S. HRG. 109–1004

A CLOSER LOOK AT THE SIZE AND SOURCES

OF THE TAX GAP

HEARING

BEFORE THE

SUBCOMMITTEE ON TAXATION AND IRS OVERSIGHT

OF THE

COMMITTEE ON FINANCE

UNITED STATES SENATE

ONE HUNDRED NINTH CONGRESS

SECOND SESSION

JULY 26, 2006

(

Printed for the use of the Committee on Finance

A CLOSER LOOK AT THE SIZE AND SOURCES OF THE TAX GAP

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38–908—PDF 2006

S. HRG. 109–1004

A CLOSER LOOK AT THE SIZE AND SOURCES

OF THE TAX GAP

HEARING

BEFORE THE

SUBCOMMITTEE ON TAXATION AND IRS OVERSIGHT

OF THE

COMMITTEE ON FINANCE

UNITED STATES SENATE

ONE HUNDRED NINTH CONGRESS

SECOND SESSION

JULY 26, 2006

(

Printed for the use of the Committee on Finance

COMMITTEE ON FINANCE

CHARLES E. GRASSLEY, Iowa, Chairman

ORRIN G. HATCH, Utah

TRENT LOTT, Mississippi

OLYMPIA J. SNOWE, Maine

JON KYL, Arizona

CRAIG THOMAS, Wyoming

RICK SANTORUM, Pennsylvania

BILL FRIST, Tennessee

GORDON SMITH, Oregon

JIM BUNNING, Kentucky

MIKE CRAPO, Idaho

MAX BAUCUS, Montana

JOHN D. ROCKEFELLER IV, West Virginia

KENT CONRAD, North Dakota

JAMES M. JEFFORDS (I), Vermont

JEFF BINGAMAN, New Mexico

JOHN F. KERRY, Massachusetts

BLANCHE L. LINCOLN, Arkansas

RON WYDEN, Oregon

CHARLES E. SCHUMER, New York

KOLAN DAVIS, Staff Director and Chief Counsel

RUSSELL SULLIVAN, Democratic Staff Director

SUBCOMMITTEE ON TAXATION AND IRS OVERSIGHT

JON KYL, Arizona, Chairman

TRENT LOTT, Mississippi

ORRIN G. HATCH, Utah

OLYMPIA J. SNOWE, Maine

MIKE CRAPO, Idaho

CRAIG THOMAS, Wyoming

RICK SANTORUM, Pennsylvania

JAMES M. JEFFORDS (I), Vermont

MAX BAUCUS, Montana

KENT CONRAD, North Dakota

BLANCHE L. LINCOLN, Arkansas

CHARLES E. SCHUMER, New York

(II)

(III)

C O N T E N T S

OPENING STATEMENTS

Page

Kyl, Hon. Jon, a U.S. Senator from Arizona, chairman, Subcommittee on

Taxation and IRS Oversight, Committee on Finance ....................................... 1

Jeffords, Hon. James M., a U.S. Senator from Vermont ...................................... 2

WITNESSES

Mazur, Dr. Mark J., Director, Research, Analysis, and Statistics, Internal

Revenue Service, Washington, DC ..................................................................... 3

Brostek, Michael, Director, Tax Issues, Strategic Issues Team, U.S. Government Accountability Office, Washington, DC .................................................... 5

George, Hon. J. Russell, Treasury Inspector General for Tax Administration,

Washington, DC ................................................................................................... 7

Olson, Nina E., National Taxpayer Advocate, Taxpayer Advocate Service,

Washington, DC ................................................................................................... 9

Wagner, Hon. Raymond T., Jr., Chairman, IRS Oversight Board, Washington,

DC; and legal and legislative vice president, Enterprise Rent-A-Car Company, St. Louis, MO ............................................................................................. 10

ALPHABETICAL LISTING AND APPENDIX MATERIAL

Baucus, Hon. Max:

Prepared statement .......................................................................................... 29

Brostek, Michael:

Testimony .......................................................................................................... 5

Prepared statement .......................................................................................... 31

Responses to questions from committee members ......................................... 53

George, Hon. J. Russell:

Testimony .......................................................................................................... 7

Prepared statement .......................................................................................... 82

Responses to questions from committee members ......................................... 110

Jeffords, Hon. James M.:

Opening statement ........................................................................................... 2

Prepared statement .......................................................................................... 161

Kyl, Hon. Jon:

Opening statement ........................................................................................... 1

Prepared statement .......................................................................................... 162

Mazur, Dr. Mark J.:

Testimony .......................................................................................................... 3

Prepared statement .......................................................................................... 164

Responses to questions from committee members, with attachments ......... 172

Olson, Nina E.:

Testimony .......................................................................................................... 9

Prepared statement .......................................................................................... 383

Responses to questions from committee members ......................................... 414

Wagner, Hon. Raymond T., Jr.:

Testimony .......................................................................................................... 10

Prepared statement .......................................................................................... 478

Responses to questions from committee members ......................................... 484

COMMUNICATION

National Treasury Employees Union ..................................................................... 517

(1)

A CLOSER LOOK AT THE SIZE AND SOURCES

OF THE TAX GAP

WEDNESDAY, JULY 26, 2006

U.S. SENATE, SUBCOMMITTEE ON TAXATION AND IRS OVERSIGHT, COMMITTEE ON FINANCE, Washington, DC.

The hearing was convened, pursuant to notice, at 2:04 p.m., in

room SD–215, Dirksen Senate Office Building, Hon. Jon Kyl (chairman of the subcommittee) presiding.

Present: Senators Jeffords and Lincoln.

Also present: Philip Shropshire, Office of the Treasury Inspector

General for Tax Administration.

OPENING STATEMENT OF HON. JON KYL, A U.S. SENATOR

FROM ARIZONA, CHAIRMAN, SUBCOMMITTEE ON TAXATION

AND IRS OVERSIGHT, COMMITTEE ON FINANCE

Senator KYL. This hearing will come to order.

This is a hearing of the Senate Finance Committee’s Subcommittee on Taxation and IRS Oversight titled, ‘‘A Closer Look at

the Size and Sources of the Tax Gap.’’

The full Finance Committee held a hearing in 2005 on the tax

gap, that is, the difference between what the U.S. taxpayers owe

and what the U.S. Treasury actually receives.

The Budget Committee held a similar hearing earlier this year.

Today’s hearing is designed as a follow-on to those hearings and

will take a much closer look at the tax gap. We will consider its

size, and what causes it to exist.

Chairman Grassley and Senator Baucus have asked the Treasury

Department and the Internal Revenue Service to develop a strategy

for addressing the tax gap. If members of this committee are going

to evaluate any such strategy, I believe we need to have a more

comprehensive understanding of the problem.

That is the purpose of this hearing, to give Senators on this committee an opportunity to learn more about the tax gap so that we

can make better decisions when we are presented with legislative

proposals designed to improve tax compliance.

Like revenue estimates produced by other government number

crunchers, the tax gap is an estimate. But if Congress is going to

push the IRS to reach a voluntary taxpayer compliance target, we

need to know how good the estimate is, and we need an understanding of where it could, and should, be improved. We also need

to understand what data might be too difficult to collect without

imposing unreasonable burdens on taxpayers.

2

In addition to understanding the numbers, we also need to consider where the current system is failing, what can be done to address those failures, and how efforts to improve tax compliance will

affect taxpayers.

In preparing for this hearing, we asked the witnesses to consider

where current IRS enforcement practices are falling short and

whether additional resources would improve compliance enough to

justify the expense.

We asked whether current enforcement tools are sufficient or if

additional tools, such as increased information reporting or withholding, would be appropriate.

Finally, we asked the witnesses to consider the extent to which

the tax system itself, with its mind-boggling complexity and special

targeted tax benefits, contributes to the tax gap.

This last point, the need for tax simplification, may be the most

reasonable way to address the tax gap. I know the Chairman of

this committee is pressing forward on tax reform, and I expect that

simplifying our tax system and improving compliance will be critical to that effort.

Most Americans are responsible, honest, and hardworking, and

we should not assume they are falling short in their tax obligations

on purpose. A more simple and straightforward tax system will reduce compliance costs and make it easier for Americans to pay the

taxes they owe.

Now, before I identify who our witnesses are and introduce them,

let me turn to our Ranking Senator, Mr. Jim Jeffords.

OPENING STATEMENT OF HON. JAMES M. JEFFORDS,

A U.S. SENATOR FROM VERMONT

Senator JEFFORDS. Thank you, Mr. Chairman. I want to commend you for holding this hearing today on the tax gap. I also want

to recognize the efforts of Chairman Grassley, and especially Senator Baucus, in calling attention to this issue over the years.

Even more important than talking about the problem, of course,

is taking action to fix it. I look forward with great interest to the

plan of action we will be receiving from the administration in the

next few months.

I have to say, I am not sure that this has been a very high priority with the administration. When I checked last week, we were

still awaiting answers from the administration to questions we

posed at our April 2005 hearing on the tax gap.

In Congress, there is plenty of the responsibility as well. We

have had lots of good recommendations for years from several

sources, including many of today’s witnesses, but have yet to act

on any of them.

I hope that, with continued efforts to shed light on this problem,

we can build support for taking concrete steps to attack it.

As Ms. Olson pointed out last year, the average tax return includes a tax gap ‘‘surtax’’ of $2,000 each year. We need to get that

number as close to zero as we possibly can.

Mr. Chairman, thank you again for calling today’s hearing. My

thanks as well to the witnesses for their willingness to help us, and

their work day-in and day-out on this very vital issue. It is a pleasure to be with you all, and I look forward to hearing you.

3

Senator KYL. Thank you, Senator Jeffords.

Our panelists are really the experts. We have Dr. Mark J.

Mazur, who is Director of Research, Analysis, and Statistics with

the Internal Revenue Service; Mr. Michael Brostek, Director of Tax

Issues, Strategic Issues Team, Government Accountability Office;

the Honorable J. Russell George, Inspector General for Tax Administration, U.S. Treasury; Ms. Nina Olson, National Taxpayer Advocate, Taxpayer Advocate Service; and Hon. Raymond T. Wagner,

Jr., Chairman of the IRS Oversight Board and legal and legislative

vice president, Enterprise Rent-A-Car Company.

As I say, we are blessed to have some real experts here, and we

very much look forward to your testimony. I think, probably, in the

order that I read the witness names and I believe you appear on

the dais, would be the proper order for you to make your presentations, so please feel free to do so at this time.

STATEMENT OF DR. MARK J. MAZUR, DIRECTOR, RESEARCH,

ANALYSIS, AND STATISTICS, INTERNAL REVENUE SERVICE,

WASHINGTON, DC

Dr. MAZUR. Thank you, Chairman Kyl and Senator Jeffords. I

am pleased to be here today to talk about the tax gap. I ask that

my entire statement be entered into the record.

Senator KYL. All statements will be entered.

Dr. MAZUR. Thank you.

[The prepared statement of Dr. Mazur appears in the appendix.]

Dr. MAZUR. My remarks today are going to focus on the tax gap

numbers themselves, as well as the methodology used to arrive at

those numbers.

As Chairman Kyl said, the tax gap is the difference between the

amount of tax imposed on taxpayers for a given tax year and the

amount that is paid voluntarily and timely. The tax gap represents,

in dollar terms, the annual amount of non-compliance with our tax

laws.

Historically, our estimates of compliance were based on what we

call the Taxpayer Compliance Measurement Program, or TCMP.

That consisted of line-by-line audits of returns from randomly selected taxpayers. This provided IRS with information on compliance trends. It also provided IRS with information to update audit

selection formulas.

However, the TCMP method of accumulating data was very burdensome on taxpayers and, as a result of concerns raised by taxpayers, Congress, and other stakeholders, the IRS discontinued

those TCMP audits with tax year 1988.

The IRS has conducted some narrow studies since then, but

nothing really gave us a comprehensive perspective on the overall

tax gap. The National Research Program came into being in 2000–

2001, and that is being used to estimate the tax gap more recently.

We tried to develop a less intrusive way of coming up with measures of tax compliance. For example, on the individual reporting

compliance study that we have done, we used a focused, statistical

sample that had fewer returns in the sample than in the previous

1988 study, even though there were more tax returns filed in tax

year 2001.

4

We think the NRP approach allows us to estimate the overall extent of reporting compliance at lower burden costs to taxpayers. We

are getting about the same high quality of data, with less burden

on taxpayers.

Part of this is because we have a couple of innovations in the

way we do the NRP audits. One is what we call case building. It

allows us to take information from prior year returns, information

documents, third party documents, and put that together in a case

file for the taxpayer’s return.

That gives the examiner a sense of what they could look at in

the return. It also prevents the examiner from asking burdensome

questions of taxpayers on documents the IRS already has, for instance, ‘‘Where is your W–2?’’ Well, we already have that.

The second innovation from the NRP was to set up a classification procedure, where an experienced examiner went through the

case file and decided where to focus the examination. Some of the

returns an experienced examiner could look at and say, these are

plausibly compliant. We did not need to contact the taxpayer at all

and could kind of put them aside. Some, we could designate for correspondence audits for one or two issues that needed to be verified,

and others had to go to a face-to-face audit. Both of these innovations allowed us to reduce the burden on taxpayers.

One thing that we want to focus on for the tax gap numbers—

and the chart behind me lays out the estimate for tax year 2001—

the overall tax gap, we estimate for tax year 2001, is about $345

billion.

That corresponds to a non-compliance rate of about 16.3 percent.

After the amounts that are collected from late payments and

through enforcement, we estimate the net tax gap is around $290

billion a year.

On the chart, you can see that non-compliance takes three forms:

non-filing, under-reporting, and under-payment of tax liability.

Under-reporting accounts for about 82 percent of the gross tax

gap, non-filing around 8 percent, and under-payments around 10

percent of the tax gap. Individual income tax under-reporting accounts for about $197 billion, or about 56 percent of the overall tax

gap.

As in previous compliance studies, the data we have suggest that

about half, or well over half, of the individual under-reporting gap

comes from understated net business income.

Approximately 28 percent comes from under-reported non-business income—wages, interest, dividends, and so on—and about

$32 billion comes from overstated subtractions from income, exaggerated deductions, or misstated tax credits.

If you add in the under-reporting on self-employment tax, that

is another 11 percent or so of the tax gap. So taken together, the

individual income tax and the self-employment tax, we have about

two-thirds of the overall tax gap accounted for in those two buckets.

One of the things that becomes apparent when you look at the

data is that the amounts that are most likely to be reported correctly on returns are those where there is third party information

reporting and where there is withholding. So, for instance, wages

and salaries have about 1 percent misreporting.

5

On the other hand, things that are not reported by third parties

and not withheld tend to have the highest misreporting. For instance, business income may be misreported about 50 percent.

On the tax gap map chart, the colors are used to indicate the

amount of confidence we have in the estimates. The blue ones are

where we have a high degree of confidence, the green ones are

where we have actual data or accounting data, and the yellow ones

are for weaker estimates.

The corporate income tax estimates, in particular, are areas

where we have not done an update of the studies in quite a while,

so those estimates are, to a large degree, weaker than the ones for

individual income tax.

Right now, we are undertaking a reporting compliance study of

S corporations. This is the first time the IRS has done this kind

of study since 1984. Back in those years, there were about 700,000

S corporations; now there are more than 3 million.

So, S corporations are more prevalent than ordinary Schedule C

corporations that pay corporate income tax, and we know very little

about their behavior. That is why we chose this as the second

study that we undertook as part of the National Research Program

Reporting Compliance Study Program.

Future reporting compliance studies will be undertaken. Our

idea is to go through the various boxes on the tax gap map and get

an understanding of all those different types of misreporting. Obviously, the constraint we have at the IRS is the amount of enforcement resources that we need to devote to those studies.

Let me just conclude, quickly, by saying that a nearly 84-percent

voluntary compliance rate for the tax system is a good one. Internationally, this puts us in a good position. It is something that we

should be proud of. Obviously, we can do better. We can reduce

that 16 percent misreporting gap to some smaller number and benefit all taxpayers.

I want to mention, we got a lot of support from the committee

and the staff in developing these studies, and we do appreciate the

support we have gotten from you.

Thank you for the opportunity to discuss the tax gap today.

Senator KYL. Thank you, Dr. Mazur.

Mr. Brostek?

STATEMENT OF MICHAEL BROSTEK, DIRECTOR, TAX ISSUES,

STRATEGIC ISSUES TEAM, U.S. GOVERNMENT ACCOUNTABILITY OFFICE, WASHINGTON, DC

Mr. BROSTEK. Mr. Chairman, Senator Jeffords, I am pleased to

participate in today’s committee hearing on approaches for reducing the tax gap.

My statement will focus on potential reductions in the tax gap

that could ensue from simplifying or reforming the code, providing

IRS more tools, and dedicating more resources to tax enforcement.

In summary, the tax gap is a persistent problem, and, as the saying goes, we will keep on getting the same result, an unacceptable

tax gap, if we keep on doing the same things. We need to try new

approaches or make greater use of current effective approaches.

While simplification, more tools, and more resources all do have

potential to help reduce the tax gap, multiple approaches are likely

6

to be the most effective strategy. No one strategy is likely to fully

and cost-effectively reduce the tax gap.

In determining a strategy to pursue, key factors to consider include, as Dr. Mazur was saying, periodically measuring non-compliance and its causes, setting reduction goals, leveraging technology,

optimizing IRS resource allocations, and evaluating the results of

any initiatives taken. An effective, well-supported strategy has the

potential to reduce the tax gap by many billions of dollars.

In terms of simplification or reform, there is no reliable estimate

of the degree to which simplification could reduce the gap. One indication of the potential is that IRS estimated a revenue shortfall

of about $32 billion occurred in 2001 due to errors that taxpayers

made in claiming credits and deductions.

Over the decade, the tax code has layered on more and more special tax provisions, with the number of these so-called tax expenditures doubling in number between 1974 and 2005.

By making rules more uniform across tax provisions, by merging

multiple related tax provisions, and by deleting provisions that

may not be accomplishing their intended purpose at an acceptable

revenue cost, the tax code could be simplified. Both intentional and

unintentional errors by taxpayers should decline with simplification.

Further, to the extent that simplification reduces errors, IRS

should be able to reallocate its resources to other, more problematic

areas of the code, giving you sort of a ‘‘two-for’’ from simplification.

However, each tax code provision was created to address an issue

that Congress had determined to be important and, thus, simplification can be challenging.

Tax reform also has the potential to reduce the tax gap, but it

is most likely to have that result if any reform system has few, if

any, exceptions to it and few complex provisions, and any taxable

transactions are transparent to the tax agency. These characteristics, however, are difficult to achieve, and, as suggested by Mr.

Mazur, to my knowledge all tax systems have tax gaps.

Tax withholding and information reporting are among the most

powerful tools for promoting compliance. If we can spread these

tools to cover more types of income that are major contributors to

the tax gap, substantial tax gap reductions might be achieved.

Our recent work suggests that requiring information reporting on

the basis for security sales like stock transactions has the potential

to improve compliance with capital gains reporting. Importantly, a

key additional benefit of these tools would be less taxpayer burden

to understand and comply with the basis reporting requirements.

Additional opportunities for withholding or information reporting

exist for payments made to independent contractors and for payments made to corporations for services that they provide to other

corporations.

Finally, devoting additional resources to enforcement has the potential to reduce the tax gap by billions of dollars. I would be remiss not to point out, however, that a balanced approach of providing services to help taxpayers comply, along with enforcement

where that is the best approach, is essential for making balanced

progress against the tax gap.

7

Nevertheless, devoting greater resources to enforcement could reduce the gap, since every year IRS identifies far more cases of

probable non-compliance than it can address.

How much the tax gap could be reduced by dedicating more resources to enforcement depends critically on how well IRS can

manage those resources. Here, information is key. Which taxpayers

are non-compliant? Why are they non-compliant? What amount of

non-compliance can be corrected for each additional investment in

IRS enforcement programs? We, and others, have frequently called

for improved information like this to ensure sound management of

IRS’s limited resources.

In part, this is why we encouraged IRS to undertake compliance

studies like NRP, and why we believe that continuing regular compliance studies is a priority.

As a caution, if additional resources are devoted to enforcement,

returns on that investment are likely to lag some as IRS uses the

additional resources, by hiring staff, training them, and putting

them on line.

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

any questions.

Senator KYL. Thank you, Mr. Brostek.

[The prepared statement of Mr. Brostek appears in the appendix.]

Senator KYL. Now, Mr. George?

STATEMENT OF HON. J. RUSSELL GEORGE, TREASURY INSPECTOR GENERAL FOR TAX ADMINISTRATION, WASHINGTON, DC

Mr. GEORGE. Thank you, Mr. Chairman.

Chairman Kyl, Senator Jeffords, thank you for the invitation to

discuss the size and sources of the tax gap, and opportunities for

reducing it.

This year, the IRS updated its previous estimate of the tax gap,

which had been based on data from 1988. The new estimates is

based on individual income tax returns for the 2001 tax year.

Despite this significant effort, the IRS still does not have sufficient information to completely and accurately assess the overall

tax gap and voluntary compliance rate.

The updated information on individual wage earners is an improvement because they comprise the largest segment of taxpayers.

However, there is no new information about employment, corporate, and other taxpayer segments.

With no firm plans to update the study for these segments, we

will be left with an unfinished picture of the tax gap and compliance rate. Without this information, comprehensive attempts to

successfully address the tax gap may be for naught.

One area that could significantly impact the tax gap involves

third party reporting. The difference in compliance rates between

individual wage earners and those operating businesses is striking.

The IRS has estimated that compliance rates are as high as 96

percent when third party reporting is involved. In contrast, selfemployed individuals are estimated to report only about 68 percent

of their income. Even more alarming, it is estimated that selfVerDate 11-MAY-2000 16:40 Feb 05, 2008 Jkt 095484 PO 00000 Frm 00015 Fmt 6633 Sfmt 6633 38908.000 SFIN1 PsN: SFIN1
8

employed individuals operating on a cash basis are reporting just

19 percent of their income.

Each year, under-reporting by individuals with business income

accounts for over 40 percent, or approximately $130 billion, of the

total tax gap. Three years ago, TIGTA recommended that the IRS

initiate a proposal for a legislative change to mandate withholding

on non-employee compensation payments. Implementing such a

provision could reduce the tax gap by billions of dollars.

IRS compliance efforts are also limited by the lack of available

information on the cost basis of investments, which could be used

to verify investment gains or losses. Such information would allow

the IRS to better focus its enforcement resources on non-compliant

taxpayers.

TIGTA has also reported on issues relating to the global economy. Investments made abroad by U.S. residents have nearly tripled in recent years, growing from $2.6 trillion in 1999 to $7.2 trillion in 2003. To address the tax compliance challenges presented

by these investments, TIGTA has recommended that the IRS make

better use of foreign-source income information.

We have also recommended that, prior to issuing refunds to citizens of foreign countries, the IRS should confirm that the amount

of withholding being claimed is valid.

Finally, I would like to address the resources available to the

IRS. Over the last decade, the number of IRS enforcement personnel declined from approximately 22,000 at the beginning of

1996, to roughly 14,000 at the end of 2005, amounting to a 35-percent decrease.

Even though the IRS has started to reverse many of the downward trends in compliance activities, the enforcement staffing level

is not much higher today than the 10-year low it experienced in the

year 2003.

Additional resources might help the IRS address the growth of

fraudulent returns being filed by incarcerated people. Last year, I

testified before the House Ways and Means Committee about this

problem.

Refund fraud committed by prisoners was growing at an alarming rate. The number of fraudulent returns filed by prisoners and

identified by the IRS grew from 4,300 in processing year 2002 to

more than 18,000 in 2004—a 318-percent increase.

It is unlikely that a massive change in voluntary compliance can

be achieved without significant changes to the tax system. Strategies have been identified to decrease this tax gap, and improvements can be realized.

However, without significant resources, the IRS faces formidable

challenges in accurately estimating the tax gap and finding effective ways to increase compliance.

Mr. Chairman, Senator Jeffords, I appreciate the opportunity to

share my views on the tax gap and the work TIGTA has done in

this area. I would be happy to answer any questions you have at

the appropriate time.

Senator KYL. Thank you, Mr. George.

[The prepared statement of Mr. George appears in the appendix.]

Senator KYL. Ms. Olson?

9

STATEMENT OF NINA E. OLSON, NATIONAL TAXPAYER

ADVOCATE, TAXPAYER ADVOCATE SERVICE, WASHINGTON, DC

Ms. OLSON. Mr. Chairman and Senator Jeffords, thank you for

inviting me to testify today.

At the outset, let me suggest that the ultimate question we

should be focused on is not, ‘‘How do we reduce the tax gap?’’ but

rather, ‘‘How can we increase voluntary compliance?’’

This is so because voluntary compliance, as opposed to enforced

compliance, creates taxpayers who are willing to work with the tax

system rather than taxpayers who hide from the tax system. Moreover, in the long run, voluntary compliance is the most costeffective way to achieve lasting compliance.

To determine how to allocate its resources most effectively to increase voluntary compliance, the IRS needs to do a better job of understanding the reasons why the tax gap exists.

At the risk of over-simplifying matters, let me suggest that we

consider three types of taxpayers: (1) taxpayers who will go to great

lengths to comply with whatever requirements exist; (2) taxpayers

who view taxes as one of the many burdens they face in everyday

life, and who will comply only if doing so is straightforward and not

time-consuming; and (3) taxpayers who willfully seek to evade their

tax obligations.

What percentage of taxpayers fall into each of these three categories? It is impossible to know with precision. But the IRS has

information that indicates the majority of taxpayer errors are attributable to inadvertent error rather than intentional noncompliance.

When IRS auditors conducted approximately 46,000 audits of individual taxpayers for purposes of the National Research Program,

the auditors were asked, for each issue they identified, to characterize the reason for non-compliance. The results were striking.

Among issues IRS auditors examined that resulted in a change

in a tax liability, the auditors listed 67 percent as inadvertent mistakes; 27 percent as computational errors or errors that flowed

automatically; and only 3 percent of the errors as intentional.

A recent GAO study on capital gains misreporting also suggests

that deliberate cheating is responsible for significantly less than

half of all reporting inaccuracies. Despite these data, I am concerned that the IRS has been proceeding on a course that emphasizes stepped-up enforcement over stepped-up taxpayer service.

The high percentage of inadvertent errors underscores the need

to go beyond classifying taxpayers simplistically as honest or dishonest, and to develop solutions to improve compliance more generally through an approach that includes components of both taxpayer service and enforcement.

The IRS needs better research to determine the most effective

use of its resources, after taking into account both the direct and

indirect effects of its activities on tax revenue. In most cases, the

indirect effects are probably greater than the direct effects.

Moreover, it should not be a question of service or enforcement.

The IRS should integrate taxpayer service within its enforcement

activities. Particularly in light of its limited resources, the IRS

should focus its enforcement activities not merely on collecting

10

taxes that were not paid in the past, but also on trying to bring

taxpayers into compliance prospectively.

In my view, the IRS could also do a better job of going where the

money is. As Dr. Mazur described, that means the cash economy.

The NRP data indicate that, where taxable payments are reported

to the IRS by third parties, reporting compliance comes to roughly

96 percent of the tax due. But where taxable payments are not reported to the IRS by third parties, reporting compliance drops

below 50 percent.

In my annual reports to Congress and in my previous Congressional testimony, I have offered numerous proposals to help the

IRS do a better job at combatting the cash economy portion of the

tax gap. Some of those proposals are summarized in the appendices

at the end of my written statement.

Even though the IRS can do more to improve voluntary compliance, I do not believe the compliance rate will rise dramatically unless Congress passes legislation to make it easier for the IRS to detect non-compliance, primarily through expanded third party information reporting or withholding.

Congress could also improve compliance by facilitating easier

payments of estimated tax, improving the offer-in-compromise program, and strengthening standards in the tax return preparation

industry. Tax simplification would help enormously as well.

In conclusion, to reduce the tax gap, Congress and the IRS must

focus on ways to increase voluntary compliance with the tax code.

There is no one-size-fits-all solution.

Through an effective combination of improved education, outreach and assistance, and targeted enforcement action, the IRS can

improve voluntary compliance. But to make a real dent in the problem, Congress must act. It must increase the transparency of cash

economy transactions through expanded third party information reporting and withholding, and Congress should simplify the tax code

to make it easier for taxpayers to comply with its requirements.

Thank you.

Senator KYL. Thank you, Ms. Olson.

[The prepared statement of Ms. Olson appears in the appendix.]

Senator KYL. We will conclude with Mr. Wagner.

STATEMENT OF HON. RAYMOND T. WAGNER, JR., CHAIRMAN,

IRS OVERSIGHT BOARD, WASHINGTON, DC; AND LEGAL AND

LEGISLATIVE VICE PRESIDENT, ENTERPRISE RENT-A-CAR

COMPANY, ST. LOUIS, MO

Mr. WAGNER. Thank you, Mr. Chairman.

Chairman Kyl, Ranking Member Jeffords, members of the subcommittee, I am Raymond T. Wagner, Jr., Chairman of the IRS

Oversight Board. Thank you for the opportunity to appear this

afternoon.

You have already heard from a full panel today, and therefore I

would like to summarize my written testimony, which shall be included in the record.

[The prepared statement of Mr. Wagner appears in the appendix.]

Mr. WAGNER. I would like to focus my remarks on how to apply

a broad set of strategies to reduce the gap. Considering the Board’s

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role in providing strategic governance to the IRS, I think describing

effective strategies is the right role for the Board.

Despite significant improvements in IRS operations in the past

6 years, the tax gap, because of its size and its persistence, is one

of the most serious problems facing tax administrators in the country today.

Our tax administration system starts with the expectations that

taxpayers will comply voluntarily with tax laws. In fact, in 2005,

taxpayers paid about $2 trillion annually. However, some taxpayers do not pay what they owe voluntarily, and that is why we

have an annual gross tax gap of $345 billion.

The IRS tries to recover what it can through enforcement actions, but only a fraction of the gap is recovered that way, as you

have heard. In 2005, enforcement revenues were about $47.3 billion, leaving a net tax gap of around $295 billion.

Let me summarize, simply, why the tax gap is offensive. It is

fundamentally unfair for honest taxpayers to carry the load for

those who cheat, it deprives the government of revenues to which

it is entitled, and it undermines the confidence that honest taxpayers need to have in our system if they are to continue to be

honest.

Let me also make some general statements about fixing the gap.

We know how to reduce the gap, but we have trouble doing it.

Every organization sitting at this table has made effective recommendations in the past on how to reduce it. Implementing the

recommendations is much more difficult than articulating them.

On the other hand, there is no one, single silver bullet that can

be implemented that will solve the problem. What is needed is a

comprehensive set of strategies with action on many fronts.

The tax code is getting more complex every year, and determining one’s correct tax obligation is hard, and getting harder

under the growing complexity of the code, which in turn hurts voluntary compliance. This relationship should be self-evident.

Voluntary compliance is far superior to enforcement. We collect

$2 trillion voluntarily, and less than $50 billion through enforcement, but roughly half of the IRS budget is for enforcement. There

is no doubt which is better.

In the words of Ben Franklin, ‘‘An ounce of prevention is worth

a pound of cure.’’ Effective strategies are needed to influence taxpayers to file and pay what they owe voluntarily. Lastly, additional

IRS resources do pay for themselves.

Let me now turn my attention to describing six strategies that

can effectively reduce the tax gap, many of which you have heard

already this afternoon.

The first recommendation is to simplify the tax code. Complexity

has three serious consequences: it makes it difficult for honest taxpayers, it gives aid to those who want to cheat, and it makes it

hard for the IRS to identify non-compliance.

Second, taxpayers who have their income reported to the IRS are

much more compliant than those who do not. The Oversight Board

recommends improved information reporting and enforcement tools

to address large areas of the tax gap related to what has been

called a cash economy.

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The administration has made several legislative recommendations in this regard. They merit Congressional discussion and consideration, but these recommendations have one thing in common:

they require legislative action to implement, and are clear examples of solutions that require coordinated action between the legislative and executive branches.

Third, the Board believes that the IRS must improve customer

service, including education and outreach to make taxpayers aware

of their legal obligations, and ease taxpayer burdens through modernization. In general, additional IRS resources are needed for both

service and enforcement.

Fourth, there should be much greater emphasis and focus on research so the IRS can more effectively target areas of major noncompliance. The board recommends that the IRS develop a longterm strategic plan for research.

Availability of up-to-date research data will allow the IRS to

more effectively focus its service and enforcement programs on

areas that have the greatest impact on taxpayer compliance and

use the change in taxpayer compliance rates as feedback to evaluate the effectiveness of IRS service and enforcement programs.

The Board commends the IRS for adding a voluntary compliance

goal for 2009 in its fiscal year 2007 Congressional budget justification, but recognizes that an effective research program must be in

place to measure the progress of achieving this goal.

Fifth, the Board urges a more productive partnership between

the IRS and the tax administration community. Tax practitioners

prepare over 60 percent of the individual tax returns and have a

great deal of influence on taxpayer compliance levels.

Although practitioners have professional obligations to represent

their clients effectively, they also have an important role in ensuring that taxpayers are complying with their legal obligations. The

Senate Finance Committee had a hearing to examine the state of

professional tax preparation services available to the public and recently found some troubling results.

Sixth, there must be more emphasis on personal integrity in

making decisions. The Board has found that the vast majority of

taxpayers state that their personal integrity is a very important

factor in influencing their tax compliance. In our 2005 survey, 82

percent of the taxpayers cite personal integrity as the principal factor for reporting and paying their taxes honestly.

In summary, the board recognizes that no single initiative or program will solve the tax gap. A multi-faceted effort must be taken

to shrink it. Although we believe more IRS resources are needed,

the plan must move from just applying additional resources to it

to doing more than is being done today.

Implementing an effective plan will be difficult and will involve

taking broad action across all branches of government. However,

the potential results are worth the effort.

Thank you, Mr. Chairman.

Senator KYL. Thank you. I want to thank all of the panelists. I

think this is enlightening, and slightly encouraging, from my perspective, but obviously raises a variety of questions that we would

like to follow up on.

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The first point that I would say is somewhat encouraging—and

I would just ask if anyone dissents from this point of view—those

who expressed a view seem to believe that the majority of the problem is inadvertent, it is not intentional, and that we would do well

to try to improve the ease by which taxpayers could comply as a

first response to this rather than immediately turning to more

enforcement-oriented recommendations.

Would that be a fair overview summary? Yes, Mr. Brostek?

Mr. BROSTEK. In general, yes. But I am concerned about whether

we really know whether the errors are intentional or not. There is

not very good information on that.

For instance, in the study that we did and reported out this year

on capital gains transactions and compliance, a lot of taxpayers

who were non-compliant appeared to us to have actually made an

intentional decision to be non-compliant because it did not appear

to them to be cost-effective.

If they had a small potential tax liability, it may not have been

worthwhile for them to pay a practitioner to research the basis of

their stock transaction or for them to spend a lot of time researching it. So I think we actually need better information before we can

really determine the proportions of intentional and unintentional.

Mr. GEORGE. Mr. Chairman, if I may.

Senator KYL. Mr. George?

Mr. GEORGE. I concur with Mr. Brostek on that. Again, we do not

have enough information. While I am a sanguine person generally,

and I agree that I would hope that most people would not intentionally cheat on their taxes, we just do not know.

Senator KYL. Maybe I should not have started with such a broad,

optimistic point of view, because obviously it is all subject to further calibration.

Ms. Olson?

Ms. OLSON. Well, I share your optimism, sir. I believe that our

lack of knowledge applies to it. We do not understand the reasons

for non-compliance across the board. The instance that Mr. Brostek

described is what I would call procedural non-compliance.

They made an intentional decision to not go and hire someone to

track down the actual basis in the stock, but it was because the

process was so complex. So if you made safe harbor rules or you

enacted basis reporting, you would eliminate that ‘‘intentional’’

non-compliance.

Senator KYL. This goes to another point. With some trepidation,

let me try this. Would it also be the case—several of you mentioned

it—that among the first things we should consider doing, is simplifying the code to make compliance easier? All right. I should have

started with that. That is something that I think has broad-based

support.

But probably, Mr. Wagner, you are one of the first to say that

the implementation of such a generally agreed upon concept is,

nonetheless, a little bit more difficult. It is easier said than done,

in other words.

Mr. WAGNER. I think that is right, Mr. Chairman. It is easy to

say that we want to simplify the code, and certainly we recognize

the complexity of that in and of itself.

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The President’s Tax Reform Panel of earlier this year had countless suggestions for simplifying the tax code. But settling on a particular portfolio of those, there are winners and losers, and that is

what makes it challenging. But that said, there are issues such as

information reporting which should be addressed and can, I think,

be addressed with some consensus.

Senator KYL. It certainly would be a good place to start.

Let me just ask—and I am not sure which of you are the best.

Perhaps Dr. Mazur—do you know what the current audit rate is

and how it compares to previous years? What I am getting at here,

is this.

Even though enforcement may not be the most efficacious way to

reduce the tax gap, is there a way, really, of analyzing the deterrent effect that audits and enforcement have?

Dr. MAZUR. Sure. A couple of things. First, there is no one single

audit rate. If you look at different groups of taxpayers you will

have different audit rates.

The largest corporations in America get audited at a rate of probably 40 or 50 percent, where individuals, on a whole, get audited

at a rate of less than 1 percent. Higher-income individuals get audited at a slightly higher rate, middle-income individuals at a

slightly lower rate.

Second, in terms of what the effect of audits are on compliance,

there are a couple of academic studies that have looked at this.

This is referred to in a couple of the testimonies, these indirect effects.

The idea of indirect effects is, if we audit Mike, Mike goes and

tells his friends he was audited, and that makes his friends somewhat more compliant. Basically, the word is out that the cop is on

the street.

So the indirect effects, as Nina pointed out in her testimony, can

be quite large. They can be 3, 5, 10 times as large as direct effects,

depending on the activity that is taking place.

Senator KYL. Any other comments? I have 20 seconds left, and

will come back for the next round. But any other comments from

the panel?

[No response.]

Senator KYL. In that case, Senator Jeffords?

Senator JEFFORDS. Dr. Mazur, I gather from your testimony that

our research on the tax gap is sporadic. I have seen a figure from

the 1970s, one from the 1980s, and we have figures from the 1988

and 2001 tax years, from such studies. Given the time lags and differing approaches, do we know if the problem is getting better or

worse in these areas?

Dr. MAZUR. What you are referring to is the taxpayer compliance

measurement program from the 1960s, 1970s, and 1980s, which

was a very comprehensive research program where IRS, every

year, did some sort of reporting compliance studies, so there were

regular report-outs of different types of compliance for different

types of taxpayers and different types of activities. There was a hiatus in the late 1980s through probably 2001 or so, where the IRS

did very little of this.

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So beginning in tax year 2001, we have a National Research Program plan that looked at individual income taxpayers and tried to

determine their behavioral compliance.

We cannot tell whether the 2001 numbers are better than 1999’s,

or worse, because we do not have all those data points to fill in.

That is part of the reason that it is important to do these types of

studies on a regular basis, because it allows you then to have a

data trail and you can tell whether you are making progress or not.

Right now, we have a couple of data points. We cannot tell

whether, in the intervening years, things got better and worse, or

things got worse and got better. We just have two data points.

Senator JEFFORDS. Let me continue with you. Since the National

Research Program relies on a sampling of tax returns, could you

describe how you estimate the tax gap for non-filers and what the

limitations are in doing so?

Dr. MAZUR. Sure. For non-filers, at the simplest level, you can

think of using two different data sets to determine what the nonfiling rate is. We can look at Census data, say from the Current

Population Survey, and determine how many individuals look like

they have a filing obligation. We can compare that with the number of returns that show up at the IRS. We say the difference is

the number of folks who had a filing obligation who did not file.

We have also worked with staff at Census to develop estimates

of the size of that dollar tax gap, where Census uses their data and

tax data, which they are legally entitled to look at for purposes of

developing the Census, and comes up with an estimate of the nonfiling gap for individual taxpayers.

It is much harder to do that for other types of taxpayers. For instance, on the corporate side we do not have a good sense of how

many corporations have a filing liability because there is no national database we can go to and say, here are all the corporations

in America that should be filing taxes.

Senator JEFFORDS. For Mr. Brostek, and anyone else who wants

to volunteer. One approach we can take is adding resources for enforcement. It seems there is a good bit of low-hanging fruit; for example, millions of a balance due account being shelved at a cost of

tens of billions of dollars. Are we being penny wise and pound foolish here?

Mr. BROSTEK. Well, I suppose that depends on what the alternative uses are of the money. There are obviously national needs

across the entire Federal budget, and it is for you and your fellow

members to make decisions about the relative priorities. I think it

is true that an additional investment in IRS enforcement activities

would yield additional funds.

Senator JEFFORDS. You used several ratios. What is the bottom

line?

Mr. BROSTEK. What is the bottom line in terms of how much

money can be raised?

Senator JEFFORDS. Yes.

Mr. BROSTEK. Unfortunately, I cannot give you a clear answer on

that. It would depend not only on how much money IRS was given,

but how it decided to allocate those funds, because there are considerably different returns on investment. Across the enforcement

tools that IRS uses they try to make judgments about what the

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best mix is in allocating their resources, but some tools do pay a

higher return than others.

Senator JEFFORDS. Mr. George, I will turn to you.

Mr. GEORGE. Actually, Senator, can I address the question, just

very briefly?

Senator JEFFORDS. Yes.

Mr. GEORGE. We need to keep in mind that another word for enforcement is audits. And while an audit can take as little as one

hour, it can also take several years. So it really depends upon what

burden you are willing to put on the taxpayer in order to accomplish that goal.

Senator JEFFORDS. Mr. George, I was interested in your comments on the limits of NRP, for example, with regard to non-individual taxes owed. I am especially interested in the 2004 figures

of the researchers in the Small Business and Self-Employed Division, which suggested a possible $1 trillion in taxable income for

a portion of non-filers. Could you expand a little on that?

Mr. GEORGE. If I may, actually, Mr. Chairman, we have the subject matter expert from TIGTA who has the expertise on this area,

and if I could ask him to address that question. His name is Philip

Shropshire.

Senator JEFFORDS. Well, I will ask him.

Mr. GEORGE. Thank you.

Senator JEFFORDS. Please come up.

Mr. SHROPSHIRE. That was a study that was done by the Internal

Revenue Service Small Business Division, and what they did is

they went out and they took information documents and matched

them to the small business filers. What they came up with was a

tremendous amount of income that had not been reported.

Now, this is all potential. They really did not go any further than

that. It was just a research project. But what is interesting about

this is that nothing further has come out of using information documents to look at business taxpayers and how compliant they are.

Senator JEFFORDS. Thank you, Mr. Chairman.

Senator KYL. Thank you, Senator Jeffords.

Ms. Olson, I think you paraphrased the old, you go where the

ducks are. The cash economy is where the dollars are, I think, is

the way you put it.

One of the concerns about our economy these days, on a cash

basis, is, of course, the extent to which illegal immigrants are paid

in cash. Since one of the potential resolutions of the illegal immigration problem relates to paying back taxes, one wonders how that

might be resolved.

Could any of you speak to the question of whether there are any

estimates as to the amount that illegal immigration contributes to

the problem of the tax gap, and any other observations relating to

the cash basis and potential for collections there?

Ms. OLSON. Well, probably Dr. Mazur can speak more about the

tax. I think that the undocumented workers in the illegal immigrant population, there is a positive effect and a negative effect.

They have withholding and Social Security taxes taken out, and

then there is a large cash economy in that population, too.

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Some of my proposals to address the overall cash economy will

impact the cash economy in the undocumented worker population.

There is a large population in the construction industry.

I have proposed a method that the United Kingdom has used for

30 years, which is to require backup withholding on the construction industry workers unless they can produce a compliance certificate from the tax authority to their employer saying they are in

compliance; they have entered into installment agreements to get

rid of back debts and/or they are making estimated tax payments,

and then the employer does not have to be burdened with withholding on an independent contractor.

I also have recommended that the IRS use existing local data, for

example business licenses, where businesses have to report their

gross receipts to local authorities, and that we match that to our

Federal returns to see if these people even show up on our rolls.

There are lots of ways to track this, because people really do touch

governments at different levels—local, State, Federal.

Senator KYL. One of the keys to resolving the problem of illegal

immigration in a comprehensive way is to ensure that employers

hire only people authorized to work. If that is done properly, then

the proper kind of withholding and payment for Social Security and

so on will be achieved, and presumably the proper tax compliance.

But it does assume that the employer is complying with the requirements of reporting in the first instance. I am wondering if

there is any estimate at all from any of you as to the magnitude

of the non-compliance on the employer part of this.

We are talking about folks who pay in cash, and the employee

takes it in cash, and really the government has no reason to ever

know that the employment has occurred or that the payment has

been made.

Yes, Dr. Mazur?

Dr. MAZUR. I have seen a couple of studies, one cited by the Pew

Hispanic Trust, where there are about 7 million unauthorized immigrants in the workforce, and probably about three-quarters of

them pay payroll taxes. So in a sense, those are in the reported

economy. Now, whether they pay payroll taxes under a valid Social

Security number and so on, that is a different issue.

Senator KYL. Presumably, they would pay a full amount of the

payroll taxes if they are on that system, so presumably about a

fourth then do not under that particular study.

Dr. MAZUR. It would be under sort of a cash——

Senator KYL. All right. Does anybody else have any data on that,

or anything else? [No response.] We will undoubtedly want to come

back to that. The whole matter of cash basis is a matter of concern.

Ms. Olson, let me ask you something else. You talked about inadvertence. Have you netted this out? I mean, obviously inadvertence

works both ways. It can be to the advantage of government as well.

So has this been netted out to reveal a result that is just to the

government’s detriment?

Ms. OLSON. I am not aware of that. Now, I know that the GAO

study looked at that in terms of capital gains basis reporting and

found 33 percent of the errors in the capital gains area was harmful to the taxpayer, they over-reported their income from capital

gains. Can you apply that to the rest? I do not know.

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Senator KYL. Any other observations on that particular point?

Yes?

Dr. MAZUR. One thing that is very hard to tease out of the data,

though, is what the motivation of the taxpayer was. I think one of

the reasons, in the data that Nina cites, where there are a very

small number that are attributable to intentional errors, is that the

standard for saying it is an intentional error is fairly high. In a

sense, you are accusing the taxpayer of doing something that is

borderline fraudulent.

Senator KYL. So the category of inadvertence may be a tad large,

for definitional reasons. Understood.

Mr. BROSTEK. Just as a small addition on that, there can be a

lot of variation in the judgment of people about whether something

is intentional or not.

Senator KYL. Sure.

Mr. BROSTEK. In the late 1980s, there was a study done on EIC

compliance. IRS had some of its Criminal Investigative Force make

an estimate of the level of compliance, and they asked those criminal investigators to make a judgment about whether the noncompliance was intentional or not.

My recollection is, there the judgment was pretty high, maybe

something on the order of 50 percent. But there can be a lot of variation in the judgment, which is subjective judgment on the part of

somebody, about the taxpayer’s motivations.

Ms. OLSON. There is a group of social scientists that has tried to

do a typology, like categories of non-compliance, rather than just

going to unintentional. They really go to the understanding of the

taxpayer, the behavior of the taxpayer. I think that is just much

more effective.

If we were to do this again, I would suggest that the IRS needs

to give better instructions to its auditors, narrow down the categories, and then you would really get some more meaningful data,

both in terms of how taxpayers behave and how to address that behavior.

Senator KYL. If any of the others have observations, fine. Otherwise, I am going to turn to Senator Jeffords for his round.

Senator JEFFORDS. I have no further questions.

Senator KYL. Well, in that case, let me continue then. Oh, I am

sorry. Senator Lincoln has arrived. How embarrassed I am that I

did not acknowledge your presence, Senator Lincoln, who have

been very, very interested in this subject, I am well aware. The

floor is yours.

Senator LINCOLN. Thank you, Mr. Chairman. I want to thank

Chairman Kyl and Senator Jeffords, because I am so glad we are

here today to really take a much closer and serious look at this

very serious issue of the tax gap.

It is an issue that I know our Ranking Member Senator Baucus

and Chairman Grassley also continue to put forth a phenomenal effort on here in the overall Finance Committee, so I am pleased that

Chairman Kyl and Senator Jeffords have brought it up in our subcommittee.

I am certainly pleased that we are continuing the discussion. I

know that the testimony that is being provided today will be very

useful as we continue our work. You all bring a whole variety and

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a wide range of perspectives in terms of what the issue is, as well

as what the solutions might be.

I continue to be astounded at the amount of taxes that are owed

and not paid. We are not talking about a small amount of revenue

loss here, we are talking about hundreds of billions of dollars which

are much needed in terms of other areas of investments that we

would like to make in this country.

So any progress we can make in closing that gap, I think, is

going to be significant, and it will make it so much easier for us

to continue making progress on our policy objectives, whatever they

may be, whether it is simplification or other initiatives.

This issue must be a priority, I think, for the Senate, and it must

be a priority for the administration. I think it is evident through

the testimony that we heard today, and that we continue to hear

through written pieces, that we have to take a multi-faceted approach to the problem, an approach that considers both our legislative options as well as administrative options.

As a result, we here in the Finance Committee, no matter how

hard we try, cannot solve the problem on our own. Not only do we

need the valuable input that you provide, we need cooperation—

real cooperation—from the Treasury and the IRS. That is going to

be essential.

So I just want to urge the administration’s officials to come to

the table on this. For us to do our job here, we need to know what

the IRS is thinking and what they are doing, what their intentions

are, and how we can be helpful in moving that forward.

I think we owe it all to the honest taxpayers in this country who

are unfairly bearing the financial burden of those who do not pay

what they owe; whether it is known or unknown to them, nonetheless, what is really owed to the country in terms of the objectives

we want to reach.

Mr. Chairman, I just have a couple of questions.

Ms. Olson, I think your point on the voluntary compliance is so

accurate. You were just mentioning in the previous question about

education. We are never going to see significant progress on this

issue if we do not first recognize that voluntary compliance is a

huge key.

Even if we were to double, triple, or quadruple the IRS enforcement resources, it is never going to be enough to police everyone.

We know that. I do not know, Mr. Chairman. Maybe it is a Southern thing. But I keep thinking that we catch more bees with honey.

I guess my question is, to any of you all, how significant is taxpayer service on the front end, through outreach and education,

better knowledge of the system, and the processes?

How important is that right now, and how big of a role could it

play? What kind of a helpful tool could it be in closing the gap

where more focus is placed on it? It seems to me that many taxpayers would probably pay what they owe if they could only figure

it out.

I can only be reminded of my husband’s comment, who looks at

the wall with 8 or 10 diplomas on it, and says, ‘‘I cannot believe

I cannot do my own taxes. With all of this education my parents

paid for, and here taxes are so complicated, I cannot seem to do

it.’’

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What kind of a role do we see that playing?

Ms. OLSON. Ten years ago, the IRS did a study that showed that,

for every dollar that the IRS spent doing return preparation, it

generated $396 of additional tax revenue. When you look at the indirect effect of something, I mean, that is a direct effect. That is

very large.

So, you would think that the IRS would be putting more emphasis on doing the income tax preparation, particularly since its returns are the most accurate of any type of preparer, by its own

measures and studies.

But since 2003, it has literally cut in half the number of returns

that it, itself, is preparing at its walk-in sites. I think that is penny

wise and pound foolish.

Senator LINCOLN. Yes.

Mr. GEORGE. Senator Lincoln, if I may.

Senator LINCOLN. Yes.

Mr. GEORGE. There is no question that simplifying the tax code

would certainly help address the problem you articulated. However,

it is not easy to simplify the tax code.

Senator LINCOLN. We know that around here. [Laughter.]

Mr. BROSTEK. Senator Lincoln, if I could jump in here. Even

without simplification, it is certainly true that service to taxpayers

is very important for them to be able to comply.

One of the things that I thought was illustrative was some work

we did 2 or 3 years ago, where we looked at whether IRS actually

takes the forms and instructions that they expect taxpayers to follow and sits down with taxpayers and asks them to go through the

forms, go through the instructions, to see if they make sense to the

taxpayer.

I forget the exact number, but there were hundreds of changes

that had been made to the tax forms in the period we looked at,

and there were less than a handful of times when they had actually tested the form with the taxpayer. We made recommendations

that they improve that effort so that up front we can reduce the

confusion of the taxpayer and increase their voluntary compliance.

Senator LINCOLN. Exactly.

Mr. WAGNER. Senator, I might add that the Oversight Board has

been focused on driving the message that taxpayer service up front

is critically important, and really is the answer. That, of course,

needs to be balanced with the proper amount of enforcement, because enforcement, too, drives voluntary compliance. So, there is a

balance there.

But up front, customer service, whether it is answering the

phones, whether it is providing walk-in service, whether it is clear

instructions, more clarified forms, they are all critically important.

Senator LINCOLN. Thank you.

Mr. Chairman, you are going to have a second round, correct?

Senator KYL. Yes.

Senator LINCOLN. I will save my next question.

Senator KYL. All right. Thank you.

Right on that same point, and I do not know all of the ins and

outs about how this is actually administered, but I noted, Mr.

Brostek, your testimony about the EIC. Six years ago, there was

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a $10 billion loss there. A lot of that is governmental administration.

So, just following up on the last point that we made, how could

we improve, just in that one area, the collection, given the fact that

there is government involvement, at least?

Mr. BROSTEK. Well, a few things come to mind there. As you

probably know, the IRS has been experimenting with some alternative techniques to try to improve the compliance level, asking

some taxpayers, some of the EIC taxpayers, to present various documents ahead of the filing season that IRS can take a look at and

try to make a judgment whether the taxpayer complies or not.

They have done this type of research, and I think part of what

would be useful is congressional oversight to see whether the results of those initiatives could, or should, be expanded from a relatively small number of taxpayers who are involved to a larger part

of the universe. I do not know for sure that that would be effective.

One of the things that must, I think, be kept in mind here, is

that a program like the Earned Income Credit has really a very

small administrative cost compared to most social services programs that are directly administered by government employees.

You sort of have a trade-off, in part. You get low administrative

cost and a lot of self-certification on the part of the taxpayer that

they qualify for this benefit, if you will.

But if you have a higher administrative cost, you have a government employee actually checking whether those qualifications are

met, and you have a lower non-compliance rate. It is a judgment

about whether we would like to turn this program more into a high

administrative cost program, but we would have an ultimately

lower non-compliance rate.

Senator KYL. Yes. Dr. Mazur?

Dr. MAZUR. A couple of things. One, as Mike Brostek points out,

having the administrative costs low does a couple of things. It

drives down the cost of running the program, but it also increases

the participation rate.

So the Earned Income Credit has one of the highest participation

rates of any social service program, which really means we have

gotten more folks in, and really it leads it to becoming a very effective anti-poverty program.

Senator KYL. The concern I have here in representing taxpayers

is this is the kind of thing that drives them nuts, because there is

a government involvement there that seems to be allowing

misreporting, perhaps even fraud. I was going to ask about the

prison system. I have forgotten which one of you mentioned the

fraud.

Mr. GEORGE. I did, Mr. Chairman.

Senator KYL. Yes. The fraud and prisoners, a 318-percent increase. Talk about things that drive people nuts. That is high profile. In one sense, it is an opportunity because it gives us something that we can get people’s attention on to begin to focus on,

which then ripples out into a lot of other areas that we can potentially improve, too. But how about a program like that?

Mr. GEORGE. And I would just point out, sir, that the Earned Income Credit is one of the credits that the prisoners are taking advantage of. The irony is, for those who have been incarcerated for

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more than 6 months, they would not qualify under the standards

laid out by the IRS for the credit.

Ms. OLSON. I think that there is one thing that you can do about

the prisoners. I believe the House has proposed some legislation on

that. I am usually a confidentiality-of-taxpayer-information hawk,

but in this instance I think it would be important for the IRS to

be able to share with the prison wardens that they have received

fraudulent returns from prisoners.

If we just stop a refund, what does that do to the prisoner? There

is no punishment. They are already in jail. So to me, take away

their cigarettes, their television privileges. We cannot do that, the

warden needs to do that.

Senator KYL. And it is a very light intrusion. There is another

question I want to get in about the relative benefit of intrusiveness.

Ms. OLSON. Right.

Senator KYL. All that is, is just sending in a name, saying, I have

got a refund here.

Ms. OLSON. Exactly.

Senator KYL. Very good.

Let me ask one more question here about the private debt collection efforts. I know that we are just beginning to potentially see

some collections there. I am not sure, Mr. George or Mr. Brostek,

who would be the best one to comment on that. But what do we

anticipate in the private debt collection area?

Mr. GEORGE. If I may start, Mr. Chairman. As you may recall,

10 years ago a pilot was attempted by the IRS, which failed and

failed miserably. It cost more than was ultimately collected. The

American Jobs Creation Act renewed this effort. We are optimistic

that, if effectively run, it can achieve the goals that Congress intends.

However, as with every other major government effort, it requires massive oversight. TIGTA is currently engaged in an effort

to educate those whom the IRS has selected to participate in this

program to, at the outset, inform them of what they should and

should not do.

This has the potential to be a great benefit to government in

terms of reaching out to taxpayers who owe debt, and it also has

the potential, sir, of being a nightmare if abused. So, we are very

concerned about this. We are going to be very aggressive. I have

communicated directly with the Commissioner about this concern.

Mr. BROSTEK. We, too, have concerns. We are doing some ongoing work right now for this committee, the Chairman and Ranking

Member. We do not have the results of that available yet.

Your specific question, I believe, was on the potential benefit. I

believe the estimate of additional revenue that could be gained

when the program began was on the order of $1 billion, maybe $1.2

billion, over a 10-year period of time. But as Mr. George says, it

is a program that will bear watching closely because of the potential down sides.

Ms. OLSON. If I might, sir. I, too, am very concerned. We have

been very involved in this initiative, prior to even the legislative

language being enacted.

I am concerned that the benefits are going to be overstated because we are not adequately measuring the actual costs. We are

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only going to be looking at what we pay out to the private debt collectors and not looking at the work that the IRS has to do in order

to pick up some of the cases that the private debt collectors cannot

handle.

My office is going to be tracking that aspect of it. I am concerned

that many of these taxpayers will come in and say, well, I will pay

the tax, but I want the penalty abated.

Constitutionally, private debt collectors cannot make that decision, so then the case needs to go back to the IRS. Maybe we

should have worked this case from the start. Now we are doing duplication of resources. We are paying the private debt collectors,

but we are also paying the IRS employees.

Mr. WAGNER. Senator, I might add that the Oversight Board has

expressed an opinion in support of the private debt collectors, with

the understanding that these organizations—TIGTA, GAO, Taxpayer Advocate—will be closely watching and overseeing the activities, and the Board itself will be involved in that.

We have observed that private debt collectors have worked at the

State level and have been successful at the State level. There are

costs, certainly, and there is talk of collecting $10 billion over 10

years, but there are indirect benefits as well.

With more boots on the ground, so to speak, engaged in enforcement activities, that does have an indirect benefit, which perhaps

is not being measured and cannot quickly be measured without the

additional research that we have talked about. So, we are certainly

open-minded and see it as a tool, as one arrow in the quiver, for

enforcement and closing the tax gap.

Senator KYL. Great. Thanks.

Senator Jeffords, you do not have any more questions?

Senator JEFFORDS. No.

Senator KYL. I will turn to Senator Lincoln.

Senator LINCOLN. Thank you, Mr. Chairman.

Dr. Mazur, as a long-time advocate for small businesses, I have

been very interested in your ongoing compliance study that focuses

on the S corporations.

While I am sure we share the same goal, that all taxpayers

should definitely pay taxes that are owed, I also want to ensure

that we do not end up placing an undue or unreasonable burden

on taxpayers, especially our small businesses. In my State, small

businesses are our largest employer. Actually, in most States they

are the largest employers.

What is the progress on your study that you might be able to

share with us? Do you have an anticipation of when you might

have your completed results?

Dr. MAZUR. Sure. The study is ongoing. We have roughly 5,000

S corporations in the study. It covers 2 tax years, tax year 2003

and tax year 2004. In very rough terms, about 1,200 returns are

for tax year 2003. Those audits are, for the most part, all started.

A few hundred are done.

The tax year 2004 ones, the audits, there are 3,800. The audits

have gone out to the folks in the field. They have begun setting up

appointments with taxpayers.

We are expecting about a 2-year cycle for these audits. They take

some period of time to complete, and the stragglers need to get

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brought in. So basically, we are expecting the results to be done

sometime in 2007/2008, and then some period of time after that,

while we massage the data and get to understand it a little bit better, have results for you.

Senator LINCOLN. Great. Thank you.

We have all talked about simplification and expressed, certainly,

how important it is. It has to be a part of our discussion. Our tax

code, in its current form, seems to be overly burdensome and far

too complex, I think, for your average taxpayer. I think it is no

wonder that they are not necessarily complying all the time.

Ms. Olson, or any others who might want to comment, would you

mind outlining for me a few of the changes, maybe, in the code that

you think would be helpful, particularly for taxpayers, as we move

toward that simplification?

Ms. OLSON. Well, over the years, in our annual report, we have

identified some. I would have to say the big one is going to have

to be the Alternative Minimum Tax. If we look forward to 2012, we

have 33 million taxpayers who are going to be impacted.

I think Treasury had projected that 92 or 94 percent of married

couples with two children, by 2010, with income between $75,000

and $100,000, will be impacted by the AMT, that for them the

AMT will be the tax rate. That is just something that is intolerable.

You talk about inadvertent non-compliance or calculated noncompliance. They just are not going to be able to figure it out.

We talked about some changes and improvements to the Earned

Income Credit. We have looked at the retirement provisions and

the education credits and incentives in the code.

We have so many retirement provisions, that people get confused, and they get confused about when they can take out early

withdrawals, and then they get taxed on that because under one

plan it is not subject to a 10-percent penalty tax, but under another

type of plan, that particular reason for a withdrawal is subject to

the additional tax.

Senator LINCOLN. Mr. George?

Mr. GEORGE. Senator Lincoln, I would associate my comments

with those of Ms. Olson. I would point out, I guess the touchstone

really should be, is the provision doing what it was intended to do

when first passed by Congress, whenever it was? Again, the first

provision I was going to point out was also the AMT.

Senator LINCOLN. Well, we always appreciate that, knowing that

our original intent is preserved. So, hopefully there will be some of

that.

Mr. BROSTEK. I agree that these are all good targets of opportunity. One piece I would add. We did some work on the education

provisions. We looked at the tax provisions, as well as the grants

and loans that are available, in one report to gather information

across all those provisions.

But we did some testing on a small number of the tax provisions

to see if we could tell whether taxpayers were making the best

choice for them. We found hundreds of thousands of individuals

who were not making the best choice for themselves.

This has nothing to do with whether they were non-compliant,

just whether they were getting the best support for post-secondary

education expenses that they had. I think that is a telling piece of

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information about how confusing this plethora of different techniques can be in the tax code.

Senator LINCOLN. So, financial literacy and the ability to marry

that financial literacy with the tax code is going to be a critical

component of making sure we are successful, it sounds like. So,

thank you.

Thank you, Mr. Chairman.

Senator KYL. Thank you. I would like to just ask one last question, really to all of you, but probably starting with Mr. Wagner,

since you are responsible for weighing, in your business, the advantages of—let me put the question another way.

Reporting by third parties can create great advantages for tax

collection, but create problems in costs for the businesses or third

parties who are doing the reporting, so weighing the relative benefits or burdens there, I think, is something we have to do. In business, one has to do that.

So do you have any suggestions, as we draw this to a close, as

a general proposition that we should be looking at in the data that

we are going to be collecting that would help us to approach this

question of weighing the relative benefits and burdens of third

party reporting? We know, in the abstract, it will certainly help us,

but we also appreciate that it will create costs for people who really

do not deserve to have those costs imposed.

Mr. WAGNER. Well, I think, Senator, you have captured the essence of it. That is, weighing and balancing the burden. The theme

of research would certainly come into play at this point in time.

But I think not all reporting is going to be as burdensome as it

may seem on the face of it. For example, you look no further than

a few years ago when Social Security numbers were a newfound requirement, and suddenly 7 million dependents fell off the tax rolls.

That was a matter of reporting.

So there are burdensome forms of reporting, but yet, much of the

information in today’s modern society, in today’s simple banking

records, statements that are received from vendors, computerized

records, could be required to be provided or kept in the ordinary

course of business, much as the new accounting requirements are

imposed upon companies, and much of this is already gathered.

So I think there could be considerable study that would achieve

the right level of intrusion and balance. Certainly, no business

wants to have any additional burdens of cost for reporting, or any

other regulatory method. But there is a proper role for that.

Senator KYL. Maybe we could give them a break. We could reduce their tax rates so they will report more data to us.

Mr. WAGNER. Well, that warrants consideration.

Senator KYL. Thank you.

Mr. Brostek?

Mr. BROSTEK. Just one thing on that. I would just make one little, slightly unrelated, plug. On the burden, I think it is important

to keep in mind that we should take into account the burden of the

taxpayers, as well as the third parties.

I think in many cases, if you add both of those burdens up, after

you go to information reporting, the net burden goes down. For instance, the cost basis. You have millions and millions of taxpayers

26

who have to individually figure out, what are these rules? Then

they have to go research to find what the history of their stock is.

If you have a central choke point, a brokerage firm that knows

those rules for all of their clients and that has record-keeping systems that are fairly sophisticated, I think you might get a net reduction in overall burden, counting both parties, by going to third

party reporting.

The unrelated plug I would like to put in is, going back to one

of the things that was mentioned earlier, the importance of the

practitioner community. One of the things that I found eye-opening

recently, work we did for this committee, was we went out and had

tax returns prepared this year in 19 instances, a small, small sample.

In every single case, the practitioners made mistakes. In half of

those instances, they were very significant mistakes from the taxpayer’s perspective, losing them $500, $2,000 apiece, sometimes

gaining them that money.

Sixty percent of taxpayers—maybe a little more than 60 percent

of taxpayers—use paid preparers these days. This is a community

that is an important choke point for compliance in our system. The

small study we did suggests that that deserves some attention.

Thank you.

Senator KYL. Good point. We appreciate it.

Dr. Mazur?

Dr. MAZUR. I just want to follow up on the point about the burden of both parties in here. Just think about if you had to figure

out what your interest income was every year rather than getting

a statement from your bank telling you what it was. You would

have to be saving the statements, you would have to be looking,

trying to figure out what it is.

Now you get a statement in January that says, here is the total,

just put it on the line. So, really, in that case, while there is some

burden on the bank to send you that statement, the combined burden has got to be less.

Ms. OLSON. To that point, burden may be something that was a

problem years ago, but today, because of technology, it is not.

Again, in the capital gains cost basis area, today there is a private

clearinghouse that is run by broker dealers, the New York Stock

Exchange, and NASDAQ. It is a cost basis reporting service. They

offer that.

We were advised that brokers that handle 80 percent of all account transfers are using this service today. Now, 10 years ago,

they were not using that, so the burden is not that great on these

folks to do that, to get that extra 20 percent.

What we had proposed was maybe give a one-time tax credit for

transition costs, because the cost of that going out the door is overcome many times by the revenue that you are going to get in by

just implementing this provision.

Mr. GEORGE. Mr. Chairman, I would just point out, again, that

under-reporting of income is the largest component of the tax gap.

So I would advocate, and I know TIGTA takes the position, that

third party reporting would certainly be an effective tool to address

that problem.

27

Senator KYL. I really appreciate all of this information. I went

less into some of the intricacies of the data collection and evaluation, which was one of the purposes for the hearing, but as you can

see, we tend to jump right to, what kind of solutions might we

want to consider?

I am sure I speak for all of the members of the committee on

both sides in expressing my gratitude to you, and my hope is that,

as we proceed, that we will be able to call upon you for continuing

advice; I know several of you have been working with the committee in the past. It is an important issue.

For those of you who are working for the U.S. Government, I

hope our constituents can be proud of the kind of work that you

do. And those who are doing volunteer service, we are proud of

that, too. So, thank you very, very much.

Senator Jeffords, any closing comments?

Senator JEFFORDS. Just to follow up on what you have just said,

I think we need to make sure that the tax code gets simpler and

that people are more knowledgeable and they have a better ability

to understand what is going on.

Senator KYL. Thank you very much.

The hearing is adjourned.

[Whereupon, at 3:25 p.m., the hearing was concluded.]

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