Tax Compliance: Better Compliance Data and Long-term Goals Would Support a More Strategic IRS Approach to Reducing the Tax Gap
Published: 2005-07-18T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: According to the Internal Revenue Service (IRS), a gap arises each year between what taxpayers pay accurately and on time in taxes and what they should pay under the law. The tax gap is composed of underreporting of tax liabilities on tax returns, underpaying of taxes due from filed returns, and nonfiling of required tax returns altogether or on time. GAO was asked to provide information on (1) the estimated amount that each major type of noncompliance contributed to the 2001 tax gap and IRS's views on the certainty of its tax gap estimates, (2) reasons why noncompliance occurs, and (3) IRS's approach to reducing the tax gap and whether the approach incorporates established results-oriented planning principles.
section_title: What GAO Found
paragraphs: IRS estimates that underreporting of taxes accounted for about $250 billion to $292 billion of the $312 billion to $353 billion tax gap for 2001, while underpayment and nonfiling accounted for about $32 billion and $30 billion, respectively. Although IRS has collected recent compliance data, it still has concerns with some outdated methodologies and data used to estimate the tax gap. IRS is taking laudable steps intended to improve the estimate, which it plans to revise by the end of 2005. IRS has also developed a proposed schedule of compliance studies, but it has no approved plans to periodically measure compliance for the tax gap components. While it may not be feasible or necessary to measure compliance for all components at the same frequency or level of investment, periodic compliance studies would support a more data-driven and risk-based approach to reducing the tax gap. IRS recently began to capture data on the reasons why taxpayers are noncompliant. However, IRS has concerns about the data, such as examiners assigning the same reason for noncompliance regardless of situation. Also, it is often difficult for examiners to determine a taxpayer's intent--whether the noncompliance is unintentional or intentional. Collecting better data on reasons can help IRS focus its activities on taxpayer service or enforcement. Although IRS is developing a system intended to capture better examination data, IRS does not have firm or specific plans to develop better reason data. IRS approaches tax gap reduction through improving taxpayer service and enforcing tax laws and has two broad strategic goals and related key efforts that are intended to support this approach. However, IRS has not established long-term, quantitative compliance goals and regularly collected data to track its progress, which would complement its current, important compliance efforts. Establishing clear goals and measuring progress towards them would be consistent with results-oriented management principles. IRS has begun to consider additional goals, but it is not yet clear if they will be compliance related. Long-term, quantitative compliance goals, coupled with updated compliance data, would provide a solid base upon which to develop a more strategic, results-oriented approach to reducing the tax gap.

section_title: Letter
paragraphs: The federal tax system relies on taxpayers to voluntarily comply with the  tax laws. However, a gap arises each year between what taxpayers pay  accurately and on time in taxes and what they should pay under the law.  Recognizing the need for current compliance data to update the tax gap  estimate, the Internal Revenue Service (IRS) implemented a new  compliance study in 2002 called the National Research Program (NRP) to  produce such data for tax year 2001 while reducing taxpayer burden. NRP  is a significant achievement and its data should be valuable in improving  IRS operations and for other uses.
Incorporating preliminary results from NRP, IRS recently estimated a  “gross” tax gap from $312 billion to $353 billion for tax year 2001. IRS  estimated that it would eventually recover some of this amount through  late payments and IRS enforcement actions, resulting in an estimated “net”  tax gap for 2001 from $257 billion to $298 billion. The tax gap estimate is  an aggregate of estimates for the three primary types of noncompliance:  (1) underreporting of tax liabilities on tax returns; (2) underpaying of  taxes due from filed returns; and (3) nonfiling, which refers to the failure  to file a required tax return altogether or on time.
The tax gap arises when taxpayers fail to comply with the tax laws, either  intentionally or unintentionally. As a result of their noncompliance, the  burden of funding the nation’s commitments, including funding growing  budget deficits, falls more heavily on taxpayers who voluntarily pay their  taxes. In addition, IRS expends substantial resources enforcing and  explaining tax laws, with the goals of increasing compliance and reducing  the tax gap.
Given your concern over the burden that the tax gap places on both the  taxpayers who voluntarily pay their taxes and the federal budget, we  testified before the Senate Committee on Finance on April 14, 2005, on a  number of tax-gap-related issues. As you requested, this report elaborates  on the testimony by providing additional information on (1) the estimated  amount that each major type of noncompliance contributed to the 2001 tax  gap and IRS’s views on the certainty of its tax gap estimates, (2) reasons  why the noncompliance occurs, and (3) IRS’s approach to reducing the tax  gap and whether the approach incorporates established results-oriented  planning principles.
To provide information on the estimated amount that each type of  noncompliance contributed to the 2001 tax gap, we reviewed IRS’s tax gap  estimates for 2001. To determine IRS’s views on the certainty of its tax gap  estimates, we reviewed IRS studies and interviewed IRS research officials  about tax gap estimation. We reviewed IRS, academic, and our prior work  and interviewed IRS officials in an attempt to identify the various reasons  for taxpayer noncompliance. To determine IRS’s approach to reducing the  tax gap and whether the approach incorporates established results- oriented planning principles, we examined IRS’s strategic and  performance plans and interviewed IRS officials. We asked IRS to identify  its key efforts to reduce the tax gap as well as the related rationales, goals,  and results. Using what we learned about IRS’s approach, we determined  the extent to which the approach incorporated selected planning  principles consistent with the Government Performance and Results Act  of 1993 (GPRA). We conducted our review from June 2004 through May  2005 in accordance with generally accepted government auditing  standards.
subsections: section_title: Background
paragraphs: IRS develops its tax gap estimate by measuring the rate of taxpayer  compliance—the degree to which taxpayers fully complied with their tax  obligations. IRS uses such compliance data, along with other data and  assumptions, to estimate the dollar amount of taxes not paid accurately  and on time. For tax year 2001, IRS estimated that from 83.4 percent to 85  percent of owed taxes were paid voluntarily and on time, and that from  $312 billion to $353 billion in taxes were not paid that should have been.  IRS also estimates the amount of the gross tax gap that it will recover  through enforcement and other actions and subtracts that to estimate the  net annual tax gap. For tax year 2001, IRS estimated that it would  eventually recover about $55 billion for a net tax gap from $257 billion to  $298 billion. As we have reported in the past, closing the entire gap may  not be feasible since it could entail more intrusive recordkeeping or  reporting than the public is willing to accept or more resources than IRS is  able to commit. However, given the size of the tax gap, even modest  reductions would yield very significant financial benefits.
IRS has estimated the tax gap on multiple occasions, beginning in 1979.  IRS’s earlier tax gap estimates relied on the Taxpayer Compliance  Measurement Program (TCMP), through which IRS periodically performed  line-by-line examinations of randomly selected tax returns. TCMP started  with tax year 1963 and examined individual returns most frequently— generally every 3 years—through tax year 1988. IRS contacted all  taxpayers selected for TCMP studies. IRS did not implement any TCMP  studies after 1988 because of concerns about costs and burdens on  taxpayers.
Under NRP, a program that we have encouraged, IRS recently completed  its initial review of about 46,000 randomly selected individual tax returns  from tax year 2001 (see app. I for a list of conducted TCMP and NRP  surveys). Unlike with TCMP studies, IRS did not need to contact taxpayers  for every tax return selected under NRP, handled some taxpayer contacts  through correspondence rather than face-to-face examinations, and  generally only asked taxpayers to explain information that it was  otherwise unable to verify through IRS and third-party databases. In  addition, unlike operational examinations, NRP examinations were  randomly selected and used to measure compliance rather than target  suspected noncompliance.
IRS has a strategic planning process through which it supports decisions  about strategic goals, program development, and resource allocation.  Under GPRA, agencies are to develop strategic plans as the foundation for  results-oriented management. GPRA requires that agency strategic plans  identify long-term goals, outline strategies to achieve the goals, and  describe how program evaluations were used to establish or revise the  goals. GPRA requires federal agencies to establish measures to determine  the results of their activities.
section_title: Scope and Methodology
paragraphs: To provide information on the estimated amount that each major type of  noncompliance contributed to the 2001 tax gap, we reviewed IRS’s tax gap  estimate for 2001. To determine IRS’s views on the certainty of its  estimate, we reviewed IRS studies about tax gap estimation and  interviewed IRS research officials to understand the data and  methodologies used. We also spoke with IRS officials regarding planned  changes to the data sources and estimation methodologies for the tax gap  estimate. We determined that the tax gap estimates presented in this  report are sufficiently reliable for the specific purposes of our  engagement, particularly since IRS already has publicly released its tax  gap estimates and disclosed their weaknesses. These purposes include  discussing the major tax gap components and the orders of magnitude for  various components, IRS’s concerns about the certainty of its estimates,  and our recommendations on IRS’s compliance data and efforts.
We reviewed IRS, academic, and our own reports and interviewed IRS  officials to identify the various reasons for noncompliance. We talked with  IRS officials to determine the extent and reliability of data and coding on  the reasons for noncompliance, and reviewed IRS’s Examination  Operational Automation Database, which is a database of tax return  examination results that includes examiners’ determinations of the  reasons for any noncompliance. We also talked with IRS officials to  determine any plans to develop better data on reasons for noncompliance.
To determine IRS’s approach to reducing the tax gap and whether the  approach incorporates established results-oriented planning principles, we  reviewed IRS strategic and performance plans and interviewed IRS  strategic planning officials at the agency and operating division levels. We  asked IRS to identify its key efforts to reduce the tax gap as well as the  related rationales, goals, and results. As part of our work on whether the  approach incorporates established results-oriented planning principles, we  used what we learned about IRS’s approach to determine the extent to  which it incorporated selected planning principles consistent with GPRA’s  requirements. For purposes of this review, we focused on elements of  results-oriented planning that, previously, we found common to leading  organizations successfully pursuing results-oriented management–defining  desired results, measuring performance, and using performance  information to support agency missions.
section_title: IRS Lacks Approved Plans to Regularly Measure Compliance, Including Underreporting Which Accounts for the Largest Portion of the Tax Gap
paragraphs: IRS estimates that underreporting of taxes accounted for about $250  billion to $292 billion of the $312 billion to $353 billion tax gap for 2001,  while underpayment and nonfiling accounted for about $32 billion and $30  billion, respectively. The actual tax gap could be higher or lower due to  various factors that affect the certainty of the estimate, such as old  compliance data. IRS is taking some steps designed to improve portions of  its compliance measurement efforts and its preliminary tax gap estimate  and plans to release a revised tax gap estimate by the end of 2005. While  IRS has proposed a schedule for NRP studies over the next several years,  IRS has no approved plans to regularly measure tax compliance, which it  could use to update the tax gap estimate and guide its compliance efforts.
subsections: section_title: Underreporting Accounted for Most of the Tax Gap Estimate
paragraphs: As table 1 indicates, underreporting of individual income taxes  represented about half of the tax gap for 2001 (the estimate ranges from  $150 billion to $187 billion out of a gross tax gap estimate that ranges from  $312 billion to $353 billion).
Within the underreporting estimate, IRS attributed about $150 billion to  $187 billion, or about 50 percent of the total tax gap, to individual income  tax underreporting, including underreporting of business income, such as  sole proprietor, informal supplier, and farm income (about $83 billion to  $99 billion); nonbusiness income, such as wages, interest and capital gains  (about $42 billion to $57 billion); overstated income adjustments,  deductions, and exemptions (about $14 billion to $16 billion); and  overstated credits (about $11 billion to $14 billion). Underreporting of  corporate income tax contributed an estimated $30 billion, or about 10  percent, to the 2001 tax gap, which included both small corporations  (those reporting assets of $10 million or less) and large corporations  (those reporting assets of over $10 million). (For a more detailed table of  IRS’s estimates for the various components of the 2001 tax gap, see app.  II).
Employment tax underreporting accounted for an estimated $66 billion to  $71 billion, or about 20 percent, of the 2001 tax gap and included several  taxes that must be paid by self-employed individuals and employers. Self- employed individuals are generally required to calculate and remit Social  Security and Medicare taxes to the U.S. Treasury each quarter. Employers  are required to withhold these taxes from their employees’ wages, match  these amounts, and remit withholdings to Treasury at least quarterly.  Underreported self-employment and employer-withheld employment  taxes respectively contributed an estimated $51 billion to $56 billion and  $14 billion to IRS’s tax gap estimate. The employment tax underreporting  estimate also includes underreporting of federal unemployment taxes  (about $1 billion).
section_title: IRS’s 2001 Tax Gap Estimate Is Inexact Due to Incomplete and Old Data, Outdated Methodologies, and Inherent Measurement Difficulties
paragraphs: Although a significant portion of IRS’s new tax gap estimate is based on  recent compliance data, IRS has concerns with the certainty of the overall  tax gap estimate in part because of incomplete and old data, outdated  methodologies, and measurement difficulties. Table 2 shows IRS’s  certainty level in the estimates, as well as the underlying data sources.
As table 2 shows, IRS’s estimate for the 2001 tax gap does not include  estimates of excise tax underreporting and nonfiling. According to IRS, the  reason for this omission is that numerous federal excise taxes, many of  which have specific exclusions or varying applications, complicate excise  tax computations. Further, data on excise tax transactions are typically  maintained at the state level and are often incomplete. Also, according to  an IRS research official, the estimate does not include corporate income  tax and employment tax nonfiling because IRS lacks good, representative  data for corporate and employment tax nonfilers. Further, data from IRS’s  operational programs to identify nonfilers exclude those whom IRS does  not know about and do not include the full tax liability of nonfilers whom  IRS has identified.
The 2001 tax gap estimate also does not include any estimates for taxes  due from illegal source income, as the magnitude of such income is  difficult to estimate. Moreover, the federal government seeks to eliminate  most illegal activities altogether, rather than derive revenue from these  activities.
subsections: section_title: Estimates for Some Components of the Tax Gap Are Based on Old Data
paragraphs: Old data also contribute to IRS’s “weaker” level of certainty for certain  segments of the underreporting portion of its 2001 tax gap estimate. For  example, IRS used data from the 1970s and 1980s to estimate  underreporting of corporate income taxes and employer-withheld  employment taxes. For large corporate income tax underreporting, IRS  based its estimate on the amount of tax recommended from operational  examinations rather than the tax ultimately assessed as part of the total  tax liability. According to IRS officials, IRS relies on the amount of tax  recommended because it is difficult to determine the true tax liability of  large corporations due to complex and ambiguous tax laws that create  opportunities for differing interpretations and that complicate the  determination. These officials further stated that because these  examinations are not randomly selected and are not focused on identifying  all tax noncompliance, the estimate produced from the examination data  is not representative of the tax gap for all large corporations. They also  explained that due to these complexities and the costs and burdens of  collecting complete and accurate data, IRS has not systematically  measured large corporation tax compliance through statistically valid  studies, even though the officials acknowledged that such studies would  be useful in estimating the related tax gap.
section_title: Tax Gap Estimates Are Affected by Outdated Methodologies
paragraphs: Further, some methodologies IRS used to estimate the tax gap are based  on older data and contribute to the uncertainty surrounding the tax gap  estimate. For example, because IRS knew that it would not detect all  underreporting noncompliance, IRS multiplied the detected amounts of  underreporting to help calculate a total estimate for underreported  individual income tax. IRS officials explained that they used a number of  “multipliers,” including one derived from the 1976 TCMP study of  individual tax returns, which was before IRS expanded and improved its  computer matching programs to better detect various types of  underreported income. In addition, IRS estimated individual income tax  nonfiling based on the assumption that the relationship between individual  income nonfiling and underreporting has been constant since the 1988  TCMP survey was conducted.
section_title: Tax Gap Is Inherently Difficult to Estimate
paragraphs: Finally, it is inherently difficult for IRS to observe and measure some types  of underreporting or nonfiling. For example, underreporting of income or  nonfiling of tax returns by informal suppliers can be hard for IRS to detect  because the tax laws generally do not require third parties to withhold  income tax or file information returns on payments made to informal  suppliers, as are required with other types of individuals such as wage  earners. Similarly, academic studies have discussed the difficulty in  tracking cash payments that businesses make to their employees, as  businesses may not report these payments to IRS in order to avoid paying  employment taxes and employees may not report these payments on their  income tax return to avoid paying income taxes.
section_title: IRS Plans to Issue a Revised Tax Gap Estimate but Has No Approved Plans to Regularly Collect Compliance Data
paragraphs: IRS is taking several steps that could improve the preliminary tax gap  estimate for tax year 2001. IRS intends to publish a revised tax gap  estimate by the end of 2005 based on the results of these steps.
For example, IRS officials stated that IRS plans to further analyze the  preliminary NRP results in an attempt to improve the certainty of the  estimate. NRP is a significant achievement and its data should be valuable  in improving IRS operations and for other uses. However, those officials  added that because IRS is still assessing the quality of the NRP data, it has  not yet finalized the certainty levels for the preliminary estimates for  individual income tax and self-employment tax underreporting. Likewise,  we cannot yet be certain about the quality of the NRP data collected  because IRS is still assessing the data.
IRS plans to implement three changes to its estimation methodology for its  revised tax gap estimate. Although it is too soon to know whether these  changes will improve the estimate, IRS expects that the changes will help  address known methodological weaknesses. According to IRS, these  changes include the following:  IRS plans to replace the multiplier it derived in the 1970s and used to  estimate individual income tax underreporting. IRS is developing a new  methodology, known as detection controlled estimation (DCE). DCE is a  regression-based model that will use 2001 NRP data and control for  variables that could affect the amount of underreporting detected.
IRS plans to develop a new technique as well as replace the data from the  1981 and 1985-1986 University of Michigan surveys to estimate the  individual income tax underreporting portion of the tax gap attributable to  informal suppliers.
IRS intends to update its estimate of individual income tax nonfiling,  which is currently based on 1988 nonfiler TCMP data, by using “Exact  Match” data provided by the U.S. Census Bureau. Census will match data  from its Current Population Survey against the IRS Master Files to identify  the extent of nonfiling by individual taxpayers. The Census data to be  provided to IRS will be aggregated and not contain information on specific  individuals.
In addition, IRS research officials are planning a compliance measurement  study that will allow IRS to update underreporting estimates involving  flow-through entities. This study, which IRS intends to begin in October  2005, would take 2 to 3 years to complete. Because individual taxpayers or  corporations may be recipients of income (or losses) from flow-through  entities, this study could affect IRS’s underreporting estimates for  individual and corporate income tax.
While these data and methodology updates could improve the tax gap  estimates, IRS has no approved plans to periodically collect more and  better compliance data over the long term beyond the study of flow- through entities. IRS Research officials said that they recently proposed a  schedule for additional NRP studies over the next several years. However,  these officials also said this proposal is under consideration but has not  been finalized. IRS has indicated that given its current research priorities,  it could not begin another NRP study of individual income tax returns  before 2008, at the earliest, and would not complete such a study until at  least 2010.
According to IRS officials, IRS has not committed to regularly collecting  compliance data because of the associated costs and burdens. Taxpayers  whose returns are examined through compliance studies such as NRP  bear costs in terms of time and money. Also, IRS incurs costs, including  direct costs and opportunity costs (or revenue that IRS potentially forgoes  by examining randomly selected returns, which are more likely to include  returns from compliant taxpayers than returns selected because they are  likely to contain noncompliance that would produce additional tax  assessments).
section_title: Regularly Measuring Compliance Can Be Beneficial, but Determining the Frequency of Measurement Involves Considering Several Factors
paragraphs: Regularly measuring compliance can offer many benefits, including  helping IRS identify new or growing types of noncompliance, identify  changes in tax laws and regulations that may improve compliance, more  effectively target examinations of tax returns, understand the  effectiveness of its programs to promote and enforce compliance, and  determine its resource needs and allocations. For example, by analyzing  1979 and 1982 TCMP data, IRS identified significant noncompliance with  the number of dependents claimed on tax returns and justified a legislative  change to address the noncompliance. As a result, for tax year 1987,  taxpayers claimed about 5 million fewer dependents on their returns than  would have been expected without the change in law.
Tax compliance data are useful outside of IRS as well. Other federal  agencies and offices use compliance data for tax policy analysis, revenue  estimating, and research. For example, the Department of Commerce’s  Bureau of Economic Analysis had used TCMP data to adjust its national  income and product accounts. Additionally, state tax authorities have  used IRS compliance data to develop state compliance programs and  estimate state tax gaps. Also, policy makers in the executive branch and  Congress can use the results from compliance measurement studies to  help decide on appropriate funding levels for IRS.
As we have reported in the past, the longer the time between compliance  measurement surveys, the less useful they become given changes in the  economy and tax law. According to IRS, without current compliance  data, it has limited capability to determine key areas of noncompliance to  address and actions to take to maximize the use of its limited resources.  For example, the formulas that IRS creates from compliance data to select  returns for examination have enabled IRS to focus examination resources  on noncompliant returns rather than burdening compliant taxpayers.  When IRS updated the formulas in the early 1990s with compliance data  from the 1988 TCMP, IRS selected a lower percentage of compliant tax  returns for examination. However, after 3 years of using formulas based  on the 1988 data, the percentage of compliant tax returns examined  increased each year through 1998, placing additional burdens on  compliant taxpayers and leaving less time for IRS to examine  noncompliant returns that resulted in an additional tax assessment.
Historically, IRS has varied how frequently it measured compliance for  particular types of taxpayers and taxes. As appendix I shows, the period  between measurements of individual income tax reporting compliance,  which consistently has accounted for the largest portion of the tax gap,  never exceeded 4 years between 1963 and 1988. In planning the 2001 NRP  to measure individual income tax compliance, IRS envisioned doing the  NRP on a 3-year cycle. Appendix I also shows that IRS measured  compliance less frequently for other types of taxpayers and taxes, such as  for small corporation income taxes, and that IRS never measured  compliance for large corporations or for excise taxes.
Although regularly measuring tax compliance can be beneficial, how often  measurements should be made is a judgment that depends on many  potential criteria including (1) the amount that a particular type of  noncompliance is thought to contribute to the tax gap, (2) whether IRS has  reason to believe that compliance may have changed (e.g., due to tax law  changes), and (3) costs, particularly when IRS officials said that resources  to conduct operational examinations are already limited. Using these  criteria, IRS would likely vary the frequency of compliance measurement  studies. Based on these criteria as well as our previous reports, decisions  about compliance measurement would also be affected by the following  factors.
Precision. The costs and benefits of measuring compliance can vary with  how precisely IRS wishes to measure compliance to achieve an intended  use (e.g., tax gap estimation or examination return selection). Obtaining  more precise and more detailed compliance data for more detailed  populations of taxpayers or tax issues (e.g., types of income or  deductions) would likely be more costly but potentially more useful.
Capacity. Each compliance measurement study requires having enough  resources such as staffing, training, tools, and systems to capture the data.  Regular compliance measurement through smaller efforts targeted at  particular types of taxpayers or taxes and sampling designs that collect  data across consecutive tax years rather than for one year could help  reduce costs and sustain long-term compliance measurement.
section_title: IRS Has Concerns with Its Data on Reasons for Noncompliance but Does Not Have Firm or Specific Plans to Develop Better Data
paragraphs: Several factors concern IRS about its data on the reasons for  noncompliance, which can be unintentional or intentional. Although IRS is  developing a system intended to capture better examination data, IRS does  not have firm or specific plans to develop better data on the reasons for  noncompliance, even though the lack of such data makes it harder to  decide whether it should address specific areas of noncompliance through  nonenforcement efforts, such as designing clearer forms or publications,  or enforcement efforts.
subsections: section_title: IRS Has Concerns with Its Data on Reasons for Noncompliance
paragraphs: IRS has concerns with its data on the unintentional and intentional  reasons for noncompliance. Various types of unintentional or intentional  reasons could explain why taxpayers fail to comply with the tax laws.  Unintentional reasons can include being unaware of recordkeeping  requirements, accidentally entering an item on the wrong line of a tax  return, or following inaccurate advice from a tax practitioner. Intentional  reasons for noncompliance can include intentionally omitting income from  a tax return or interpreting vague tax laws to evade tax liability.
IRS collects data on the reasons for noncompliance for specific tax issues  during its operational examinations of tax returns. In many of these  cases, it is difficult for examiners to determine a taxpayer’s intent– whether the noncompliance is unintentional or intentional. Unless the  evidence clearly points to the reason, the examiner would have to make  subjective judgments about why the noncompliance occurred. IRS has a  number of other concerns with the data:    The database is incomplete because not all examination results, including  data on reasons for noncompliance, were being entered into the  database.
IRS has not tested the adequacy of the controls for data entry or the  reliability of the data being collected. IRS has found instances where  examiners close examinations without assigning a reason for  noncompliance or by assigning the same reason to all instances of  noncompliance, regardless of the situation.
IRS has not trained all examiners to ensure consistent understanding and  use of the various codes to indicate the reason for noncompliance.
The data do not represent the population of noncompliant taxpayers but  rather only those who had their tax returns examined.
section_title: IRS Does Not Have Firm or Specific Plans to Develop Better Data on Reasons for Noncompliance, which Could Help IRS’s Efforts to Address Tax Noncompliance
paragraphs: According to IRS officials, the agency does not have firm or specific plans  to develop better data on the reasons for noncompliance. One official  explained that IRS decided not to improve the consistency of its current  reason data because it is devoting its limited resources to other efforts,  such as developing the Examination Desktop Support System (EDSS).  Although this system is intended to allow examiners to capture better  examination data, specific system features have not yet been identified to  improve examiners’ selection of reason codes. IRS officials said that the  system could be enhanced in the future to improve the reason data and  that they plan to consider such enhancements.
As the National Taxpayer Advocate recently testified, data on whether  taxpayers are unintentionally or intentionally noncompliant with specific  tax provisions are critical to IRS for deciding whether its efforts to address  specific areas of noncompliance should focus on nonenforcement  activities, such as improved forms or publications, or enforcement  activities to pursue intentional noncompliance. For example, taxpayers  may unintentionally claim the Earned Income Tax Credit (EITC) because  they do not understand the child residency requirements for this credit  (i.e., a dependent must live with the taxpayer for more than half of the  year). This type of unintentional noncompliance may require IRS to more  clearly explain the EITC requirements within related forms and  publications. However, other taxpayers may file false EITC claims with the  intent of evading tax liability, which may suggest a strategy that relies on  IRS’s enforcement programs and tools. Similar situations could exist for  other tax code provisions.
If IRS is to develop better data on the reasons for noncompliance, it will be  important for IRS to consider factors in data collection such as the  following.
Data reliability. To minimize examiner subjectivity and ensure that the  data are complete and accurate, IRS would need to refine the reason  categories, provide adequate training, establish system and data entry  controls, and provide supervisory oversight.
Scope. IRS would need to decide whether the reason categories are to be  captured for selected types of noncompliance or all types of  noncompliance.
Examination selection. IRS currently collects reason data annually  through hundreds of thousands of operational examinations. IRS also  collected reason data through NRP. In the future, IRS would need to  decide whether to collect reason data (1) during all operational  examinations, (2) for a statistical sample of operational examinations, or  (3) for examinations performed through periodic compliance studies such  as NRP. Collecting data for a sample of examinations or through periodic  compliance studies might be done with a smaller cadre of examiners  specially trained and overseen to maximize consistency of decisions about  the reasons why taxpayers are noncompliant. Also, data from samples of  examinations could be used to generalize reasons for noncompliance for  all examinations, and data from compliance studies of all taxpayers could  be used to generalize these reasons for the population of taxpayers.
Our past reports have supported the concept of rigorously researching  the causes of noncompliance. Recognizing the benefits of better  compliance data, the National Taxpayer Advocate has also urged IRS to  consider performing additional research into causes of noncompliance.
section_title: IRS’s Approach to Reducing the Tax Gap Focuses on Service and Enforcement but Lacks Long-term, Quantitative Compliance Goals and Measures That Are Consistent with Results-Oriented Management Principles
paragraphs: IRS approaches tax gap reduction through improving service to taxpayers  and enforcing tax laws and has established two broad strategic goals and  related key efforts that are intended to support this approach. However,  IRS has not established long-term, quantitative compliance goals and  regularly collected data to track progress in reducing the tax gap, which  would complement its current important compliance efforts. Establishing  clear compliance goals and measuring progress towards them benefits  both IRS and external stakeholders and are consistent with the results- oriented performance management principles set forth in GPRA. Although  IRS has lacked such data in the past and faces other challenges, NRP and  EITC data provide an improved base for setting compliance goals and  reexamining existing programs intended to reduce the tax gap.
subsections: section_title: IRS Approaches Tax Gap Reduction through Broad Goals and Numerous Efforts to Improve Taxpayer Service and Enforce Tax Laws
paragraphs: IRS’s overall approach to reducing the tax gap consists of improving  service to taxpayers and enhancing enforcement of the tax laws. Through  efforts such as education and outreach programs, IRS seeks to improve  voluntary compliance with the tax system by helping people understand  their tax obligations. In addition, IRS attempts to simplify the tax process,  such as by revising forms and publications to make them more easily  understood by diverse taxpayer communities and electronically  accessible. In conjunction with taxpayer service, IRS uses its enforcement  authority to ensure that taxpayers are reporting and paying the proper  amount of taxes. Through efforts such as examining tax returns and  collaborating with state governments to share leads on abusive tax  avoidance transactions, IRS seeks to detect and deter noncompliance.
Two of IRS’s three strategic goals, along with their associated objectives  and strategies, are intended to directly support this approach.
Goal 1—Improve Taxpayer Service—is intended to promote voluntary  compliance. This goal has three objectives (1) improve service options for  the tax paying public (2) facilitate participation in the tax system by all  sectors of the public and (3) simplify the tax process.
Goal 2—Enhance Enforcement of the Tax Law—is intended to ensure,  through IRS’s enforcement authority, that taxpayers are meeting their tax  obligations. The four objectives for this goal are (1) discourage and deter  noncompliance with emphasis on corrosive activity by corporations, high- income individual taxpayers, and other contributors to the tax gap; (2)  ensure that attorneys, accountants, and other tax practitioners adhere to  professional standards and follow the law; (3) detect and deter domestic  and off-shore-based tax and financial criminal activity; and (4) deter abuse  within tax-exempt and governmental entities and misuse of such entities  by third parties for tax avoidance or other unintended purposes. To  achieve these objectives, IRS has 15 strategies, such as “re-examine and  adjust audit processes to target likely areas of noncompliance.”
In addition to these goals, IRS’s service and enforcement efforts outlined  in its strategic plan are also intended to support tax gap reduction. IRS’s  strategic plan mentions over 60 service and enforcement efforts targeted  at improving taxpayer compliance. Because the plan did not prioritize  these efforts, we asked IRS officials to identify the key efforts in reducing  the tax gap. In response, IRS provided over 40 key efforts. Enforcement  efforts included pursuing high income nonfilers (taxpayers with income  over $100,000 who have not filed a tax return) through direct enforcement  actions and identifying higher priority collection cases through analytical  models. Service, or nonenforcement, efforts included a taxpayer education  program on tip reporting. (See app. III for a summary of the key efforts  provided.)
section_title: IRS’s Tax Gap Reduction Approach Does Not Establish Long-term, Quantitative Compliance Goals or Regular Data Collection to Measure Progress
paragraphs: IRS has developed a strategic planning and budgeting process to help the  agency comply with GPRA requirements. However, IRS’s strategies for  improving compliance generally lack a clear focus on long-term,  quantitative goals and results measurement. IRS has established broad  qualitative goals and strategies for improving taxpayer service and  enhancing enforcement of the tax laws. IRS has also identified measures,  such as compliance rates for tax reporting, filing, and payment as well as  the percentage of Americans who think it is acceptable to cheat on their  taxes, which are intended to gauge the progress of its strategies toward  its broad goals. However, IRS does not collect recent data to update all of  these compliance measures and has not established quantitative goals  against which to compare the measures and judge any progress made  through its compliance strategies.
Although IRS has not focused on quantitative, results-oriented goals for  improving voluntary compliance, IRS has established many output-related  goals and measures that track activity level, such as the number of  taxpayers contacted, collection cases closed, or returns examined. In  contrast, IRS has fewer outcome-related goals and measures that track  results, such as refund timeliness or examination quality.
In the past, IRS had set a long-term goal of improving overall compliance  to 90 percent by 2001. This goal was to be achieved through a research  approach rooted in IRS’s Compliance 2000 philosophy. The Compliance  2000 philosophy envisioned using nonenforcement efforts to correct  unintentional noncompliance and reserving enforcement efforts for  intentional noncompliance. To carry out this philosophy, in the early  1990s, IRS initiated many research projects across IRS’s 63 district offices  to identify noncompliant market segments, root causes for the  noncompliance, and innovative ways to improve compliance. However,  the lack of objective compliance data, among other factors, limited the  success of this approach. Recently, external stakeholders, such as the IRS  Oversight Board, have supported the concept of setting a numeric, long- term goal for increasing the voluntary compliance rate.
In response to a President’s Management Agenda initiative to better  integrate budget and performance information, IRS officials said that they  are considering various long-term goals for the agency. IRS has not yet set  a time frame for publicly releasing the goals. Nor have IRS officials  indicated whether any goals will be related to improving taxpayer  compliance or whether they will be quantitative and results-oriented.
section_title: Long-term, Quantitative Compliance Goals and Measures Are Beneficial and Consistent with Results-Oriented Management Principles
paragraphs: Focusing on outcome-oriented goals and establishing measures to assess  the actual results, effects, or impact of a program or activity compared to  its intended purpose can help agencies improve performance and  stakeholders determine whether programs have produced desired results.  As such, long-term, quantitative compliance goals offer several benefits for  IRS, as discussed below.
Perhaps most important, compliance goals coupled with periodic  measurements of compliance levels would provide IRS with a better basis  for determining to what extent its various service and enforcement efforts  contribute to compliance. Additionally, long-term, quantitative goals may  help IRS consider new strategies to improve compliance, especially since  these strategies could take several years to implement. For example, IRS’s  progress toward the goal of having 80 percent of all individual tax returns  electronically filed by 2007 has required enhancement of its technology,  development of software to support electronic filing, education of  taxpayers and practitioners, and other steps that could not be completed  in a short time frame. Focusing on intended results can also promote  strategic and disciplined management decisions that are more likely to be  effective because managers who use fact-based performance analysis are  better able to target areas most in need of improvement and select  appropriate interventions. Likewise, agency accountability can be  enhanced when both agency management and external stakeholders such  as Congress can assess an agency’s progress toward meeting its goals.  Finally, setting long-term, quantitative goals would be consistent with  results-oriented management principles that are associated with high- performing organizations and incorporated into the statutory management  framework Congress has adopted through GPRA.
section_title: Updated Compliance Data Provide Opportunities for IRS to Establish a More Results-Oriented Tax Gap Reduction Approach
paragraphs: Not unlike other agencies we have reported on in the past, IRS faces  challenges in implementing a results-oriented management approach, such  as identifying and collecting the necessary data to make informed  judgments about what goals to set and to subsequently measure its  progress in reaching its goals. However, having completed the NRP review  of income underreporting by individuals, IRS now has an improved  foundation for setting goals for improving taxpayers’ compliance.
IRS’s effort to address noncompliance with the EITC provides an example  of how a more data-driven planning approach can help IRS become more  results-oriented over time. IRS’s most recent EITC compliance study  estimated that between $8.5 billion and $9.9 billion, or between 27 percent  and 32 percent, respectively, of the EITC claims filed for tax year 1999  should not have been paid. Following the release of this study, a task force  of IRS and Treasury officials determined the three leading types of errors  that accounted for about $7 billion annually in overclaims. On the basis of  compliance data and other research, IRS started an initiative to improve  service, fairness, and compliance and designed specific corrective actions  targeting the three types of errors. IRS is evaluating these actions to  determine their effectiveness at reducing the overclaim rate in each of the  three errors. Because IRS targeted its EITC effort based on data on the  sources and extent of taxpayer errors, it was better able to determine what  actions to take and how well, using systematic data collection and  program evaluation, the effort is meeting its intended purpose.
Measuring progress toward any goals that may be set could be challenging.  For example, IRS researchers have found it difficult to determine the  extent to which its enforcement actions deter noncompliance or its  services improve compliance among taxpayers who want to comply.  Although widespread agreement exists that IRS enforcement programs  generally increase voluntary tax compliance, challenges such as collecting  reliable compliance data, developing reasonable assumptions about  taxpayer behavior, and accounting for factors outside of IRS’s actions that  can affect taxpayer compliance, such as changes in tax law, make it  difficult to estimate the effect of IRS’s enforcement and service activities.  Even if IRS is unable to empirically estimate the extent to which its  actions directly affected compliance rates, periodic measurements of  compliance levels can indicate the extent to which compliance is  improving or declining and provide a basis for reexamining existing  programs and triggering corrective actions if necessary.
Recently, several research studies have offered insights to better  understand the direct tax revenue effects of IRS’s activities as well as the  indirect effects on voluntary tax compliance. IRS researchers have  hypothesized that the indirect effect of an examination varies among  taxpayer segments. Further, a recent study concluded that criminal  investigations have positive direct and indirect tax effects. Although these  studies generally indicate that IRS activities have positive tax effects, the  magnitude of these effects is not yet known with a high level of confidence  given compliance measurement challenges, as mentioned earlier.  According to IRS, these studies serve as a valuable baseline for further  research, but it has not yet determined how it will use these studies to  make operational decisions.
section_title: Conclusions
paragraphs: As discussed in our recent testimony on the tax gap before the Senate  Committee on Finance, and underscored by IRS, periodic tax compliance  measurement is critically important to IRS’s ability to estimate the tax gap  and design compliance programs intended to reduce the tax gap. Without  current, reliable compliance data, it can be difficult for IRS to monitor  trends or identify new types of noncompliance, determine its compliance  resource needs and how to allocate such resources, and justify budget and  staffing requests to policy makers in Congress and the executive branch.  Consequently, completion of NRP, which covered the largest portion of  the tax gap and was designed and implemented with an eye to reducing  the costs and burdens of data collection, is a substantial achievement.  However, although IRS has recently proposed a schedule for future NRP  studies, it has no approved plans to repeat this study or periodically  measure compliance across the various components of the tax gap. Doing  periodic compliance studies in areas that have previously been measured,  such as individual income tax underreporting, would provide valuable  information to support a more data-driven and risk-based approach  towards improving compliance and reducing the tax gap. Although it may  not be feasible or necessary to measure compliance for all components of  the tax gap at the same frequency or with the same level of investment,  where practical methodologies exist, periodic measurements should be  taken. Where practical methodologies do not yet exist, such as for excise  tax or for large corporations, looking for ways to overcome challenging  compliance measurement difficulties would be worthwhile.
The tax gap is both a measure of the burden and frustration of taxpayers  who want to comply but are tripped by tax code complexity and of willful  tax cheating by a minority who do not wish to pay their fair share to  support government programs. As such, collecting data on the reasons  why noncompliance occurs can help IRS more effectively tailor its efforts  to improve compliance. It can be difficult for IRS examiners to  consistently determine the reasons why taxpayers have failed to comply  with the tax laws. However, IRS has no specific plans to address this issue  and, as a result, is missing opportunities to gather better data than it  already collects. Certain immediate steps, like improving reason codes,  better training examiners in applying the codes, and possibly reducing the  number of examiners who would be responsible for making judgments on  the reasons taxpayers are noncompliant may improve the data IRS  currently collects. Nevertheless, given the difficulty of consistently  determining why taxpayers are noncompliant, sustained research on these  reasons also would be needed to develop a better understanding.
Reducing the tax gap will be a challenging task given persistent levels of  noncompliance and will not likely be achieved through a single solution.  Rather, the tax gap must be attacked on multiple fronts and with multiple  strategies over a sustained period of time. Without long-term, quantitative  voluntary compliance goals and related performance measures, it will be  more difficult for IRS to determine the success of its strategies, adjust its  approach when necessary, and remain focused on results, especially since  factors that affect compliance change over time. Having compliance goals,  coupled with recently collected NRP data, would provide a solid base  upon which IRS can develop a more strategic, results-oriented approach to  reducing the tax gap.
Taken together, these steps—periodically measuring compliance,  determining the reason taxpayers are noncompliant, and setting results- oriented long-term goals—can help IRS build a foundation to understand  how its taxpayer service and enforcement efforts affect compliance,  improve its efforts, and make progress on reducing the tax gap.
section_title: Recommendations for Executive Action
paragraphs: To establish a stronger foundation for improving IRS’s efforts to reduce  the tax gap, the Commissioner of Internal Revenue should do the  following.
Develop plans to periodically measure tax compliance for areas that have  been previously measured, such as for individual income tax  underreporting, and study ways to cost effectively measure compliance for  other components of the tax gap that have not been measured, such as for  excise tax and large corporations. Those plans and that study should take  into account risk management factors such as the amount the component  contributes to the gap, changes that may have affected compliance levels  since a measurement was last taken, and the cost of measuring  compliance.
Take steps to ensure that IRS regularly collects complete, accurate, and  consistent data, to the extent possible, on the reasons taxpayers are  noncompliant and that sufficient broader research is undertaken to  continue learning about the reasons why noncompliance occurs.
Establish a long-term, quantitative voluntary compliance goal for  individual income tax underreporting and for tax underpayment, as well as  for other areas of noncompliance as data become available.
section_title: Agency Comments and Our Evaluation
paragraphs: The Commissioner of Internal Revenue provided written comments on a  draft of this report in a letter dated July 6, 2005, which is reprinted in  appendix IV. In the letter, the Commissioner agreed with our  recommendations. In response to the recommendation that IRS develop  plans to periodically measure tax compliance, the Commissioner  recognized the need for and value of developing and regularly updating  compliance measures for various taxpayer populations and said that IRS  will continue to consult with stakeholders to develop and refine its  compliance measurement plans. In response to our recommendation that  IRS take steps to regularly collect complete, accurate, and consistent data  on the reasons for noncompliance, the Commissioner agreed that a better  understanding of taxpayer noncompliant behavior would be useful in  shaping strategic priorities and defining efforts to improve compliance. He  further said that the operating divisions will continue to partner with the  IRS research community to identify and better understand specific reasons  for noncompliance and that IRS will ensure that auditors are trained to  properly apply reason codes in the new report-writing system IRS is  developing. In response to the recommendation that IRS develop long- term quantitative compliance goals, the Commissioner agreed with the  concept of developing such goals and discussed factors that make goal- setting challenging. We appreciate IRS’s current actions related to our  recommendations and recognize the challenges involved in balancing a  number of complex issues related to obtaining and using tax compliance  data.
As agreed with your offices, unless you publicly announce its contents  earlier, we plan no further distribution of this report until 30 days from its  issue date. At that time, we will send copies to the Chairman and Ranking  Minority Member, House Committee on Ways and Means; the Secretary of  the Treasury; the Commissioner of Internal Revenue; the Director, Office  of Management and Budget; and other interested parties. We will make  copies available to others on request. In addition, the report will be  available at no charge on the GAO Web site at http://www.gao.gov/.
If you or your staff have any questions, please contact me at (202) 512-9110  or brostekm@gao.gov. Contact points for our Offices of Congressional  Relations and Public Affairs may be found on the last page of this report.  Key contributors to this report are listed in appendix V.
section_title: Appendix I: IRS Compliance Measurement Surveys
paragraphs: The following table summarizes the Internal Revenue Service’s (IRS)  efforts to measure voluntary compliance using TCMP surveys and the  National Research Program (NRP) survey of individual income tax returns  for tax year 2001. Years provided for individual income tax surveys refer to  tax years. Years provided for surveys for all other types of tax refer to  return processing years.
section_title: Appendix II: Detailed Tax Gap Estimates, Data Sources, and Level of Certainty
paragraphs: The following table shows estimates for the various portions of the  preliminary 2001 tax gap, the sources, including the age, of the data the  Internal Revenue Service (IRS) used for these estimates, IRS’s level of  certainty for each estimate, and areas for which IRS could not develop an  estimate because of insufficient data.
section_title: Appendix III: IRS Key Efforts to Reduce the Tax Gap
paragraphs: The Internal Revenue Service’s (IRS) strategic plan outlines, but does not  prioritize, service and enforcement efforts to improve compliance.  Therefore, we asked IRS officials to identify IRS’s key efforts to reduce the  tax gap. IRS’s divisions provided lists that totaled 47 efforts, which are  described in the following examples.
The Small Business/Self-Employed Division identified 15 efforts such as  models to identify higher priority collection cases to pursue, a computer  matching program to identify underreported income, initiatives on high  income nonfilers, attempts to improve tip income reporting, and efforts to  identify abusive tax avoidance transactions.
The Wage and Investment Division identified 7 efforts including various  initiatives on tax collection, Earned Income Tax Credit, and using private  contractors to collect certain types of tax debts.
The Large and Mid-Sized Business Division identified 5 efforts such as  identifying compliance risks, starting examinations sooner and doing them  faster, and improving the treatment of abusive tax avoidance transactions.
The Tax Exempt and Government Entities Division identified 8 efforts  including abusive tax avoidance transactions in employee plans, abuses in  tax-exempt bond financing, pension plan noncompliance, and abuses by  credit counseling organizations.
The Criminal Investigation Division identified 12 efforts including those  involving questionable refunds, nonfilers, employment tax evasion,  corporation fraud, and offshore abusive tax schemes.
section_title: Appendix IV: Comments from the Internal Revenue Service
section_title: Appendix V: GAO Contact and Staff Acknowledgments
subsections: section_title: GAO Contact
section_title: Acknowledgments
paragraphs: In addition to the contact named above, Jeff Arkin, Ralph Block, Elizabeth  Curda, Elizabeth Fan, Evan Gilman, Shannon Groff, George Guttman,  Michael Rose, Sam Scrutchins, and Tom Short made key contributions to     ithis report.