Tax Gap: Sources of Noncompliance and Strategies to Reduce It
Published: 2012-04-19T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: In January 2012, IRS estimated that the gross tax gapthe difference between taxes owed and taxes paid on timewas $450 billion for tax year 2006. IRS estimated that it would collect $65 billion through enforcement actions and late payments, leaving a net tax gap of $385 billion. From 2001 to 2006, IRS estimated that the gross tax gap increased by $105 billion. However, the percentage of taxes owed that were paid on time remained relatively constant at 83.1 percent in 2006, compared to 83.7 percent in 2001.
Given persistent levels of noncompliance and large and growing structural deficits, it will be important to understand the causes of tax noncompliance and develop new approaches to minimize it.
This testimony addresses two questions: (1) What types of taxpayers are responsible for the tax gap, and what is the nature of their noncompliance? (2) What are strategies for reducing the tax gap? The statement also discusses potential long-term strategies to prevent refund fraud related to identity theft. This statement is based largely on GAOs recent reports and recommendations on tax noncompliance and updates GAOs 2011 testimony on the tax gap.
section_title: What GAO Found
paragraphs: Noncompliance does not have a single source but occurs across different types of taxes and taxpayers. For example, individual income tax accounts for the largest portion of the tax gap, but corporate income tax and employment tax are also significant. Further, misreporting by individuals involves business income, non-business income, deductions, and credits. The extent of misreporting depends on the extent to which income tax is withheld or reported to the Internal Revenue Service (IRS) by third parties. For example, nearly 40 percent, or $179 billion, of the 2006 gross tax gap is due to misreporting of non-corporate business income and related self-employment taxes. Much of this misreporting can be attributed to sole proprietors underreporting receipts or over-reporting expenses. Unlike wage and some investment income, sole proprietors income is not subject to withholding and only a portion is reported to IRS by third parties.
Because noncompliance has multiple causes and spans different types of taxes and taxpayers, multiple approaches are needed to reduce the tax gap. The following strategies could help and will require actions by Congress or IRS.
Enhancing information reporting by third parties to IRS could reduce tax evasion and help taxpayers comply voluntarily. However, identifying additional reporting opportunities can be challenging because third parties may not have accurate information available in a timely manner. Also, adding reporting requirements creates burden for both third parties and IRS.
Ensuring high-quality services to taxpayers , such as by telephone and correspondence or online, can help taxpayers who wish to comply with tax laws but do not understand their obligations. However, tax law changes and funding priorities have recently affected IRSs ability to provide quality taxpayer services.
Devoting additional resources to enforcement would enable IRS to contact millions of potentially noncompliant taxpayers it identifies but cannot contact. To determine the appropriate level of enforcement resources, policymakers would need to consider how to balance taxpayer service and enforcement activities and how effectively and efficiently IRS currently uses its resources.
Expanding compliance checks before IRS issues refunds would involve matching information returns to tax returns during, rather than after, the tax filing season. This approach would require a major reworking of some fundamental IRS computer systems but could help address identity theft-related fraud and allow IRS to use enforcement resources on other compliance problems.
Leveraging external resources, such as paid tax return preparers and whistleblowers , can help improve tax compliance because paid preparers actions have an enormous impact on IRSs ability to effectively administer tax laws, and whistleblowers provide IRS information on suspected noncompliance.
Modernizing information systems would allow IRS to post more comprehensive tax return information to its computer systems, which could facilitate the examination process and expedite taxpayer contacts for faster resolution.
Simplifying the tax code could help taxpayers understand and voluntarily comply with their tax obligations and limit opportunities for tax evasion.
section_title: What GAO Recommends
paragraphs: GAO has made numerous prior recommendations regarding actions to close the tax gap. Congress and IRS have acted on some, while others are reflected in the strategies presented in this testimony.

section_title: Letter
paragraphs: I am pleased to be here to discuss the tax gap and related fraud, such as  identity theft based refund fraud, and how to reduce it. In January 2012,  the Internal Revenue Service (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 a myriad of congressional and IRS efforts to reduce it,  as the rate at which taxpayers voluntarily comply with United States tax  laws has changed little over the past three decades. In past testimonies,  we have said that there are no easy fixes to this problem, and given  persistent levels of noncompliance, 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. Whether mistakes are intentional or unintentional, misreporting is  unfair to compliant taxpayers and undermines the equity of the tax  system. Moreover, in the face of large and growing structural deficits, it  will be especially important to understand the causes of tax  noncompliance today and continue to develop new approaches to  minimize it.
My testimony today will answer two questions: (1) What types of  taxpayers are responsible for the tax gap, and what is the nature of their  noncompliance? (2) What are strategies for reducing the tax gap? As  requested, we will also provide information on potential long-term  strategies to prevent refund fraud related to identity theft. My testimony is  based largely on our recent reports on tax noncompliance and updates  our 2011 testimonies on the tax gap and identity theft. information on our scope and methodology is available in our published  products.
GAO, Tax Gap: Complexity and Taxpayer Compliance, GAO-11-747T (Washington,  D.C.: June 28, 2011), and Taxes and Identity Theft: Status of IRS Initiatives to Help  Victimized Taxpayers, GAO-11-721T (Washington, D.C.: June 2, 2011).
This testimony and the reports and testimonies upon which it is based  were conducted 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.
For this hearing, we updated prior reported information about the  estimated amounts for various components of the 2006 tax gap, the data  and methodology used to estimate the 2006 tax gap, and actions IRS has  taken to address our recommendations to improve taxpayer compliance.  We confirmed the new information with IRS officials.
subsections: section_title: The Tax Gap Is Spread across Various Types of Taxpayers and Taxes
subsections: section_title: Characteristics of the Tax Gap
paragraphs: The gross tax gap has grown in dollar terms since IRS’s previous  estimate for tax year 2001, increasing from $345 billion to $450 billion for  tax year 2006. However, given the growth of the economy and total  federal tax liability over that period, the percentage of taxes owed that  taxpayers paid voluntarily and on time, known as the voluntary  compliance rate, has remained relatively constant—83.7 percent in 2001  and 83.1 percent in 2006.
The tax gap estimate is an aggregate of estimates for the three primary  types of noncompliance: (1) underreporting of tax liabilities on tax returns;  (2) underpayment of taxes due from filed returns; and (3) nonfiling, which  refers to the failure to file a required tax return altogether or on time. The  estimate also covers the five types of taxes that IRS administers— individual income, corporate income, employment, estate, and excise  taxes.
The tax gap includes unintentional errors as well as intentional evasion,  such as intentionally underreporting income, intentionally over-reporting  expenses, and engaging in abusive tax shelters or frivolous tax schemes.  It does not include legal tax avoidance activities (legally lowering tax  liability), taxes due from illegally derived income, or various forms of  fraud. For example, in general, refund fraud related to identity theft would  not be included in the tax gap estimate because it does not involve  evading a tax liability. Nevertheless, as discussed later in the testimony,  actions taken to improve overall compliance and reduce the tax gap could  also potentially address identity theft related fraud.
A critical step toward reducing the tax gap is to understand the sources  and nature of taxpayer noncompliance. As shown in table 1,  noncompliance does not come from a single source but rather occurs  across different types of taxes and taxpayers. For example, individual  income tax accounted for most of the tax gap estimate for tax year 2006.  However, corporate income tax and employment tax also contributed a  significant portion.
As shown in table 2, individual income tax underreporting includes both  nonbusiness income tax and business income tax underreporting.  Business income for individuals includes income from a variety of  business types, including sole proprietors, partnerships, and S  corporations, many of which are small businesses. Nearly 40 percent, or  $179 billion, of the 2006 gross tax gap can be attributed to these types of  business taxpayers who underreport their business income tax, and by  extension their self-employment tax, on their individual income tax  returns. Further, the misreporting of business income tax can take on a  variety of forms. For example, misreporting of non-corporate business  income tax can be largely attributed to sole proprietors who understated  receipts or overstated expenses.
A key reason for this misreporting is  well known. Unlike wage and some investment income, sole proprietors’  income is not subject to withholding and only a portion is subject to  information reporting to IRS by third parties.
As shown in figure 1, the extent to which individual taxpayers accurately  report their income is related to the extent to which the income is reported  to them and IRS by third parties or taxes on the income are withheld. For  example, for types of income for which there is little or no information  reporting, such as business income, individual taxpayers tend to  misreport over half of their income. In contrast, employers report most  wages, salaries, and tip compensation to employees and IRS through  Form W-2. Also, banks and other financial institutions provide information  returns (Forms 1099) to account holders and IRS showing the taxpayers’  annual income from some types of investments. Findings from IRS’s  study of individual tax compliance indicate that nearly 99 percent of these  types of income are accurately reported on individual tax returns.
Taxpayers misreport income and expenses for a variety of reasons.  Some misreporting is intentional; some is unintentional. Often it is  impossible to tell from a tax return whether errors are intentional or  unintentional or even who made the error. For example, paid tax return  preparers could make errors or taxpayers could fail to share relevant  information with their preparers. Our past reports shed some light on the  extent of unintentional errors. In our report on securities cost basis  reporting, we found that among individual taxpayers who misreported  securities sales, roughly one-third over-reported income (i.e., they  overstated gains or understated losses). For sole proprietors, we  reported that 9 percent over-reported their net income, while 61 percent  underreported their net income in 2001.instances of over-reporting could be due to unintentional errors.
section_title: Measuring the Tax Gap
paragraphs: We have long encouraged regular tax gap measurement because these  estimates are important to gauge progress in addressing the tax gap and,  perhaps more importantly, because analyzing the data used to estimate it  can help identify ways to improve tax compliance. One source of such  data is the National Research Program (NRP), which uses audits of a  stratified, random sample of tax returns to produce statistically valid  estimates of noncompliance for the entire population of tax return filers.  IRS uses the NRP sample results to better target its enforcement  examinations of noncompliant taxpayers. Better targeting examinations to  taxpayers who are noncompliant reduces burden on compliant taxpayers.
Updated compliance data can also help identify changes in tax laws and  regulations that may improve compliance. For example, we analyzed  NRP data on individual taxpayer compliance and reported that, among  other things, Congress could consider requiring brokers to report to both  taxpayers and IRS the adjusted basis of securities that taxpayers sell.  Congress enacted this provision,Taxation estimated would raise $6.7 billion in revenue through 2018.   which the Joint Committee on  As we have reported in the past, closing the entire gap may not be  feasible since it could entail more intrusive recordkeeping or reporting  than the public is willing to accept or more resources than IRS is able to  commit. However, given the size of the tax gap, even modest reductions would yield very significant financial benefits. We have made numerous  recommendations over time that could address the tax gap, as follows.
section_title: Various Strategies Are Required to Reduce the Tax Gap
paragraphs: Multiple approaches are needed to reduce the tax gap. No single  approach is likely to fully and cost-effectively address noncompliance  since the noncompliance has multiple causes and spans different types of  taxes and taxpayers. While the tax gap will remain a challenge into the  future, the following strategies could help. These strategies would require  actions by Congress or IRS.
subsections: section_title: Enhancing Information Reporting by Third Parties to IRS
paragraphs: Information reporting is a powerful tool that reduces tax evasion and  helps taxpayers comply voluntarily. Several major new information  requirements have recently taken effect, based at least in part on our  work and recommendations.
Brokers are required to report their clients’ basis for securities sales,  starting in 2012.
Banks and other third parties are required to report businesses’ credit  card and similar receipts, starting in 2011.
Under the Foreign Account Tax Compliance Act, starting in 2014, U.S.  financial institutions and other entities are required to withhold a  portion of certain payments made to foreign financial institutions that  have not entered into an agreement with IRS to report details on U.S.  account holders to IRS.
As these three sets of information reporting requirements have only  recently taken effect, it is too soon to tell the actual impact they are  having on taxpayer compliance.
We have identified other options for information reporting.
GAO, Tax Administration: Costs and Uses of Third-Party Information Returns,  GAO-08-266 (Washington, D.C.: Nov. 20, 2007).
Service payments to corporations. Currently, businesses must  report to IRS payments for services they make to unincorporated  persons or businesses, but payments to corporations generally do not  have to be reported.
Service payments made by landlords. Taxpayers who rent out real  estate are required to report to IRS expense payments for certain  services, such as payments for property repairs, only if their rental  activity is considered a trade or business. However, the law does not  clearly spell out how to determine when rental real estate activity is  considered a trade or business.
Broader requirements for these two forms of information reporting,  covering goods in addition to services, were enacted into law in 2010 but  were later repealed. We believe the more narrow extensions of  information reporting to include services, but not goods, remain important  options for improving compliance.
Additionally, we have identified existing information reporting  requirements that could be enhanced.
Higher education expenses. Eligible educational institutions are  currently required to report information on qualified tuition and related  expenses for higher education so that taxpayers can determine the  amount of educational tax benefits they can claim. IRS revising the  information reporting form could improve the usefulness of reported  information.
Mortgaged properties. Requiring third parties, such as mortgage  lenders, to report mortgaged property addresses in addition to  information they are already required to report on mortgaged  properties would help IRS identify potential noncompliance.
Identifying additional third-party reporting opportunities is challenging.  Considerations include whether any third parties have accurate  information available in a timely manner, the burden of reporting on the  third parties, and whether IRS can enforce the reporting requirement. To  illustrate, in a 2009 report, we found that a major reason why little  information reporting on sole proprietor expenses exists is because of the   For example, there is no third party that  difficulty identifying third parties.could verify the business use of cars or trucks by sole proprietors.
section_title: Ensuring High-Quality Services to Taxpayers
paragraphs: Ensuring high-quality taxpayer services, such as by telephone and  correspondence or online, can help taxpayers who wish to comply with  tax laws but do not understand their obligations. However, in recent years  and continuing this year, IRS’s service performance has seen declines.  Tax law changes and other funding priorities have affected IRS’s ability to  provide quality taxpayer services. For example, we recently reported that  call volume has increased nearly 35 percent from the same time period  last year, which IRS attributed, in part, to taxpayer questions about tax  law changes. Concurrently, taxpayers’ ability to get through to IRS  telephone assistors has declined.percent of callers seeking to talk to an IRS telephone assistor got  through, compared to 70 percent for 2011. To improve service, we have  recommended that IRS determine the costs and benefits of creating  additional automated telephone applications and finalize a more   Through late February of this year, 65  comprehensive plan for online services, including an assessment of  granting taxpayers the ability to update their account information online.
section_title: Devoting Additional Resources to Enforcement
paragraphs: Devoting additional resources to enforcement would enable IRS to  contact millions of potentially noncompliant taxpayers that it currently  identifies but cannot contact given resource constraints. However,  determining the appropriate level of enforcement resources to provide  IRS requires taking into account factors such as how effectively and  efficiently IRS is currently using its resources, how to strike the proper  balance between IRS’s taxpayer service and enforcement activities, and  competing federal funding priorities. For example, in a 2009 report, we  found that despite investing nearly a quarter of all revenue agent time in  2008, IRS was able to examine (audit) about 1 percent of estimated  noncompliant sole proprietors. Not only are these exams burdensome for  businesses, they are also costly for IRS and yield less revenue than  examinations of other categories of taxpayers, in part because most sole  proprietorships are small in terms of receipts.
section_title: Expanding Compliance Checks Before IRS Issues Refunds
paragraphs: IRS could reduce the tax gap by expanding compliance checks before  issuing refunds to taxpayers. The Commissioner of Internal Revenue has  talked about a long-term vision to increase compliance activities before  refunds are sent to taxpayers. In one example, IRS is exploring a  requirement that third parties send information returns to IRS and  taxpayers at the same time as opposed to the current requirement that  some information returns go to taxpayers before going to IRS. The intent  is to allow IRS to match those information returns to tax returns during tax  return filing season rather than after the filing season is complete.will be discussed later, this approach could also help IRS address identity  theft-related fraud and could also allow IRS to use its enforcement  resources on other significant compliance problems. However, the  Commissioner made clear that his vision for more prerefund compliance  checks will take considerable time to implement, will require a major  reworking of some fundamental IRS computer systems, and could impose  some additional burden on third parties.
section_title: Leveraging External Resources Such as Paid Tax Return Preparers and Whistleblowers
paragraphs: Another way IRS may be able to reduce the tax gap is by leveraging  external resources.
Paid tax return preparers prepare approximately 60 percent of all tax  returns filed, and IRS has acknowledged that paid preparers’ actions  have an enormous impact on its ability to administer tax laws  effectively. Based in part on our work and recommendations, IRS  recently developed new requirements for paid preparers, such as  competency testing, which it has concluded will increase tax  compliance. IRS’s goals for the program include leveraging  relationships with paid preparers and improving the accuracy of the  tax returns they prepare.
Tax whistleblowers can help improve tax compliance by providing  information to IRS on others’ suspected tax noncompliance. We have  made several recommendations for IRS to improve its whistleblower  program through enhanced data collection and whistleblower claim  processing timeliness. According to IRS, it is in the process of implementing these recommendations.
section_title: Modernizing Information Systems
paragraphs: Modernization of IRS’s information systems could improve taxpayer  compliance. IRS is engaged in a multiyear effort to replace the systems it  uses to process individual tax returns and receive electronically filed tax  returns. IRS had identified various compliance benefits to replacing the  system it uses to process individual tax returns, including increasing  taxpayer and paid preparer voluntary compliance and examination case  selection.allow IRS to accept taxpayers’ prior-year returns and portable document  format (PDF) files attached to their tax returns. According to IRS officials,   Among other benefits, replacing its electronic filing system will  posting more comprehensive information from individual income tax  returns to its computer systems could facilitate the examination process,  expedite taxpayer contacts for faster resolution, and potentially better  define specific tax gap issues.
section_title: Simplifying the Tax Code or Fundamental Tax Reform
paragraphs: Tax code complexity can lead to noncompliance. Efforts to simplify or  reform the tax code may help reduce the tax gap by making it easier for  individuals and businesses to understand and voluntarily comply with  their tax obligations. For example, eliminating or combining tax  expenditures, such as exemptions, deductions, and credits, could help  taxpayers reduce unintentional errors and limit opportunities for tax  evasion.
Policymakers may find it useful to compare any proposed changes to the  tax code based on a set of widely accepted criteria for assessing  alternative tax proposals. These criteria include the equity, or fairness, of  the tax system; the economic efficiency, or neutrality, of the system; and  the simplicity, transparency, and administrability of the system. These  criteria can sometimes conflict, and the weight one places on each  criterion will vary among individuals. Our publication, Understanding the  Tax Reform Debate: Background, Criteria, & Questions, may be useful in  guiding policymakers as they consider tax reform proposals.
Our recent reports show how changing tax laws to include more  consistent definitions across tax provisions could help taxpayers more  easily understand and comply with their obligations.
For example, higher education expenses that qualify for some of the  savings and credit provisions in the tax code differ by provision. These  dissimilar definitions require that taxpayers keep track of expenses  separately, applying some expenses to some tax preferences but not  others.
Likewise, more clarity would help taxpayers determine how to treat  certain financial derivative products for tax purposes. Unique  characteristics of financial derivatives make them particularly difficult  for the tax code and IRS to address. Deferring gains or accelerating  losses, changing ordinary income into capital gains or vice versa for  losses, and altering the source of gains to avoid withholding taxes are  examples of inconsistent tax rules for financial derivatives resulting in  equivalent economic outcomes being taxed differently.
section_title: Challenges to Addressing Identity Theft
paragraphs: Identity theft creates problems for both taxpayers and IRS. In refund fraud  cases, an identity thief uses a legitimate taxpayer’s identity to fraudulently  file a tax return and claim a refund during the filing season. In these  cases, the identity thief typically uses a stolen Social Security Number  (SSN) to file a forged tax return and obtain a refund early in the filing  season. The legitimate owner of the SSN may not be aware that this has  occurred until he or she files a tax return later in the filing season and IRS  discovers that two returns have been filed using the same SSN. In this  instance, the legitimate taxpayer’s refund will likely be frozen until IRS  can determine the legitimate owner of the SSN.
In our June 2011 testimony before this subcommittee, we reported that  IRS faced various challenges in resolving, detecting, and preventing  identity theft. These challenges included limitations in coordinating with  other agencies and taxpayers because of privacy and other laws, inability  to detect suspicious cases until after fraud has occurred, and the lack of  resources and authority to investigate and prosecute identity thieves.
Addressing these challenges will require significant, long-term changes in  IRS’s operations and systems. As previously discussed, the  Commissioner’s long-term vision to increase up-front compliance  activities could help. For example, matching employer information with tax  returns before refunds are issued could prevent identity thieves from  using phony W-2s to claim fraudulent refunds. However, significant  changes would be needed before this matching could occur. Third-party  information returns would need to be filed with IRS earlier in the filing  season. systems; IRS’s current Customer Account Data Engine (CADE 2) effort is  one key step.
IRS would also need to improve its automated processing  Chairman Platts, Ranking Member Towns, and Members of the  Subcommittee, this completes my prepared statement. I would be  pleased to respond to any questions that you may have at this time.
section_title: GAO Contacts and Staff Acknowledgements
paragraphs: If you or your staff have any questions about this testimony, 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 statement. GAO staff who made key contributions to  this testimony are listed in appendix II.
Many information returns, such as forms W-2 filed by employers, are not due to the  government until the end of February.
section_title: Appendix I: 2006 Tax Gap Estimate Data and Methodology
paragraphs: The Internal Revenue Service’s (IRS) tax gap estimates are based on a  variety of data sources and methodologies. For example, IRS studied  individual taxpayer compliance through the National Research Program  (NRP) and used the resulting compliance data to estimate the tax gap for  individual income tax underreporting and the portion of employment tax  underreporting attributed to self-employment taxes for tax year 2006.
The 2006 Individual NRP involved auditing a random selection of about  13,000 to 14,000 individual tax returns and is much smaller than the tax  year 2001 Individual NRP of approximately 45,000 returns. Starting with  the 2006 Individual NRP compliance study, IRS is using a rolling sample,  which will combine samples across three years.  According to IRS, this  change will reduce cost and provide more up to date compliance data.  The sample design for the 2006 Individual NRP included 11 primary  strata, which were based on the examination classes used in audit  workload selection. Also, the 2006 Individual NRP was designed to  oversample returns with business income reported on Schedule C, E, or  F or Form 2106.
The individual underreporting gap for tax year 2006 was based on  findings from the 2006 Individual NRP and from an econometric analysis  of tax year 2001 NRP data. This econometric analysis, called Detection- Controlled Estimation (DCE), attempts to account for income that  taxpayers do not report on their tax returns and that NRP auditors could  not detect.  Because insufficient NRP data has been accumulated for tax  year 2006 and later years for full DCE analysis, an improved DCE was  undertaken using tax year 2001 NRP data and adjusted using other  information to estimate undetected income for tax year 2006 NRP returns.
We have not verified the accuracy of IRS’s estimate of the tax gap.  According to IRS, a significant portion of IRS’s 2006 tax gap estimate is  based on recent compliance data and improved estimation methods.  However, the tax gap estimate continues to be incomplete and partly  based on older data. For example, the underreporting estimates for both  FICA and unemployment taxes are projections based on applying the  estimated compliance rates for 1984 to currently reported taxes.
To estimate the 2006 individual nonfiling gap, IRS used tax year 2005  third-party information returns, rather than the Census Exact Match study,  as it did for the tax year 2001 estimate. The underpayment component of  the tax gap is not an estimate but rather represents the actual tax  amounts that taxpayers reported on time, but did not pay on time.
section_title: Appendix II: GAO Contact and Staff Acknowledgments
subsections: section_title: GAO Contact
section_title: Staff Acknowledgments
paragraphs: In addition to the contact named above, Jeff Arkin, Assistant Director;  Elizabeth Fan, Analyst-in-Charge; David Lewis; Karen O’Conor; and  Sonya Vartivarian made key contributions to this report. Gregory Borecki,  Shannon Finnegan, Tom Gilbert, Lois Hanshaw, Ed Nannenhorn, Jeff  Niblack, Jeff Schmerling, and Joanna Stamatiades also provided valuable  assistance.
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