Tax Compliance: Reducing the Tax Gap Can Contribute to Fiscal Sustainability but Will Require a Variety of Strategies
Published: 2005-04-14T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: The Internal Revenue Service's (IRS) recent estimate of the difference between what taxpayers timely and accurately paid in taxes and what they owed ranged from $312 billion to $353 billion for tax year 2001. IRS estimates it will eventually recover some of this tax gap, resulting in a net tax gap from $257 billion to $298 billion. The tax gap arises when taxpayers fail to comply with the tax laws by underreporting tax liabilities on tax returns; underpaying taxes due from filed returns; or "nonfiling," which refers to the failure to file a required tax return altogether or in a timely manner. The Chairman and Ranking Minority Member of the Senate Committee on Finance asked GAO to review a number of issues related to the tax gap. This testimony will address GAO's longstanding concerns regarding tax compliance; IRS's efforts to ensure compliance; and the significance of reducing the tax gap, including some steps that may assist with this challenging task. For context, this testimony will also address GAO's most recent simulations of the long-term fiscal outlook and the need for a fundamental reexamination of major spending and tax policies and priorities.
section_title: What GAO Found
paragraphs: Our nation's fiscal policy is on an unsustainable course. As long-term budget simulations by GAO, the Congressional Budget Office, and others show, over the long term we face a large and growing structural deficit due primarily to known demographic trends and rising health care costs. All simulations indicate that the long-term fiscal challenge is too big to be solved by economic growth alone or by making modest changes to existing spending and tax policies. Rather, a fundamental reexamination of major policies and priorities will be important to recapture our fiscal flexibility. Especially relevant to this committee will be deciding whether and how to change current tax policies and how to ensure that tax compliance is as high as practically possible. Tax law enforcement is one factor affecting compliance that has caused concern in the past, due in part to declines in IRS enforcement occupations, examinations, and other enforcement results. The recent turnaround in staffing and some enforcement results is good news, but IRS's recent compliance estimate indicates that compliance levels have not improved and may be worse than it originally estimated. Thus, sustained progress in improving compliance is needed. Reducing the tax gap would help improve fiscal sustainability, but will be challenging given persistent noncompliance. This task 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, including reducing tax code complexity, providing quality services to taxpayers, enhancing enforcement of tax laws, and evaluating the success of IRS's efforts to promote compliance. Also important is obtaining current information on the extent of, and reasons for, noncompliance. IRS's 2001 tax gap estimate is based in part on recently collected compliance data for individual income tax underreporting. However, IRS does not have firm plans to obtain compliance data for other areas of the tax gap or again collect data on individual income tax underreporting. Finally, IRS lacks quantitative, long-term goals for improving taxpayer compliance, which would be consistent with results-oriented management.

section_title: Letter
paragraphs: I appreciate this opportunity to discuss the annual tax gap—the difference  between what taxpayers timely and accurately pay in taxes and what they  should pay under the law—and how reducing that gap can help the nation  cope with its large and growing long-term fiscal challenges.  Most recently,  the Internal Revenue Service (IRS) estimated a gross tax gap from  $312 billion to $353 billion for tax year 2001.  IRS estimated that it would  eventually recover some of this amount through late payments and IRS  enforcement actions, resulting in an estimated “net” tax gap for 2001 from  $257 billion to $298 billion.  The tax gap arises when taxpayers fail to  comply with the tax laws, either intentionally or unintentionally.  As a  result of their noncompliance, the burden of funding the nation’s  commitments, including funding growing budget deficits, falls more heavily  on taxpayers who voluntarily pay their taxes.  In addition, IRS expends  substantial resources enforcing and explaining tax laws, with the goals of  increasing compliance and reducing the tax gap.
For context in considering the tax gap, I will first provide the committee  with the results of our most recent simulations of the long-term fiscal  outlook.  I will also discuss briefly the need for a fundamental  reexamination of major spending and tax policies and priorities that will be  important to recapturing our fiscal flexibility and updating our programs  and priorities to respond to emerging social, economic, and security  challenges.  Next, I will discuss our long-standing concerns regarding tax  compliance and IRS’s efforts to ensure compliance.  Finally, I will discuss  the significance of reducing the tax gap and a number of issues related to  this challenging task, including various means to potentially improve  compliance, measuring the extent of the tax gap, IRS’s understanding of the  reasons why taxpayers are noncompliant, and IRS’s plans and strategies for  reducing the gap.  My remarks are based on our previous reports on a  variety of issues as well as work we are performing for this committee on  the tax gap, which we will address in greater detail in a forthcoming report,  and will be performed under generally accepted government auditing  standards.
Let me begin by highlighting several major points:  The overall picture on the long-term fiscal outlook is not news to this  committee.  Simply put, our nation’s fiscal policy is on an imprudent and  unsustainable course. In addition, our long-term fiscal gap grew much  larger in fiscal year 2004.  Long-term budget simulations by GAO, the  Congressional Budget Office (CBO), and others show that over the long  term we face large and growing structural deficits due primarily to  known demographic trends and rising health care costs. Continuing on  this unsustainable fiscal path will gradually erode, if not suddenly  damage, our economy, our standard of living, and ultimately our  national security. Our current path also will increasingly constrain our  ability to address emerging and unexpected budgetary needs and  increase the burdens that will be faced by our children, grandchildren,  and future generations.
Regardless of the assumptions used, all simulations indicate that the  long-term fiscal challenge is too big to be solved by economic growth  alone or by making modest changes to existing spending and tax  policies.  Rather, a fundamental reexamination of major spending and  tax policies and priorities will be important to recapturing our fiscal  flexibility and updating our programs and priorities to respond to  emerging social, economic, and security challenges. Ultimately, this  reexamination will need to entail a national discussion about what  Americans want from their government and how much they are willing  to pay for those things.  Especially relevant to this committee will be  determining whether and how to change our current tax policies— including the type of tax base, the degree of progressivity in our tax  system, or the extent of tax preferences in our system—and how to  ensure that compliance with any tax system we may choose is as high as  practically possible.
We have long been concerned about tax noncompliance and IRS’s  efforts to address it.  Since 1990 we have had various aspects of tax  noncompliance on our high-risk list, and this year we have affirmed our  broad concern by consolidating two prior high-risk areas into one— Enforcement of Tax Laws.  Tax law enforcement is a high-risk area in  part because past declines in IRS’s enforcement activities threatened to  erode taxpayer compliance.  Declines in key IRS enforcement  occupations and examinations and other enforcement results reinforce  the need to focus greater attention on tax compliance.  The turnaround  that has begun in staffing and some enforcement results is good news.   However, IRS’s preliminary new compliance estimate indicates that  compliance has not improved and may be worse than IRS originally  estimated.  Therefore, sustained progress in improving compliance is  needed.
Reducing the current tax gap would contribute to our fiscal  sustainability while simultaneously improving fairness for those citizens  who fully and timely meet their tax obligations.  Although closing the  entire tax gap is not practical, even modest reductions will have very  significant financial benefits—each 1 percent reduction in the tax gap  that we could achieve would likely generate more than $2.5 billion in  revenue annually to help reduce deficits and/or fund our most pressing  national priorities. Reducing the tax gap will be a challenging task given  persistent levels of noncompliance and will not likely be achieved  through a single solution.  Rather, the tax gap must be attacked on  multiple fronts and with multiple strategies over a sustained period of  time.  These strategies could include efforts to simplify the tax code,  provide quality services to taxpayers, and utilize enforcement tools such  as tax withholding and information reporting.
Regularly measuring the extent and nature of noncompliance is critical  to effective efforts to reduce the tax gap given changes in the economy  and tax law.  A significant portion of IRS’s preliminary tax gap estimate  for 2001 is based on recently collected compliance data on individual  income tax reporting, which accounts for nearly 50 percent of the tax  gap.  However, for some areas of the tax gap, the estimate relies on  outdated data and methodologies, including data from the 1970s and  1980s used to estimate corporate income tax underreporting and some  employment tax underreporting.  IRS does not have firm plans for  obtaining more contemporary information on compliance for these  areas of the tax gap or again measuring individual income reporting  compliance.  Further, IRS has missed opportunities to develop a better  understanding of why taxpayers were noncompliant, which can guide  IRS in determining what tools and techniques to use to address  noncompliance.  Finally, IRS’s strategies for improving compliance do  not have the clear focus on quantitative long-term goals and results  measurement that are associated with high-performing organizations  and that are incorporated into statutory management framework  Congress has adopted.
subsections: section_title: Background
paragraphs: The tax gap is an estimate of the difference between the taxes—including  individual income, corporate income, employment, estate, and excise  taxes—that should have been timely and accurately paid and what was  actually paid for a specific year. The 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 timely. Estimates for each type of noncompliance include  estimates for some or all of the five types of taxes that IRS administers.
IRS develops its tax gap estimates by measuring the rate of taxpayer  compliance—the degree to which taxpayers fully and timely complied with  their tax obligations.  That rate is then used, along with other data and  assumptions, to estimate the dollar amount of taxes not timely and  accurately paid.  For instance, IRS recently estimated that for tax year  2001, from 83.4 percent to 85 percent of owed taxes were paid voluntarily  and timely, which translated into an estimate gross tax gap from  $312 billion to $353 billion in taxes not paid that should have been.  IRS also  estimates the amount of the unpaid taxes that it will recover through  enforcement and other actions and subtracts that to estimate the net  annual tax gap.  For tax year 2001, IRS estimated that it would eventually  recover about $55 billion for a net tax gap from $257 billion to $298 billion.
IRS has estimated the tax gap on multiple occasions, beginning in 1979.   IRS’s earlier tax gap estimates relied on the Taxpayer Compliance  Measurement Program (TCMP), through which IRS periodically performed  line-by-line examinations of randomly selected tax returns.  TCMP started  with tax year 1963 and examined individual returns most frequently— generally every 3 years—through tax year 1988.  IRS contacted all  taxpayers selected for TCMP studies.  IRS did not implement any TCMP  studies after 1988 because of concerns about costs and burdens on  taxpayers.
Recognizing the need for current compliance data, in 2002 IRS  implemented a new compliance study called the National Research  Program (NRP) to produce such data while minimizing taxpayer burden.   Under NRP, a program that we have encouraged, IRS recently completed its  initial review of about 46,000 randomly selected individual tax returns from  tax year 2001. Unlike with TCMP studies, IRS did not need to contact  taxpayers for every tax return selected under NRP; handled some taxpayer  contacts through correspondence, as opposed to face-to-face  examinations; and during face-to-face examinations, generally only asked  taxpayers to explain information that it was otherwise unable to verify  through IRS and third-party databases.
IRS has a strategic planning process through which it supports decisions  about strategic goals, program development, and resource allocation.   Under the Government Performance and Results Act of 1993 (GPRA),  agencies are to develop strategic plans as the foundation for results- oriented management.  GPRA requires that agency strategic plans identify  long-term goals, outline strategies to achieve the goals, and describe how  program evaluations were used to establish or revise the goals.  GPRA  requires federal agencies to establish measures to determine the results of  their activities.
section_title: Long-term Fiscal Challenge Provides Impetus to Reexamine Tax Policies and Compliance
paragraphs: The nation is facing a range of important new forces that are already  working to reshape American society, our place in the world, and the role  of the federal government.  Our capacity to address these and other  emerging needs and challenges will be predicated on when and how we  deal with our fiscal challenges—the long-term fiscal pressures we face are  daunting and unprecedented in the nation’s history.  As this committee is  well aware, the size and trend of our projected longer-term deficits means  that the nation cannot ignore the resulting fiscal pressures—it is not a  matter of whether the nation deals with the fiscal gap, but when and how.   Unless we take effective and timely action, our near-term and longer-term  deficits present the prospect of chronic and seemingly perpetual budget  shortfalls and constraints becoming a fact of life for years to come.  Not  only would continuing deficits eat away at the capacity of everything the  government does, but they will erode our ability to address the wide range  of emerging needs and demands competing for a share of a shrinking  budget pie.
Our long-term simulations illustrate the magnitude of the fiscal challenges  we will face in the future.  Figures 1 and 2 present these simulations under  two different sets of assumptions.  In the first, we begin with CBO's  January 2005 baseline—-constructed according to the statutory  requirements for that baseline. Consistent with these requirements,  discretionary spending is assumed to grow with inflation for the first  10 years and tax cuts scheduled to expire are assumed to expire.  After  2015, discretionary spending is assumed to grow with the economy, and  revenue is held constant as a share of gross domestic product (GDP) at the  2015 level.  In the second figure, two assumptions are changed: (1)  discretionary spending is assumed to grow with the economy after 2005  rather than merely with inflation and (2) all temporary tax cuts are  extended.  For both simulations, Social Security and Medicare spending is  based on the 2005 Trustees' intermediate projections, and we assume that  benefits continue to be paid in full after the trust funds are exhausted.
As both these simulations illustrate, absent policy changes on the spending  or revenue side of the budget, the growth in spending on federal retirement  and health entitlements will encumber an escalating share of the  government's resources.  Indeed, when we assume that recent tax  reductions are made permanent and discretionary spending keeps pace  with the economy, our long-term simulations suggest that by 2040 federal  revenues may be adequate to pay little more than interest on the federal  debt.  Neither slowing the growth in discretionary spending nor allowing  the tax provisions to expire—nor both together—would eliminate the  imbalance.  Although revenues will be part of the debate about our fiscal  future, assuming no further borrowing, making no changes to Social  Security, Medicare, Medicaid, and other drivers of the long-term fiscal gap  would require at least a doubling of taxes, and that seems highly  implausible.  Such significant tax increases would also likely have an  adverse effect on economic growth and disposable income available to  Americans.  Accordingly, substantive reform of Social Security and our  major health programs remains critical to recapturing our future fiscal  flexibility.
Although considerable uncertainty surrounds long-term budget  projections, we know two things for certain: the population is aging and the  baby boom generation is approaching retirement age.  The aging  population and rising health care spending will have significant  implications not only for the budget but also the economy as a whole.   Figure 3 shows the total future draw on the economy represented by Social  Security, Medicare, and Medicaid.  Under the 2005 Trustees' intermediate  estimates and CBO's long-term Medicaid estimates, spending for these  entitlement programs combined will grow to 15.2 percent of GDP in 2030  from today's 8.5 percent.  It is clear that taken together Social Security,  Medicare, and Medicaid represent an unsustainable burden on future  generations.
Early action to change these programs would yield the highest fiscal  dividends for the federal budget and would provide a longer period for  prospective beneficiaries to make adjustments in their own planning.   Waiting to build economic resources and reform future claims entails risks.   First, we lose an important window during which today's relatively large  workforce can increase saving and enhance productivity, two elements  critical to growing the future economy.  We also lose the opportunity to  reduce the burden of interest in the federal budget, thereby creating a  legacy of higher debt as well as elderly entitlement spending for the  relatively smaller workforce of the future.  Most critically, we risk losing  the opportunity to phase in changes gradually so that all can make the  adjustments needed in private and public plans to accommodate this  historic shift.  Unfortunately, the long-range challenge has become more  difficult, and the window of opportunity to address the entitlement  challenge is narrowing.
subsections: section_title: A Fundamental Review, Reexamination, and Reprioritization Is Needed
paragraphs: Confronting the nation’s fiscal challenge will require nothing less than a  fundamental review, reexamination, and reprioritization of all major  spending and tax policies and programs that may take a generation or more  to resolve.  Traditional incremental approaches to budgeting will need to  give way to more fundamental and periodic reexaminations of the base of  government.  Many, if not most, current federal programs and policies were  designed decades ago to respond to trends and challenges that existed at  the time of their creation.  If government is to respond effectively to 21st  century trends, it cannot accept what it does, how it does it, who does it,  and how it gets financed as “given.”  Not only do outmoded commitments,  operations, choices of tools, management structures, and tax programs and  policies constitute a burden on future generations, but they also erode the  government's capacity to align itself with the needs and demands of the 21st  century.
Reexamining the base of government will be a challenging task, and we at  GAO believe we have an obligation to assist and support Congress in this  endeavor.  To that end, we recently issued a report that provides examples  of the kinds of difficult choices the nation faces with regard to  discretionary spending; mandatory spending, including entitlements; as  well as tax policies and compliance activities.  Regarding tax policy, a  debate is under way about the future of our tax system that is partly about  whether the goals for the nation's tax system can be best achieved using  the current structure or a fundamentally reformed tax structure.  The  debate is also motivated by increasing globalization, the growing  complexity of our tax system, and the growing use of tax preferences  whose aggregate revenue loss has exceeded all discretionary spending in  5 of the past 10 years.
Although outside the scope of this hearing, today's pressing tax challenges  raise important questions.  For example:   Given our current tax system, what tax rate structure is more likely to  raise sufficient revenue to fund government and satisfy the public's  perception of fairness?
Which tax preferences need to be reconsidered because they fail to  achieve the objectives intended by the Congress, their costs outweigh  their benefits, they duplicate other programs, or other more cost  effective means exist for achieving their objectives?
Should the basis of the existing system be changed from an income to a  consumption base? Would such a change help respond to challenges  posed by demographic, economic, and technological changes?  How  would such a change affect savings and work incentives?  How would  reforms address such issues as the impact on state and local tax systems  and the distribution of burden across the nation's taxpayers?
Regarding compliance with our tax laws, the success of our tax system  hinges greatly on the public's perception of its fairness and  understandability.  Compliance is influenced not only by the effectiveness  of IRS's enforcement efforts but also by Americans' attitudes about the tax  system and their government.  A recent survey indicated that about  12 percent of respondents say it is acceptable to cheat on their taxes.   Furthermore, the complexity of, and frequent revisions to, the tax system  make it more difficult and costly for taxpayers who want to comply to do  so and for IRS to explain and enforce tax laws.  Complexity also creates a  fertile ground for those intentionally seeking to evade taxes and often trips  others into unintentional noncompliance.  The lack of transparency also  fuels disrespect for the tax system and the government.  Thus, a crucial  challenge for reexamination will be to determine how we can best  strengthen enforcement of existing laws to give taxpayers confidence that  their friends, neighbors, and business competitors are paying their fair  share.
section_title: Enforcement of Tax Laws Is on GAO’s High-Risk List
paragraphs: We have long been concerned about tax noncompliance and IRS efforts to  address it.  Collection of unpaid taxes was included in our first high-risk  series report in 1990, with a focus on the backlog of uncollected debts  owed by taxpayers.  In 1995, we added Filing Fraud as a separate high-risk  area, narrowing the focus of that high-risk area in 2001 to Earned Income  Credit Noncompliance because of the particularly high incidence of fraud  and other forms of noncompliance in that program.  We expanded our  concern about the Collection of Unpaid Taxes in our 2001 high-risk report  to include not only unpaid taxes (including tax evasion and unintentional  noncompliance) known to IRS, but also the broader enforcement issue of  unpaid taxes that IRS has not detected.  In our high-risk update that we  issued in January, we consolidated these areas into a single high-risk  area—Enforcement of the Tax Laws—because we believe the focus of  concern on the enforcement of tax laws is not confined to any one segment  of the taxpaying population or any single tax provision.
Tax law enforcement is a high-risk area in part because past declines in  IRS’s enforcement activities threatened to erode taxpayer compliance.  In  recent years, the resources IRS has been able to dedicate to enforcing the  tax laws have declined.  For example, the number of revenue agents (those  who examine complex returns), revenue officers (those who perform field  collection work), and special agents (those who perform criminal  investigations) decreased over 21 percent from 1998 through 2003.   However, IRS achieved some staffing gains in 2004 and expects modest  gains in 2005.  IRS’s proposal for fiscal year 2006, if funded and  implemented as planned, would return enforcement staffing in these  occupations to their highest levels since 1999.
Concurrently, IRS's enforcement workload—measured by the number of  taxpayer returns filed—has continually increased.  For example, from 1997  through 2003, the number of individual income tax returns filed increased  by about 8 percent.  Over the same period, returns for high income  individuals grew by about 81 percent. Due to their income levels, IRS  believes that these individuals present a particular compliance risk.  In light  of declines in enforcement staffing and the increasing number of returns  filed, nearly every indicator of IRS's coverage of its enforcement workload  has declined in recent years.  Although in some cases workload coverage  has begun to increase, overall IRS's coverage of known workload is  considerably lower than it was just a few years ago.  Figure 4 shows the  trend in examination rates—the proportion of tax returns that IRS  examines each year—for field, correspondence, and total examinations  since 1995.  Field examinations involve face-to-face examinations and  correspondence examinations are typically less comprehensive and  complex, involving communication through written notices.  IRS  experienced steep declines in examination rates from 1995 to 1999, but the  examination rate has slowly increased since 2000.  However, as the figure  shows, the increase in total examination rates of individual filers has been  driven mostly by correspondence examinations, while more complex field  examinations continue to decline.
On the collection front, IRS’s use of enforcement sanctions, such as liens,  levies, and seizures, dropped precipitously during the mid- and late 1990s.   In fiscal year 2000, IRS’s use of these three sanctions was at 38 percent,  7 percent, and 1 percent, respectively, of fiscal year 1996 levels.  However,  beginning in fiscal year 2001, IRS’s use of liens and levies began to  increase. By fiscal year 2004, IRS’s use of liens, levies, and seizures  reached 71 percent, 65 percent, and 4 percent of 1996 levels, respectively.
Further, IRS's workload has grown ever more complex as the tax code has  grown more complex.  IRS is challenged to administer and explain each  new provision, thus absorbing resources that otherwise might be used to  enforce the tax laws.  Concurrently, other areas of particularly serious  noncompliance have gained the attention of IRS and Congress, such as  abusive tax shelters and schemes employed by businesses and wealthy  individuals that often involve complex transactions that may span national  boundaries.  Given the broad declines in IRS's enforcement workforce,  IRS's decreased ability to follow up on suspected noncompliance, and the  emergence of sophisticated evasion concerns, IRS is challenged in  attempting to ensure that taxpayers fulfill their obligations.
IRS is working to further improve its enforcement efforts.  In addition to  recent favorable trends in enforcement staffing, correspondence  examinations, and the use of some enforcement sanctions, IRS has recently  made progress with respect to abusive tax shelters through a number of  initiatives and recent settlement offers that have resulted in billions of  dollars in collected taxes, interest, and penalties.  In addition, IRS is  developing a centralized cost accounting system, in part to obtain better  cost and benefit information on compliance activities, and is modernizing  the technology that underpins many core business processes.  It has also  redesigned some compliance and collections processes and plans  additional redesigns as technology improves.  Finally, the recently  completed NRP study of individual taxpayers not only gives us a  benchmark of the status of taxpayers’ compliance but also gives IRS a  better basis to target its enforcement efforts.   However, IRS’s preliminary  compliance estimate based on NRP indicates that compliance has not  improved and may be worse than IRS originally estimated.  As such,  sustained progress toward improving compliance is needed.
section_title: Multiple Service and Enforcement Strategies, Periodic Compliance Measurement, and A Results-Oriented Compliance Approach May Help IRS Reduce the Tax Gap
paragraphs: Reducing the tax gap would be a step toward improving our fiscal  sustainability while simultaneously enhancing fairness for those citizens  who meet their tax obligations.  That said, reducing the tax gap is a  challenging task, and closing the entire tax gap is not practical.  Reducing  the tax gap will not likely be achieved through a single solution, but will  likely involve multiple strategies that include reducing tax code complexity,  providing quality services to taxpayers, and enhancing enforcement of the  tax laws through the use of tools such as tax withholding and information  reporting that increase the transparency of income and deductions to both  IRS and taxpayers.  Also, as IRS moves forward in continuing to address  the tax gap, building and maintaining a base of information on the extent  of, and reasons for, noncompliance as well as defining desired changes in  the tax gap and measuring results of efforts to address it will be critical.
subsections: section_title: Reducing the Tax Gap Could Have a Positive Fiscal Impact but Will Require Multiple Strategies
paragraphs: Given its size, even small or moderate reductions in the net tax gap could  yield substantial returns.  For example, based on IRS’s most recent  estimate, each 1 percent reduction in the net tax gap would likely yield  more than $2.5 billion annually.  Thus, a 10 percent to 20 percent reduction  of the net tax gap would translate into from $25 billion to $50 billion or  more in additional revenue annually.
Although reducing the tax gap may be an attractive means to improve the  nation’s fiscal position, achieving this end will be a challenging task given  persistent levels of noncompliance.  IRS has made efforts to reduce the tax  gap since the early 1980s; yet the tax gap is still large—although without  these efforts it could be even larger.  Also, IRS is challenged in reducing the  tax gap because the tax gap is spread across the five different types of  taxes that IRS administers, and a substantial portion of the tax gap is  attributed to taxpayers who are not subject to withholding or information  reporting requirements.  Moreover, as we have reported in the past,  closing the entire tax gap may not be feasible nor desirable, as it could  entail more intrusive recordkeeping or reporting than the public is willing  to accept or more resources than IRS is able to commit.
Although much of the tax gap that IRS currently recovers is through  enforcement actions, a sole focus on enforcement will not likely be  sufficient to further reduce the net tax gap.  Rather, the tax gap must be  attacked on multiple fronts and with multiple strategies on a sustained  basis.  For example, efforts to simplify the tax code and otherwise alter  current tax policies may help reduce the tax gap by making it easier for  individuals and business to understand and voluntarily comply with their  tax obligations.  For instance, reducing the multiple tax preferences for  retirement savings or education assistance might ease taxpayers’ burden in  understanding and complying with the rules associated with these options.   Also, simplification may reduce opportunities for tax evasion through  vehicles such as abusive tax shelters.  However, for any given set of tax  policies, IRS’s efforts to reduce the tax gap and ensure appropriate levels of  compliance will need to be based on a balanced approach of providing  service to taxpayers and enforcing the tax laws.
Furthermore, providing quality services to taxpayers is an important part of  any overall strategy to improve compliance and thereby reduce the tax gap.   As we have reported in the past, one method of improving compliance  through service is to educate taxpayers about confusing or commonly  misunderstood tax requirements. For example, if the forms and  instructions taxpayers use to prepare their taxes are not clear, taxpayers  may be confused and make unintentional errors.  One method to ensure  that forms and instructions are sufficiently clear is to test them before use.   However, we reported in 2003 that IRS had tested revisions to only five  individual forms and instructions from July 1997 through June 2002,  although hundreds of forms and instructions had been revised in 2001  alone.
Finally, in terms of enforcement, IRS will need to use multiple strategies  and techniques to find noncompliant taxpayers and bring them into  compliance.  However, a pair of tools has been shown to lead to high levels  of compliance: withholding tax from payments to taxpayers and having  third parties report information to IRS and the taxpayers on income paid to  taxpayers.  For example, 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.  Similarly, most  wages, salaries, and tip compensation are reported by employers to  employees and IRS through Form W-2.  Preliminary findings from NRP  indicate that more than 98.5 percent of these types of income are  accurately reported on individual returns.
In the past, we have identified a few potential areas where additional  withholding or information reporting requirements could serve to improve  compliance: Requiring tax withholding and more or better information return  reporting on payments made to independent contractors.  Past  IRS data have shown that independent contractors report 97 percent of  the income that appears on information returns, while contractors that  do not receive these returns report only 83 percent of income.  We have  also identified other options for improving information reporting for  independent contractors, including increasing penalties for failing to file  required information returns, lowering the $600 threshold for requiring  such returns, and requiring businesses to separately report on their tax  returns the total amount of payments to independent contractors.
Requiring information return reporting on payments made to  corporations.  Unlike payments made to sole proprietors, payments  made to corporations for services are generally not required to be  reported on information returns.  IRS and GAO have contended that the  lack of such a requirement leads to lower levels of compliance for small  corporations.  Although Congress has required federal agencies to  provide information returns on payments made to contractors since  1997, payments made by others to corporations are generally not  covered by information returns.
Require more data on information returns dealing with capital  gain income.  Past IRS studies have indicated that much of the  noncompliance associated with capital gains is a result of taxpayers  overstating an asset’s “basis,” the amount of money originally paid for  the asset.  Currently, financial institutions are required to report the  sales prices, but not the purchase prices, of stocks and bonds on  information returns.  Without information on purchase prices, IRS  cannot use efficient and effective computer-matching programs to  check for compliance and must use much more costly means to  examine taxpayer returns in order to verify capital gain income.
Although withholding and information returns are highly effective in  encouraging compliance, such additional requirements generally impose  costs and burdens on the businesses that must implement them.  However,  continued reexamination of opportunities to expand information reporting  and tax withholding could increase the transparency of the tax system.   Such reexamination could be especially relevant toward improving  compliance in areas that are particularly complex or challenging to  administer, such as noncash charitable contributions or net income and  losses passed through from “flow-through” entities such as S corporations  and partnerships to their shareholders and partners.
Finally, making progress on closing the tax gap requires that the tools and  techniques being used to promote compliance are evaluated to ensure that  they actually are effective.  IRS evaluates some of its efforts to assess how  well they work, perhaps most notably its current effort to test new  procedures designed to reduce noncompliance with the Earned Income  Tax Credit, but misses other opportunities.  For example, the lack of  testing for forms and instructions mentioned earlier is one instance where  improved evaluation would be worthwhile.  We also reported in 2002 that  the effectiveness of the Federal Tax Deposit Alert program—a program  that since 1972 has been intended to reduce delinquencies in paying  employment taxes—could not be evaluated because IRS had no system to  track contacts IRS made with delinquent employers. The availability of  current compliance information should enhance IRS’s ability to evaluate  the success of its efforts to promote compliance.
section_title: Regular Compliance Measurement Can Support Informed Decisions to Reduce the Tax Gap, but IRS Lacks Firm Plans for Such Measurement
paragraphs: Regularly measuring compliance can offer many benefits, including helping  IRS identify new or major types of noncompliance, identify changes in tax  laws and regulations that may improve compliance, more effectively target  examinations of tax returns or other enforcement programs, understand  the effectiveness of its programs to promote and enforce compliance, and  determine its resource needs and allocations.  For example, by analyzing  1979 and 1982 TCMP data, IRS identified significant noncompliance with  the number of dependents claimed on tax returns and justified a legislative  change to address the noncompliance.  As a result, for tax year 1987  taxpayers claimed about 5 million fewer dependents on their returns than  would have been expected without the change in law.  In addition, tax  compliance data are useful outside of IRS for tax policy analysis, revenue  estimating, and research.
A significant portion of IRS’s new tax gap estimate is based on recent  compliance data.  IRS used data from NRP to update individual income tax  underreporting and the portion of individual employment tax  underreporting from self-employed individuals.  Completion of NRP is a  substantial achievement—as table 1 indicates, underreporting of individual  income taxes represented about half of the tax gap for 2001 (the estimate  ranges from $150 billion to $187 billion out of a gross tax gap estimate that  ranges from $312 billion to $353 billion).  Also, from $51 billion to  $56 billion of the $66 billion to $71 billion in estimated underreported  employment tax was due to self-employment tax underreporting. IRS used  current, actual data from its Master Files to calculate the underpayment  segment of the tax gap.
IRS has concerns with the certainty of the overall tax gap estimate in part  because some areas of the estimate rely on old data and IRS has no  estimates for other areas of the tax gap.  IRS does not have estimates for  corporate income, employment, and excise tax nonfiling or for excise tax  underreporting.  For these types of noncompliance, IRS maintains that the  data are either difficult to collect, imprecise, or unavailable.  IRS has not  recently collected compliance data for the remaining segments of the tax  gap.  For example, IRS used data from the 1970s and 1980s to estimate  underreporting of corporate income taxes and employer-withheld  employment taxes.
IRS is taking several steps that could improve the tax gap estimate for tax  year 2001.  IRS plans to further analyze the preliminary results from NRP  and expects to publish a revised estimate by the end of 2005.  The revised  estimate will incorporate new methodologies, including those for  estimating overall individual income tax underreporting as well as for the  portion attributable to self-employed individuals who operate businesses  informally, and for estimating individual income tax nonfiling.  In addition,  IRS research officials have proposed a compliance measurement study that  will allow IRS to update underreporting estimates involving flow-through  entities.  This study, which IRS intends to begin in fiscal year 2006, would  take 2 to 3 years to complete.  Because either individual taxpayers or  corporations may be recipients of income (or losses) from flow-through  entities, this study could affect IRS’s estimates for the underreporting gap  for individual and corporate income tax.
While these data and methodology updates could improve the tax gap  estimates, IRS has no documented plans to periodically collect more or  better compliance data over the long term.  Other than the proposed study  of flow-through entities, IRS does not have plans to collect compliance data  for other segments of the tax gap.  Also, IRS has indicated that given its  current research priorities, it would not begin another NRP study of  individual income tax returns before 2008, if at all, and would not complete  such a study until at least 2010.  When IRS initially proposed the NRP study,  it had planned to study individual income tax underreporting on a 3-year  cycle.
According to IRS officials, IRS has not committed to regularly collecting  compliance data because of the associated costs and burdens.  Taxpayers  whose returns are examined through compliance studies such as NRP bear  costs in terms of time and money.  Also, IRS incurs costs, including direct  costs and opportunity costs—revenue that IRS potentially forgoes by using  its resources to examine randomly selected returns, which may include  returns from compliant taxpayers, as opposed to traditional examinations  that focus on taxpayer returns that likely contain noncompliance and may  more consistently produce additional tax assessments.
Although the costs and burdens of compliance measurement are legitimate  concerns, as we have reported in the past, we believe compliance studies to  be good investments.  Without current compliance data, IRS is less able to  determine key areas of noncompliance to address and actions to take to  maximize the use of its limited resources.  The lack of firm plans to  continually obtain fresh compliance data is troubling because the  frequency of data collection can have a large impact on the quality and  utility of compliance data.  As we have reported in the past, the longer the  time between compliance measurement surveys, the less useful they  become given changes in the economy and tax law.
In designing the NRP study, IRS balanced the costs, burdens, and  compliance risk of studying that area of the tax gap.  Any plans for  obtaining and maintaining reasonably current information on compliance  levels for all portions of the tax gap would similarly need to take into  account costs, burdens, and compliance risks in determining which areas  of compliance to measure and the scope and frequency of such  measurement.
section_title: Knowing the Reasons for Noncompliance Could Help Guide Compliance Efforts, but IRS Has Concerns with Its Data on These Reasons
paragraphs: Data on whether taxpayers are unintentionally or intentionally  noncompliant with specific tax provisions are critical to IRS for deciding  whether its efforts to address specific areas of noncompliance should focus  on nonenforcement activities, such as improved forms or publications, or  enforcement activities to pursue intentional noncompliance.  Recognizing  such benefits, the National Taxpayer Advocate has urged IRS to consider  performing additional research into causes of noncompliance. We have  also reported in the past that rigorous research of the causes of  noncompliance seems intuitive.
IRS collects data on the reasons for noncompliance for specific tax issues  during its examinations of tax returns, including those reviewed for NRP.   However, IRS has a number of concerns with the data:  The database is incomplete as not all examiners have been sending  information on the results, including reasons, of closed examinations to  be entered into the database.
IRS has not tested the adequacy of the controls for data entry or the  reliability of the data being collected.  IRS has found instances where  examiners close examinations without assigning a reason for  noncompliance or by assigning the same reason to all instances of  noncompliance, regardless of the situation.
IRS has not trained all examiners to deal with the subjectivity of  determining reasons to ensure consistent understanding of the reason  categories.
The data are not representative of the population of noncompliant  taxpayers because the examined tax returns were not selected  randomly.
As IRS continues to collect data on the reasons for noncompliance in the  future, it will be important to take these concerns into account.   Additionally, as with its efforts to measure compliance, it will be important  for IRS to consider the costs and burden of obtaining data on the reasons  for noncompliance.
section_title: Long-term, Quantitative Goals for Improving Taxpayers’ Compliance Would Be Consistent with Results-Oriented Management
paragraphs: Focusing on outcome-oriented goals and establishing measures to assess  the actual results, effects, or impact of a program or activity compared to  its intended purpose can help agencies improve performance and  stakeholders determine whether programs have produced desired results.  As such, establishing long-term, quantitative compliance goals offers  several benefits for IRS.  Perhaps most important, compliance goals  coupled with periodic measurements of compliance levels would provide  IRS with a better basis for determining to what extent its various service  and enforcement efforts contribute to compliance.  Additionally, long-term,  quantitative goals may help IRS consider new strategies to improve  compliance, especially since these strategies could take several years to  implement.  For example, IRS’s progress toward the goal of having  80 percent of all individual tax returns electronically filed by 2007 has  required enhancement of its technology, development of software to  support electronic filing, education of taxpayers and practitioners, and  other steps that could not be completed in a short time frame.  Focusing on  intended results can also promote strategic and disciplined management  decisions that are more likely to be effective because managers who use  fact-based performance analysis are better able to target areas most in  need of improvement and select appropriate interventions.  Likewise,  agency accountability can be enhanced when both agency management  and external stakeholders such as Congress can readily measure an  agency’s progress toward meeting its goals.  Finally, setting long-term,  quantitative goals would be consistent with results-oriented management  principles that are associated with high-performing organizations and  incorporated into the statutory management framework Congress has  adopted through GPRA.
IRS’s strategies for improving compliance generally lack a clear focus on  long-term, quantitative goals and results measurement.  Although IRS has  established broad qualitative goals and strategies for improving taxpayer  service and enhancing enforcement of the tax laws, it has not specified by  how much it hopes these strategies will improve compliance. IRS has also  identified measures, such as compliance rates for tax reporting, filing, and  payment as well as the percentage of Americans who think it is acceptable  to cheat on their taxes, which are intended to gauge the progress of its  strategies toward its broad goals.  However, IRS does not always collect  recent data to update these measures and has not established quantitative  goals against which to compare the measures.  In response to a President's  Management Agenda initiative to better integrate budget and performance  information, IRS officials said that they are considering various long-term  goals for the agency.  These goals are to be released by May 2005.  The  officials have not indicated how many goals will be related to improving  taxpayer compliance or whether they will be quantitative and results- oriented.
Not unlike other agencies, IRS faces challenges in implementing a results- oriented management approach, such as identifying and collecting the  necessary data to make informed judgments about what goals to set and to  subsequently measure its progress in reaching such goals.  However, having  completed the NRP review of income underreporting by individuals, IRS  now has an improved foundation for setting a goal or goals for improving  taxpayers’ compliance.  Nevertheless, measuring progress toward any  goals that may be set could be challenging. For example, IRS researchers  have found it difficult to determine the extent to which its enforcement  actions deter noncompliance or its services improve compliance among  taxpayers who want to comply.  Measuring these effects is complicated in  part because many factors outside of IRS’s actions can affect compliance.   However, as the National Taxpayer Advocate’s 2004 annual report to  Congress pointed out, current and existing data on noncompliance may  help IRS better understand and address this challenge.  Furthermore, even  if IRS is unable to show that its actions directly affected compliance rates,  periodic measurements of compliance levels can indicate the extent to  which compliance is improving or declining and provide a basis for  reexamining existing programs and triggering corrective actions if  necessary.
section_title: Concluding Observations
paragraphs: The nation is currently on an imprudent and unsustainable fiscal path that  threatens our future.  If we act now to address the looming fiscal  challenges facing the nation, the lives of our children and grandchildren  will be measurably better than if we wait. Nevertheless, the decisions we  must make will not be easy.  They involve difficult choices about the role of  government in our lives and our economy.  Acting now will impose  sacrifices, but today we have more options with less severe consequences  than if we wait.
Reducing the tax gap is one option that would help.  While our long term- fiscal imbalance is too large to be eliminated by one strategy, reducing the  tax gap can ease the difficult decisions that are needed.  But, regardless of  the contribution that a reduced tax gap can make to easing our long-term  challenges, we need to make concerted efforts to address the tax gap  because it is fundamentally unfair and threatens Americans’ trust in their  government.  The tax gap is both a measure of the burden and frustration of  taxpayers who want to comply but are tripped by tax code complexity and  of willful tax cheating by a minority who want the benefits of government  services without paying their fair share.
Chairman Grassley, Senator Baucus, and Members of the Committee, this  concludes my testimony.  At the request of the committee, in the near  future, we will issue a report that addresses the tax gap in greater detail  and, as appropriate, may make recommendations related to the topics  covered in my statement.  We look forward to continuing to support the  committee’s oversight of the tax gap and related issues.  I would be happy  to answer any questions you may have at this time.
section_title: Contact and Acknowledgments
paragraphs: For further information on this testimony, please contact Michael Brostek  on (202) 512-9110 or brostekm@gao.gov.  Individuals making key  contributions to this testimony include Jeff Arkin, Elizabeth Fan, Shannon  Groff, George Guttman, Michael Rose, and Tom Short.
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