United States General Accounting Office

GAO Testimony

Before the National Commission on Restructuring the

Internal Revenue Service

For Release

on Delivery

Expected at

11:00 a.m. EST

Thursday

January 9, 1997

TAXPAYER COMPLIANCE

Analyzing the Nature of the

Income Tax Gap

Statement of Lynda D. Willis, Director, Tax Policy and

Administration Issues, General Government Division

GAO/T-GGD-97-35

Statement 

Taxpayer Compliance: Analyzing the Nature

of the Income Tax Gap

Messrs. Chairmen and Members of the Commission:

We are pleased to be invited by you to discuss the income tax gap—the

difference between income taxes owed and those voluntarily paid. The

Internal Revenue Service (IRS) has estimated that taxpayers do not

voluntarily pay more than $100 billion annually of taxes due on income

from legal sources.1

 While such “tax gap” estimate is necessarily

imprecise, it indicates significant noncompliance and the challenge that IRS

faces in finding ways to reduce the tax gap.

When some taxpayers do not pay all the taxes they owe, that part of the

burden of funding approved government programs shifts to taxpayers who

fully comply. Thus, maintaining high levels of compliance and reducing the

tax gap are important for equity reasons. However, it would be unrealistic

to assume that our tax system, or any tax system, can achieve 100-percent

compliance and thus eliminate the tax gap.

My statement covers four points which are based on our previous reports

and ongoing work. These points are:

• First, IRS’ data suggest that U.S. taxpayers voluntarily pay about 83 percent

of the income taxes they owe and ultimately pay about 87 percent after IRS

enforcement programs. This compliance level, in combination with

economic growth, translates into billions of “tax gap” dollars.

• Second, IRS’ estimates show that voluntary compliance in reporting income

varies across groups of individuals. Among those filing income tax returns,

wage earners report 99 percent of their wages; self-employed individuals

who operate formally report 68 percent of their business income; and

“informal suppliers,” self-employed individuals who operate informally on

a cash basis, report just 19 percent of such income on their tax returns.

• Third, IRS data show that compliance is highest under tax withholding, a

little lower without withholding but with information reporting to IRS, and

much lower when neither system is in place. In addition to the relative

visibility of the income to tax administrators, other factors also influence

the level of compliance. For example, complex tax laws can lead to more

noncompliance.

• Fourth, IRS faces many challenges in reducing the income tax gap. For

example, some of the “tax gap” may not be collectible at an acceptable

cost. Such collection might require either more intrusive record keeping or

1

Income tax gap estimates released in 1988 and 1996 have excluded unpaid income taxes owed from

illegal activities such as drug dealing and prostitution. IRS’ tax gap estimates in 1979 and 1983 included

such an estimate. Since then, IRS researchers have decided that the data and methodology for reliably

making this estimate are lacking.

Page 1 GAO/T-GGD-97-35
Statement 

Taxpayer Compliance: Analyzing the Nature

of the Income Tax Gap

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

can commit. Thus, it is important that IRS know as much as possible about

current compliance with the tax laws and use that knowledge to focus its

resources in a cost-effective way.

Successfully reducing the tax gap may depend on several systematic

factors in addition to overcoming the challenges faced by tax

administrators. Before discussing these points, I would like to discuss the

“tax gap” estimates and how they are derived.

Tax Gap Estimates Tax gap estimates, for the most part, have traditionally begun with IRS’

Taxpayer Compliance Measurement Program (TCMP). Under this program,

IRS auditors did line-by-line audits of randomly selected tax returns to

identify under- and overreporting for a line item. IRS used these results to

estimate compliance for the taxpayers included in the TCMP. TCMP has been

used since 1963 to measure compliance on income tax returns filed by

individuals about every third tax year. The last TCMP for such individual

filers covered tax year 1988. IRS also has done a few TCMPs for individual

nonfilers and for small corporations (those reporting less than $10 million

in assets). Other data from IRS enforcement programs and special studies

have been used to supplement TCMP results or to estimate the tax gap for

large corporations and informal suppliers.

IRS’ most recent estimate (1996) projects tax gap numbers for individuals

in tax years 1985, 1988, and 1992. Previous IRS estimates provided

projections for other tax years as well as for corporations.2 IRS estimated

that the income tax gap for individuals reached as high as $95 billion for

tax year 1992. IRS data show the tax gap has grown over time even though

the compliance rate has remained roughly the same because the economy

has grown and changes in the tax laws have had the unintended effect of

increasing opportunities for noncompliance. After making adjustments for

tax law changes and shifts in types of income, IRS estimated that overall

individuals have been paying about 83 percent of the total income taxes

owed.

2

IRS last updated in 1990 an estimate of the corporate income tax gap. That tax gap estimate was

$33 billion for tax year 1992. It did not include the most recent TCMP for small corporations, which

showed that their income tax compliance, dropped from 81 percent in 1980 to 61 percent in 1987. IRS

Research Division did not know when it would have the time and resources to finish updating the

corporate tax gap estimates.

Page 2 GAO/T-GGD-97-35
Statement 

Taxpayer Compliance: Analyzing the Nature

of the Income Tax Gap

IRS has been able to recover a portion of the tax gap through its

enforcement programs, such as audits and document matching.3 IRS

estimates that its enforcement programs have, on average, recovered

about 4 percent of all individual and corporate income taxes due in any

particular tax year. Thus, IRS estimates that overall compliance reaches

about 87 percent after IRS enforcement programs. However, because of the

time consumed by these programs and by any subsequent appeals and

litigation, the 87-percent compliance level cannot be reached until a

number of years after the taxes were due.

Components of the

Tax Gap

As shown in table I.1, IRS’ estimate attributes about three-fourths of the

gross income tax gap to individuals and one-fourth to corporations. For

tax year 1992, the individual tax gap primarily arose from individuals not

fully reporting their income on filed tax returns ($59 billion of the

$95 billion estimate). The most recent estimate of the corporate tax gap

projected it to be $33 billion for tax year 1992. Noncompliance in reporting

income, deductions, and other offsets to income or tax comprised most of

the total—$24 billion by large corporations and $7 billion by small

corporations.

Within these overall tax gap estimates, compliance varied by type of

individual taxpayers filing the tax returns (see table I.2), as follows:

• Wage earners whose wages are subject to tax withholding (the most

systematic method for making income visible to IRS) are estimated to

report 99 percent of their wages.

• Individuals are estimated to report 98 percent of their interest income and

92 percent of their dividend income, most of which is subject to

tax-information reporting but not tax-withholding requirements.

• In contrast, IRS estimates that self-employed individuals who formally

operate businesses other than farms report about 68 percent of their

business income, which is neither subject to withholding nor necessarily

covered by information reporting.

• Finally, self-employed informal suppliers, who are even less likely to have

income reported to IRS on information returns, report an estimated

19 percent of their business income.

The tax gap for individual taxpayers who did not file tax returns for tax

year 1992 was almost $14 billion. Other components of the individual tax

3

IRS’ 1996 estimate for individuals noted that IRS enforcement programs recovered about $15 billion of

the $95 billion income tax gap for 1992, leaving a net gap of $80 billion.

Page 3 GAO/T-GGD-97-35
Statement 

Taxpayer Compliance: Analyzing the Nature

of the Income Tax Gap

gap included overreported deductions, credits and other offsets to income

($14 billion), and taxes not remitted along with the filed return ($8 billion).

Similarly, variations in compliance exist in the corporate sector. Small

corporations tend to mirror the compliance patterns of self-employed

individuals. Unreported business income is the biggest compliance

problem, and sufficient documentation of income is often lacking. In large

corporations, by contrast, the tax gap typically arises from different

interpretations of an ambiguous and complex tax code. Upon audit, IRS

auditors may interpret the tax provisions differently and, as a result,

recommend adjustments to the corporation’s tax liability.4

Systematic Factors

That Influence Tax

Compliance

Tax administrators around the globe have worked to promote compliance

with whatever tax system is in place. On the basis of our previous work5

,

we have identified some common principles that have influenced their

success.

First: The simpler the rules, the better. This reflects the basic

principle that the simpler the tax code, the more certain the results in

applying it and the fewer the opportunities for disagreements over the

“fine points” of tax law. However, we have reported that the existing U.S.

system is neither simple nor certain. For example, some paragraphs in the

Internal Revenue Code have generated as many as 250 pages of

implementing regulations.

Second: Collecting from fewer sources is easier. Tax withholding

allows the tax collector to focus on the relatively small number of

employers rather than on all employees. For example, Congress followed

this reasoning in changing the collection point for diesel fuel taxes to the

smaller number of businesses earlier in the production chain. Subsequent

to this and other changes in the taxation scheme for diesel fuel, collections

have risen significantly.

Third: More visible tax information promotes higher compliance.

Tax withholding and information reporting are two means of making

income and some deductions visible to both the taxpayer and the tax

administrator; this visibility leads to significantly higher compliance rates.

4

IRS’ primary basis for estimates of the large corporation tax gap arise from these recommended audit

adjustments. When any taxpayer appeals the recommendation, the appeal process may result in the

recommended tax liability being reduced in whole or in part.

5

Reducing the Tax Gap: Results of a GAO-Sponsored Symposium (GAO/GGD-95-157, Jun. 2, 1995).

Page 4 GAO/T-GGD-97-35
Statement 

Taxpayer Compliance: Analyzing the Nature

of the Income Tax Gap

Good records and other types of paper trails also lead to better results

when the tax administrator audits a return or takes some other

enforcement action.

Fourth: Good information is critical to identifying compliance

problems. This principle recognizes the importance of systematically

estimating the extent of noncompliance and variations in taxpayer

behavior. In this way, the tax administrator can identify areas warranting

attention, tax returns to audit, and the results of any efforts to improve

compliance.

Fifth: Focus compliance efforts where they will do the most good.

Having information on the most significant compliance problems helps the

tax administrator to tailor its enforcement efforts accordingly. At present,

the largest component of the U.S. income tax gap arises from individuals

not fully reporting their income, particularly income that is not subject to

tax withholding. This knowledge has helped IRS to train its auditors to

better detect unreported income.

Sixth: Deal with compliance problems quickly. IRS has found that the

longer it takes to reach a taxpayer, whether through enforcement or

assistance, the less success in correcting the compliance problem.

The Challenge for IRS IRS’ goal has been to improve the compliance level from 87 percent to

90 percent by 2001. The tax gap estimates have provided ways for

determining whether compliance is improving. At the broadest level, the

estimates provide an indicator of the seriousness of the compliance

problems and any related inequities. To the extent that sufficient details

are known, the estimates also provide insights on the types of tax issues or

taxpayers associated with low and high compliance.

One method by which IRS hopes to improve compliance is by increasing its

compliance presence. Over the last 30 years, the rates at which IRS has

audited income tax returns have declined over 75 percent. While

alternative mechanisms such as document matching reach many types of

income that may not be reported, IRS has no substitute for auditing in the

case of more complex tax issues. Another method of improving

compliance is to educate the taxpayer about confusing or commonly

misunderstood tax requirements. IRS has initiated efforts to develop better

information that should help IRS to improve its compliance presence as

Page 5 GAO/T-GGD-97-35
Statement 

Taxpayer Compliance: Analyzing the Nature

of the Income Tax Gap

well as to secure more opportunities for outreach and education with

taxpayer groups.

To support such efforts, IRS has been reorganizing its compliance research

function to push more research into field offices. IRS hopes that systematic

research, combined with detailed knowledge about tax and enforcement

issues, can provide a road map to large-scale compliance gains. With this

end in mind, IRS has been scheduling various research projects and

attempting to build new databases to allow its researchers access to

current data related to the compliance of various taxpayer groups. Finally,

IRS is considering different ways to measure how well our voluntary tax

system is working.

The importance of these steps has increased with the demise of TCMP. In

October 1995, concerns about costs and burdens on taxpayers prompted

IRS to cancel a planned tax year 1994 TCMP for individuals, small

corporations, and other types of small businesses.6 IRS has not yet

developed an alternative to the comprehensive, statistically valid estimates

on tax compliance that TCMP provided. Lacking such a replacement to date,

IRS hopes that its enhanced research activities will provide a partial

substitute.

It is not yet clear whether IRS will be able, absent TCMP data, to continue to

provide a comprehensive tax gap estimate with any statistical precision at

the national level. Without such an estimate, IRS and Congress will not

know how well our voluntary tax system works overall and the extent that

all types of taxpayers are paying their fair share of taxes. Nor will IRS and

Congress have a broad context by which to judge the seriousness of the

compliance problems uncovered in field research of selected tax issues

and taxpayer groups.

One factor IRS must balance against its desire to increase voluntary

compliance is the additional costs and burdens that are incurred by both

IRS and the taxpayer. Depending on the actions taken, improving the

compliance rate could dramatically increase the costs to IRS and the

burdens on taxpayers. Reaching for a near-perfect compliance rate very

6

While TCMP audits would actually reduce the overall long-term burden on taxpayers to the extent

that fewer compliant taxpayers would be selected for IRS audits in the future, the time and

documentation requirements for taxpayers selected for a TCMP audit can be burdensome. For a

discussion of the difficulties of measuring tax system burden, see our prior testimony entitled Tax

System Burden: Tax Compliance Burden Faced by Business Taxpayers (GAO/T-GGD-95-42, Dec. 9,

1994).

Page 6 GAO/T-GGD-97-35
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Taxpayer Compliance: Analyzing the Nature

of the Income Tax Gap

likely would mean imposing burdens and costs that our society may not

accept.

IRS is hoping that its enhanced research efforts will allow it to target

noncompliance in a systematic way and thus guide enforcement and

educational activities while minimizing costs and burdens. We have

reported7

 that IRS’ approach of supplementing its enforcement efforts with

research into the causes of noncompliance strikes us as being intuitively

logical. However, we found mixed support among IRS officials for this

approach causing tensions that could have an adverse impact on its

success. Further, IRS had not completed the infrastructure for planning and

managing the research, although progress has been made. If the research

efforts fall short of expectations, IRS may have to rely on other means,

some possibly more intrusive or more burdensome, to select taxpayers for

enforcement activities such as audits.

In summary, I would like to reiterate how important it is for IRS (or any

other tax administrator) to invest resources in measuring compliance. It is

also important for IRS to use the results to balance efforts among its

competing goals of (1) maximizing collection of taxes owed, (2) promoting

uniform compliance, and (3) minimizing taxpayer burden. I would

welcome any questions.

7

Tax Research: IRS Has Made Progress but Major Challenges Remain (GAO/GGD-96-109, Jun. 5, 1996).

Page 7 GAO/T-GGD-97-35
Appendix I 

Selected Tax Gap Statistics

Table I.1: Gross Tax Gap Estimates for

Tax Year 1992 (Dollars in Billions)

Source of tax gap

Tax gap

amount

Tax gap

distribution

(percent)

Individual tax gap $95.3 74.3%

Unreported income on filed returns 58.6 45.6

Sole proprietors 29.2 22.7

All other income 29.4 22.9

Overstated deductionsa 14.4 11.2

Nonfiler 13.8 10.7

Individual remittance gap 8.4 6.5

Math errors 0.1 0.1

Corporate tax gap 33.1 25.8

Small corporations 7.0 5.5

Large corporations 23.7 18.5

Otherb 0.4 0.3

Corporate remittance gap 2.0 1.6

Total tax gapc $128.4 100.0%

aIncludes subtractions for erroneous deductions, exemptions, credits, and other adjustments.

bIncludes unreported income and overstated deductions for exempt organizations’ unrelated

business income and for fiduciaries.

cTotals may not add due to rounding.

Source: Income Tax Compliance Research, IRS Publication 1415 (7-88); Income Tax Compliance

Research, IRS Publication 1415 (4-90); and Federal Tax Compliance Research, IRS Publication

1415 (4-96).

Page 8 GAO/T-GGD-97-35
Appendix I 

Selected Tax Gap Statistics

Table I.2:

1992 Underreporting—Individual Tax

Gap by Source (Dollars in Billions)

Description

1992 tax

gap

amount

Net reporting

percentage

Underreported income

Wages and salaries $3.2 99.1%

Interest 0.9 97.7

Dividends 1.3 92.2

State tax refund a 99.2

Alimony 0.1 86.7

Capital gains 2.5 92.8

IRS Form 4797 0.7 72.0

Pensions and annuities 1.8 96.0

Taxable unemployment 0.3 93.1

Farm income 3.4 67.8

Partnership and small business corporation income 3.6 92.5

Rents and royalties 3.7 82.8

Informal suppliers 12.3 18.6

Other sole proprietors 16.9 67.7

Other income 7.6 75.1

Taxable Social Security 0.2 95.8

Overstated offsets

Adjustments to income 0.2 98.0

Deductions 5.1 95.6

Exemptions 2.9 95.5

Credits 6.2 59.8

Total underreporting tax gapb $73.1

aLess than $0.1 billion dollars.

bTotals may not add due to rounding.

Source: Federal Tax Compliance Research, IRS Publication 1415 (4-96).

Page 9 GAO/T-GGD-97-35
Appendix I 

Selected Tax Gap Statistics

Table I.3: Gross Income Tax Gap for

Selected Tax Years 1985, 1988, and

1992 (Dollars in Billions)

Gross income tax gap

Tax year Total

Individual

income tax

Corporate

income taxa

1985 $85.9 $70.4 $15.5

1988 105.2 80.9 24.3

1992 128.4 95.3 33.1

aAmount may be understated since the corporate income tax nonfiler number is not available for

inclusion in the total.

Source: Income Tax Compliance Research, IRS Publication 7285 (3-88); Income Tax Compliance

Research, IRS Publication 1415 (4-90); Federal Tax Compliance Research, IRS Publication 1415

(4-96); and Information from IRS’ Research Division.

(268778) Page 10 GAO/T-GGD-97-35
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