Tax Compliance: Inflation Has Significantly Decreased the Real Value of Some Penalties
Published: 2007-08-23T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: Civil tax penalties are an important tool to encourage taxpayer compliance with the tax laws. A number of civil tax penalties have fixed dollar amounts--a specific dollar amount, a minimum or maximum amount--that are not indexed for inflation. Because of Congress's concerns that civil penalties are not effectively achieving their purposes, we agreed to (1) determine the potential effect of adjusting civil tax penalties for inflation on the Internal Revenue Service's (IRS) assessment and collection amounts and (2) describe the likely administrative impact of regularly adjusting civil tax penalties on IRS and tax practitioners. GAO examined IRS data on civil tax penalties and conducted interviews with IRS employees and tax practitioners.
section_title: What GAO Found
paragraphs: Adjusting civil tax penalties for inflation on a regular basis to maintain their real values over time may increase IRS collections by tens of millions of dollars per year. Further, the decline in real value of the fixed dollar amounts of civil tax penalties may weaken the deterrent effect of these penalties and may result in the inconsistent treatment of taxpayers over time. If civil tax penalty fixed dollar amounts were adjusted for inflation, the estimated increase in IRS collections would have ranged from $38 million to $61 million per year from 2000 to 2005. Almost all of the estimated increase in collections was generated by four penalties. These increases result because some of the penalties were set decades ago and have decreased significantly in real value--by over one-half for some penalties. According to those we interviewed, the likely administrative burden associated with adjusting the fixed dollar amounts of civil tax penalties for inflation on a regular basis would not be significant for IRS and would be low for tax practitioners. However, officials from the Office of Penalties, a relatively small office that would be responsible for coordinating the required changes among multiple IRS divisions, said that such adjustments might be considerable depending on the number of penalties being adjusted and would require a reprioritization of work. IRS officials said that the work required would be easier to implement with each subsequent update.

section_title: Letter
paragraphs: Civil tax penalties are an important tool to encourage taxpayer compliance  with the tax laws. The Internal Revenue Code (IRC) has over 150 civil  penalties that potentially deter taxpayer noncompliance. For some of the  penalties, the amount of the penalty is determined as a percentage of tax  liability. For others, the amount of the penalty is a specific dollar amount.  Still other penalties have minimum or maximum amounts that are  specified in dollars. These specific dollar amounts are not indexed for  inflation and decline in real value over time because of inflation, which  may weaken their deterrent effect. Because of your concerns that civil tax  penalties are not effectively achieving their purposes, we agreed to   (1) determine the potential effect of adjusting civil tax penalties for  inflation on assessment and collection amounts and (2) describe the likely  administrative impact on the Internal Revenue Service (IRS) and tax  practitioners of regularly adjusting civil tax penalties.
To determine the potential effect of adjusting civil tax penalties for  inflation on assessment and collection amounts, we analyzed IRS civil tax  penalty assessment and collection data using the Consumer Price Index- Urban as a basis for inflation adjustments. To gather information on the  likely administrative impact on IRS officials and tax practitioners of  regularly adjusting civil tax penalties, we interviewed officials across IRS  and a limited number of tax practitioners affiliated with relevant  professional organizations. Our interviews with tax practitioners cannot  be used to make inferences about the effect of regular penalty adjustments  on the work of all practitioners and those we interviewed were giving  personal opinions, not the views of the professional associations of which  they are members. We determined that the civil tax penalty assessment  and collection data are sufficiently reliable for our purposes. We  conducted our work from September 2006 through July 2007 in  accordance with generally accepted government auditing standards. For a  more detailed description of our scope and methodology, as well as  limitations of the penalty data, see appendix I.
subsections: section_title: Background
paragraphs: Although Congress has not established mechanisms for regularly adjusting  for inflation the fixed dollar amounts of civil tax penalties administered by  IRS, it has done so for penalties administered by other agencies. When the  Federal Civil Penalties Inflation Adjustment Act of 1990 (Inflation  Adjustment Act) was enacted, Congress noted that inflation had  weakened the deterrent effect of many civil penalties. The stated purpose  of the 1990 act was “to establish a mechanism that shall (1) allow for  regular adjustment for inflation of civil monetary penalties; (2) maintain  the deterrent effect of civil monetary penalties and promote compliance  with the law; and (3) improve the collection by the Federal Government of  civil monetary penalties.” Congress amended the Inflation Adjustment Act  in 1996 and required some agencies to examine their covered penalties at  least once every 4 years thereafter and, where possible, make penalty  adjustments. The Inflation Adjustment Act exempted penalties under the  IRC of 1986, the Tariff Act of 1930, the Occupational Safety and Health Act  of 1970, and the Social Security Act.
As stated earlier, some civil tax penalties are based on a percentage of  liability and therefore are implicitly adjusted for inflation. For example,  the penalty for failure to pay tax obligations is 0.5 percent of the tax owed  per month, not exceeding 25 percent of the total tax obligations. However,  other civil penalties have fixed dollar amounts, such as minimums or  maximums, which are not linked to a percentage of liability. For example,  a minimum penalty of $100 exists for a taxpayer who fails to file a tax  return.
section_title: Adjusting Civil Tax Penalties for Inflation May Increase IRS Assessments and Collections
paragraphs: Adjusting civil tax penalties for inflation on a regular basis to maintain  their real values over time may increase IRS assessments and collections.  Based on our analysis, if the fixed dollar amounts of civil tax penalties  had been adjusted for inflation, the increase in IRS assessments potentially  would have ranged from an estimated $100 million to $320 million and the  increase in collections would have ranged from an estimated $38 million to  $61 million per year from 2000 to 2005, as shown in table 1.
The majority of the estimated increase in collections from adjusting these  penalties for inflation was generated from the following four types of  penalties: (1) failure to file tax returns, (2) failure to file correct  information returns, (3) various penalties on returns by exempt  organizations and by certain trusts, and (4) failure to file partnership  returns. The estimated increases in collections associated with these  penalties for 2004 are shown in table 2. We highlight 2004 data because,  according to IRS officials, approximately 85 percent of penalties are  collected in the 3 years following the assessment. The same four penalty  types account for the majority of the estimated increase in collections for  the prior years. Our analysis showed that these four penalties would  account for approximately 99 percent of the estimated $61 million in  additional IRS collections for assessments made in calendar year 2004.
Because penalty amounts have not been adjusted for decades in some  cases, the real value of the fixed dollar amounts of these penalties has  decreased. For example, the penalty for failing to file a partnership return  was set at $50 per month in 1979, which is equivalent to about $18 today,  or a nearly two-thirds decline in value, as shown in table 3. If the deterrent  effect of penalties depends on the real value of the penalty, the deterrent  effect of these penalties has eroded because of inflation. In addition, not  adjusting these penalties for inflation may lead to inconsistent treatment  of otherwise equal taxpayers over time because taxpayers penalized when  the amounts were set could effectively pay a higher penalty than taxpayers  with the same noncompliance pay years later. Finally, if the real value of  penalties declines, but IRS’s costs to administer them do not, imposing  penalties becomes less cost-effective for IRS and could lead to a decline in  their use.
In the past, Congress has established fixed penalty amounts, increased  fixed penalty amounts, or both in order to deter taxpayer noncompliance  with the tax laws. For example, the $100 minimum for failure to file a tax  return was created in 1982 because many persons who owed small  amounts of tax ignored their filing obligations. In addition, Congress  increased penalties for failure to file information returns in 1982 because it  believed that inadequate information reporting of nonwage income was a  substantial factor in the underreporting of such income by taxpayers. As  recently as 2006, IRS’s National Research Program confirmed Congress’s  belief that compliance is highest where there is third-party reporting.  Congress has also recently adjusted some civil penalties that have fixed  dollar amounts. For example, the minimum penalty for a bad check was  raised from $15 to $25 in May 2007, and the penalty for filing a frivolous  return was raised from $500 to $5,000 in December 2006.
section_title: Administrative Impact of Implementing Inflation Adjustment to Civil Penalties Is Expected to Be Low
paragraphs: We spoke with officials from offices across IRS whose workloads would  be affected if regular adjustments of penalties occurred. IRS officials from  all but one unit said that regularly updating the fixed dollar amounts of  civil tax penalties would not be a significant burden. Officials from one  relatively small office—the Office of Penalties—said that such adjustments  might be considerable depending on the number of penalties being  adjusted and would require a reprioritization of their work since their  office would have lead responsibility for monitoring the administrative  steps necessary to implement the adjustments and coordinating tasks  among a wide range of functions within IRS. In addition, the limited  number of tax practitioners we interviewed told us that the administrative  burden associated with adjusting these penalties for inflation on a regular  basis would be low.
subsections: section_title: Administrative Impact on IRS Expected to Be Relatively Low
paragraphs: Officials from all but one unit we spoke to within IRS said that regularly  adjusting civil tax penalties for inflation would not be burdensome. Some  officials added that adequate lead time and minimally complex changes  would reduce the administrative impact. For example, officials from the  Office of Forms and Publications and the Office of Chief Counsel said that  adjustments to civil penalty amounts would not affect their work  significantly. While each office would have to address the penalty changes  in documents for which they are responsible, in some cases these  documents are updated regularly already. Similarly, officials responsible  for programming IRS’s computer systems explained that these changes  would not require out of the ordinary effort, unless they had little lead  time in which to implement the changes.
However, officials from the Office of Penalties within the Small  Business/Self-Employed division (SB/SE)—the unit which would be  responsible for coordinating IRS’s implementation of any adjustments to  penalties among a wide range of functions within IRS—felt that the  administrative burden associated with these changes might be  considerable depending on the number of penalties being adjusted. The  Office of Penalties, which currently consists of 1 manager and 10 analysts,  provides policies, guidelines, training, and oversight for penalty issues IRS- wide, not just within SB/SE. When legislation affecting penalties is  enacted, the Office of Penalties creates an implementation team that helps  determine what IRS needs to do to implement the new legislation. In the  case of adjusting penalties for inflation, the Office of Penalties would work  with numerous other IRS units to coordinate the necessary changes to  forms, training materials, computer systems, and guidance, among other  things. Regularly changing four penalties would take less effort than  regularly changing all penalties. In addition, the ability of the office to  make these changes would require reprioritization of its work or receiving  more resources. While the Office of Penalties has not done a formal  analysis of the resources needed, an official stated that the additional  work would not require a significant increase in staffing, such as a  doubling of the size of the office. As a result, the amount of additional  resources necessary for the penalty adjustment do not appear to be of  sufficient scale to have a large impact on IRS overall.
Further, officials we interviewed from other IRS units who would perform  the work described by the Office of Penalties said that the administrative  burden would not be significant for them. Some IRS officials who oversee  the implementation of other periodic updates to IRS databases and  documents said that the legislative changes requiring regular updates are  most burdensome initially but become less of an issue in each subsequent  year. Some officials also said that with enough advance notice, they would  be able to integrate the necessary changes into routine updates. For  example, program changes could be integrated into the annual updates  that some Modernization and Information Technology Service programs  receive. Other areas in IRS, such as the Office of Forms and Publications,  already conduct annual and in some cases quarterly updates of their  forms, and according to officials, a change to the tax penalty amount could  easily be included in these regularly scheduled updates.
IRS has a variety of experiences that may provide guidance that would be  relevant to adjusting civil tax penalties with fixed dollar amounts for  inflation. IRS has extensive procedures for implementing statutory  changes to the tax code. Further, IRS has experience implementing  inflation adjustment calculations. For example, tax brackets, standard  deduction amounts, and the itemized deduction limit are among the  inflation adjustments conducted annually by IRS. In addition, the  administrative changes associated with regular updates to the interest rate  have some similarities to the types of changes that an inflation adjustment  may require. For example, the Office of Chief Counsel issues quarterly  guidance on interest rates and the Communications & Liaison Office  provides regular updates on interest changes to the tax professional  community, including practitioner associations. Changes to the civil tax  penalty fixed dollar amounts could be handled in a similar manner.
section_title: Tax Practitioners Expected Administrative Impact to Be Relatively Low
paragraphs: The limited number of tax practitioners that we spoke with also expected  the impact on their work from adjustments to the fixed dollar amounts of  civil tax penalties for inflation to be relatively low. For example, one tax  practitioner said that he expected to spend more time explaining different  penalty amounts to clients, particularly in situations where taxpayers who  receive the same penalty in different tax years may not understand why  different penalty amounts were applied. In addition, three other  practitioners we spoke with said that the changes may lead to an increased  reliance on software programs that tax preparers often use to assist them  with determining penalty amounts since making the calculations involving  inflation adjustments could become more onerous for the tax practitioners  to do without software.
section_title: Concluding Observations
paragraphs: The real value and potential deterrent effect of civil tax penalties with  fixed dollar amounts has decreased because of inflation. Periodic  adjustments to the fixed dollar amounts of civil tax penalties to account  for inflation, rounded appropriately, may increase the value of collections  by IRS, would keep penalty amounts at the level Congress initially  believed was appropriate to deter noncompliance, and would serve to  maintain consistent treatment of taxpayers over time. Regularly adjusting  the fixed dollar amounts of civil tax penalties for inflation likely would not  put a significant burden on IRS or tax practitioners.
section_title: Matter for Congressional Consideration
paragraphs: Congress should consider requiring IRS to periodically adjust for inflation,  and round appropriately, the fixed dollar amounts of the civil penalties to  account for the decrease in real value over time and so that penalties for  the same infraction are consistent over time.
section_title: Agency Comments
paragraphs: On July 30, 2007, we sent a draft of this report to IRS for its comment. We  received technical comments that have been incorporated where  appropriate.
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  date. At that time, we will send copies of this report to appropriate  congressional committees and the Acting Commissioner of Internal  Revenue. We also will make copies available to others upon 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 concerning this report, please  contact me at (202) 512-9110 or at brostekm@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 II.
section_title: Appendix I: Scope and Methodology
paragraphs: To determine the potential effect that adjusting civil tax penalties for  inflation would have on the dollar value of penalty assessments and  collections, we used the Consumer Price Index-Urban (CPI-U) to adjust  actual penalty assessment and collection information contained in the  Enforcement Revenue Information System (ERIS), which was created to  track Internal Revenue Service (IRS) enforcement revenues.
We provided inflation-adjusted estimates for penalties that had been  assessed for at least $1 million in any one year from 2000 to 2005 and had  either a fixed minimum or set amount. This excluded less than two one- hundredths of a percentage of all assessments each year. In addition, we  assumed that assessment rates and collection rates would stay the same  regardless of penalty amount. This assumption may bias our estimates  upwards because higher penalties may encourage taxpayers to comply  with tax laws and, therefore, IRS would not assess as many penalties.  However, improved compliance could also increase revenues. For  collections, we assumed that a particular collection would increase the  inflation-adjusted penalty amount only if the unadjusted penalty  assessment had been paid in full. For example, if a taxpayer paid $50 of a  $100 penalty assessment, we assumed that the $50 collected was all that  would have been collected even with a higher assessment, and therefore  did not adjust the collection amount. We made this assumption in order to  avoid overstating the effect that adjusting penalties for inflation would  have on collections because the data did not tell us why a penalty was  partially collected. To the extent that taxpayers who paid the unadjusted  penalty amount in full would not pay the adjusted penalty amount in full,  our estimates would overstate additional collections. One reason for a  partial collection is that it is all the taxpayer can afford.
We did not include penalties that are percentage based but have a fixed  maximum in our inflation adjustments. Two penalty categories in the ERIS  data set that we received have fixed maximums and had total assessments  of over $1 million for at least 1 year from 2000 to 2005. In both cases, we  could not determine how much a penalty assessment for the current  maximum would have risen if the maximum had been higher. However, we  estimated an upper bound for the potential increase in collections due to  adjusting the maximums for inflation by assuming that penalties assessed  at the current maximum would have increased by the full rate of inflation.  As a result, we concluded that at most, collections would have risen by  approximately $196,000 over the years 2000 to 2005 if these maximums  had been adjusted for inflation. We also did not include penalties that are  based solely on a percentage of tax liability in our analysis because they  are implicitly adjusted for inflation.
The data contained in the ERIS database were reliable for our purposes,  but some limitations exist. To assess the reliability of the data, we  reviewed relevant documentation, interviewed relevant IRS officials, and  performed electronic data testing. One limitation of the ERIS data is that it  does not include penalties that are self-assessed and paid at the time of  filing. IRS officials estimated that this is about 6 to 7 percent of all penalty  assessments, but that a large majority of these are percentage based with  no fixed dollar amount. For example, many people self-assess and pay the  penalty for withdrawing money from their Individual Retirement Accounts  early. Further, IRS officials acknowledged that some penalties were  incorrectly categorized in the database making it impossible for us to  determine which penalties were being assessed. We determined that 0.4  percent to 1.4 percent of assessments per year from 2000 to 2005 were  incorrectly categorized. For example, in 2000, over $144 million in  assessments and over $28 million in collections were incorrectly  categorized. In 2005, over $343 million in assessments and over $86 million  in collections were incorrectly categorized. These two limitations may bias  our estimates downwards.
The federal government produces several broad measures of price  changes, including the CPI-U and the Gross Domestic Product (GDP) price  deflator. The CPI-U measures the average change over time in the prices  paid by consumers for a fixed market basket of consumer goods and  services. The GDP price deflator measures changes over time in the prices  of broader expenditure categories than the CPI-U. We used the CPI-U for  the purposes of this analysis because it is used currently in the tax code to  make inflation adjustments to several provisions, such as the tax rate  schedule, the amount of the standard deduction, and the value of  exemptions.
To determine the likely effect that regularly adjusting penalties for  inflation would have on the administrative burden of IRS officials, we  interviewed officials in offices across IRS who would be affected if regular  adjustments of penalties occurred. These offices are the    Office of Penalties within the Small Business/Self Employed division  (SB/SE);    Learning and Education within SB/SE;    Wage and Investment division (W&I);    Tax Exempt/Government Entity division;    Large and Mid-Size Business division;    Research, Analysis and Statistics division;    Legislative Analysis Tracking and Implementation Services;    Office of Chief Counsel;    Business Forms and Publications within W&I;    Enforcement Revenue Data;    Communications and Liaison; and    Modernization and Information Technology Services, including officials  who work on the Business Master File, the Financial Management  Information System, the Automated Trust Fund Recovery system,  Report Generation Software, Automated Offers in Compromise,  Penalty and Interest Notice Explanation, Integrated Data Retrieval  System, and the Payer Master File Processing System.
To determine the likely effect that regularly adjusting penalties for  inflation would have on the administrative burden of tax practitioners, we  interviewed tax practitioners affiliated with the American Institute of  Certified Public Accountants, the National Association of Enrolled Agents,  the National Society of Tax Professionals, and the American Bar  Association. In total, we spoke with 28 practitioners. Results from the  nongeneralizable sample of practitioners we selected cannot be used to  make inferences about the effect of regular adjustments of penalties on  the work of all tax practitioners. Additionally, those we spoke with  presented their personal views, not those of the professional associations  through which they were contacted.
We conducted our work from September 2006 through July 2007 in  accordance with generally accepted government auditing standards.
section_title: Appendix II: GAO Contact and Staff Acknowledgments
subsections: section_title: Acknowledgments
paragraphs: In addition to the contact named above, Jonda Van Pelt, Assistant  Director; Benjamin Crawford; Evan Gilman; Edward Nannenhorn;  Jasminee Persaud; Cheryl Peterson; and Ethan Wozniak made key  contributions to this report.