Tax Gap: IRS Could Significantly Increase Revenues by Better Targeting Enforcement Resources
Published: 2012-12-05T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: Heightened attention to federal deficits has increased pressure on IRS to reduce the tax gap--the difference between taxes owed and taxes paid on time--and better enforce taxpayer compliance. Resource limitations and concern over taxpayer burden, however, prevent IRS from auditing more than a small fraction of individual income tax returns filed. How IRS allocates these limited resources demands careful consideration.
As requested, this report (1) describes how IRS allocates resources across individual taxpayer compliance enforcement programs and across types of taxpayers within each program; (2) estimates the direct revenue return on investment for the individual taxpayer enforcement programs and the extent of variation across those programs and across types of taxpayers; and (3) determines the potential for gains from shifting resources from lower-yielding programs and types of taxpayers to higher-yielding ones.
To accomplish these objectives GAO analyzed IRS data on 2007 and 2008 tax returns, reviewed IRS documentation, and interviewed appropriate IRS officials.
section_title: What GAO Found
paragraphs: The Internal Revenue Service (IRS) spends most of its enforcement resources on examinations. Correspondence exams of individual tax returns, which target fewer and simpler compliance issues, are significantly less costly on average than the broader and more complex field exams. GAO estimated that the average cost (including overhead) of correspondence exams opened in 2007 and 2008 was $274, compared to an average of $2,278 for field exams. IRS spent almost 20 percent of the $1.6 billion per year that it devoted to exams on returns from taxpayers with positive income of at least $200,000, even though such returns accounted for only 3 percent of the 136 million individual returns filed per year. (Positive income, a measure that IRS uses to classify returns for exam planning purposes, disregards losses that may offset this income).
GAO estimated that, for the 2 years of cases reviewed, correspondence exams were significantly more productive in terms of direct revenue produced per dollar of cost than field exams. Both types of exams of taxpayers with positive incomes of at least $200,000 were significantly more productive than exams of lower-income taxpayers.
GAO demonstrated how these estimates could be used to inform resource allocation decisions. For example, a hypothetical shift of a small share of resources (about $124 million) from exams of tax returns in less productive groups shown in the figure to exams in the more productive groups could have increased direct revenue by $1 billion over the $5.5 billion per year IRS actually collected (as long as the average ratio of direct revenue to cost for each category of returns did not change). These gains would recur annually, relative to the revenue that IRS would collect if it did not change its resource allocation. This particular resource shift would not reduce exam coverage rates significantly and, therefore, should have little, if any, negative effect on voluntary compliance.
section_title: What GAO Recommends
paragraphs: GAO recommends that IRS review disparities in the ratios of direct revenue yield to costs across different enforcement programs and across different groups of cases and consider this evidence as a potential basis for adjusting its allocation of enforcement resources each year. IRS agreed with the recommendations.

section_title: Letter
paragraphs: Heightened attention to federal deficits has increased pressure on the  Internal Revenue Service (IRS) to reduce the tax gap—the difference  between taxes owed and taxes paid on time—and better enforce taxpayer  compliance. Resource limitations and interest in minimizing taxpayer  burden, however, prevent IRS from auditing anything but a small fraction  of the total number of individual income tax returns filed for a given tax  year. Of the approximately 141 million individual tax returns filed in 2010,  only 1.1 percent were formally audited. IRS has developed several  compliance enforcement programs with the goal of increasing taxpayer  compliance, using resources more efficiently, and minimizing taxpayer  burden. These programs, which include computer-based matching  systems and streamlined correspondence audits (which do not involve  face-to-face meetings with taxpayers) designed for less complex issues,  fill different roles in the compliance enforcement strategy. Every year IRS  publishes information regarding the coverage rates and additional taxes  assessed through these various programs, but relatively little information  is available on how much revenue is actually collected as a result of these  enforcement activities (called direct revenue). Even less information is  available regarding program performance with respect to identifiable  subpopulations (varying in terms of income levels, and types of income)  covered by the enforcement programs.
Given the importance of appropriately allocating limited resources, you  asked us to assess the performance of IRS’s enforcement programs. In  this report we (1) describe how IRS allocates resources across individual  taxpayer compliance enforcement programs and across types of  taxpayers within each program; (2) estimate the direct revenue return on  investment for the individual taxpayer compliance enforcement programs  and the extent of variation across those programs and across types of  taxpayers; and (3) determine the potential for gains from shifting  resources from lower-yielding programs and types of taxpayers to higher- yielding ones.
To describe how IRS allocates resources across individual taxpayer  compliance enforcement programs and across types of taxpayers within  each program, we compared the amounts of resources that IRS devotes  to each of four broad enforcement programs for individuals who file form  1040 tax returns—Automated Underreporter (AUR), Automated  Substitute for Return (ASFR), correspondence examination, and field  examination. These programs are described below in the background  section. We also report the cost of cases worked and the percentage of  total returns covered by correspondence and field exam programs. For  the correspondence and field exam programs, we make these  comparisons across the principal groups of individual taxpayers (defined  in terms of positive income size and characteristics of their returns, such  as the presence of the earned income tax credit (EITC)) that IRS uses for  exam planning purposes. We use program cost data obtained from IRS’s  Integrated Financial System (IFS) and data on the number of cases from  IRS’s Enforcement Revenue Information System (ERIS). We also use  data on coverage rates from IRS’s Data Book. Our analyses to support  all three of our objectives cover enforcement cases opened in fiscal years  2007 and 2008 (the latest years of data available at the time of our  analysis in which the large majority of cases have worked their way  through the collection process).
To estimate the direct revenue return on investment for the individual  taxpayer compliance enforcement programs, we obtained data from ERIS  on collections of tax, interest, and penalties directly attributable to specific  types of exams for different groups of taxpayers, as well as those  attributable to AUR and ASFR cases. We also obtained cost data from  IFS for these four programs. For the field exam program, available data  allow us to incorporate differences in the length, difficulty, and location of  audits into our cost comparisons. Our return on investment measure is  computed as the ratio of revenues over costs with the value of the  revenues discounted for any delays between the year in which IRS  expended the money on the enforcement cases and the year in which the  revenues were collected.
To determine the potential for gains from shifting resources from lower- yielding programs and types of taxpayers to higher-yielding ones, we use  our results from the second objective to demonstrate how modest  reallocations of resources would affect total collections, assuming that  additional cases examined in a particular group would be approximately  as productive as the average case in that group. We also interviewed IRS  officials and reviewed the technical literature on tax enforcement to  identify factors beyond the direct revenue return on investment that IRS  should consider when making adjustments to its resource allocations.
We determined for the purposes of this review that the data used were  reliable. (See app. I for additional information about our methodology.)  We conducted this performance audit from November 2009 through  December 2012 in accordance with generally accepted government  auditing standards. Those standards require that we plan and perform the  audit to obtain sufficient, appropriate evidence to provide a reasonable  basis for our findings and conclusions based on our audit objectives. We  believe that the evidence obtained provides a reasonable basis for our  findings and conclusions based on our audit objectives.
subsections: section_title: Background
paragraphs: In January 2012, IRS estimated that the gross tax gap—the difference  between taxes owed and taxes paid on time—was $450 billion in tax year  2006. IRS estimated that it would eventually recover about $65 billion of  this amount through late payments and enforcement actions, leaving a  net tax gap of $385 billion. The tax gap has been a persistent problem in  spite of extensive congressional and IRS efforts to reduce it. In past work  we have said that reducing the tax gap 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. On the  enforcement front, IRS’s efforts to ensure compliance of individual  taxpayers combine several distinct programs that collectively monitor and  correct noncompliance with income tax filing, reporting, and payment  requirements. These programs fill different roles in the enforcement  process and vary in the number of taxpayers covered, the resources  used, and their level of automation.
IRS’s Math Error program electronically checks all filed tax returns for  obvious math errors as returns are processed. The Math Error program  reviews and adjusts items specifically listed in Internal Revenue Code  section 6213. The specific issues that the program has authority to review  include calculation errors, entries that are inconsistent with or exceed  statutory limits, various omissions, inclusions, and entries of information,  or incorrect use of an IRS table.
IRS collects information on taxpayers from employers, financial  institutions, and other third parties and compiles these data in the  Information Returns Processing (IRP) system. The Automated  Underreporter (AUR) program electronically matches the IRP data  against the information that taxpayers report on their forms 1040 as a  means of identifying potentially underreported income or unwarranted  deductions or tax credits. The matching process takes place months after  taxpayers have filed their tax returns. For tax year 2010, AUR identified  approximately 23.8 million potential discrepancies between taxpayer  income, deduction, and other information reported by third parties and the  information supplied by taxpayers on their individual income tax returns.  IRS officials said that resource constraints prevent them from contacting  taxpayers for all of the cases in which discrepancies are identified. If a  mismatch exceeds a certain tax threshold, AUR reviewers decide if it  warrants a notice to the taxpayer asking for an explanation of the  discrepancy or payment of any additional tax assessed. IRS guidance  directs reviewers to consider the reasonableness of the taxpayers’  responses, but reviewers generally do not examine the accuracy of the  information in the responses because they do not have examination  authority. For certain issues, AUR reviewers may refer cases for a  correspondence examination.
The Automated Substitute for Return (ASFR) program uses data from the  IRP system to identify persons who did not file returns, construct tax  returns for certain nonfilers, and assess tax, interest, and penalties based  on those substitute returns. IRS does not pursue all of the constructed  returns. Potential cases fall into one of ten priority levels and are worked  highest-priority first. ASFR officials said they make budget decisions by  taking into account the resources available to the program and determine  the level of new cases that will be worked over the following year. In fiscal  year 2011, the ASFR program closed nearly 1.4 million cases.
Correspondence examinations are formal audits of individual taxpayers  but do not involve face-to-face meetings with taxpayers. Instead, these  examinations target specific issues that are limited in scope and  complexity, easily documented, and can be handled quickly and efficiently  through correspondence between the taxpayer and the IRS examiner.  Tax returns are selected as potential cases through automated business  rules that filter or select tax returns according to predetermined criteria.  These business rules can detect multiple potential issues, all of which can  be worked through a single correspondence exam. Examiners have the  authority to review additional issues on a return even if they were not  identified by the automatic filters.
Field examinations are conducted in face-to-face meetings between the  taxpayer and the IRS examiner. These audits are targeted at individual  returns with broader and more complex issues. Unlike correspondence  examinations, the field examination program has a classification process  where an experienced tax examiner will review a potential case to  determine which, if any, issues should be examined. Individual tax returns  are selected for field examination in a variety of ways. Some returns are  selected in the pursuit of specifically identified compliance issues, such as  abusive transactions or offshore compliance. Others are selected on the  basis of a statistical formula that attempts to predict the potential for  additional tax assessments, and yet others are selected randomly for  research purposes. Regardless of why the return was initially selected for  audit, an examiner will review the return in its entirety to determine if other  issues are present.
The responsibility for operating these individual taxpayer enforcement  programs largely rests with IRS’s Small Business/Self-Employed (SB/SE)  Division, which handles complex individual returns, and Wage and  Investment (W&I) Division, which handles simpler returns. SB/SE  operates parts of all four IRP and exam programs; W&I operates parts of  three programs, excluding field examinations.
section_title: Examinations of Taxpayers with Less than $200,000 in Positive Income Accounted for Most of the Total Cost of the Four Enforcement Programs
subsections: section_title: Most IRS Enforcement Resources are Spent on Examinations
paragraphs: Correspondence and field exams accounted for more than 80 percent of  the total administrative costs of the four programs we reviewed over the  2-year period we examined. (Total costs include direct examination time,  training and other offline activities of examiners, supervisory and  administrative support, and other overhead costs allocable to each  program.) Based on data for hourly costs and time spent on different  types of cases that IRS provided, we estimated that the cost per case for  field exams, $2,278, was many times greater than those for  correspondence exams, $274, AUR, $52, and ASFR, $72. (See fig. 1.)
IRS spent almost 20 percent of the $1.6 billion per year that it devoted to  exams opened in 2007 and 2008 on returns with positive income of at  least $200,000, even though such returns accounted for only 3 percent of  the 136 million individual income tax returns filed per year. The share of  total cost for these returns was greater than their share of total returns  because they were examined at above average rates and, compared to  lower-income returns, field exams were a greater proportion of their  examinations. (See fig. 2.)
section_title: Direct Revenue Return on Investment Was Highest for Examinations of Taxpayers with at Least $200,000 in Positive Income
paragraphs: For the 2 years of cases we reviewed, exams (both correspondence and  field) of taxpayers with positive incomes of at least $200,000 produced  significantly more direct revenue per dollar of cost than exams of lower- income taxpayers. Across income groups, correspondence exams were  significantly more productive than field exams in terms of discounted  direct revenue per dollar of cost. (See fig. 3 and table 1 in app. II.) We  estimated that the average direct revenue yield per dollar of cost across  all correspondence exams of individual taxpayers was $7. In contrast, the  average direct yield per dollar for field exams of individual taxpayers was  $1.8. We also estimated that the direct revenue per dollar of cost was  about $22 for AUR cases and about $31 for ASFR cases.
Exams that are more complicated than average are likely to require both  more time to complete and more highly skilled examiners, who cost more  per hour. In estimating the results for field exams in figure 3, we  incorporated differences in the amount of time spent on each field exam,  which is recorded in the ERIS database, but we did not account for  differences in hourly costs relating to varying skill levels of examiners  across cases because the data available for that purpose were limited.Nevertheless, to test the potential sensitivity of our results to this missing  factor, we estimated an alternative set of field exam results, using an  ERIS data element that reflects the expected difficulty of an exam. We  also tested the effect of differences in locality pay for field examiners in  different geographic locations. (See app. I for further details.) We found  that adjusting for skill levels likely reduces some of the differences in  direct revenue per dollar of cost across field exam categories; adjusting  for location has a negligible effect. (See table 3 in app. II.) IRS would be  able to estimate ratios of direct revenue to cost that better incorporate  differences in the hourly costs across examiners with different skill levels  if data from IRS’s timekeeping system that records the number of hours  that each employee charged to specific exam cases were matched to  revenue data for the same cases.
section_title: Although Some Caution is Warranted, Exam Resource Reallocation Could Produce Significant Direct Revenue Gains
subsections: section_title: Modest Reallocations Might Raise Billions of Dollars in Direct Revenue with Little, If Any, Decline in Voluntary Compliance
paragraphs: Our analysis of a hypothetical reallocation of IRS examination resources  for this 2-year period indicates that a shift of about $124 million in  enforcement resources could have increased direct revenue by $1 billion  over the $5.5 billion per year IRS actually collected. This result is based  on shifting the $124 million from exams of lower-income returns with the  earned income tax credit (EITC) and lower-income business returns  without EITC to exams of higher-income returns and lower-income  nonbusiness returns without EITC. The result holds true as long as the  average ratio of direct revenue to cost for each category of returns  remained unchanged. (See fig. 4.) Similar gains would recur annually,  relative to the revenue that IRS otherwise would collect if it did not  change its resource allocation and taxpayer behavior remained  substantially the same.
We took account of several constraints when designing our hypothetical  resource reallocation example. First, we did not want to suggest a large- scale change because some reallocations cannot be made quickly,  particularly if they require a different distribution of examiner skills than  exists in IRS’s current workforce. The $124 million that we shifted  represents less than 8 percent of the $1.6 billion per year that IRS  devoted to examinations of individual tax returns for the 2 years we  studied and we shifted less than 5 percent of existing field exam  resources ($1.1 billion per year) to correspondence exams. Second, we  did not want to end up with extreme coverage rates (either high or low) in  any return category. Therefore, we did not reduce the combined coverage  rate for any category for which the coverage rate was already close to or  below 1 percent, and we kept the highest coverage rate (for returns with  positive incomes of $1 million or more) under 11 percent.that 11 percent rate is almost twice the current rate for that category.)  Finally, given that certain compliance issues can be reviewed effectively  only through a field exam, we did not decrease field exam resources in  any return category for which we increased correspondence exam  resources.
Exam resource reallocation can also affect tax collections indirectly by  influencing the voluntary compliance of nonexamined taxpayers. These  indirect effects are difficult to estimate and IRS has no empirical evidence  that would allow it to say whether overall voluntary compliance would  increase or decrease as a result of specific resource reallocations.  Changes in exam coverage rates are generally believed to affect  voluntary compliance by altering taxpayers’ perceived risks of being  audited. The higher the risk of being audited, the less inclined taxpayers  are to evade taxes. As shown in figure 5, our hypothetical reallocation  would have increased combined coverage rates in most of the tax return  categories we examined. For those categories in which coverage rates  declined, the declines were relatively modest. For these reasons we  believe that the direct revenue gains associated with our hypothetical  reallocation would not likely be offset by significant indirect revenue  losses. However, if larger resource allocations were considered, the lack  of empirical evidence on the potential changes in voluntary compliance  could leave IRS uncertain of the extent to which direct revenue gains  might be offset by negative indirect revenue effects. Although research on  this issue is challenging, IRS might be able to leverage its existing efforts  to study voluntary compliance through the National Research Program  (NRP) to get better information on the influence of enforcement activity on  voluntary compliance.
Our analysis focused upon ratios of average direct revenue to average  cost. We did not incorporate other potentially important considerations  due to data constraints. One such consideration is the extent to which the  ratio of direct revenue per dollar of cost may decline for a particular  category of exams as additional resources are devoted to that category.  The revenue yield of each additional return that IRS exams within a  particular return category may be lower than the average revenue- productivity rates we estimated, particularly if IRS’s return selection  process for examinations results in returns with the greatest revenue  potential being worked first and those with the least potential being  worked last. Little is known about the relationship between marginal and  average revenue and cost within specific return categories because IRS  currently does not identify the marginal cases worked each year.IRS collects some information on marginal cases, such as how the broad  characteristics of those returns that would likely be selected (or not  selected) in a modest program expansion (or contraction) would differ  from the average return actually audited now, planners would have to rely  solely upon ratios of average direct revenue to average cost—a less  accurate basis for estimating the direct revenue consequences of specific  exam resource allocations.
An analysis of the marginal revenue yields for specific categories of  returns might also enable IRS to reduce the number of audits that result  in no direct change in tax liability (although they may have beneficial  effects on voluntary compliance). These no-change cases impose  burdens on compliant taxpayers. Further, substantial variations across  return categories in the percentage of exams that result in no change  could be viewed as inequitable because compliant taxpayers in some  categories have a greater chance of being burdened than compliant  taxpayers in other categories. No-change rates in some higher-income  return categories are already relatively high, compared to rates for lower- income categories. For example, the no-change rate for correspondence  exams of tax returns with positive income of $1 million or more was about  53 percent for fiscal years 2007 to 2008. (See table 1 in app. II.)  However, the highest no-change rates are associated with  correspondence exams, which should be less burdensome than field  exams. High no-change rates could also be associated with declining  revenue yields in marginal cases; however, without a specific study of  marginal cases, it is not possible to say whether no-change cases are  concentrated among the last cases examined in a particular category or  whether they are spread relatively evenly across exams worked  throughout the course of the year.
Factors other than revenue yields and IRS budget costs also matter for  purposes of an overall cost-benefit evaluation of IRS exam activities.  These activities impose compliance costs on taxpayers and economic  efficiency costs on society. Return categories with low ratios of direct  revenue to IRS budget costs could have offsetting advantages in terms of  lower efficiency and compliance costs; however, no empirical evidence of  variations in these other effects or costs across the return categories  exists, nor would it be easy to obtain. (See app. III for further discussion  of these tradeoffs.)
section_title: Conclusions
paragraphs: The results of our analyses suggest that there is potential for IRS to  increase the direct revenue yield of selected enforcement programs by  hundreds of millions of dollars per year without significant (if any) adverse  effect on the indirect effect that examinations have on revenues.  However, our results are preliminary and limited in scope. The collection  and analysis of additional data would help to both confirm our basic  conclusion and assist IRS in more finely adjusting its resource allocation  decisions. One priority would be to study the feasibility of estimating the  marginal revenue and marginal costs within each program within each  taxpayer group. It would be helpful, for example, to estimate at least how  the broad characteristics of those returns that would likely be selected (or  not selected) in a modest program expansion (or contraction) would differ  from the average return actually audited now. Such information would  help IRS assess the extent to which revenue productivity would likely  decline, if at all, if more exam resources are devoted to a particular group  of taxpayers. Another useful project would be to see if some linkage could  be made between the amounts of time that specific examiners spend on  each case and the revenue collection amounts for each case that are  recorded in ERIS. Such a link would enable IRS to estimate ratios of  direct revenue to cost that better incorporate differences in the hourly  costs across examiners with different skill levels. The collection or  estimation of other information that would be useful when allocating  resources, such as the influence of enforcement activity on voluntary  compliance, is challenging, which is why little is known about those topics  to date. Nevertheless, IRS might be able to leverage its existing efforts to  study voluntary compliance through the NRP to get better information on  the influence of enforcement activity on voluntary compliance.
In the absence of the additional data identified above, IRS planners can  use the results of an analysis such as ours in combination with their  professional judgment to decide whether the potential for direct revenue  gains more than offsets the potential for reductions in indirect revenue or  in equity and any increases in compliance or efficiency costs. If the  answer is positive, they can adjust their allocation of resources  accordingly. Nevertheless, the better empirical basis IRS planners have  for making such judgments, the more confident they can be that they are  allocating their limited resources to the best effect.
section_title: Recommendations
paragraphs: To better ensure that IRS’s limited enforcement resources are allocated in  a manner that maximizes the revenue yield of the income tax, subject to  other important objectives of tax administration, such as minimizing  compliance costs and ensuring equitable treatment across different  groups of taxpayers, the Commissioner of Internal Revenue should:  review disparities in the ratios of direct revenue yield to costs across  different enforcement programs and across different groups of cases  within programs and determine whether this evidence provides a  basis for adjusting IRS’s allocation of enforcement resources each  year.
As part of this review, IRS should: develop estimates of the marginal direct revenue and marginal direct  cost within each enforcement program and each taxpayer group;  compile data on the amount of time that specific grades of examiners  and downstream employees spend on specific categories of exams  that can be identified in ERIS; and explore the potential of estimating the marginal influence of  enforcement activity on voluntary compliance, potentially taking  advantage of new NRP data.
section_title: Agency Comments
paragraphs: We requested written comments from the Commissioner of Internal  Revenue and received a letter from IRS Deputy Commissioner for  Services and Enforcement on November 29, 2012, (which is reprinted in  app. IV). IRS agreed with our recommendations and agreed that the  development of additional key data will require considerable work. In  recognition of the time it will take to obtain this information, IRS said it will  consider how to apply interim methods, findings, or approximations.
As agreed with your offices, unless you publicly announce the contents of  this report earlier, we plan no further distribution until 30 days from the  report date. At that time, we will send copies to interested congressional  committees, the Secretary of the Treasury, the Commissioner of Internal  Revenue, and other interested parties. In addition, the report also will be  available at no charge on the GAO website at http://www.gao.gov.
If you or your staff have any questions about this report, please contact  me at (202) 512-9110 or whitej@gao.gov. Contact points for our Offices  of Congressional Relations and Public Affairs may be found on the last  page of this report. GAO staff who made major contributions to this report  are listed in appendix V.
section_title: Appendix I: Summary Methodology for Data Analysis
paragraphs: Our principal analysis compares the costs and direct revenues associated  with correspondence and field exams that were opened during fiscal  years 2007 and 2008 across the principal categories of individual  taxpayers that the Internal Revenue Service (IRS) uses for exam planning  purposes. These categories, defined in terms of income size and the  nature of items reported on the returns, are shown in table 1 of   appendix II.
subsections: section_title: Exam Costs
paragraphs: IRS provided us with total cost estimates for correspondence exams (with  and without the earned income tax credit (EITC)) and field exams (with  and without EITC) from its Integrated Financial System. These total cost  estimates included all direct examiner costs, training and other off-line  activities of examiners, supervisory and administrative support, and other  overhead costs allocable to each program. We estimated hourly costs by  dividing the total costs by the average examination hours per case, which  IRS provided for correspondence exams (with and without the earned  income tax credit (EITC)) and field exams (with and without EITC) from its  Audit Information Management System (AIMS). These hourly cost  estimates are adequate for the relatively high-level comparisons we  present in this report. IRS would be able to make more precise estimates  for more detailed categories of exams if data from IRS’s timekeeping  system that records the number of hours that each employee charged to  specific exam cases were matched to revenue data for the same cases.
To estimate the cost for each category of field exams we multiplied the  hourly cost rates by the number of direct hours reported in the  Enforcement Revenue Information System (ERIS) for each category of   According to IRS officials the ERIS data relating to time spent on  exam. correspondence exams is not reliable for our purposes. On their advice,  given that neither the time spent on 1040 correspondence exams nor the  skill level of examiners typically vary significantly from case to case, we  used the same cost estimate for all cases, which IRS provided to us. We  restated the costs for each case in terms of 2011 dollars by adjusting for  inflation. Due to limitations of the ERIS data our cost estimates do not  include any downstream costs that IRS’s Collections function may have  devoted to these cases or any costs associated with examinations of  pass-through entities that could have improved the productivity of some of  these 1040 exams. We do not know whether the prevalence of these  missing costs varies significantly across our exam categories; however,  we do note that the one category we studied that specifically excluded  returns with pass-through income had ratios of revenue to costs that were  greater or equal to the ratios for the one category identified as likely to  include such returns.
section_title: Direct Revenues
paragraphs: We aggregated all of the tax, interest, and penalty collections recorded in  ERIS for the same fiscal years, exam types, and taxpayer categories  used for the cost side of our analysis. We also included amounts of  refunds disallowed due to examinations in our definition of revenues.  These amounts represent revenue saved for the government, even  though IRS does not have to collect it after the exams. We compiled the  revenue data for each fiscal year in which the collections were made  (through the end of fiscal year 2011) and restated the revenue in terms of  2011 dollars by adjusting for inflation.collections over the gap between the fiscal year in which IRS incurred the  exam costs (which we estimated as being the midpoint of the exam) and  the fiscal year in which the revenue was collected. The purpose of this  discounting, which is standard practice for cost-benefit analyses, is to   Then we discounted the value of  account for the time-value of money between the time at which the  government bears the cost of an activity or investment and the time at  which it receives the related benefit. (We used a real discount rate for this  discounting because we had already adjusted all of our figures for  inflation.)
section_title: Incorporating Exam Difficulty and Location
paragraphs: The first set of estimates that we present in this report do not reflect  potential differences in costs across exams due to the degree of  experience demanded of the examiner or the location at which the exam  was conducted. For a second set of estimates we adjusted the cost of  field exams for relative difficulty. To do this we used ERIS data on hours  by grade to compute a weighted average pay rate for all exams (for each  combination of EITC and non-EITC and field or correspondence for each  year).  We then adjusted costs for each record by multiplying the cost by  the mid-point pay rate for the grade of the record, divided by the weighted  average difficulty pay rate for the relevant year and EITC status. For a  third set of estimates we made this difficulty adjustment for field exams  and then we also adjusted the costs of both correspondence and field  exams for location differences by using data on the location of exams,  hours, and locality pay for each location to compute a national average  locality pay rate (weighted by the number of hours in each location) for  each combination of field and correspondence exams of returns with and  without EITC and a locality pay rate for each location. We then multiplied  the cost estimate for each exam by the ratio of the national rate over the  relevant location-specific rate.
section_title: Effects of a Hypothetical Resource Reallocation
paragraphs: The columns labeled “Change in Resources” in table 2 of appendix II  show the amounts of IRS budget resources we moved out of or into  specified exam categories for our hypothetical reallocation. These shifts  were guided by the considerations we noted earlier. We estimated the  revenue effect of each shift by multiplying the gain or loss of resources for  each category by our estimated ratios of direct revenue to cost for those  categories. We estimated the effect on the coverage rate within each  category by multiplying the coverage rate prior to the reallocation by the  percentage change in each category’s resources caused by the  reallocation.
section_title: Appendix II: Detailed Tables
paragraphs: Appendix II: Detailed Tables ($ millions) ($ millions)
Change in  resources  ($ millions)
Change in  direct  revenue   ($ millions)
Change in  resources   ($ millions)
Change in  direct  revenue   ($ millions)
section_title: Appendix III: Economic Guidelines for Enforcement Resource Allocation Decisions
paragraphs: An economic cost-benefit evaluation of IRS’s overall activities would  involve a comparison of the social costs and social benefits associated  with those activities. IRS’s function is to collect tax revenue that the  federal government transfers among citizens as cash payments or in the  form of goods and services. The collection process imposes costs on  society but produces no direct benefit itself. The government’s use of the  collected revenue may ultimately produce a net benefit for society if the  social value of that use exceeds the social cost of raising the revenue.  IRS has no influence over how tax revenue is used; it can only contribute  to increasing the net social benefit by increasing the amount of revenue  collected for a given amount of social cost (or decreasing the social cost  of raising a given amount of revenue). Specific resource allocation  choices can be compared on the basis of the amount of revenue they  produce for a given amount of total social costs.
subsections: section_title: Components of Total Social Costs
paragraphs: The social costs of tax collection comprise the following:
Tax burden. This is the actual money collected from taxpayers.
IRS budget costs.
Amounts collected as a result of IRS enforcement activities from  taxpayers who, otherwise, would have been noncompliant may have a  zero social cost. The cost that those amounts represent can be  attributed to the tax law, rather than to IRS enforcement efforts. If  those additional amounts of taxes due are not collected, the tax  burdens evaded by noncompliant individuals are offset by the  additional taxes that compliant taxpayers must pay in order to support  a given government budget.
Compliance burden. IRS’s enforcement activities can affect the costs  that taxpayers incur when complying with the tax law by increasing  the time and money that they spend preparing their returns and  interacting with IRS.
Efficiency costs. IRS’s enforcement activities can alter the tax  avoidance and evasion behavior of individuals, which affects the  efficiency of resource allocation in the economy. If an enforcement  activity increases the aggregate costs of tax avoidance and evasion,  economic efficiency and the average standard of living is reduced.  Conversely, if the activity reduces such aggregate costs, economic  efficiency would improve.
Equity costs. IRS’s resource allocation can affect how exam-related  compliance burdens are distributed across different groups of  taxpayers and also how the risk of noncompliant taxpayers getting  penalized for evasion varies across groups. It is difficult to know what  society as a whole would view as an equitable distribution of these  burdens and risks; therefore it is difficult to assess the equity effects of  any particular reallocation of resources.
The only component of social costs that can be reliably measured is the  IRS budget cost, and it is difficult to attribute even that cost to very  specific enforcement activities (such as specific audits). Consequently,  IRS planners cannot consider all types of social costs in a rigorously  quantitative manner when making their resource allocation decisions.
section_title: Marginal Analysis
paragraphs: Economists use the term “margin” when referring to the scopes of the  various types of decisions that individuals make. For example, if IRS  examination planners were deciding how to allocate the last million  dollars of their budget between different types of audits, the marginal  social cost of the choice they made would be a million dollars, plus the  sum of all other social costs resulting from the IRS activities supported by  that million dollars. The marginal revenue would be the amount of  additional tax collections attributable (both directly and indirectly) to those  activities. The most economically efficient choice would be the one that  produced the highest ratio of marginal revenue to marginal social cost.
The ratio of marginal revenue to marginal social cost provides a basis for  comparing the cost of collecting taxes by different approaches. Such  comparisons can be made across broadly defined approaches (e.g.,  increasing taxpayer services to promote higher voluntary compliance  versus increasing enforcement efforts to reduce noncompliance).  Alternatively, as in this study, comparisons could be made across more  narrowly defined alternatives (e.g., devoting more resources to audits of  taxpayers with incomes below a certain amount versus devoting those  resources to audits of taxpayers with incomes above that amount).
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: Staff Acknowledgments
paragraphs: In addition to the contact named above, James Wozny (Assistant  Director), Kevin Daly (Assistant Director), Michael Brostek, Ethan  Wozniak, Suzanne Heimbach, Sara Daleski, Lois Hanshaw, Karen  O’Conor, Ray Bush, Elizabeth Fan, and Robert MacKay made key  contributions to this report.