United States Government Accountability Office

GAO Testimony 

Before the Committee on Finance, 

U.S. Senate

INDIVIDUAL INCOME TAX 

POLICY 

Streamlining, Simplification, 

and Additional Reforms Are 

Desirable 

Statement of David M. Walker 

Comptroller General of the United States 

For Release on Delivery

Expected at 10:30 a.m. EDT 

Thursday, August 3, 2006 

 

GAO-06-1028T 
What GAO Found

United States Government Accountability Office

Why GAO Did This Study

Highlights

Accountability Integrity Reliability

August 3, 2006

INDIVIDUAL INCOME TAX POLICY

Streamlining, Simplification, and 

Highlights of GAO-06-1028T, a testimony Additional Reforms are Desirable 

before the Committee on Finance, 

U.S. Senate 

The federal government currently 

relies heavily on the individual

income tax and payroll taxes for 

about 80 percent of its total annual

revenue. Long-range projections 

show that without some form of 

policy change, the gap between 

revenues and spending will 

increasingly widen. The debate 

about the future tax system is 

partly about whether the goals for 

the nation’s tax system can be best

achieved by reforming the current 

income tax so that it has a broader

base and flatter rate schedule, or 

switching to some form of 

consumption tax. 

This testimony reviews the revenue 

contribution of the current 

individual income tax as well as its 

complexity, economic efficiency, 

equity, and taxpayer compliance 

issues; discusses some common 

dimensions to compare tax

proposals; and draws some

conclusions for tax reform. 

This statement is based on 

previously published GAO work

and reviews of relevant literature. 

The United States faces a large and growing structural budget deficit as

current projected revenues are not sufficient to fund projected spending. 

The individual income tax has long been the largest source of federal 

revenue—amounting to $927 billion (7.5 percent of Gross Domestic Product 

(GDP)) in 2005. (Total revenues that year amounted to 17.5 percent of 

GDP.) Income tax policy, including existing tax expenditures, such as the 

exclusion of employer-provided health insurance from individual income,

and enforcement approaches, need to be key elements of a multipronged 

approach that reexamines federal policies and approaches to address our 

nation’s large and growing long-term fiscal imbalance. 

Concerns regarding the complexity, efficiency, and equity of the individual 

income tax have contributed to calls for a substantial restructuring of the 

individual income tax or its full or partial replacement with some form of 

consumption tax. The widely recognized complexity of the tax results in 

(1) significant compliance costs, frustration, and anxiety for taxpayers; 

(2) decreased voluntary compliance; (3) increased difficulties for the 

Internal Revenue Service (IRS) in administering the tax laws; and (4) 

reduced confidence in the fairness of the tax. The tax also causes taxpayers 

to change their work, savings, investment, and consumption behavior in 

ways that reduce economic efficiency and, thereby, taxpayers’ well-being. 

 

Taxpayer noncompliance with the current individual income tax is another 

factor that could motivate reform. For tax year 2001, IRS estimated that 

noncompliance with the individual income tax accounted for about 

70 percent of the $345 billion gross tax gap, which is the difference between 

the taxes that should have been paid voluntarily and on time and what was 

actually paid. Reducing this gap can improve the nation’s fiscal stability, as 

each 1 percent reduction in the tax gap would likely yield about $3 billion 

annually. Reducing the tax gap within the current income tax structure will 

require exploring new and innovative administrative and legislative 

approaches. 

 

In moving forward on tax reform, policymakers may find it useful to 

compare alternative proposals along some common dimensions. These 

include, in part, whether proposed tax systems over time will generate 

enough revenue to fund expected expenditures, whether the base is as broad 

as possible so rates can be as low as possible, whether the system meets our 

future needs, and whether it has attributes that promote compliance. Our 

publication, Understanding the Tax Reform Debate (GAO-05-1009SP), 

provides background, criteria, and questions that policymakers may find 

useful. 

www.gao.gov/cgi-bin/getrpt?GAO--06-1028T.

To view the full product, including the scope 

and methodology, click on the link above. 

For more information, contact James White at 

(202) 512-9110 or whitej@gao.gov. 
Mr. Chairman and Members of the Committee: 

I appreciate this opportunity to contribute to your consideration of 

fundamental tax reform by discussing the individual income tax. Although

the focus of my statement is the individual income tax, it clearly makes 

sense to consider a broader reform encompassing both the individual and

corporate income taxes and much of my message is applicable to broad 

reforms.1

As the Committee is well aware, two fundamental objectives of a tax 

system are (1) to raise revenue sufficient to fund projected spending and 

(2) to do so in a manner that is fair, relatively easy to administer, and 

minimizes negative effects on the economy. Unfortunately, over time, the 

accumulated changes to our individual tax system have not been 

consistent with these objectives and, not surprisingly, there is a growing 

debate about the fundamental design of the current tax system. 

The debate about the future tax system is partly about whether the goals 

for the nation’s tax system can be best achieved by reforming the current

income tax so that it has a broader base and a flatter rate schedule, or 

switching in whole or in part to some form of a consumption tax. The 

President’s Advisory Panel on Federal Tax Reform has taken a major step 

in beginning this debate.2

 The Panel suggested two alternative proposals 

for coordinated reform of the individual and corporate income taxes and

thereby advanced the public debate over how best to simplify these taxes 

and their proposals include the desirable combination of broader tax 

bases and lower tax rates. 

My statement reviews the revenue contribution of the current individual 

income tax as well as its complexity, economic efficiency, equity, and 

taxpayer compliance issues. It also draws some conclusions regarding the

need for tax reform. My statement today makes the following points: 

• The debate about the fundamental design of the tax system is occurring at 

a time when the nation also faces a large and growing structural budget 

 1

I addressed a number of issues relating to the corporate income tax in a statement before 

this committee several weeks ago. See GAO, Tax Compliance: Challenges to Corporate

Tax Enforcement and Options to Improve Securities Basis Reporting, GAO-06-851T 

(Washington, D.C.: June 13, 2006). 

2

President’s Advisory Panel on Federal Tax Reform, Simple, Fair, and Pro-Growth: 

Proposals to Fix America’s Tax System, (Washington, D.C.: November 2005). 

Page 1 GAO-06-1028T 
deficit, as under current policy, the gap between revenues and spending 

will widen over the next few decades. The individual income tax has long 

been the single largest source of federal tax revenue—amounting to 

$927 billion in 2005. Individual income tax policy, including existing tax 

expenditures and enforcement approaches, needs to be an element of a 

multipronged approach that reexamines existing federal policies and 

approaches to address the nation’s large long-term fiscal imbalance.

• Concerns regarding the complexity, economic efficiency, and overall 

equity of the individual income tax have contributed to calls for a 

substantial restructuring of the individual tax or its full or partial 

replacement with some form of consumption tax. The widely recognized 

complexity of the tax results in (1) significant compliance costs, 

frustration and anxiety for taxpayers; (2) decreased voluntary compliance;

(3) increased difficulties for the Internal Revenue Service (IRS) in 

administering the tax laws; and (4) reduced confidence in the fairness of 

the tax. As discussed in our publication, Understanding the Tax Reform 

Debate3

 the individual income tax also causes taxpayers to change their 

work, savings, investment, and consumption behavior in ways that reduce 

economic efficiency and taxpayers’ well-being. 

• Taxpayer noncompliance with the current individual income tax is another 

factor that could motivate reform. For tax year 2001, IRS estimated that 

noncompliance with the individual income tax accounted for about 70 

percent of the $345 billion gross tax gap, which is the difference between 

the taxes that should have been paid voluntarily and on time and what was 

actually paid. Reducing this gap can improve the nation’s fiscal stability, as 

each 1 percent reduction in the tax gap would likely yield about $3 billion

annually. Given its persistence and size, reducing the tax gap within the 

current income tax structure will require exploring new and innovative 

administrative and legislative approaches. 

• In moving forward on tax reform, policymakers may find it useful to 

compare alternative proposals along some common dimensions. Among 

these are whether a proposed tax system will generate sufficient revenue

over time to fund whatever spending path is chosen, whether the base is as 

broad as possible so rates can be as low as possible, and whether it has 

attributes that promote compliance. Our publication, Understanding the 

 3

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

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

Page 2 GAO-06-1028T 
Tax Reform Debate, provides background, criteria, and questions that 

policymakers should find useful. 4

My statement today is drawn from previous GAO reports and testimonies, 

which were done in accordance with generally accepted government 

auditing standards, as well as reviews of relevant literature. 

The base of the individual income tax covers income paid to individuals, 

such as wages, interest, dividends, realized net capital gains, various forms 

of business income, and income from pensions, annuities, trusts and 

estates. This tax base is reduced by personal exemptions for taxpayers and 

their spouses and children, as well as by numerous preferences—

statutorily defined as tax expenditures—such as the deduction for 

mortgage interest, the earned income tax credit, and the exclusion of the 

value of employer-provided health insurance from individuals’ taxable 

income and taxable wage base. The statutory rates of tax on net taxable 

income range from 10 percent to 35 percent. Lower rates (5 percent and

15 percent, depending on taxable income) apply to long-term capital gains 

and dividend income. 

Individuals may also pay tax under the alternative minimum tax (AMT). 

The base of this tax equals regular taxable income, plus the value of 

various tax items, including personal exemptions and certain itemized 

deductions that are added back into the base. This AMT income base is 

then reduced by a substantial exemption and then taxed at a rate of 

26 percent or 28 percent, depending on the taxpayer’s income level.

Taxpayers compare their AMT tax liabilities to their regular tax liabilities 

and pay the greater of the two. 

Although the income tax applies to all who have taxable income, nearly all 

workers pay social insurance taxes to fund retirement, disability and 

retiree health programs. According to Congressional Budget Office 

estimates, in 2000 over 40 percent of households paid more in just their 

portion of social insurance taxes than they paid in income taxes. Further, 

when both their contribution and their employers’ is counted, over 

70 percent of households paid more in social insurance taxes than they did 

in income taxes. The consensus among economists is that the employees 

ultimately bear the entire social insurance tax burden. In 2005 workers 

Background 

 4

GAO-05-1009SP. 

Page 3 GAO-06-1028T 
paid a total of $794 billion in social insurance taxes to fund federal social

insurance, retirement, disability, and retiree health programs. This amount 

was in addition to their income tax liabilities. From the taxpayers’ view, 

these taxes may not appear significantly different than income taxes. They

reduce the workers’ take-home pay each pay period and, although the 

taxes are set aside in a separate account to fund specific benefits, the 

portion of these taxes not immediately needed for current beneficiaries 

goes to fund current government expenses just like income taxes. 

Three long-standing criteria—equity; economic efficiency; and a 

combination of simplicity, transparency, and administrability—are 

typically used to evaluate tax policy. These criteria are often in conflict 

with each other and, as a result, there are usually trade-offs to consider 

and people are likely to disagree about the relative importance of the 

criteria. 

To the extent that a tax is not simple and efficient, it imposes costs on 

taxpayers beyond the payments they make to the U.S. Treasury. As shown 

in figure 1, the total cost of any tax from a taxpayer’s point of view is the 

sum of the tax liability, the cost of complying with the tax system, and the 

economic efficiency costs that the tax imposes. In deciding on the size of 

government, we balance the total cost of taxes with the benefits provided 

by government programs. 

Figure 1: Components of the Total Cost of a Tax to Taxpayers 

Over the long term, the United States faces a large and growing structural 

budget deficit primarily caused by known demographic trends and rising 

health care costs, and this deficit is exacerbated over time by growing 

interest on the ever larger federal debt. Continuing on this imprudent and 

unsustainable fiscal path will gradually erode, if not suddenly damage, our

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

Addressing the nation’s long-term fiscal imbalances constitutes a major 

transformational challenge that may take a generation or more to resolve. 

The United States 

Faces a Large and 

Growing Structural 

Budget Deficit 

Page 4 GAO-06-1028T 
Fiscal necessity may prompt a fundamental review of major program and 

policy areas. Many current federal programs and policies—including tax

policies—were designed decades ago to respond to trends and challenges

that existed then but may no longer suit our 21st century needs. Clearly, 

the individual income, social insurance, and corporate income taxes, 

which have been the federal government’s three largest sources of 

revenue, will need to be considered in any plan for addressing the nation’s 

long-term fiscal imbalance. 

Over the next few decades, as the baby boom generation retires, federal 

spending on retirement and health programs, such as Social Security, 

Medicare, and Medicaid, will grow dramatically and bind the nation’s fiscal 

future. Absent policy changes on the spending and/or revenue sides of the 

budget, a growing imbalance between federal spending and tax revenues 

will mean escalating and ultimately unsustainable federal deficits and 

debt. In simple terms, the gap between projected spending and expected 

revenues grows larger every year. For example, as figure 2 indicates, if 

discretionary spending grows at the same rate as the economy, all expiring 

tax provisions are extended, and then federal revenues are held as a 

constant share of the economy, revenues could be adequate to cover little

more than interest on the federal debt by 2040. 

Revenues from the Current 

Tax System Are Not 

Sufficient to Fund 

Projected Spending 

Page 5 GAO-06-1028T 
Figure 2: Composition of Federal Spending as a Share of GDP, Assuming Discretionary Spending Grows with GDP after 2006 

and That Expiring Tax Provisions Are Extended 

Note: The revenue projection in this figure includes certain tax provisions that expired at the end of

2005, such as the increased alternative minimum tax exemption amount. 

We cannot grow our way out of this long-term fiscal challenge because the 

imbalance between spending and revenue is so large. We will need to 

make tough choices using a multipronged approach: (1) revise budget

processes and financial reporting requirements; (2) restructure entitlement 

programs; (3) reexamine the base of discretionary spending and other 

spending; and (4) review and revise tax policy, including tax expenditures 

and tax enforcement programs. Individual income tax policy, tax 

Page 6 GAO-06-1028T 
expenditures, and enforcement need to be key elements of the overall tax 

review. 

One promising—and perhaps necessary—approach to tackling both the 

tax and entitlements part of our long-term fiscal challenge is a credible, 

capable, and bipartisan Tax and Entitlements Reform Commission. Such 

an approach would help ensure that any decisions made on taxes and 

spending are well coordinated and will produce a sustainable fiscal system 

that meets agreed-upon objectives. 

The Individual Income Tax 

Is the Largest Single

Source of Federal 

Revenues

The individual income tax has long been the single largest source of 

federal tax revenue. In 2005, individual taxpayers paid $927 billion in 

income taxes. Figure 3 shows the relative importance of federal taxes. 

Since 1962, the individual income tax has ranged between a low of 

7 percent (in 2004) and a high of 10.3 percent (in 2000) of gross domestic 

product (GDP). Over the same period, social insurance taxes have grown 

considerably in importance—from 3 percent of GDP in 1962 to 6.5 percent 

of GDP (or $794 billion) in 2005. Revenue from the individual income tax 

has historically accounted for between 40 percent and 50 percent of total

federal tax revenue. In contrast, in the early 1960s, social insurance taxes 

accounted for less than 20 percent of the total; however, they have grown 

to represent 37.1 percent of revenue in 2005. 

Figure 3: Federal Revenues as a Percentage of GDP, 1962 to 2005 

Page 7 GAO-06-1028T 
Concerns about the complexity, efficiency, and equity of the individual 

income tax have motivated calls for a substantial restructuring of the tax 

or its replacement with some form of consumption tax. The widely 

recognized complexity of the tax results in (1) significant compliance 

costs, frustration, and anxiety for taxpayers; (2) decreased voluntary 

compliance; (3) increased difficulties for IRS in administering the tax laws; 

and (4) reduced confidence in the fairness of the tax. The individual 

income tax also causes taxpayers to change their work, savings, 

investment, and consumption behavior in ways that reduce their wellbeing.5

 These reductions in well-being, known to economists as efficiency 

costs, are likely to be large—perhaps on the order of 2 percent of GDP or 

more. The success of our tax system hinges very much on the public’s 

perception of its fairness and transparency. There are differences of 

opinion about the overall fairness of the individual income tax and 

concerns have been expressed about the equity of many specific features 

of the tax. 

Individual Income Tax 

Complexity, 

Compliance, and 

Efficiency Costs and 

Equity Concerns 

Contribute to Calls for 

Reform 

Important Sources of 

Complexity Are Income 

Documentation 

Requirements and Tax 

Expenditure Rules 

If they are to take advantage of the many tax benefits in the tax code, 

virtually all taxpayers must familiarize themselves with, or pay someone to 

advise them on, the sometimes complex rules for determining whether 

they qualify (and, if so, to what extent). Moreover, in cases where multiple 

tax expenditures have similar purposes, taxpayers may have to devote 

considerable time to learn and plan in order to make optimal use of these 

tax benefits. For example, the IRS publication Tax Benefits for Education6

outlines 12 tax expenditures, including 4 different tax expenditures for 

educational saving. The use of one of these tax expenditures can affect 

whether (or how) a taxpayer is allowed to use the other tax expenditures. 

Adding to the taxpayer’s challenge to select the best educational tax 

benefit, the use of one of these tax expenditures may affect a student’s 

 5

GAO-05-1009SP. 

6

Department of the Treasury, IRS, Publication 970, Tax Benefits for Education, 2004. 

Page 8 GAO-06-1028T 
eligibility for other forms of federal assistance for higher education, such 

as Pell grants and subsidized loans.7

The tax benefits, or tax expenditures, available under the income tax are 

usually justified on the grounds that they promote certain social or 

economic goals. They grant special tax relief (through deductions, credits, 

exemptions, etc.) that encourages certain types of behavior by taxpayers 

or aids taxpayers in certain circumstances. Tax expenditures can promote 

a wide range of goals, like encouraging economic development in 

disadvantaged areas, financing postsecondary education, or stimulating 

research and development. For example, a wide range of tax provisions 

are intended to help individuals save for their retirement. These include 

traditional and Roth Individual Retirement Accounts (IRA) and various 

plans administered by employers or available to self-employed individuals. 

Again, individuals face complex choices to select the best options as well 

as complex rules to stay in compliance once they select a retirement 

savings option. From a public policy perspective, all of this complexity and 

the burden it imposes on taxpayers would most likely be worthwhile if the 

tax incentives are successful in achieving their intended purposes. 

However, in many cases this is questionable or unknown. Although 

research results vary, many studies suggest that IRAs result in little actual 

increase in retirement saving. One concern is that individuals can take a 

lump sum withdrawal and, depending on how the sum is used, the 

individual may not have a sufficient stream of income over his/her 

remaining lifetime. 

The sum of the revenue loss estimates associated with tax expenditures 

was more than $775 billion in 2005 and the vast majority of this loss was 

for tax expenditures provided to individuals, rather than to corporations.8

Tax Expenditures Have Been 

Growing 

 7

Three of the tax incentives for saving—Coverdell Education Savings Accounts, Qualified 

Tuition Programs, and U.S. education savings bonds—differ across more than a dozen

dimensions. Similarly, three other tax expenditures, all of which help students meet current 

costs—the Hope credit, Lifetime Learning credit, and the tuition deduction—differ in terms 

of eligibility criteria, benefit levels, and income-related phase-outs. For a fuller discussion,

including estimates of the number of taxpayers who made suboptimal choices in selecting 

among three tax provisions, see GAO, 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). 

8

Summing the individual tax expenditure estimates is useful for gauging the general 

magnitude of the federal revenue involved, but it does not take into account possible 

interactions between individual provisions. 

Page 9 GAO-06-1028T 
As the data in figure 4 indicate, revenue losses due to tax expenditures 

exceeded discretionary spending for half of the last decade. 

Figure 4: Trends in Spending and Tax Expenditure Revenue Losses, 1982-2005 

Note: Summing the individual tax expenditure estimates is useful for gauging the general magnitude 

of the federal revenue involved, but it does not take into account possible interactions between 

individual provisions. 

Much of the revenue loss due to individual income tax expenditures is 

attributable to a small number of large tax expenditures. The seven tax 

expenditures shown in figure 5—each with an annual revenue loss 

estimated at $36 billion or more—accounted for about half of the sum of 

revenue losses for all tax expenditures for fiscal year 2005. With revenue

losses estimated at $4.9 billion, the earned income tax credit (EITC) does 

not appear on this list. The EITC has both revenue losses and outlays 

when a taxpayer’s refund exceeds their tax liability. If $34.6 billion in 

associated outlays were included, this refundable credit would rank 

among the largest tax expenditures. 

Page 10 GAO-06-1028T 
Figure 5: Revenue Loss Estimates for the Seven Largest Reported Tax 

Expenditures for Individuals, Fiscal Year 2005 

0

20

40

60

80

100

120

140

Estimated dollars in billions

Source: OMB, Analytical Perspectives, Budget of the United States Government, Fiscal Year 2007.

Exclusion of employer contributions for insurance premiums and medical care

Deductibility of mortgage interest on owner-occupied dwellings

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

Child tax credit

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

Deductibility of nonbusiness state and local taxes other than on owner-occupied homes

Capital gains exclusion on home sales

118.4a

62.2

50.6

41.8b

37.4 36.5 36.0

a

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

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

b

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

Although Difficult to 

Measure, Compliance 

Burden Is Likely a 

Significant Cost to 

Taxpayers 

The costs of complying with the individual income tax are large but 

unclear. IRS’s most recent estimates suggest that these costs are roughly 

on the order of 1⁄2 to 1 percent of GDP. These costs include the time and 

money spent complying with the computational, reporting, planning, and

recordkeeping requirements of the tax system. Estimates of compliance 

costs are uncertain because taxpayers generally do not keep relevant 

records documenting their time and money spent complying with the tax 

system and many important elements of the costs are difficult to measure 

Page 11 GAO-06-1028T 
because, among other things, federal tax requirements often overlap with 

recordkeeping and reporting that taxpayers do for other purposes. 

The available compliance cost estimates do not represent the potential 

cost savings to be gained by replacing the current federal individual 

income tax. Any replacement tax system will impose significant 

compliance costs of its own. Moreover, given that many state and local

government income taxes depend upon the same compliance activities as 

the federal income tax does, taxpayers would still bear the costs of those 

activities unless those other governments replaced their own taxes to 

conform to the new federal system. In addition, if some of the subsidies, 

such as the earned income tax credit and child tax credit, which are 

provided by the current federal tax system, are replaced by spending 

programs under a reformed system, tax compliance costs may be reduced, 

but only as a result of their being shifted to those new programs. Similarly, 

if a replacement tax system no longer requires individuals to compute and 

document their incomes, individuals will still need to document their 

incomes for borrowing and other purposes, and government statistical 

agencies will incur expenses to replace the data that they currently obtain 

from income tax returns. 

Taxes Generally Reduce 

Economic Efficiency 

Taxes impose efficiency costs by altering taxpayers’ behavior, inducing 

them to shift resources from higher valued uses to lower valued uses in an

effort to reduce tax liability. This change in behavior can cause a reduction 

in taxpayers’ well-being that, for example, may include lost production (or 

income) and consumption opportunities. One important behavioral change 

attributable to the income tax arises from the fact that investment in 

housing is given more favorable treatment than investment in business 

activities. Economists generally agree that this differential tax treatment

reduces the amount of money available to businesses for investment in 

productivity-enhancing technology. This in turn results in employees 

receiving lower wages because increases in wages are generally tied to 

increases in productivity. The tax exclusion for the exclusion of employerprovided health insurance from individuals’ taxable income, discussed in 

text box 1, is another example of an income tax provision that clearly 

reduces economic efficiency. The exclusion encourages more extensive 

insurance coverage, but introduces a well-known problem with health 

insurance. Because much of the cost of medical treatment is paid for by 

the insurer, patients and doctors are generally unaware of, or 

disconnected from, the total costs of health care and have little incentive 

to economize on health care spending. 

Page 12 GAO-06-1028T 
Efficiency costs, along with the tax liability paid to the government and 

the costs of complying with tax laws, are part of the total cost of taxes to 

taxpayers. However, this does not mean that taxes are not worth paying. 

One reason people bear taxes is they desire the benefits of government 

programs and services. (The government does deliver some services 

effectively and often provides services that otherwise would not be 

available.) Taxpayers implicitly or explicitly balance the costs of taxes 

with the benefits of government. 

Nevertheless, minimizing efficiency costs is one criterion for a good tax. 

Economists agree that taxes with broad bases and low rates generally

cause lower efficiency costs than do taxes with narrow bases and high 

rates. The goal of tax policy is to design a tax system that produces 

revenue needed to pay current bills and deliver on future promises while 

at the same time balancing economic efficiency with other objectives, 

such as equity, simplicity, transparency, and administrability. Moreover, as 

noted earlier, the failure to provide sufficient tax revenues to finance the 

level of spending we choose as a nation gives rise to deficits and debt. 

Large, sustained deficits could ultimately have a negative impact on 

economic growth, productivity, and potentially our national security. 

Large structural deficits also raise serious stewardship and 

intergenerational equity issues. 

Page 13 GAO-06-1028T 
Text Box 1: Tax Expenditure for Employer-Provided Medical Insurance Premiums and 

Medical Care 

The current U.S. tax system excludes employer-provided health insurance from 

individuals' taxable income even though such insurance is a form of income (noncash 

compensation). The Department of the Treasury estimates that the tax exclusion for 

employer-provided health insurance resulted in $118.4 billion in lost revenue during 

2005, not including forgone social insurance taxes and state taxes. Including forgone 

federal social insurance taxes, an estimated $177.6 billion in revenue was forgone due 

to this exclusion. 

The tax exclusion increases the proportion of the population covered by health 

insurance. In 2004, nearly 46 million Americans were without health insurance. The 

tax exclusion encourages employers to offer and employees to participate in health 

insurance plans, increasing the proportion of workers covered. Because individuals 

may be better able to anticipate their health care needs than insurers, health care 

plans may attract customers with higher risk of poor health, resulting in higher 

premiums. By encouraging the pooling of high-and low-risk individuals, the tax 

exclusion may help to reduce premiums below those that individuals would face if they 

purchased insurance on their own. 

However, some question whether the tax subsidy for health insurance is the best way 

to increase health insurance coverage. For example, the tax exclusion provides the 

most assistance to taxpayers who have high marginal tax rates (those with high 

incomes)—the exclusion saves those taxpayers more in taxes owed than it saves 

those with lower marginal tax rates. 

The tax exclusion for health insurance also contributes to higher health care costs. 

The exclusion, by lowering premiums, encourages more extensive insurance 

coverage, which compounds another well-known problem with health insurance. 

Because much of the cost of medical treatment is paid for by a third party (the insurer), 

patients and doctors are generally unaware of, or disconnected from, the total costs of 

health care and have little incentive to economize on health care spending.

Unlike the tax exclusion for employer-provided health insurance, an ideal health care 

payment system would foster the delivery of care that is both effective and efficient, 

resulting in better value for the dollars spent on health care. 

Efficiency Costs Resulting 

from the Individual Income 

Tax Are Likely to Be Large 

but Can Only Be Estimated 

with Considerable 

Uncertainty 

Estimating the efficiency costs of the federal tax system is an enormous, 

complicated, and uncertain task, given the complexity of existing tax 

rules, the breadth and diversity of the U.S. economy and population, and

the limited empirical evidence available on how individuals and businesses 

change their behavior in response to tax rules. In practice, researchers 

have not been able to obtain and analyze all of the detailed data they need 

Page 14 GAO-06-1028T 
to produce efficiency cost estimates that are free from a large degree of 

uncertainty. 

The two studies that have made the most comprehensive estimates of the 

efficiency costs arising from the individual income tax in the past two 

decades suggest that those costs are considerable. The first study, which 

examined the combined efficiency costs of the individual income and 

payroll taxes, estimated those costs to have been on the order of 2 to 

5 percent of GDP in 1994.

9

 Estimates from the second study indicate that 

the efficiency cost of the individual income tax was on the order of 

2 percent of GDP in 1997.

10 Efficiency cost estimates such as these are 

often quite sensitive to the assumed magnitude of key behavioral 

responses and those assumptions are often based on empirical research 

that continues to evolve over time or, in other cases, has yet to be 

undertaken. For example, the consensus of recent research is that 

individuals are less responsive to changes in taxes than the first study 

assumed them to be. 

The extent to which efficiency gains could be realized by switching to an

alternative tax system depends critically on the detailed characteristics of 

the alternative. All of the alternative tax system proposals that have 

received serious consideration in recent decades would have imposed 

significant efficiency costs. Moreover, in assessing the potential efficiency 

gains from any tax reform proposal it is also important to consider 

compensating changes that may be made on the spending side of the 

federal budget. For example, if any tax expenditures in the current federal

income taxes are replaced by grants, spending programs, regulations, or 

other forms of nontax subsidies, those subsidies can result in efficiency 

costs similar in magnitude to those associated with the tax expenditures 

they replaced. 

Perceptions of Inequities 

in the Tax System Can 

Undermine Its Success 

The success of our tax system hinges very much on the public’s perception

of its fairness and transparency. The myriad of tax deductions, credits, 

special rates, and so forth cause taxpayers to doubt the fairness of the tax 

 9

Martin Feldstein, “Tax Avoidance and the Deadweight Loss of the Income Tax,” The 

Review of Economics and Statistics (1999). 

10Dale Jorgenson and Kun-Young Yun, Investment Volume 3: Lifting the Burden: Tax

Reform, the Cost of Capital, and U.S. Economic Growth (Cambridge, Ma.: MIT Press),

2001. 

Page 15 GAO-06-1028T 
system because they do not know whether those with the same ability to

pay actually pay the same amount of tax. Fairness is ultimately a matter of

personal judgment about issues such as how progressive tax rates should 

be and what constitutes ability to pay. 

Public confidence in the nation’s tax laws and tax administration is critical 

because we rely heavily on a system of voluntary compliance. If taxpayers 

do not believe that the tax system is credible, easy to understand, and 

treats everyone fairly, then voluntary compliance is likely to decline. The 

latest available IRS estimates indicate that about 84 percent of total taxes 

due for tax year 2001 were paid voluntarily and on time. Complexity and

the lack of transparency it can create exacerbate doubts about the current 

tax system’s fairness. 

There are differences of opinion about the fairness of the individual 

income tax. Likewise, concerns have been expressed about the equity of 

many specific features of the tax, such as: 

• marriage penalties (and bonuses) built into the tax under which the 

combined tax liabilities of two individuals differ, depending on whether or 

not those individuals are married; 

• the inconsistent treatment between taxable wages and salaries and other 

components of total employee compensation, such as employer-provided 

health benefits that are not taxed; 

• the fact that many low-income individuals face high effective marginal tax

rates over certain income ranges as the benefits of tax preferences, such 

as the earned income tax credit, phase out; 

• the provision of certain tax benefits in the form of deductions, which are 

more valuable to taxpayers in higher income brackets, rather than as tax 

credits; 

• the requirement that a taxpayer must own a home in order to receive the 

significant advantage of tax-preferred borrowing; and 

• the greater ease with which self-employed individuals can underreport 

income, compared to employees whose incomes are subject to 

withholding and third-party reporting. 

Judging the equity of the individual income tax can depend substantially 

on the frame of reference used. For example, for many, a progressive tax 

code is considered to be more equitable. When looked at in isolation, the 

individual income tax system is somewhat progressive. If the frame of 

reference is expanded, however, and payroll taxes are also taken into 

Page 16 GAO-06-1028T 
account, total progressivity drops.11 As mentioned earlier, more than 

70 percent of taxpayers are estimated to pay more in payroll taxes than 

individual income taxes when the combined employee and employer 

shares are considered.12 These frames of reference, of course, look only at

the payment of taxes. An even wider frame of reference would take into 

account the benefits taxpayers receive, which could alter yet again 

judgments about the equity of the tax system. In fact, it could be argued

that the full effect of federal government policies on different groups of 

individuals can only be determined by examining the effects of all federal

taxes, spending programs, and regulations. 

The extent of individual taxpayer noncompliance with the current tax laws

is another factor that could motivate calls for reform. Ensuring 

compliance with our nation’s tax laws is a challenging process for both 

taxpayers and IRS. The difficulty in ensuring compliance is underscored 

by the tax gap—the difference between the taxes that should be paid

voluntarily and on time and what is actually paid—that arises every year 

when taxpayers fail to comply fully with the tax laws. Most recently, IRS 

estimated the gross tax gap for tax year 2001 to be $345 billion, including 

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

taxes. IRS estimated it would eventually recover about $55 billion of the 

Ensuring Individual 

Taxpayer Compliance 

with the Tax Laws Is 

Challenging 

 11Although it makes sense to consider the significant additional burden of social insurance 

taxes when evaluating individual tax burdens, there is some disagreement regarding the 

proper way to analyze the two taxes jointly. Many economists consider the portion of 

payroll taxes that fund Old-Age and Survivors Insurance benefits to be materially different 

from other federal taxes because individuals receive future benefits that are directly 

related to the amount of tax they pay. In their view some account should be made of the

redistributive nature of the social security benefits formula. (See, for example, Richard V.

Burkhauser and John A. Turner, “Is the Social Security Payroll Tax a Tax?,” 13 Public 

Finance Quarterly, (1985) and Andrew Mitrusi and James Poterba, “The Distribution of 

Payroll and Income Tax Burdens, 1979-99,” National Tax Journal, Vol. 53 no. 3 Part 2

(September 2000) pp. 765-794.) Other observers assert that future benefits are an 

entitlement based on participation in the workforce, not on the payment of tax, and that all 

social insurance taxes should be treated the same as individual income taxes when 

analyzing the distribution of tax burdens. (See Patricia E. Dilley, “Taking Public Rights 

Private: The Rhetoric and Reality of Social Security Privatization,” Boston College Law 

Review, 975 (2000) and Deborah A. Geier, “Integrating the Federal Tax Burden on Labor 

Income,” Tax Notes, January 27, 2003), pp. 563-583.) 

12The Tax Policy Center, using its tax simulation model, has estimated that 96 percent of 

taxpayers pay more in payroll taxes than individual income taxes when both the employee

and employer shares of taxes are considered. Economists widely agree that the employee

bears the full amount of the payroll tax. 

Page 17 GAO-06-1028T 
gross tax gap through late payments and enforcement actions, resulting in 

a net tax gap of $290 billion.13

About 70 percent of the gross tax gap for tax year 2001, or an estimated 

$244 billion, was attributed to the individual income tax. As shown in table 

1, individual taxpayers that underreported their income, underpaid their 

taxes, or failed to file an individual tax return altogether or on time 

(nonfiling) accounted for $197 billion, $23 billion, and $25 billion of the tax 

gap, respectively. 

Table 1: Individual Income Tax Portion of the Tax Year 2001 Gross Tax Gap

Estimate 

Type of noncompliance Tax gap (dollars in billions)

Underreporting $197

 Business income 109

 Nonfarm proprietor income 68

 Partnership, S-Corp, estate and trust 22

 Rents & royalties 13

 Farm income 6

 Nonbusiness income 56

 Capital gains 11

 Wages, salaries, tips 10

 Pensions and annuities 4

 Interest and dividend income 3

 Other 28

 Credits 17

 Deductions, exemptions, adjustments 15

Underpayment 23

Nonfiling 25

Total $244

Source: IRS. 

Note: Figures may not sum to totals because of rounding. 

Improving compliance and reducing the tax gap would help improve the 

nation’s fiscal stability. Even modest progress would yield significant 

revenue; each 1 percent reduction would likely yield nearly $3 billion 

 13Unless otherwise noted, references to the tax gap refer to the gross tax gap. 

Page 18 GAO-06-1028T 
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. As such, we need to consider not only options that 

have been previously proposed but also explore new and innovative 

approaches to improving compliance including fundamental reform of the 

tax system as well as providing IRS with additional enforcement tools and 

ensuring that significant resources are devoted to enforcement. 

Fundamentally reforming our tax system has the potential to improve 

compliance, especially if a new system has few tax preferences or 

complex tax code provisions and if taxable transactions are transparent to 

tax administrators. One factor that some believe contributes to the 

difficulty of achieving compliance is the complexity of our tax system. The 

complexity of, and frequent revisions to, the tax system make it more 

difficult and costly for taxpayers who want to comply to do so and for IRS 

to explain and enforce tax laws. Complexity also creates a fertile ground 

for those intentionally seeking to evade taxes, and often trips others into 

unintentional noncompliance. Likewise, the complexity of the tax system 

challenges IRS in its ability to administer our tax laws. 

Whether under our current income tax system or a reformed one, 

enforcement tools, particularly information reporting14 and tax

withholding,15 are key to high levels of compliance. The extent to which 

individual taxpayers accurately report the income they earn has been 

shown to be related to the extent to which the income is reported to them 

and IRS by third parties or taxes on the income are withheld, as shown in 

figure 6. Taxpayers tend to report income subject to tax withholding or 

information reporting with high levels of compliance because the income 

is transparent to the taxpayers as well as to IRS. For example, 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 recent study of individual tax compliance indicate that nearly 

 14Information 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. 

15An example of tax withholding is when employers withhold taxes on the wages that 

employees earn and remit them to IRS. 

Page 19 GAO-06-1028T 
99 percent of these types of income are accurately reported on individual

tax returns. For types of income for which there is little or no information 

reporting, individual taxpayers tend to misreport over half of their income. 

Figure 6: Individual Net Income Misreporting Categorized by the Extent of Income

Subject to Withholding and Information Reporting 

Ensuring that significant resources are devoted to enforcement also has 

the potential to minimize the tax gap for our current income tax system as 

well as for reformed systems Congress may adopt. For the current system, 

devoting more resources has the potential to 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. 

Importantly, expanded enforcement efforts could reduce the tax gap more 

than through direct tax revenue collection, as widespread agreement 

Page 20 GAO-06-1028T 
exists that IRS enforcement programs have an indirect effect through 

increases in voluntary tax compliance.16 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. 

Generally, when holding IRS accountable for the use of resources, it is 

also desirable to focus on the outcomes achieved rather than on how IRS 

allocates the resources it receives. Results are really what counts. If IRS, 

or any other agency, can figure out how to more cost effectively achieve a 

result, then reallocation of resources to other problem areas could be an

appropriate strategy, within the restrictions applying to appropriation 

accounts, for making the best use of limited resources. In sum, regardless 

of the tax system, Congress needs to assure itself that the revenue agency

has sufficient resources and reasonable flexibility to achieve desired 

outcomes and hold the agency accountable for those outcomes. 

In moving forward on tax reform, policymakers may find it useful to 

compare proposals on common dimensions. These comparisons can be 

helpful whether reform is of the individual income tax, the current tax 

system more broadly, or in considering new systems altogether. 

First, is the tax base as broad as possible? Broad-based tax systems with 

minimal exceptions have many advantages. Fewer exceptions generally

means less complexity, less compliance cost, less economic efficiency 

loss, and by increasing transparency may improve equity or perceptions of

equity. In terms of the individual income tax, this suggests that eliminating 

or consolidating the myriad of tax expenditures must be considered. We 

need to be sure that the benefits achieved from having these special 

provisions are worth the associated revenue losses just as we must ensure 

that outlay programs—which may be attempting to achieve the same 

purposes as tax expenditures—achieve outcomes commensurate with 

their costs. To the extent tax expenditures are retained, consideration 

should be given to whether they are better targeted to meet an identified 

Comparing Proposals 

on Common 

Dimensions 

 16Two 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. 

Page 21 GAO-06-1028T 
need. Many tax expenditures are broadly available and, in fact, provide 

greater “assistance” to those that most would consider least in need. This 

is broadly true of any tax expenditure that is worth more to higher income 

taxpayers than to lower income taxpayers, like the exclusion for the value

of employer-provided health insurance and the mortgage interest 

deduction. 

Broad based tax systems can yield the same revenue as more narrowly 

based systems at lower tax rates. The combination of less direct 

intervention in the marketplace from special tax preferences, and the 

lower rates possible from broad based systems, can have substantial 

benefits for economic efficiency. For instance, some economists estimate 

that the economic efficiency costs of tax increases rise proportionately 

faster than the tax rates. In other words, a 50 percent tax increase could

more than double the economic efficiency costs of a tax system. 

Does the proposed system raise sufficient revenue over time to fund our 

expected expenditures? As I mentioned earlier, we will fall woefully short 

of achieving this end if current spending and/or revenue trends are not 

altered. The economic efficiency costs of our current tax system likely will 

become an even more important issue as we grapple with the nation’s 

long-term fiscal challenges. Although we clearly must restructure major 

entitlement programs and the basis of other federal spending, it is unlikely 

that our long-term fiscal challenge will be resolved solely by cutting 

spending. If we must raise revenues, doing so from a broad base and a

lower rate will help minimize economic efficiency costs. 

In this regard, the President’s Advisory Panel on Tax Reform has taken a

useful step forward for tax reform, helping, for example, to focus the 

debate on specific proposals. Those proposals incorporate broader bases,

with lower rates. However, the Panel acted within the guidance it was 

given, and one result is that the proposed reforms, if implemented as 

proposed, appear to provide much less than the necessary revenue to fund

expected government spending. Although we have not evaluated the 

revenue effects of these proposals, other respected analysts have and they 

point to future revenue yields that would worsen the already difficult fiscal 

challenges the nation faces. 

Does the proposal look to future needs? Like many spending programs, 

the current tax system was developed in a profoundly different time. We 

live now in a much more global economy, with highly mobile capital, and 

investment options available to ordinary citizens that were not even 

imagined decades ago. We have growing concentrations of income and 

Page 22 GAO-06-1028T 
wealth. More firms operate multi-nationally and willingly move operations 

and capital around the world as they see best for their firms. 

Do the revenues for the proposed system hold up in the future? As an 

adjunct to looking forward when making reforms, the revenue 

consequences of all major tax changes should be estimated well into the 

future. Such long-term projections undoubtedly will be subject to 

uncertainty, but at the very least we should have the best estimates 

possible of whether the revenue trend is likely to shift up or down over the 

long-term. 

Does the proposed system have attributes associated with high 

compliance rates? Because any tax system can be subject to tax gaps, the 

administrability of reformed systems should be considered as part of the 

debate for change. In general, a reformed system is most likely to have a 

small tax gap if the system has few tax preferences or complex provisions 

and taxable transactions are transparent. Transparency in the context of 

tax administration is best achieved when third parties report information 

both to the taxpayer and the tax administrator. 

What transition issues exist and have they been dealt with in an equitable

fashion that minimizes additional complexity and any adverse effects on 

the benefits to be gained from the new tax system? Under the current 

individual income tax system, citizens have made fundamental life choices

based at least in part on the incentives in the tax system. For many, the 

favorable tax treatment of owner-occupied housing has led to choices to 

invest disproportionately in housing. Others have made long-term 

investments in tax-favored college savings plans. Thus, changes to the tax

system can materially affect citizens’ futures. Still others make their livings 

advising taxpayers, helping them understand tax provisions and complete

their tax returns, and helping them devise investment and other financial

plans taking into account current tax rules. 

Our publication, Understanding the Tax Reform Debate: Background, 

Criteria, and Questions,

17 may be useful in guiding policymakers as they 

consider tax reform proposals. It was designed to aid policymakers in 

thinking about how to develop tax policy for the 21st century. While not 

designed to break new conceptual ground, this report brings together a 

number of topics that tax experts have identified as those that should be 

 17GAO-05-1009SP. 

Page 23 GAO-06-1028T 
considered when evaluating tax policy. It attempts to provide information 

about these topics in a clear, concise, and easily understandable manner 

for a non-technical audience. 

The problems that I have reviewed today relating to the compliance costs, 

efficiency costs, equity and tax gap associated with the current individual 

income tax system—many of which arise from the complex accumulation

of tax preferences in that system—would seem to make an overwhelming 

case for a comprehensive review and reform of our tax policy. Further, we 

live a world that is profoundly different than when the individual income 

tax and many of its provisions were adopted. Despite numerous and 

repeated calls for such reform, progress has been slow. One reason why 

reform is difficult to accomplish is that the provisions of the tax code that 

generate compliance costs, efficiency costs, the tax gap and inequities also

benefit many taxpayers and the individuals and companies that advise 

taxpayers and help them with their tax filing obligations. Reform is also 

difficult because, even when there is agreement on the amount of revenue

to raise, there are differing opinions on the appropriate balance among the 

often conflicting objectives of equity, efficiency, and administrability. This, 

in turn, leads to widely divergent views on even the basic direction of 

reform. 

Fiscal necessity, prompted by the nation’s unsustainable fiscal path, will 

eventually force changes to our spending and tax policies. We must 

fundamentally rethink policies and everything must be on the table. Tough

choices will have to be made about the appropriate degree of emphasis on 

cutting back federal programs versus increasing tax revenue.

Tax reform, if it broadens the tax base, could reduce the costs of raising a 

given amount of revenue by reducing the associated efficiency costs. Such 

a reform also likely would reduce inequities, compliance burden, and 

administrative costs. The recent report of the President’s Advisory Panel

on Federal Tax Reform recommended two different tax reform plans. 

Although each plan provides for significant simplification, neither of them 

addresses the growing imbalance between federal spending and revenues 

that I highlighted earlier. One approach for getting the process of 

comprehensive fiscal reform started would be through the establishment 

of a credible, capable, and bipartisan commission, to examine options for 

a combination of entitlement and tax reform. 

As policymakers consider proposals to reform the current individual 

income tax, or the entire tax system, they may find it useful to compare 

Concluding 

Observations 

Page 24 GAO-06-1028T 
the proposals on common dimensions. Our publication, Understanding 

the Tax Reform Debate, may be useful when making these comparisons. 

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

statement. I would be pleased to answer any questions you may have at

this time. 

For further information on this testimony please contact James White on 

(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 testimony. Individuals making key contributions to this testimony 

include Michael Brostek, Director; Kevin Daly and Jim Wozny, Assistant 

Directors; Jeff Arkin; Elizabeth Fan; Tom Gilbert; Don Marples; and Jeff 

Procak. 

Contact and 

Acknowledgments 

Page 25 GAO-06-1028T (450509) 
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