Tax Administration: Electronic Filing's Past and Future Impact on Processing Costs Dependent on Several Factors
Published: 2002-01-10T00:00:00

Fast Facts:

Highlights:
section_title: What GAO Found
paragraphs: From fiscal years 1997 through 2000, the number of individual and business tax returns filed electronically increased from 23 million to 41 million. During the same period, the Internal Revenue Service's (IRS) expenditures for submission processing grew from $795 million to $924 million, an increase of 16 percent. Because it costs less to process an electronic return than a paper return, a growth in processing costs seemed improbable. Interviews with IRS officials and an analysis of relevant documentation identified several factors that limited the impact of electronic filing. Specifically, (1) the overall number of individual and business tax returns filed increased, and the resources needed to process that increase partially offset the resources saved by processing more electronic returns; (2) the number of the most costly to process individual income tax returns filed on paper essentially stayed the same; and (3) the number of individual income tax returns filed on paper and received during the peak filing period stayed relatively the same, and peak processing needs drive the resources needed to process individual paper returns. Although electronic filing increased, so did the demands placed on paper processing staff. In particular, (1) processing changes increased the workload for units responsible for reviewing returns for completeness and coding them for entry data, and correcting errors; (2) because most electronic filers still sent a paper signature document to IRS, the work done by paper processing staff was not entirely eliminated when taxpayers filed electronically; and (3) front-line paper processing staff spent increasing amounts of time on activities, including training, not specifically related to processing returns. Future reductions in processing costs as a result of electronic filing are possible.

section_title: Letter
paragraphs: From fiscal years 1997 through 2000, the number of individual and business tax returns filed electronically increased from almost 23 million to almost 41 million. At the same time, the Internal Revenue Service’s (IRS) actual expenditures for submission processing (which includes funds for processing returns filed on paper and electronically) grew from about $795 million in 1997 to about $924 million in 2000, an increase of 16 percent, or 11 percent in inflation-adjusted dollars. Because it costs less, on average, to process an electronic return compared with a paper return, a growth in processing costs at the same time electronic filing is growing seems contradictory.
At your request and as agreed with your office, this report addresses (1) the factors, if any, that limited the impact of electronic filing on the amount of resources (both dollars and staff years) devoted to processing returns and (2) the prospects for future reductions in processing costs as a result of electronic filing.
subsections: section_title: Background
paragraphs: IRS has 10 submission processing centers located throughout the country  that are responsible for processing paper returns, 5 of which also process  electronic returns. Electronic returns are relatively easy to process, while  the processing of paper returns involves several additional steps, as shown  in figure 1.
The fewer steps involved in processing electronic returns rather than  paper returns relate to a cost avoidance experienced by the IRS. In  response to a question raised by the House Appropriations Committee in  2001, IRS estimated that 50 million individual income tax returns would be  filed electronically in fiscal year 2002. IRS estimated that it would need  3,150 more full-time equivalent staff years if none of those returns were  filed electronically. At IRS’ estimate of $36,300 per staff year, that would  be a cost avoidance of $114.3 million. Therefore, if no returns were filed  electronically and using IRS’ estimates, which we did not verify, IRS’ fiscal  year 2002 budget request of $615 million for submission processing would  have increased to about $729 million. The major focus of our review was  on factors that worked against an even greater reduction in submission  processing costs.
section_title: Scope and Methodology
paragraphs: To address our objectives, we interviewed IRS National Office officials  and officials at 2 of the 10 submission processing centers—Atlanta and  Cincinnati—to obtain their opinions about any factors that limited the  impact of electronic filing on the amount of resources devoted to  processing returns from fiscal years 1997 through 2000. We reviewed IRS  documents and GAO reports that contained information related to these  factors. We analyzed a report prepared for IRS by the consulting firm of  Booz-Allen & Hamilton about future prospects for cost reductions in  submission processing and obtained IRS officials’ opinions on that subject.  We performed our work between January and October 2001 in accordance  with generally accepted government auditing standards.  We discuss our  scope and methodology in greater detail in appendix I.
section_title: Several Factors Limited the Impact of Electronic Filing on the Resources Devoted to Processing Returns
paragraphs: Several factors limited the impact of electronic filing on the resources  devoted to processing returns from fiscal years 1997 through 2000. These  factors fell into two broad categories—filing trends that partially offset the  potential savings from increases in electronic filing and expanded  demands on paper processing staff.
subsections: section_title: Potential Savings From Increase in Electronic Filing Partially Offset by Other Filing Trends
paragraphs: Even though the number of electronic returns filed from 1997 though 2000  increased, the potential savings from that increase were partially offset by  the following filing trends:
The increase in electronically filed returns was partially offset by an  increase in total returns filed.
The number of the most complex individual income tax returns filed on  paper—standard Form 1040s—essentially stayed the same.
The number of paper individual income tax returns received by IRS during  the peak filing period stayed relatively the same from 1997 through 2000,  and peak processing needs drive the resources needed to process  individual paper returns.
section_title: Increase in Electronically Filed Returns Partially Offset by Increase in Total Returns Filed
paragraphs: About 17.9 million more individual and business tax returns were filed  electronically in 2000 than in 1997. However, as shown in table 1, because  of an overall increase in the total number of returns filed from 1997  through 2000, the net decline in paper returns over that period was much  less than the 17.9 million net increase in electronic filings. Thus, the  increase in electronic returns had less of an impact on processing costs  than might have been expected because any savings from that increase  would be partially offset by the costs to process the overall increase in  returns filed.
section_title: Number of Most Complex Paper Returns Essentially Stayed the Same
paragraphs: From 1997 through 2000, the number of complex individual returns filed  on paper essentially remained the same. The complexity of a return varies  according to the form on which it is filed. Complexity is determined by the  number of lines of data that need to be entered on a form. According to  IRS submission processing officials, the standard Form 1040 is the most  complex. Complexity then decreases from the Form 1040 to the Form  1040A, and finally to the Form 1040EZ. The more complex a return, the  longer it takes to process and the greater the processing costs. For  example, according to data developed for IRS by a consulting firm for  fiscal year 1999, the average direct labor cost to process a Form 1040 filed  on paper was $1.93 compared to $1.50 to process a paper 1040A and $1.01  to process a paper 1040EZ.
As shown in table 2, the number of Form 1040s filed on paper only  decreased by about 1 percent from 1997 through 2000, with the only  decrease occurring between 1999 and 2000. The reductions in paper  1040As and 1040EZs were much larger during the years covered by our  study—15 and 23 percent, respectively.
Any reductions in processing costs that IRS may have been able to realize  as more taxpayers filed electronically depended, in great part, on the cost  of processing those same returns filed on paper. IRS would have been able  to reduce costs more if a greater number of taxpayers who were filing the  more complex (and thus more costly to process) returns on paper had  started filing electronically.
section_title: Volume of Returns Received During Peak Filing Period Drives Resource Needs; Peak Volume Stayed About the Same From 1997 Through 2000
paragraphs: Another filing trend that limited the impact of electronic filing on  processing costs was the increase in the number of paper returns filed by  individuals during the peak filing period—the 2 weeks of the year when  the most individual income tax returns are filed. The peak filing period for  paper returns filed by individuals is mid-April. Business returns do not  experience the same peak phenomenon. Businesses have various fiscal  years, which affect their filing period. In addition, many business returns  must be filed quarterly.
As shown in table 3, while the overall number of individual returns filed on  paper decreased from 1997 through 2000, the number of paper returnsfiled during the peak period stayed relatively the same.
The number of paper individual returns received during the peak filing  period drives the amount of resources needed to process individual paper  returns. According to the Director of Submission Processing, when  Submission Processing determines its resource needs, the first priority is  the resources (including staff, equipment, and space) needed during the  peak period. The Director added that, all things considered, if the number  of individual paper returns received during the peak period increases  while the total number of paper returns received during the entire year  decreases, the increase during the peak period would have more of an  impact on submission processing resources than would the overall  decrease in paper receipts.
IRS’ goal of improving business results also directly affects the resources  needed during the peak filing period. To help achieve this goal, in 2000, 85  percent of refund checks for paper returns were to be processed within 40  days. Doing so also contributes to IRS’ goal of improving taxpayer  satisfaction. Thus, to meet these goals, IRS has to ensure that there are  enough resources to process the increased number of peak period returns  within this time frame.
section_title: Demands Placed on Paper Processing Staff Were Expanded
paragraphs: Another factor that limited the impact of electronic filing on the resources  devoted to paper processing was the increase in demands placed on paper  processing staff from 1997 through 2000. These increased demands  included the following:
Numerous processing changes increased the workload for units  responsible for (a) reviewing returns for completeness and coding them  for data entry, (b) transcribing data, and (c) correcting errors.
Because most electronic filers submitted a paper signature document, the  work done by paper processing staff was not totally eliminated when  taxpayers filed electronically and the volume of that work increased as  electronic filing increased.
Front-line employees spent increasing amounts of time on activities,  including training, not specifically related to processing returns.
subsections: section_title: Paper Processing Staff’s Workload Increased
paragraphs: Numerous changes were made in the processing of returns from 1997  through 2000, which according to IRS officials, resulted in an increased  workload. For paper processing staff, these changes generally increased  the amount of time spent reviewing returns and coding them for data entry, number of keystrokes entered, and number of IRS and taxpayer errors to be corrected.
Table 4 illustrates the estimated effects of some of these changes  according to IRS’ data.
Some processing changes, such as the validation of secondary Social  Security numbers, were made to help ensure compliance with the tax law.  Other changes stemmed from changes in the tax law that established new  credits and deductions for which IRS had to enter data into its computer  system.
Although the numbers of additional seconds and keystrokes cited in table  4 for any one change are small, the overall effect of these processing  changes, considering the number of returns involved, is to increase the  number of staff years needed to process returns. For example, the  additional second needed to review and code 41.6 million returns for  secondary Social Security number validation equates to about 11,556  hours or (on the basis of 2,088 hours per staff year) 5.5 staff years.  Similarly, a total of about 584.5 million additional keystrokes would have  had to be made to process the four changes in table 4, which, we roughly  estimated using IRS data on average keystrokes per hour, would consume  at least 78,000 additional hours or 37.4 staff years at a cost of almost $1.4  million.Although these changes in workload may not be of great  magnitude, they required additional resources that offset some of the  potential savings from electronic filing.
The workload of error correction staff can also be affected by changes in  the accuracy of work done by other processing staff. In that regard, the  accuracy of staff who reviewed and coded tax returns for transcription  increased from 95 percent in 1997 to 96.6 percent in 2000, while the  accuracy of data transcribers decreased from 94.7 percent to 93.9 percent.  We do not know how much, if at all, the volume of error correction work  actually changed as a net result of these increases and decreases in  accuracy.
The increase in responsibilities can also affect the staff’s productivity.  Using IRS information on average keystrokes per hour for various tax  forms as a measure of data transcribers’ productivity, table 5 shows that  there was a general decline in productivity in 1999, which is when  transcribers began using a new computer system, and a general  improvement in productivity in 2000. For example, IRS data for Other- Than-Full-Paid Form 1040s showed that the average keystrokes per hour  went from 7,503 in 1997 to 7,250 in 1998 and 6,802 in 1999 before rising to  7,108 in 2000.
Submission Processing officials said that many factors affected accuracy  and productivity and that it would be difficult to determine specifically  what caused them to decrease. However, they believed that the learning  curve associated with using a new computer system in 1999 was probably  the major contributing factor to the decrease in data transcribers’  productivity. They added that there has been high turnover in the  Submission Processing Centers for the past few years due to the  availability of higher paying jobs elsewhere within IRS or in the private  sector. As a result, they have less experienced staff, which may have  contributed to lower accuracy and productivity rates.
section_title: Work Done by Paper Processing Staff Not Totally Eliminated by Electronic Filing
paragraphs: During the years covered by our study, electronic filing was not entirely  paperless. Most electronic filers continued to submit a paper signature  document, even though in 1999, IRS began testing electronic options to  replace the document. Thus, any savings IRS realized when taxpayers  switched to electronic filing were partially offset by the costs incurred in  processing the increase in the volume of paper signature documents that  resulted from the increase in electronic filing.
Before 1999, individual taxpayers who filed electronically had to submit a  paper signature document that was processed by the staff who processed  paper returns. Beginning in 1999, IRS provided two options that could be  used in place of submitting a paper signature document. In 2000, about  6.8 million (or about 19 percent) of the 35.4 million taxpayers who filed  their individual income tax returns electronically used one of those  options. However, that meant that IRS still had to process about 28.6  million paper signature documents. According to a March 2000 study  prepared for IRS by a consulting firm, it cost IRS $0.26 in direct labor costs  to process each paper signature document in 1999. Assuming that same  rate in 2000, it would have cost IRS about $7.4 million in labor costs to  process the 28.6 million signature documents.
section_title: Increased Time Spent by Front- Line Employees on Nonprocessing Activities
paragraphs: Front-line paper processing employees spent greater amounts of their time  on activities not specifically related to processing returns in fiscal year  2000 than they did in 1997. The Submission Processing Director and the  Processing Division Branch Chiefs at the Atlanta and Cincinnati  Submission Processing Centers said that personnel were spending more  time (1) in required training not related to processing returns and (2) on  required activities related to the Employee Satisfaction Survey. Some of  the required training, such as training about the circumstances under  which IRS employees can be charged with misconduct and terminated,  was provided in order to apprise staff of new statutory requirements. IRS  plans to use results from the Employee Satisfaction Survey to improve  operations. According to the Branch Chiefs, these activities, while  important, reduced the amount of time that employees were able to devote  to processing returns.
According to data in IRS’ Work, Planning, and Control System, the amount  of time paper processing staff spent on all training, including training  related to processing returns, and on actions related to the Employee  Satisfaction Survey increased from fiscal years 1997 through 2000. The  percentage of time spent on these activities grew from 7.8 percent to 9.9  percent. Because IRS records did not separately identify all training  related to processing and nonprocessing activities, it was not possible to  determine the change in the amount of time spent in nonprocessing­ related training. Data in the Work, Planning, and Control System also  showed that the number of hours submission processing staff spent on  activities related to the Employee Satisfaction Survey increased from  about 12,000 in fiscal year 1997 to almost 96,000 in fiscal year 2000.
According to the Submission Processing Director, finding the time to  spend on nonprocessing related training and the Employee Satisfaction  Survey, both of which were required, was more difficult for Submission  Processing than other units in IRS. This was because some units could  absorb these activities by doing less direct work, such as opening fewer  collection cases. Submission Processing, on the other hand, could not  process fewer returns, so any additional required activities meant working  more overtime, keeping seasonal employees longer, or hiring more  employees than originally planned, resulting in an increase in costs. The  Director added that the Employee Satisfaction Survey was completed  during the peak filing period to help ensure that IRS obtained the views of  seasonal staff.
section_title: Future Cost Reductions Hinge on Increases in Electronic Filing and Changes in Processing Operations
paragraphs: According to a report prepared for IRS by a national consulting firm,  future reductions in processing costs are possible, with the amount of any  reduction dependent on the nature and extent of future increases in the  number of returns filed electronically and changes in submission  processing’s operations. Whether these reductions are realized will depend  not only on the actual number of returns filed electronically and the extent  to which different operational changes are implemented, but also on the  extent of any changes in the workload of paper processing staff due to tax  law changes or increased IRS compliance efforts.
subsections: section_title: Consulting Firm’s Estimates of Potential Processing Cost Reductions
paragraphs: In a March 2000 report prepared for IRS, the national consulting firm of  Booz-Allen & Hamilton analyzed how various scenarios might affect IRS’  processing costs starting in 2007. The firm developed eight scenarios that  involved a growth in volume of returns and a growth in electronic filing of  individual, business, and other types of forms, as well as several  operational changes, such as making additional business forms available  for electronic filing and consolidating submission processing centers. The  firm also developed four cost-reduction estimates for each scenario based  on differing percentages of electronic filing for individual, business, and  other returns. Those cost-reduction estimates ranged from $27 million to  $243 million. Figure 2 shows that the firm’s estimates when using the  highest electronic filing projections—80 percent for individual returns,  45 percent for business returns, and 30 percent for other returns—ranged  from $104 million to $243 million.
80 percent of individual returns filed electronically. 45 percent of business returns filed electronically. 30 percent of supplemental and information returns filed electronically.
Eliminate scanning and filing by telephone.
The estimates in figure 2 assume that IRS will meet its goal of having  80 percent of all individual income tax returns filed electronically by 2007.  However, our assessment of IRS’ 2001 tax filing season in response to  another request from this Subcommittee showed that (1) about 31 percent  of individual income tax returns were filed electronically in 2001 (through  October 26, 2001) and (2) fewer individuals filed electronically in 2001  than IRS had projected (40 million filed vs. 42 million projected). With  2001 as a starting point and assuming that the total number of individual  income tax returns filed and the number of such returns filed  electronically each continue to grow at the same annual rate as achieved  between 2000 and 2001 (1.85 percent and 13.7 percent, respectively), we  projected that only about 60 percent of individual income tax returns  would be filed electronically in 2007. Using the estimates in the  consultant’s March 2000 report for a 65-percent level of individual  electronic filing, the cost reductions would range from $74 million to  $170 million annually in 2007, or about 30 percent less than at the 80- percent electronic filing level for individuals.
section_title: Certain Factors Could Alter the Consultant’s Projections
paragraphs: The consultant’s report focused on reductions that could be realized by  making specific changes related to processing returns and not on potential  increases in the type and amount of data on paper returns that IRS would  need to process due to tax law changes or enhanced compliance efforts.Consequently, any reductions in overall processing costs would depend on  the level of any such increases.
In that regard, IRS made at least one significant change in submission  processing’s workload in 2001 that increased costs. IRS’ 2001 budget  included 378 additional full-time equivalent staff years in submission  processing for transcribing Schedule K-1s (Beneficiary’s, Partner’s, or  Shareholder’s Share of Income, Deductions, Credits, etc.). IRS plans to  compare the transcribed K-1 information to that reported on the tax  returns filed by beneficiaries, partners, and shareholders to determine if  income was accurately reported.
The Director of Submission Processing told us that the cost reductions in  the consultant’s study may also be overstated because the study did not  consider the resources needed to process returns during the peak filing  period. The consulting firm official responsible for developing the data in  the study said that the maximum cost reductions included in the study  would not be affected by peak filing period resource needs, because the  reductions were based on the assumption that 80 percent of individual  taxpayers would file electronically. To achieve that level of electronic  filing, the number of returns filed on paper would have to decrease  significantly from the fiscal year 2000 levels previously described in this  report. Once this happens, fewer resources would be needed to process  paper returns during the peak filing period. The official added that at some  lower percentage of electronic filing, peak period filing needs would affect  possible cost reductions, but he did not know what that level would be.
section_title: Agency Comments and Our Evaluation
paragraphs: The Commissioner of Internal Revenue provided written comments on a  draft of this report in a December 17, 2001, letter which is reprinted in  appendix II.  The Commissioner said that our report provided useful  explanations for the continued increase in submission processing costs,  despite the increase in the number of electronically filed returns.  At his  suggestion, we revised the report to clarify the objective of the March 2000  consultant’s study.
The Commissioner also suggested that we revise the report to  acknowledge the steps IRS has taken to reduce the processing costs  associated with electronic filing, specifically with respect to the paper  signature document.  Our report recognizes the steps IRS has taken to  enable electronic filers to sign their returns electronically.  However, most  electronic returns were still filed with paper signature documents.  Of the  about 40 million returns filed electronically in 2001, about 9 million were  filed using an electronic signature.  The other about 31 million returns  were filed using a paper signature document—an increase of about  2.4 million returns compared to 2000.  Using the direct labor cost included  in the March 2000 consultant’s study for processing paper signature  documents--$0.26 per document—it cost IRS about $624,000 more in 2001  than in 2000 to process these documents.
As agreed with your office, unless you publicly announce its contents  earlier, we plan no further distribution of this report until 30 days from the  date of this report.  At that time, we will send copies of this report to the  Chairmen and Ranking Minority Members of the Senate Committee on  Finance and the House Committee on Ways and Means and to the Ranking  Minority Member of this Subcommittee. We are also sending copies to the  Secretary of the Treasury; the Commissioner of Internal Revenue; the  Director, Office of Management and Budget; and other interested parties.  We will also make copies available to others on request.
This report was prepared under the direction of David J. Attianese,  Assistant Director. If you have any questions about this report, please  contact me or Mr. Attianese on (202) 512-9110. Key contributors to this  report were Julie Schneiberg, Margaret Skiba, and Shellee Soliday.
section_title: Appendix I: Objectives, Scope, and Methodology
paragraphs: Our first objective was to determine what factors, if any, limited the  impact of electronic filing on the resources devoted to processing paper  returns. To address this objective, we interviewed several Internal  Revenue Service (IRS) officials responsible for submission processing and  electronic tax administration. We also visited 2 of IRS’ 10 submission  processing centers, including 1 that had an electronic filing unit—  Cincinnati—and 1 that did not have an electronic filing unit—Atlanta. At  both centers, we interviewed the Center Directors and several Processing  and Post Processing Division officials. These divisions have primary  responsibility for processing returns. At Cincinnati, we also interviewed  the Lead Tax Examiner in the Electronic Filing Unit to obtain details about  the Unit’s role in electronic return processing.
We selected Cincinnati from among the five centers that had an electronic  filing unit because Submission Processing’s Monitoring Section was  located there and officials would be able to provide information related to  processing both paper and electronic returns. We selected Atlanta from  among the five centers that did not have an electronic filing unit because it  was convenient to our audit staff. Because these two centers were  judgmentally selected, our results cannot be projected to all 10 centers.  However, the Director of Submission Processing said that the opinions  provided by officials at these two centers would be representative of the  opinions that would be provided by officials at the other eight centers.
To further address the first objective, we analyzed several studies  prepared either by or for IRS, including a consulting firm’s study of the  costs to process electronic returns. We analyzed available IRS statistics  related to several topics, including training, filings by type of return, the  number of keystrokes associated with new data to be entered into the  computer by data transcribers, and average keystrokes per hour. We also  reviewed our past reports to obtain information about the accuracy of  work done by paper processing staff.
Our work on the first objective focused on fiscal years 1997 through 2000.  We selected this 4-year period because (1) at the time we began our  review, fiscal year 2000 was the last complete year for which data were  available and (2) we wanted data for enough years before 2000 to be able  to analyze trends. We decided that a total of 4 years would provide  sufficient trend data. We included fiscal year 2001 data about the peak  filing period and the number of individual returns filed electronically  because it was readily available.
Our second objective was to determine the prospects for future reductions  in submission processing costs. We interviewed the Director of  Submission Processing, reviewed the previously referred to report on  costs to process electronic returns, and interviewed the consulting firm  official who had responsibility for developing the data in the report. This  report presented eight scenarios involving a growth in the volume of  returns filed and a growth in electronic filing and included estimates of the  cost reductions that IRS would realize under each scenario. The scenarios  included different combinations of several variables, including increases in  electronic filing by individual or business taxpayers, elimination of the  paper signature document, and increases in the number of business forms  that can be filed electronically. We also reviewed information that IRS  provided to the House Appropriations Committee in June 2001 on the  number of additional full-time equivalent staff years IRS would need to  process returns if all returns were filed on paper.
We performed our work between January and October 2001 in accordance  with generally accepted government auditing standards. We obtained  written comments from the Commissioner of Internal Revenue on a draft  of this report. The comments are discussed near the end of this report and  are reprinted in appendix II.