United States Government Accountability Office

GAO Testimony 

Before the Subcommittee on Taxation and 

IRS Oversight, Committee on Finance, 

U.S. Senate

TAX COMPLIANCE 

Opportunities Exist to 

Reduce the Tax Gap Using a 

Variety of Approaches 

Statement of Michael Brostek 

Director, Tax Issues 

Strategic Issues Team 

For Release on Delivery

Expected at 2:00 p.m. EDT

Wednesday, July 26, 2006

 

GAO-06-1000T 
What GAO Found

United States Government Accountability Office

Why GAO Did This Study

Highlights

Accountability Integrity Reliability

July 26, 2006

TAX COMPLIANCE

Opportunities Exist to Reduce the Tax 

Highlights of GAO-06-1000T, a testimony Gap Using a Variety of Approaches 

to the Subcommittee on Taxation and IRS 

Oversight, Committee on Finance, U.S. 

Senate 

The tax gap—the difference 

between the tax amounts taxpayers 

pay voluntarily and on time and 

what they should pay under the 

law—has been a long-standing

problem in spite of many efforts to 

reduce it. Most recently, the 

Internal Revenue Service (IRS)

estimated a gross tax gap for tax 

year 2001 of $345 billion and 

estimated it would recover $55 

billion of this gap, resulting in a net 

tax gap of $290 billion. When some

taxpayers fail to comply, the

burden of funding the nation’s 

commitments falls more heavily on 

compliant taxpayers. Reducing the 

tax gap would help improve the 

nation’s fiscal stability. For 

example, each 1 percent reduction 

in the net tax gap would likely yield

$3 billion annually. 

GAO was asked to discuss the tax 

gap and various approaches to

reduce it. This testimony discusses 

to what extent the tax gap could be

reduced through three

approaches—simplifying or

reforming the tax system, providing

IRS with additional enforcement 

tools, and devoting additional 

resources to enforcement—as well 

as various factors that could guide 

decision-making when devising a 

strategy to reduce the tax gap. This 

statement is based on prior GAO 

work.

What GAO Recommends

GAO is not making any new 

recommendations but highlights

new areas for possible attention. 

Simplifying the tax code or fundamental tax reform has the potential to 

reduce the tax gap by billions of dollars. IRS has estimated that errors in 

claiming tax credits and deductions for tax year 2001 contributed $32 billion 

to the tax gap. Thus, considerable potential exists. However, these

provisions serve purposes Congress has judged to be important and 

eliminating or consolidating them could be complicated. Fundamental tax 

reform would be most likely to result in a smaller tax gap if the new system 

has few, if any, exceptions (e.g., few tax preferences) and taxable 

transactions are transparent to tax administrators. These characteristics are 

difficult to achieve, and any tax system could be subject to noncompliance. 

Withholding and information reporting are particularly powerful tools to 

reduce the tax gap. They could help reduce the tax gap by billions of dollars, 

especially if they can make currently underreported income transparent to 

IRS. These tools have been shown to lead to high, sustained levels of 

taxpayer compliance. Using these tools can also help IRS better allocate its 

resources to the extent they help IRS identify and prioritize its contacts with 

noncompliant taxpayers. As GAO previously suggested, reporting the cost,

or basis, of securities sales is one option to improve taxpayers’ compliance. 

However, designing additional withholding and information reporting 

requirements may be challenging given that many types of income are 

already subject to reporting, there are many forms of underreporting, and 

withholding and reporting requirements impose costs on third parties. 

Devoting additional resources to enforcement has the potential to help 

reduce the tax gap by billions of dollars. However, determining the 

appropriate level of enforcement resources for IRS requires taking into 

account many factors such as how well 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. If Congress 

decides to provide IRS more enforcement resources, the amount the tax gap 

could be reduced would depend on factors such as the size of budget 

increases, how IRS manages any additional resources, and the indirect 

increase in taxpayers’ voluntary compliance resulting from expanded 

enforcement. Increasing IRS’s funding would enable it to contact millions of 

potentially noncompliant taxpayers it identifies but does not have resources 

to contact. 

Finally, using multiple approaches may be the most effective strategy to 

reduce the tax gap, as no one approach is likely to fully and cost effectively 

address noncompliance. Key factors to consider in devising a tax gap 

reduction strategy include periodically measuring noncompliance and its 

causes, setting reduction goals, leveraging technology, optimizing IRS’s 

allocation of resources, and evaluating the results of any initiatives. 

www.gao.gov/cgi-bin/getrpt?GAO-06-1000T. 

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. 
Mr. Chairman and Members of the Subcommittee: 

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

between what taxpayers pay in taxes voluntarily and on time and what 

they should pay under the law—and what is achievable in reducing the 

gap. Most recently, the Internal Revenue Service (IRS) estimated that for 

tax year 2001, taxpayers paid about 84 percent of the taxes that should 

have been paid on time under the law, resulting in an estimated gross tax 

gap of $345 billion. IRS estimated that it would eventually recover around 

$55 billion of the 2001 tax gap through late payments and IRS enforcement 

actions, leaving a net tax gap of $290 billion.1

 Because of taxpayer 

noncompliance, the burden of funding the nation’s commitments falls 

more heavily on taxpayers who willingly and accurately pay their taxes. 

Reducing the tax gap would help improve the nation’s fiscal stability. For 

example, based on IRS’s estimate, each 1 percent reduction in the net tax 

gap would likely yield nearly $3 billion annually. However, 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 

our tax laws has changed little over the past three decades. Likewise, 

factors such as globalization and the ever-increasing complexity of the tax

code further challenge IRS’s ability to administer the tax code. 

My remarks focus on what is achievable in reducing the tax gap through a

variety of approaches, specifically by (1) simplifying or reforming the tax 

system; (2) providing IRS additional enforcement authority and tools, such 

as information reporting2

 and tax withholding,3 through changes to the tax 

laws; and (3) devoting additional resources to enforcement under the 

existing tax laws. I will also discuss various factors that could guide 

decision making when devising a strategy to reduce the tax gap. My 

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

 1

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

otherwise noted. 

2

Information reporting involves the filing of information returns with IRS and taxpayers 

that contain information on certain transactions, such as wage and salary information

employers report to employees and IRS through Form W-2. 

3

An example of tax withholding is when employers withhold taxes on the wages that 

employees earn and remit them to IRS. 

Page 1 GAO-06-1000T 
particular, recent testimonies and a report on reducing the tax gap.4

 These 

efforts were conducted in accordance with generally accepted government 

auditing standards. 

Let me begin by highlighting four major points: 

• Simplifying the tax code or fundamental tax reform has the potential to 

reduce the tax gap by many billions of dollars. For example, IRS estimated 

that errors in claiming tax credits and deductions for tax year 2001 

contributed $32 billion to the tax gap. Reducing the number of such credits 

and deductions therefore has some direct potential to reduce the tax gap. 

However, these credits and deductions serve purposes Congress has 

judged to be important, and eliminating them likely would be complicated. 

Fundamental tax reform, such as shifting to a consumption tax system, 

would most likely result in a smaller tax gap if the new system has few, if 

any, exceptions (e.g., few or no tax preferences) and taxable transactions

are transparent to tax administrators. These characteristics are difficult to

achieve in any system, and any tax system could be subject to

noncompliance. 

• Providing IRS with more enforcement tools, particularly withholding and 

information reporting, also has the potential to reduce the tax gap by

billions of dollars, especially if those tools help IRS deal with the largest 

contributor to the tax gap—underreported income. Tax withholding and 

information reporting have been shown to lead to high, sustained levels of

taxpayer compliance because the income taxpayers earn is transparent to 

them and IRS. Also, using these tools can help IRS better allocate its 

resources by improving its ability to identify and prioritize noncompliant 

taxpayers it contacts. For example, we found that having third parties 

report to taxpayers and IRS the cost, or basis, of stocks and mutual funds 

that taxpayers sell could help taxpayers improve their voluntary 

compliance and help IRS allocate its enforcement efforts concerning these

transactions. However, designing withholding or information reporting 

requirements to address underreporting may be challenging given that 

 4

GAO, Tax Gap: Making Significant Progress in Improving Tax Compliance Rests on

Enhancing Current IRS Techniques and Adopting New Legislative Actions, GAO-06-453T 

(Washington, D.C.: Feb. 15, 2006); 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); Tax Compliance: Better Compliance Data and Longterm Goals Would Support a More Strategic IRS Approach to Reducing the Tax Gap, 

GAO-05-753 (Washington, D.C.: July 18, 2005); and 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). 

Page 2 GAO-06-1000T 
many types of income are already subject to such requirements, there are 

many forms of underreporting, and any requirements could impose costs 

and burdens on the third parties that withhold or report. 

• Devoting additional resources to enforcement has the potential to help 

reduce the tax gap by billions of dollars. 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. If Congress were to provide IRS more enforcement 

resources, the amount of the tax gap that could be reduced depends in 

part on factors such as the size of budget increases, how IRS manages any 

additional resources, and the indirect increase in taxpayers’ voluntary 

compliance resulting from expanded enforcement. Providing IRS with 

additional funding would enable it to contact millions of potentially 

noncompliant taxpayers it identifies but currently cannot contact given 

resource constraints. 

• Each approach to reducing the tax gap—simplifying or reforming the tax

code, providing IRS with more enforcement tools, or devoting additional 

resources to enforcement—has the potential to reduce the tax gap, 

although using multiple approaches may be the most effective strategy 

since no one approach is likely to fully and cost effectively address 

noncompliance. Some key factors to consider in designing a strategy to 

reduce the tax gap include periodically measuring noncompliance and its 

causes, setting tax gap reduction goals and measuring progress against the 

goals, leveraging technology to enhance IRS’s efficiency, identifying and

considering the costs and benefits of possible approaches, optimizing the 

allocation of IRS’s resources, and evaluating the results of any initiatives 

to reduce the tax gap. 

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 paid voluntarily and on time 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 

Background 

Page 3 GAO-06-1000T 
altogether or on time.5

 IRS’s tax gap estimates for each type of

noncompliance include estimates for some or all of the five types of taxes 

that IRS administers. As shown in table 1, underreporting of tax liabilities 

accounted for most of the tax gap estimate for tax year 2001. 

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 because of rounding. 

IRS has estimated the tax gap on multiple occasions, beginning in 1979,

relying on its Taxpayer Compliance Measurement Program (TCMP). IRS 

did not implement any TCMP studies after 1988 because of concerns about 

costs and burdens on taxpayers. Recognizing the need for current 

compliance data, in 2002 IRS implemented a new compliance study called

the National Research Program (NRP) to produce such data for tax year 

2001 while minimizing taxpayer burden. 

IRS has concerns with the certainty of the tax gap estimate for tax year 

2001 in part because some areas of the estimate rely on old data, IRS has 

no estimates for other areas of the tax gap, and it is inherently difficult to

measure some types of noncompliance. IRS used data from NRP to 

estimate individual income tax underreporting and the portion of 

employment tax underreporting attributed to self-employed individuals. 

The underpayment segment of the tax gap is not an estimate, but rather 

represents the tax amounts that taxpayers reported on time but did not 

pay on time. Other areas of the estimate, such as corporate income tax and 

employer-withheld employment tax underreporting, rely on decades-old 

data. Also, IRS has no estimates for corporate income, employment, and 

 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-06-1000T 
excise tax nonfiling or for excise tax underreporting.6

 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.7

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

service to taxpayers and enhancing enforcement of the tax laws. IRS seeks 

to improve voluntary compliance through efforts such as education and

outreach programs and by attempting to simplify the tax process, such as 

by revising forms and publications to make them electronically accessible 

and more easily understood by diverse taxpayer communities. IRS uses its 

enforcement authority to ensure that taxpayers are reporting and paying

the proper amounts of taxes through efforts such as examining tax returns 

and matching the amount of income taxpayers report on their tax returns 

to the income amounts reported on information returns it receives from 

third parties. IRS reports that it collected over $47 billion in 2005 from 

noncompliant taxpayers it identified through its various enforcement 

programs. 

In spite of IRS’s efforts to improve taxpayer compliance, the rate at which 

taxpayers pay their taxes voluntarily and on time has tended to range from

around 81 percent to around 84 percent over the past three decades. Any 

significant reduction of the tax gap would likely depend on an

improvement in the level of taxpayer compliance.8

 6

For these types of noncompliance, IRS maintains that the data are either difficult to 

collect, imprecise, or unavailable. 

7

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

the tax gap, see GAO-05-753. 

8

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 even if the level of compliance remains unchanged because the amount of 

taxes that should be paid has been reduced. The tax gap would also tend to increase over

time, even if the rate of taxpayer compliance remained unchanged, because of inflation. 

Page 5 GAO-06-1000T 
Tax law simplification and reform both have the potential to reduce the 

tax gap by billions of dollars. The extent to which the tax gap would be 

reduced depends on which parts of the tax system would be simplified and 

in what manner as well as how any reform of the tax system is designed 

and implemented. Neither approach, however, will eliminate the gap.

Further, changes in the tax laws and system to improve tax compliance 

could have unintended effects on other tax system objectives, such as 

those involving economic behavior or equity. 

Simplification has the potential to reduce the tax gap for at least 3 broad 

reasons. First, it could help taxpayers to comply voluntarily with more 

certainty, reducing inadvertent errors by those who want to comply but 

are confused because of complexity. Second, it may limit opportunities for 

tax evasion, reducing intentional noncompliance by taxpayers who can 

misuse the complex code provisions to hide their noncompliance or to 

achieve ends through tax shelters. Third, tax code complexity may erode

taxpayers’ willingness to comply voluntarily if they cannot understand its 

provisions or they see others taking advantage of complexity to 

intentionally underreport their taxes.

Reducing the Tax Gap 

through Tax 

Simplification or Tax 

System Reform 

Depends on Their 

Design and May Have 

Effects Beyond Tax 

Compliance 

Simplification could take multiple forms. One form would be to retain 

existing laws but make them simpler. For example, in our July 2005 report

9

on postsecondary tax preferences, we noted that the definition of a 

qualifying postsecondary education expense differed somewhat among 

some tax code provisions, for instance with some including the cost to 

purchase books and others not. Making definitions consistent across code 

provisions may reduce taxpayer errors. Although we cannot say the errors 

were due to these differences in definitions, in a limited study of paid 

preparer services to taxpayers, we found some preparers claiming 

unallowable expenses for books.10 Further, the Joint Committee on 

Taxation suggested that such dissimilar definitions may increase the 

likelihood of taxpayer errors and increase taxpayer frustration.11

 9

GAO, 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). 

10GAO, Paid Tax Return Preparers: In a Limited Study, Chain Preparers Made Serious

Errors, GAO-06-563T (Washington, D.C.: Apr. 4, 2006). 

11U.S. Congress, Joint Committee on Taxation, Study of the Overall State of the Federal

Tax System, vol. II, 125-6 (April 2001). 

Page 6 GAO-06-1000T 
Another tax code provision in which complexity may have contributed to 

the individual tax gap involves the earned income tax credit, for which IRS 

estimated a tax loss of up to about $10 billion for tax year 1999.12 Although 

some of this noncompliance may be intentional, we13 and the National 

Taxpayer Advocate14 have previously reported that confusion over the 

complex rules governing eligibility for claiming the credit could cause 

taxpayers to fail to comply inadvertently. 

Although retaining but simplifying tax code provisions may help reduce 

the tax gap, doing so may not be easy, may conflict with other policy 

decisions, and may have unintended consequences. The simplification of 

the definition of a qualifying child across various code sections is an 

example. We suggested in the early 1990s that standardizing the definition

of a qualifying child could reduce taxpayer errors and reduce their 

burden.15 A change was not made until 2004.16 However, some have 

suggested that the change has created some unintended consequences, 

such as increasing some taxpayers’ ability to reduce their taxes in ways 

Congress may not have intended. 

Another form of simplification could be to eliminate or consolidate tax 

expenditures. Among the many causes of tax code complexity is the 

growing number of preferential provisions in the code, defined in statute17

as tax expenditures, such as tax exemptions, exclusions, deductions, 

credits, and deferrals.18 The number of these tax expenditures has more 

than doubled from 1974 through 2005. Tax expenditures can contribute to

the tax gap if taxpayers claim them improperly. For example, IRS’s recent 

 12IRS measured the extent of noncompliance with the earned income tax credit in a study 

separate from NRP. 

13GAO-06-208T. 

14Internal Revenue Service, Taxpayer Advocate Service, National Taxpayer Advocate 2004 

Annual Report to Congress (Washington, D.C.: Dec. 31, 2004). 

15See GAO, Tax Administration: Erroneous Dependent and Filing Status Claims, 

GAO/GGD-93-60, (Washington, D.C: Mar.19, 1993). 

16Pub. L. No. 108-311 (2004). 

17The Congressional Budget and Impoundment Control Act of 1974, Pub. L. No. 93-344, § 3,

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

18GAO, 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). 

Page 7 GAO-06-1000T 
tax gap estimate includes a $32 billion loss in individual income taxes for 

tax year 2001 because of noncompliance with these provisions. 

Simplifying these provisions of the tax code would not likely yield $32 

billion in revenue because even simplified provisions likely would have 

some associated noncompliance. However, the estimate suggests that 

simplification could have important tax gap consequences, particularly if

simplification also accounted for any noncompliance that arises because 

of complexity on the income side of the tax gap for individuals.

19

However, these credits and deductions serve purposes that Congress has 

judged to be important to advance federal goals. Eliminating them or 

consolidating them likely would be complicated, and would likely create 

winners and losers. Elimination also could conflict with other objectives 

such as encouraging certain economic activity or improving equity. 

Similar trade-offs exist with possible fundamental tax reforms that would 

move away from an income tax system to some other system, such as a 

consumption tax, national sales tax, or value added tax. Fundamental tax 

reform would most likely result in a smaller tax gap if the new system has 

few tax preferences or complex tax code provisions and if taxable 

transactions are transparent. However, these characteristics are difficult 

to achieve in any system and experience suggests that simply adopting a 

fundamentally different tax system may not by itself eliminate any tax

gap.20 Any tax system could be subject to noncompliance, and their design 

and operation, including the types of tools made available to tax 

administrators affect the size of any corresponding tax gap. Further, the 

motivating forces behind tax reform likely include factors beyond tax

compliance, such as economic effectiveness, equity, and burden, which 

could in some cases carry greater weight in designing an alternative tax

system than ensuring the highest levels of compliance. 

 19The tax gap for underreported individual income taxes exceeded $150 billion for tax year 

2001. However, IRS does not have data on how much of this noncompliance arose because 

of complexity. 

20For example, in a 2004 report, the National Audit Office in the United Kingdom reported

on the 15.7 percent gap for the value added tax, which was introduced three decades

earlier. 

Page 8 GAO-06-1000T 
Changing the tax laws to provide IRS with additional enforcement tools, 

such as expanded tax withholding and information reporting, could also 

reduce the tax gap by many billions of dollars, particularly with regard to

underreporting—the largest segment of the tax gap. Tax withholding 

promotes compliance because employers or other parties subtract some 

or all of the taxes owed from a taxpayer’s income and remit them to IRS. 

Information reporting tends to lead to high of compliance because income

taxpayers earn is transparent to them and IRS. In both cases, high levels of

compliance tend to be maintained over time. Also, because through 

withholding and information reporting IRS can better identify 

noncompliant taxpayers and prioritize contacting them by the potential for 

additional revenue, these tools can enable IRS to better allocate its 

resources. However, designing new withholding or information reporting 

requirements to address underreporting can be challenging given that 

many types of income are already subject to at least some form of 

withholding or information reporting, there are varied forms of 

underreporting, and the requirements could impose costs and burdens on 

third parties. 

Providing IRS with 

Additional 

Enforcement Tools 

Potentially Could 

Improve Compliance 

Significantly, but 

Identifying and 

Designing Such Tools 

Can Be Challenging 

Taxpayers tend to report income subject to tax withholding or information 

reporting with high levels of compliance, as shown in figure 1, because the 

income is transparent to the taxpayers as well as to IRS. Additionally, once

withholding or information reporting requirements are in place for 

particular types of income, compliance tends to remains high over time. 

For example, for wages and salaries, which are subject to tax withholding 

and substantial information reporting, the percentage of income that 

taxpayers misreport report has consistently been measured at around 1 

percent over time. 

Page 9 GAO-06-1000T 
Figure 1: Individual Net Income Misreporting Categorized by the Extent of Income

Subject to Withholding and Information Reporting, Tax Year 2001 

Percentage of net income misreported

Source: IRS. 

0 

10 

20 

30 

40 

50 

60 

Little or no

reporting

• Nonfarm proprietor 

 income

• Informal supplier 

 income

• Other income

• Rents and royalties

• Farm income

• Form 4947 income

• Adjustments

Some information

reporting

• Deductions

• Partnership/S-Corp

 income

• Exemptions

• Capital gains

• Alimony income

Substantial

information

reporting

• Pensions and annuities

• Dividend income

• Interest income

• Unemployment

 compensation

• Social Security benefits

Substantial

information reporting

and withholding

• Wages and salaries

1.2 

53.9 

8.6 

4.5 

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

withholding or information reporting requirements could serve to improve 

compliance:

• Require more data on information returns dealing with capital 

gains income from securities sales. Recently, we reported that an 

estimated 36 percent of taxpayers misreported their capital gains or losses 

from the sale of securities, such as corporate stocks and mutual funds.21

 21GAO, Capital Gains Tax Gap: Requiring Brokers to Report Securities Cost Basis Would

Improve Compliance if Related Challenges Are Addressed, GAO-06-603 (Washington, D.C.: 

June 13, 2006). 

Page 10 GAO-06-1000T 
Further, around half of the taxpayers who misreported did so because 

they failed to report the securities’ cost, or basis, sometimes because they

did not know the securities’ basis or failed to take certain events into 

account that required them to adjust the basis of their securities. When 

taxpayers sell securities like stock and mutual funds through brokers, the 

brokers are required to report information on the sale, including the 

amount of gross proceeds the taxpayer received; however, brokers are not 

required to report basis information for the sale of these securities. We 

found that requiring brokers to report basis information for securities 

sales could improve taxpayers’ compliance in reporting their securities 

gains and losses and help IRS identify noncompliant taxpayers. However, 

we were unable to estimate the extent to which a basis reporting 

requirement would reduce the capital gains tax gap because of limitations 

with the compliance data on capital gains and because neither IRS nor we 

know the portion of the capital gains tax gap attributed to securities sales. 

• Requiring tax withholding and more or better information return 

reporting on payments made to independent contractors. Past IRS 

data have shown that independent contractors report 97 percent of the 

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

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

identified other options for improving information reporting for 

independent contractors, including increasing penalties for failing to file 

required information returns, lowering the $600 threshold for requiring 

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

returns the total amount of payments to independent contractors.22 IRS’s 

Taxpayer Advocate Service recently recommended allowing independent 

contractors to enter into voluntary withholding agreements.23

• 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 1997,24 payments made by 

 22GAO, Tax Administration: Approaches for Improving Independent Contractor 

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

23Internal Revenue Service, Taxpayer Advocate Service, National Taxpayer Advocate 2005 

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

24Taxpayer Relief Act of 1997, Pub. L. No. 105-34 (1997). 

Page 11 GAO-06-1000T 
others to corporations are generally not covered by information returns. 

The Taxpayer Advocate Service has recommended requiring information 

reporting on payments made to corporations,25 and the administration’s 

fiscal year 2007 budget has proposed requiring additional information 

reporting on certain good and service payments by federal, state, and local 

governments.26

In addition to improving taxpayer compliance, information reporting can 

help IRS to better allocate its resources to the extent that it helps IRS 

better identify noncompliant taxpayers and the potential for additional 

revenue that could be obtained by contacting these taxpayers. For 

example, IRS officials told us that receiving information on basis for 

taxpayers’ securities sales would allow IRS to determine more precisely 

taxpayers’ income for securities sales through its document matching 

programs and would allow it to identify which taxpayers who misreported 

securities income have the greatest potential for additional tax 

assessments. Similarly, IRS could use basis information to improve both 

aspects of its examination program—examinations of tax returns through 

correspondence and examinations of tax returns face-to-face with the 

taxpayer. Currently, capital gains issues are too complex and time 

consuming for IRS to examine through correspondence. However, IRS 

officials told us that receiving cost basis information might enable IRS to 

examine noncompliant taxpayers through correspondence because it 

could productively select tax returns to examine. Also, having cost basis 

information could help IRS identify the best cases to examine face-to-face, 

making the examinations more productive while simultaneously reducing 

the burden imposed on compliant taxpayers who otherwise would be 

selected for examination. As a result of all these benefits, basis reporting 

would allow IRS to better allocate its resources that focus on securities 

misreporting across its enforcement programs. 

Although withholding and information reporting lead to high levels of 

compliance, designing new requirements to address underreporting could 

be challenging given that many types of income, including wages and 

salaries, dividend and interest income, and income from pensions and 

Social Security are already subject to withholding or substantial 

information reporting. Also, there are challenges involved with

 25Internal Revenue Service, Taxpayer Advocate Service, 2005. 

26Executive Office of the President, Office of Management and Budget, Budget of the 

United States Government, Fiscal Year 2007. 

Page 12 GAO-06-1000T 
establishing new withholding or information reporting requirements for 

certain other types of income where there is extensive underreporting of 

income. Challenges exist because taxable income may be difficult to 

determine because of complex tax laws, complex transactions, or the lack

of a practical and reliable third-party source to provide the information. 

For example, with regard to reporting securities basis information, we 

reported that it would be difficult for brokers to report information for 

some types of transactions because of complex tax laws and that 

representatives from the securities industry told us that a set of rules 

would need to be developed to establish clearly what types of transactions

would be subject to any reporting requirement. 

Likewise, a persistent and large part of the tax gap relates to nonfarm sole 

proprietor and informal supplier income.27 As shown in figure 1, this 

income is not subject to information reporting, and these taxpayers 

misreported about half of the income they earned for tax year 2001. 

Although establishing withholding or information reporting requirements 

for these forms of income would likely improve taxpayers’ compliance, 

practical and effective information reporting mechanisms are difficult to

identify. For example, informal suppliers by definition receive income in 

an informal manner through services they provide to a variety of individual 

citizens or small businesses. Whereas businesses may have the capacity to

perform withholding and information reporting functions for their 

employees, it may be challenging to extend withholding or information 

reporting responsibilities to the individual citizens that receive services, 

who may not have the resources or knowledge to comply with such 

requirements. Consequently, innovative approaches likely will be needed if 

tools like withholding and information returns are to be extended to cover 

more sources of the tax gap. 

Finally, implementing tax withholding and information reporting 

requirements generally imposes costs and burdens on the businesses that 

must implement them, and, in some cases, on taxpayers. For example, 

expanding information reporting on securities sales to include basis 

 27Nonfarm proprietors are self-employed individuals other than farmers who should file 

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. 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 Schedule C. 

Page 13 GAO-06-1000T 
information will impose costs on the brokers that would track and report 

the information. Further, trying to close the entire tax gap with these 

enforcement tools could entail more intrusive recordkeeping or reporting 

than the public is willing to accept. Considering these costs and burdens 

should be part of any evaluation of additional withholding or information 

reporting requirements. 

Although I have focused on information reporting and tax withholding, I 

want to mention one other enforcement tool that can potentially deter 

noncompliance, which is the use of penalties for filing inaccurate or late 

tax and information returns. Congress has placed a number of civil penalty

provisions in the tax code. However, as with civil penalties related to other 

federal agencies, inflation may have weakened the deterrent effect of IRS 

penalties. For example, the Treasury Inspector General for Tax 

Administration has noted that the $50 per partner per month penalty for a 

late-filed partnership tax return, established by Congress in 1978, would 

equate to $17.22 in 2004 dollars. In its fiscal year 2007 budget, the 

administration has proposed expanding penalty provisions applicable to 

paid tax return preparers to include non-income tax returns and related 

documents. In addition, Congress recently increased certain penalties 

related to tax shelters and other tax evasion techniques.28 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. 

Devoting more resources to enforcement has the potential to help reduce 

the tax gap by billions of dollars in that IRS would be able to expand its 

enforcement efforts to reach a greater number of potentially noncompliant 

taxpayers. However, determining the appropriate level of enforcement 

resources to provide IRS requires taking into account many 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. If 

Congress were to provide IRS more enforcement resources, the amount of 

the tax gap that could be reduced depends in part on the size of any 

increase in IRS’s budget, how IRS would manage any additional resources, 

Devoting Additional 

Resources to 

Enforcement Likely

Could Reduce the Tax 

Gap, but to What 

Extent Is Difficult to 

Predict 

 28American Jobs Creation Act of 2004, Pub. L. No. 108-357 (2004). 

Page 14 GAO-06-1000T 
and the indirect increase in taxpayers’ voluntary compliance that would 

likely result from expanded IRS enforcement. 

As I previously mentioned, IRS is able to secure tens of billions of dollars 

in tax revenue from noncompliant taxpayers it identifies through its 

various enforcement programs. However, given resource constraints, IRS 

is unable to contact millions of additional taxpayers for whom it has 

evidence on potential noncompliance. With additional resources, IRS 

would be able to assess and collect additional taxes and further reduce the 

tax gap. In 2002, IRS estimated that a $2.2 billion funding increase would 

allow it to take enforcement actions against potentially noncompliant 

taxpayers it identifies but cannot contact and would yield an estimated $30 

billion in revenue.29 For example, IRS estimated that it contacted about 3 

million of the over 13 million taxpayers it identified as potentially 

noncompliant through its matching of tax returns to information returns. 

IRS estimated that contacting the additional 10 million potentially 

noncompliant taxpayers it identified, at a cost of about $230 million, could 

yield nearly $7 billion in potentially collectible revenue. However, we did 

not evaluate the accuracy of the estimate, and as will be discussed below, 

many factors suggest that it is difficult to estimate reliably net revenue

increases that might come from additional enforcement efforts.30

Although additional enforcement funding has the potential to reduce the 

tax gap, the extent to which it would help depends on several factors. 

First, and perhaps most obviously, the amount of tax gap reduction would 

depend in part on the size of any budget increase. Generally, larger budget 

increases should result in larger reductions in the tax gap. IRS prioritizes 

the cases of potentially noncompliant taxpayers it reviews through its 

enforcement programs based on factors, such as the likelihood that a 

taxpayer is noncompliant, the potential amount of additional taxes that 

could be assessed, and collection potential. As such, it is likely that IRS 

would begin to experience diminishing returns as it began to review 

additional, lower priority cases of potentially noncompliant taxpayers. 

Given the diminishing returns IRS would likely experience as it moves to 

working less and less productive cases, the amount of expected reduction

 29Commissioner of Internal Revenue Charles O. Rossotti, Report to the IRS Oversight 

Board: Assessment of IRS and the Tax System, October 2002. 

30There are many aspects to the overall tax gap. Thus, if the tax gap in a specific area is 

reduced either through congressional actions like simplifying provisions or through IRS 

actions, the size of the overall gap may not be reduced if other portions of the gap increase. 

Page 15 GAO-06-1000T 
in the tax gap for each additional dollar of funding would decline. Further,

reductions in the tax gap that could be derived from additional 

enforcement funding may not be immediate. The reductions may occur 

gradually as IRS is able to hire and train enforcement personnel. 

Recently, IRS obtained some additional funding targeted for enforcement 

activities that it estimated will result in additional revenue. In its fiscal 

year 2006 budget request, IRS requested millions of dollars to expand its 

tax return examination and tax collection activities with the goal of 

increasing individual taxpayer compliance and addressing concerns raised 

by GAO31 and others regarding the erosion of IRS’s enforcement presence 

and the continued growth in noncompliance. In estimating the revenue

that it would obtain from the increased funding, IRS took several factors 

into account, including opportunity costs because of training, which draws 

experienced enforcement personnel away from the field; differences in 

average enforcement revenue obtained per full-time employee by 

enforcement activity; and differences in the types and complexity of cases 

worked by new hires and experienced hires. IRS forecasted that in the 

initial year after expanding enforcement activities, the additional revenue

it expects to collect is less than half the amount it expects to collect 

annually in later years. This example underscores the logic that if IRS is to 

receive a relatively large funding increase, it likely would be better to 

provide it in small but steady amounts. 

The amount of tax gap reduction likely to be achieved from any budget

increase Congress may choose to provide also depends on how well IRS 

can manage the additional resources. As previously mentioned, IRS does 

 31GAO issued a number of products regarding the erosion of IRS’s enforcement presence 

and a continued growth in noncompliance. See GAO, Internal Revenue Service: 

Assessment of Fiscal Year 2005 Budget Request and 2004 Filing Season Performance, 

GAO-04-560T (Washington, D.C: Mar. 30, 2004); Internal Revenue Service: Assessment of 

Fiscal Year 2004 Budget Request and 2003 Filing Season Performance to Date, 

GAO-03-641T (Washington, D.C: Apr. 8, 2003); Internal Revenue Service: Assessment of 

Fiscal Year 2003 Budget Request and Interim Results of the 2002 Tax Filing Season, 

GAO-02-580T (Washington, D.C: Apr. 9, 2003); Tax Administration: Impact of Compliance

and Collection Program Declines on Taxpayers, GAO-02-674 (Washington, D.C.: May 22,

2003); Compliance and Collection: Challenges for IRS in Reversing Trends and

Implementing New Initiatives, GAO-03-732T (Washington, D.C.: May 7, 2003); IRS 

Modernization: Continued Progress Necessary for Improving Service to Taxpayers and

Ensuring Compliance, GAO-03-796T (Washington, D.C.: May 20, 2003); High Risk Series:

An Update, GAO-05-207 (Washington, D.C.: January 2005); and our products on the tax gap

mentioned earlier in this statement, GAO-06-453T, GAO-06-208T, GAO-05-753, and 

GAO-05-527T. 

Page 16 GAO-06-1000T 
not have compliance data for some segments of the tax gap and others are 

based on old data. Periodic measurements of compliance levels can 

indicate the extent to which compliance is improving or declining and 

provide a basis for reexamining existing programs and triggering 

corrective actions, if necessary. Also, regardless of the type of 

noncompliance, IRS has concerns with its information on whether 

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

Knowing the reasons why taxpayers are noncompliant can help IRS decide 

whether its efforts to address specific areas of noncompliance should 

focus on nonenforcement activities, such as improved forms or 

publications, or enforcement activities to pursue intentional 

noncompliance. For those portions of the tax gap that rely on old data and 

where IRS does not know the reason for taxpayers’ noncompliance, IRS 

may be less able to target resources efficiently to achieve the greatest tax 

gap reduction at the least burden to taxpayers. 

As part of an effort to make the best use of its enforcement resources, IRS 

has developed rough measures of return on investment in terms of tax 

revenue that it assesses from uncovering noncompliance. Generally, IRS 

cites an average return on investment for enforcement of 4:1, that is, IRS 

estimates that it collects $4 in revenue for every $1 of funding. Where IRS 

has developed return on investment estimates for specific programs, it 

finds substantial variation depending on the type of enforcement action.

For instance, the ratio of estimated tax revenue gains to additional 

spending for pursuing known individual tax debts through phone calls is 

13:1 versus a ratio of 32:1 for matching the amount of income taxpayers 

report on their tax returns to the income amounts reported on information 

returns. However, in addition to current returns on investment estimated 

being rough, IRS also lacks information on the incremental returns on 

investment for some enforcement programs. Developing such measures is 

difficult because of incomplete information on all the costs and all the tax 

revenue ultimately collected from specific enforcement efforts. Because 

IRS’s current estimates of the revenue effects of additional funding are 

imprecise, the actual revenue that might be gained from expanding 

differing enforcement efforts is subject to uncertainty. 

Given the variation in estimated returns on investment for differing types 

of IRS compliance efforts, the amount of tax gap reduction that may be 

achieved from an increase in IRS’s resources would depend on IRS’s 

decisions about how to allocate the increase. Although it might be 

tempting to allocate resources heavily toward those areas with the highest 

estimated return, allocation decisions must take into account diverse and 

difficult issues. For instance, although one enforcement activity may have

Page 17 GAO-06-1000T 
a high estimated return, that return may drop off quickly as IRS works its 

way through potential noncompliance cases. In addition, IRS dedicates 

examination resources across all types of taxpayers so that all taxpayers 

receive some signal that noncompliance is being addressed. Further, 

issues of fairness can arise if IRS focuses its efforts only on particular 

groups of taxpayers. 

Importantly, expanded enforcement efforts could reduce the tax gap more 

than through direct tax revenue collection, as widespread agreement 

exists that IRS enforcement programs have an indirect effect through 

increases in voluntary tax compliance.32 The precise magnitude of the 

indirect effects of enforcement is not known with a high level of 

confidence given challenges in measuring compliance; developing 

reasonable assumptions about taxpayer behavior; and accounting for 

factors outside of IRS’s actions that can affect taxpayer compliance, such

as changes in tax law. However, several research studies have offered 

insights to help better understand the indirect effects of IRS enforcement 

on voluntary tax compliance and show that they could exceed the direct 

effect of revenue obtained.33

Although closing the entire tax gap is neither feasible nor desirable due to

costs and intrusiveness, reducing the tax gap is worthwhile for many 

reasons, including fairness to those who are compliant and also because it 

is a means to improve our nation’s fiscal position. Each of the three 

approaches I have discussed could make a contribution to reducing the 

tax gap, although using multiple approaches may be the most effective 

strategy since no one approach is likely to address noncompliance fully 

Various Factors 

Should Be Considered 

in Devising Strategies 

to Reduce the Tax 

Gap 

 32Two types of indirect effect are (1) the increase in voluntary compliance in the larger 

population resulting from examinations or other enforcement and nonenforcement actions

on targeted taxpayers, and (2) the increase in voluntary compliance of the targeted 

taxpayer in subsequent years. 

33Economists have estimated the indirect effect of an examination on voluntary compliance 

to range from 6 to 12 times the amount of proposed tax adjustments. See Alan H. Plumley,

The Determinants of Individual Income Tax Compliance: Estimating The Impacts of 

Tax Policy, Enforcement, and IRS Responsiveness, Publication 1916 (Rev. 11-96) 

(Washington, D.C.: November 1996), 2, 35-36; Jeffrey A. Dubin, Michael J. Graetz and Louis 

L. Wilde, “The Effect of Audit Rates on the Federal Individual Income Tax, 1977-1986,” 43

National Tax Journal, (1990), 395, 396, 405; and Jeffrey A. Dubin, “Criminal Investigation 

Enforcement Activities and Taxpayer Noncompliance” (paper written for the IRS Research

Conference, June 2004), http://www.irs.gov/pub/irs-soi/04dubin.pdf (downloaded July 1, 

2005). 

Page 18 GAO-06-1000T 
and cost effectively. However, in deciding on one or more of the three 

broad approaches to use, many factors or issues could affect strategic 

decisions. Among the broad factors to consider are the likely effectiveness 

of any approach, fairness, enforceability, and sustainability. Beyond these,

our work points to the importance of the following: 

• Measuring compliance levels periodically. Regularly measuring the 

magnitude of, and the reasons for, noncompliance provides insights on 

how to reduce the gap through potential changes to tax laws and IRS 

programs. In July 2005, we recommended that IRS periodically measure 

tax compliance, identify reasons for noncompliance, and establish 

voluntary compliance goals.34 IRS agreed with the recommendations and 

established a voluntary tax compliance goal of 85 percent by 2009. In 

terms of measuring tax compliance, we have also identified alternative

ways to measure compliance, including conducting examinations of small 

samples of tax returns over multiple years, instead of conducting 

examinations for a larger sample of returns for one tax year, to allow IRS 

to track compliance trends annually.

• Leveraging technology. Better use of technology could help IRS be more 

efficient in reducing the tax gap. IRS is modernizing its technology, which

has paid off in terms of telephone service, resource allocation, electronic 

filing, and data analysis capability. However, this ongoing modernization 

will need strong management and prudent investments to maximize 

potential efficiencies. 

• Considering the costs and burdens. Any action to reduce the tax gap 

will create costs and burdens for IRS; taxpayers; and third parties, such as 

those who file information returns. As discussed earlier, for example, 

withholding and information reporting requirements impose some costs 

and burdens on those that track and report information. These costs and 

burdens need to be reasonable in relation to the improvements expected 

to arise from new compliance strategies. 

• Optimizing resource allocation. As previously discussed, developing

reliable measures of the return on investment for strategies to reduce the

tax gap would help inform IRS resource allocation decisions. IRS has 

rough measures of return on investment based on the additional taxes it

assesses. Developing such measures is difficult because of incomplete 

data on the costs of enforcement and collected revenues. Beyond direct 

 34GAO-05-753. 

Page 19 GAO-06-1000T 
revenues, IRS’s enforcement actions have indirect revenue effects, which 

are difficult to measure. However, indirect effects could far exceed direct

revenue effects and would be important to consider in connection with 

continued development of return on investment measures. 

• Evaluating the results. Evaluating the actions taken by IRS to reduce 

the tax gap would help maximize IRS’s effectiveness. Evaluations can be 

challenging because it is difficult to isolate the effects of IRS’s actions 

from other influences on taxpayers’ compliance. Our work has discussed 

how to address these challenges, for example by using research to link 

actions with the outputs and desired effects. 

When taxpayers do not pay all of their taxes, honest taxpayers carry a 

greater burden to fund government programs and the nation is less able to

address its long-term fiscal challenges. Thus, reducing the tax gap is 

important, even though closing the entire tax gap is neither feasible nor 

desirable because of costs and intrusiveness. All of the approaches I have

discussed have the potential to reduce the tax gap alone or in

combination, and no one approach is clearly and always superior to the 

others. As a result, IRS needs a strategy to attack the tax gap on multiple 

fronts with multiple approaches. 

Mr. Chairman and Members of the Subcommittee, this concludes my 

testimony. I would be happy to answer any question you may have at this 

time. 

For further information on this testimony, please contact Michael Brostek 

on (202) 512-9110 or brostekm@gao.gov. Contact points for our Offices of 

Congressional Relations and Public Affairs may be found on the last page 

of this testimony. Individuals making key contributions to this testimony 

include Tom Short, Assistant Director; Jeff Arkin; Cheryl Peterson; and 

Jeff Procak. 

Concluding 

Observations 

Contact and 

Acknowledgments 

Page 20 GAO-06-1000T (450512) 
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