individual tax returns to report profits and losses from their businesses. 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.

A key reason for this misreporting is 

7

S corporations provide limited liability protection to shareholders and “pass through” 

gains and losses to shareholders’ individual tax returns without generally paying taxes at 

the entity level. Limited liability protection means that a shareholder’s financial liability for a 

company is limited to the amount of their investment in the company. Owners of S 

corporations are referred to as shareholders.

8

Self-employed individuals are generally required to calculate and remit Social Security 

and Medicare taxes to the U.S. Treasury each quarter. As employment taxes and income 

taxes for self-employed taxpayers are largely assessed on the same income, selfemployed individuals who underreport their income consequently underreport the 

employment tax due on that income.

9

GAO, Tax Gap: A Strategy for Reducing the Gap Should Include Options for Addressing 

Sole Proprietor Noncompliance, GAO-07-1014 (Washington, D.C.: July 13, 2007).
 

Page 5 GAO-12-651T 

well known. Unlike wage and some investment income, sole proprietors’ 

income is not subject to withholding and only a portion is subject to 

information reporting to IRS by third parties.

Table 2: Underreporting Portion of IRS’s Tax Year 2006 Gross Tax Gap Estimates 

Dollars in billions

Tax gap component Estimated underreporting amount

Individual income tax $235 

Nonbusiness income 68 

Business income 122 

Adjustments, deductions, and exemptions 17 

Credits 28 

Corporate income tax $67 

Small corporations 19 

Large corporations 48 

Employment tax $72 

 Self-employment tax 57 

FICA and unemployment tax 15 

Estate tax $2 

Total underreporting $376

Source: IRS.

As shown in figure 1, the extent to which individual taxpayers accurately 

report their income is related to the extent to which the income is reported 

to them and IRS by third parties or taxes on the income are withheld. For 

example, for types of income for which there is little or no information 

reporting, such as business income, individual taxpayers tend to 

misreport over half of their income. In contrast, employers report most 

wages, salaries, and tip compensation to employees and IRS through 

Form W-2. Also, 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. Findings from IRS’s 

study of individual tax compliance indicate that nearly 99 percent of these 

types of income are accurately reported on individual tax returns.
 

Page 6 GAO-12-651T 

Figure 1: Effect of Information Reporting on Taxpayer Compliance, Tax Year 2006

Taxpayers misreport income and expenses for a variety of reasons. 

Some misreporting is intentional; some is unintentional. Often it is 

impossible to tell from a tax return whether errors are intentional or 

unintentional or even who made the error. For example, paid tax return 

preparers could make errors or taxpayers could fail to share relevant 

information with their preparers. Our past reports shed some light on the 

extent of unintentional errors. In our report on securities cost basis 

reporting,10

 

10Generally, a taxpayer’s gain or loss from a securities sale is simply the difference 

between the gross proceeds from the sale and the original purchase price, or original cost 

basis. However, before taxpayers can determine any gains or losses from securities sales, 

they must determine if and how the original cost basis of the securities must be adjusted 

to reflect certain events, such as stock splits, nontaxable dividends, or nondividend 

distributions.

we found that among individual taxpayers who misreported 

securities sales, roughly one-third over-reported income (i.e., they 
 

Page 7 GAO-12-651T 

overstated gains or understated losses).11 For sole proprietors, we 

reported that 9 percent over-reported their net income, while 61 percent 

underreported their net income in 2001.12 It seems likely that such 

instances of over-reporting could be due to unintentional errors.

We have long encouraged regular tax gap measurement because these 

estimates are important to gauge progress in addressing the tax gap and, 

perhaps more importantly, because analyzing the data used to estimate it 

can help identify ways to improve tax compliance. One source of such 

data is the National Research Program (NRP), which uses audits of a 

stratified, random sample of tax returns to produce statistically valid 

estimates of noncompliance for the entire population of tax return filers. 

IRS uses the NRP sample results to better target its enforcement 

examinations of noncompliant taxpayers. Better targeting examinations to 

taxpayers who are noncompliant reduces burden on compliant taxpayers.

Updated compliance data can also help identify changes in tax laws and 

regulations that may improve compliance. For example, we analyzed 

NRP data on individual taxpayer compliance and reported that, among 

other things, Congress could consider requiring brokers to report to both 

taxpayers and IRS the adjusted basis of securities that taxpayers sell.13

Congress enacted this provision,14

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

feasible since it could entail more intrusive recordkeeping or reporting 

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

commit.

which the Joint Committee on 

Taxation estimated would raise $6.7 billion in revenue through 2018.

15

 

11GAO, Capital Gains Tax Gap: Requiring Brokers to Report Securities Cost Basis Would 

Improve Compliance if Related Challenges Are Addressed, 

However, given the size of the tax gap, even modest reductions 

GAO-06-603 (Washington, 

D.C.: June 13, 2006). 

12 GAO-07-1014. 

13GAO-06-603. 

14Energy Improvement and Extension Act of 2008, Pub. L. No 110-343, § 403, 122 Stat. 

3768, 3854 (Oct. 3, 2008).

15GAO, Taxpayer Compliance: Analyzing the Nature of the Income Tax Gap, 

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

Measuring the Tax Gap
 

Page 8 GAO-12-651T 

would yield very significant financial benefits. We have made numerous 

recommendations over time that could address the tax gap, as follows.

Multiple approaches are needed to reduce the tax gap. No single 

approach is likely to fully and cost-effectively address noncompliance 

since the noncompliance has multiple causes and spans different types of 

taxes and taxpayers. While the tax gap will remain a challenge into the 

future, the following strategies could help. These strategies would require 

actions by Congress or IRS.

Information reporting is a powerful tool that reduces tax evasion and 

helps taxpayers comply voluntarily. Several major new information 

requirements have recently taken effect, based at least in part on our 

work and recommendations.

• Brokers are required to report their clients’ basis for securities sales, 

starting in 2012.16

• Banks and other third parties are required to report businesses’ credit 

card and similar receipts, starting in 2011.17

• Under the Foreign Account Tax Compliance Act, starting in 2014, U.S. 

financial institutions and other entities are required to withhold a 

portion of certain payments made to foreign financial institutions that 

have not entered into an agreement with IRS to report details on U.S. 

account holders to IRS.18

As these three sets of information reporting requirements have only 

recently taken effect, it is too soon to tell the actual impact they are 

having on taxpayer compliance.

We have identified other options for information reporting.

 

16GAO-06-603. 

17GAO, Tax Administration: Costs and Uses of Third-Party Information Returns, 

GAO-08-266 (Washington, D.C.: Nov. 20, 2007). 

18GAO, Reporting Foreign Accounts to IRS: Extent of Duplication Not Currently Known, 

but Requirements Can Be Clarified, GAO-12-403 (Washington, D.C.: Feb 28, 2012).

Various Strategies Are 

Required to Reduce 

the Tax Gap

Enhancing Information 

Reporting by Third Parties 

to IRS
 

Page 9 GAO-12-651T 

• Service payments to corporations. Currently, businesses must 

report to IRS payments for services they make to unincorporated 

persons or businesses, but payments to corporations generally do not 

have to be reported.19

• Service payments made by landlords. Taxpayers who rent out real 

estate are required to report to IRS expense payments for certain 

services, such as payments for property repairs, only if their rental 

activity is considered a trade or business. However, the law does not 

clearly spell out how to determine when rental real estate activity is 

considered a trade or business.20

Broader requirements for these two forms of information reporting, 

covering goods in addition to services, were enacted into law in 2010 but 

were later repealed. We believe the more narrow extensions of 

information reporting to include services, but not goods, remain important 

options for improving compliance.

Additionally, we have identified existing information reporting 

requirements that could be enhanced.

• Higher education expenses. Eligible educational institutions are 

currently required to report information on qualified tuition and related 

expenses for higher education so that taxpayers can determine the 

amount of educational tax benefits they can claim.21 IRS revising the 

information reporting form could improve the usefulness of reported 

information.22

• Mortgaged properties. Requiring third parties, such as mortgage 

lenders, to report mortgaged property addresses in addition to 

 

19GAO, Tax Gap: IRS Could Do More to Promote Compliance by Third Parties with 

Miscellaneous Income Reporting Requirements, GAO-09-238 (Washington, D.C.: Jan. 28, 

2009).

20GAO, Tax Gap: Actions That Could Improve Rental Real Estate Reporting Compliance, 

GAO-08-956 (Washington, D.C.: Aug. 28, 2008). 

2126 U.S.C. § 6050S. 

22GAO, 2009 Tax Filing Season: IRS Met Many 2009 Goals, but Telephone Access 

Remained Low, and Taxpayer Service and Enforcement Could Be Improved, GAO-10-225

(Washington, D.C.: Dec. 10, 2009). 
 

Page 10 GAO-12-651T 

information they are already required to report on mortgaged 

properties would help IRS identify potential noncompliance.23

Identifying additional third-party reporting opportunities is challenging. 

Considerations include whether any third parties have accurate 

information available in a timely manner, the burden of reporting on the 

third parties, and whether IRS can enforce the reporting requirement. To 

illustrate, in a 2009 report, we found that a major reason why little 

information reporting on sole proprietor expenses exists is because of the 

difficulty identifying third parties.24 For example, there is no third party that 

could verify the business use of cars or trucks by sole proprietors.

Ensuring high-quality taxpayer services, such as by telephone and 

correspondence or online, can help taxpayers who wish to comply with 

tax laws but do not understand their obligations. However, in recent years 

and continuing this year, IRS’s service performance has seen declines. 

Tax law changes and other funding priorities have affected IRS’s ability to 

provide quality taxpayer services. For example, we recently reported that 

call volume has increased nearly 35 percent from the same time period 

last year, which IRS attributed, in part, to taxpayer questions about tax 

law changes.25 Concurrently, taxpayers’ ability to get through to IRS 

telephone assistors has declined.26

 

23GAO, Home Mortgage Interest Deduction: Despite Challenges Presented by Complex 

Tax Rules, IRS Could Enhance Enforcement and Guidance, 

Through late February of this year, 65 

percent of callers seeking to talk to an IRS telephone assistor got 

through, compared to 70 percent for 2011. To improve service, we have 

recommended that IRS determine the costs and benefits of creating 

additional automated telephone applications and finalize a more 

GAO-09-769 (Washington, 

D.C.: July 29, 2009); Tax Administration: Expanded Information Reporting Could Help IRS 

Address Compliance Challenges with Forgiven Mortgage Debt, GAO-10-997

(Washington, D.C.: Aug 31, 2010); and GAO-08-956. 

24GAO, Tax Gap: Limiting Sole Proprietor Loss Deductions Could Improve Compliance 

but Would Also Limit Some Legitimate Losses, GAO-09-815 (Washington, D.C.: Sept. 10, 

2009). 

25GAO, 2011 Filing Season: Processing Gains, but Assistance Could Be Enhanced by 

More Self-Service Tools, GAO-12-176 (Washington, D.C.: Dec. 15, 2011). 

26GAO, Internal Revenue Service: Interim Results of 2012 Tax Filing Season and 

Summary of the Fiscal Year 2013 Budget Request, GAO-12-566 (Washington, D.C.: Mar. 

20, 2012). 

Ensuring High-Quality 

Services to Taxpayers
 

Page 11 GAO-12-651T 

comprehensive plan for online services, including an assessment of 

granting taxpayers the ability to update their account information online.

Devoting additional resources to enforcement would enable IRS to 

contact millions of potentially noncompliant taxpayers that it currently 

identifies but cannot contact given resource constraints. However, 

determining the appropriate level of enforcement resources to provide 

IRS requires taking into account factors such as how effectively and 

efficiently IRS is currently using its resources, how to strike the proper 

balance between IRS’s taxpayer service and enforcement activities, and 

competing federal funding priorities. For example, in a 2009 report, we 

found that despite investing nearly a quarter of all revenue agent time in 

2008, IRS was able to examine (audit) about 1 percent of estimated 

noncompliant sole proprietors. Not only are these exams burdensome for 

businesses, they are also costly for IRS and yield less revenue than 

examinations of other categories of taxpayers, in part because most sole 

proprietorships are small in terms of receipts.27

IRS could reduce the tax gap by expanding compliance checks before 

issuing refunds to taxpayers. The Commissioner of Internal Revenue has 

talked about a long-term vision to increase compliance activities before 

refunds are sent to taxpayers. In one example, IRS is exploring a 

requirement that third parties send information returns to IRS and 

taxpayers at the same time as opposed to the current requirement that 

some information returns go to taxpayers before going to IRS. The intent 

is to allow IRS to match those information returns to tax returns during tax 

return filing season rather than after the filing season is complete.28

 

27

As 

will be discussed later, this approach could also help IRS address identity 

theft-related fraud and could also allow IRS to use its enforcement 

resources on other significant compliance problems. However, the 

Commissioner made clear that his vision for more prerefund compliance 

checks will take considerable time to implement, will require a major 

reworking of some fundamental IRS computer systems, and could impose 

some additional burden on third parties.

GAO-09-815. 

28GAO, Taxpayer Account Strategy: IRS Should Finish Defining Benefits and Improve 

Cost Estimates, GAO-11-168 (Washington, D.C.: Mar. 24, 2011). 

Devoting Additional 

Resources to Enforcement

Expanding Compliance 

Checks Before IRS Issues 

Refunds 
 

Page 12 GAO-12-651T 

Another way IRS may be able to reduce the tax gap is by leveraging 

external resources.

• Paid tax return preparers prepare approximately 60 percent of all tax 

returns filed, and IRS has acknowledged that paid preparers’ actions 

have an enormous impact on its ability to administer tax laws 

effectively. Based in part on our work and recommendations, IRS 

recently developed new requirements for paid preparers, such as 

competency testing, which it has concluded will increase tax 

compliance.29

• Tax whistleblowers can help improve tax compliance by providing 

information to IRS on others’ suspected tax noncompliance. We have 

made several recommendations for IRS to improve its whistleblower 

program through enhanced data collection and whistleblower claim 

processing timeliness.

IRS’s goals for the program include leveraging 

relationships with paid preparers and improving the accuracy of the

tax returns they prepare.

30 According to IRS, it is in the process of 

implementing these recommendations.

Modernization of IRS’s information systems could improve taxpayer 

compliance. IRS is engaged in a multiyear effort to replace the systems it 

uses to process individual tax returns and receive electronically filed tax 

returns.31 IRS had identified various compliance benefits to replacing the 

system it uses to process individual tax returns, including increasing 

taxpayer and paid preparer voluntary compliance and examination case 

selection.32

 

29GAO, Tax Preparer Regulation: IRS Needs a Documented Framework to Achieve Goal 

of Improving Taxpayer Compliance, 

Among other benefits, replacing its electronic filing system will 

allow IRS to accept taxpayers’ prior-year returns and portable document 

format (PDF) files attached to their tax returns. According to IRS officials, 

GAO-11-336 (Washington, D.C.: Mar. 31, 2011); Tax 

Preparers: Oregon’s Regulatory Regime May Lead to Improved Federal Tax Return 

Accuracy and Provides a Possible Model for National Regulation, GAO-08-781

(Washington, D.C.: Aug. 15, 2008); and Internal Revenue Service: Fiscal Year 2009 

Budget Request and Interim Performance Results of IRS’s 2008 Tax Filing Season, 

GAO-08-567 (Washington, D.C.: Mar. 13, 2008). 

30GAO, Tax Whistleblowers: Incomplete Data Hinders IRS’s Ability to Manage Claim 

Processing Time and Enhance External Communication, GAO-11-683 (Washington, D.C.: 

Aug. 10, 2011).

31GAO-12-176. 

32GAO-11-168. 

Leveraging External 

Resources Such as Paid 

Tax Return Preparers and 

Whistleblowers 

Modernizing Information 

Systems
 

Page 13 GAO-12-651T 

posting more comprehensive information from individual income tax 

returns to its computer systems could facilitate the examination process, 

expedite taxpayer contacts for faster resolution, and potentially better 

define specific tax gap issues.33

Tax code complexity can lead to noncompliance. Efforts to simplify or 

reform the tax code may help reduce the tax gap by making it easier for 

individuals and businesses to understand and voluntarily comply with 

their tax obligations. For example, eliminating or combining tax 

expenditures, such as exemptions, deductions, and credits, could help 

taxpayers reduce unintentional errors and limit opportunities for tax 

evasion.

Policymakers may find it useful to compare any proposed changes to the 

tax code based on a set of widely accepted criteria for assessing 

alternative tax proposals. These criteria include the equity, or fairness, of 

the tax system; the economic efficiency, or neutrality, of the system; and 

the simplicity, transparency, and administrability of the system. These 

criteria can sometimes conflict, and the weight one places on each 

criterion will vary among individuals. Our publication, Understanding the 

Tax Reform Debate: Background, Criteria, & Questions, may be useful in 

guiding policymakers as they consider tax reform proposals.34

Our recent reports show how changing tax laws to include more 

consistent definitions across tax provisions could help taxpayers more 

easily understand and comply with their obligations.

• For example, higher education expenses that qualify for some of the 

savings and credit provisions in the tax code differ by provision. These 

dissimilar definitions require that taxpayers keep track of expenses 

 

33GAO, Tax Administration: 2007 Filing Season Continues Trend of Improvement, but 

Opportunities to Reduce Costs and Increase Tax Compliance Should be Evaluated, 

GAO-08-38 (Washington, D.C.: Nov. 15, 2007). 

34GAO, Understanding the Tax Reform Debate: Background, Criteria, & Questions, 

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

Simplifying the Tax Code 

or Fundamental Tax 

Reform 
 

Page 14 GAO-12-651T 

separately, applying some expenses to some tax preferences but not 

others.35

• Likewise, more clarity would help taxpayers determine how to treat 

certain financial derivative products for tax purposes. Unique 

characteristics of financial derivatives make them particularly difficult 

for the tax code and IRS to address. Deferring gains or accelerating 

losses, changing ordinary income into capital gains or vice versa for 

losses, and altering the source of gains to avoid withholding taxes are 

examples of inconsistent tax rules for financial derivatives resulting in 

equivalent economic outcomes being taxed differently.36

Identity theft creates problems for both taxpayers and IRS. In refund fraud 

cases, an identity thief uses a legitimate taxpayer’s identity to fraudulently 

file a tax return and claim a refund during the filing season. In these 

cases, the identity thief typically uses a stolen Social Security Number 

(SSN) to file a forged tax return and obtain a refund early in the filing 

season. The legitimate owner of the SSN may not be aware that this has 

occurred until he or she files a tax return later in the filing season and IRS 

discovers that two returns have been filed using the same SSN. In this 

instance, the legitimate taxpayer’s refund will likely be frozen until IRS 

can determine the legitimate owner of the SSN.37

In our June 2011 testimony before this subcommittee, we reported that 

IRS faced various challenges in resolving, detecting, and preventing 

identity theft. These challenges included limitations in coordinating with 

other agencies and taxpayers because of privacy and other laws, inability 

 

35GAO, Student Aid and Postsecondary Tax Preferences: Limited Research Exists on 

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).

36GAO, Financial Derivatives: Disparate Tax Treatment and Information Gaps Create 

Uncertainty and Potential Abuse, GAO-11-750 (Washington, D.C.: Sept. 20, 2011). 

37Identity theft may also involve employment fraud. This occurs when an identity thief uses 

someone else’s name and SSN to obtain a job. In this instance, IRS would receive a Form 

W-2 or a Form 1099 reporting income on the taxpayer’s account, which the rightful owner 

of the SSN had not earned and does not report as income to IRS. As a result, the 

taxpayer may be subject to enforcement action when, during the filing process, IRS 

matches what the employer and the taxpayer report and it appears that he or she earned 

more income than was reported on his or her tax return.

Challenges to 

Addressing Identity 

Theft 
 

Page 15 GAO-12-651T 

to detect suspicious cases until after fraud has occurred, and the lack of 

resources and authority to investigate and prosecute identity thieves.38

Addressing these challenges will require significant, long-term changes in 

IRS’s operations and systems. As previously discussed, the 

Commissioner’s long-term vision to increase up-front compliance 

activities could help. For example, matching employer information with tax 

returns before refunds are issued could prevent identity thieves from 

using phony W-2s to claim fraudulent refunds. However, significant 

changes would be needed before this matching could occur. Third-party 

information returns would need to be filed with IRS earlier in the filing 

season.39 IRS would also need to improve its automated processing 

systems; IRS’s current Customer Account Data Engine (CADE 2) effort is 

one key step.40

Chairman Platts, Ranking Member Towns, and Members of the 

Subcommittee, this completes my prepared statement. I would be 

pleased to respond to any questions that you may have at this time.

If you or your staff have any questions about this testimony, please 

contact me at (202) 512-9110 or whitej@gao.gov. Contact points for our 

Offices of Congressional Relations and Public Affairs may be found on 

the last page of this statement. GAO staff who made key contributions to 

this testimony are listed in appendix II.

 

38GAO, Tax Administration: IRS Has Implemented Initiatives to Prevent, Detect, and 

Resolve Identity Theft-Related Problems, but Needs to Assess Their Effectiveness, 

GAO-09-882 (Washington, D.C.: Sept. 8, 2009), and GAO-11-721T. 

39Many information returns, such as forms W-2 filed by employers, are not due to the 

government until the end of February.

40GAO-11-18. 

GAO Contacts and 

Staff 

Acknowledgements 
Appendix I: 2006 Tax Gap Estimate Data and 

Methodology

Page 16 GAO-12-651T 

The Internal Revenue Service’s (IRS) tax gap estimates are based on a 

variety of data sources and methodologies. For example, IRS studied 

individual taxpayer compliance through the National Research Program 

(NRP) and used the resulting compliance data to estimate the tax gap for 

individual income tax underreporting and the portion of employment tax 

underreporting attributed to self-employment taxes for tax year 2006. 

The 2006 Individual NRP involved auditing a random selection of about 

13,000 to 14,000 individual tax returns and is much smaller than the tax 

year 2001 Individual NRP of approximately 45,000 returns. Starting with 

the 2006 Individual NRP compliance study, IRS is using a rolling sample, 

which will combine samples across three years. According to IRS, this 

change will reduce cost and provide more up to date compliance data. 

The sample design for the 2006 Individual NRP included 11 primary 

strata, which were based on the examination classes used in audit 

workload selection. Also, the 2006 Individual NRP was designed to 

oversample returns with business income reported on Schedule C, E, or 

F or Form 2106.

The individual underreporting gap for tax year 2006 was based on 

findings from the 2006 Individual NRP and from an econometric analysis 

of tax year 2001 NRP data. This econometric analysis, called DetectionControlled Estimation (DCE), attempts to account for income that 

taxpayers do not report on their tax returns and that NRP auditors could 

not detect. Because insufficient NRP data has been accumulated for tax 

year 2006 and later years for full DCE analysis, an improved DCE was 

undertaken using tax year 2001 NRP data and adjusted using other 

information to estimate undetected income for tax year 2006 NRP returns.

We have not verified the accuracy of IRS’s estimate of the tax gap. 

According to IRS, a significant portion of IRS’s 2006 tax gap estimate is 

based on recent compliance data and improved estimation methods. 

However, the tax gap estimate continues to be incomplete and partly 

based on older data. For example, the underreporting estimates for both 

FICA and unemployment taxes are projections based on applying the 

estimated compliance rates for 1984 to currently reported taxes.

To estimate the 2006 individual nonfiling gap, IRS used tax year 2005 

third-party information returns, rather than the Census Exact Match study, 

as it did for the tax year 2001 estimate. The underpayment component of 

the tax gap is not an estimate but rather represents the actual tax 

amounts that taxpayers reported on time, but did not pay on time.

Appendix I: 2006 Tax Gap Estimate Data and 

Methodology 
Appendix II: GAO Contact and Staff 

Acknowledgments

Page 17 GAO-12-651T 

James R. White, (202) 512-9110 or whitej@gao.gov

In addition to the contact named above, Jeff Arkin, Assistant Director; 

Elizabeth Fan, Analyst-in-Charge; David Lewis; Karen O’Conor; and 

Sonya Vartivarian made key contributions to this report. Gregory Borecki, 

Shannon Finnegan, Tom Gilbert, Lois Hanshaw, Ed Nannenhorn, Jeff 

Niblack, Jeff Schmerling, and Joanna Stamatiades also provided valuable 

assistance.

Appendix II: GAO Contact and Staff 

Acknowledgments 

GAO Contact

Staff 

Acknowledgments 

(450975)
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