Tax Gap: Complexity and Taxpayer Compliance
Published: 2011-06-28T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: Taxes are necessary because they fund the services provided by government. Several years ago, the Internal Revenue Service (IRS) estimated that the gross tax gap--the difference between taxes owed and taxes paid on time--was $345 billion for 2001. In the face of large and growing deficits, it is important to seek out potential causes and solutions to the tax gap. Achieving high levels of voluntary compliance is made more challenging as the tax code expands. Tax expenditures--preferential provisions in the code such as exemptions, exclusions, deductions, credits, and deferral of tax liability--have expanded the tax code, more than doubling in number since 1974. GAO's statement focuses on four key areas: (1) how complexity adds to taxpayer burden and economic efficiency costs; (2) how complexities in reporting income contribute to the tax gap; (3) how tax expenditures add complexity and contribute to the tax gap; and (4) possible strategies for addressing the tax gap. The statement is based largely on GAO's previous work conducted on tax compliance issues affecting individual taxpayers from 2005 through 2011.
section_title: What GAO Found
paragraphs: The federal tax system contains complex rules. These rules may be necessary, for example, to ensure proper measurement of income, target benefits to specific taxpayers, and address areas of noncompliance. However, these complex rules also impose a wide range of recordkeeping, planning, computational, and filing requirements upon businesses and individuals. Complying with these requirements costs taxpayers time and money. In 2005 GAO reviewed existing studies and reported that even using the lowest available compliance cost estimates for the personal and corporate income tax, combined compliance costs would total $107 billion (roughly 1 percent of gross domestic product) per year; other studies estimate costs 1.5 times as large. Economic efficiency costs, which are reductions in economic well-being caused by changes in behavior due to taxes, are estimated to be even larger. Although many taxpayers have simple forms of income, others do not--especially those who receive income from capital gains, rents, self-employment, and other sources--and they may be required to do complicated calculations and keep detailed records. This complexity can engender errors and underpaid taxes. For example, GAO has documented millions of taxpayer errors in following complex rules for determining taxpayers' "basis"--generally the taxpayer's investment in a property--in securities they sold or corporations they own. Tax expenditures add to tax code complexity in part because they require taxpayers to learn about, determine their eligibility for, and choose between tax expenditures that have similar purposes. Tax expenditures also complicate tax planning, as taxpayers must predict their own future circumstances as well as future tax rules to make the best choice among provisions. Taxpayer errors contribute to the tax gap. For example, in 2001 taxpayers underreported $6.3 billion in net income due to misreported Individual Retirement Arrangement (IRA) distributions. But taxpayers also may underclaim benefits to which they are entitled. According to GAO's past analysis, of tax filers who appeared to be eligible for a higher-education tax credit or tuition deduction in tax year 2005, about 19 percent, representing about 412,000 returns, failed to claim any of them. No single approach is likely to fully and cost-effectively address the tax gap, but several strategies could improve taxpayer compliance. These strategies could require actions by Congress or IRS. For example, Congress can simplify the tax code by eliminating some tax expenditures and by making definitions more consistent across the tax code. IRS and Congress could take steps to enhance information reporting by third parties or expand compliance checking before refunds are issued. GAO does not make any new recommendations in this testimony.

section_title: Letter
paragraphs: I am pleased to be here today to discuss complexity in the tax code,  taxpayer burden, and steps to improve compliance. Taxes are necessary  because they fund the services provided by government. Complexity, and  the lack of transparency that it can create, exacerbate doubts about the  current tax system’s fairness. Public confidence in the nation’s tax laws  and tax administration is critical because we rely heavily on a system of  voluntary compliance. If taxpayers do not have confidence in the tax  system or do not believe that it is easy to understand and treats everyone  fairly, then voluntary compliance is likely to decline.
The current tax system is widely viewed as complex, thereby reducing the  ability of individuals to understand and comply with tax laws. According  to a 2010 report by the National Taxpayer Advocate, the tax code has  grown so long that it has become challenging even to figure out how long  it is. Important sources of tax code complexity are income documentation  requirements and tax expenditure rules, which I will discuss in more detail  later in my statement.
Several years ago, the Internal Revenue Service (IRS) estimated that the  gross tax gap—the difference between taxes owed and taxes paid on  time—was $345 billion in 2001. We have said in past testimonies that there  are no easy fixes to this problem. But in the face of large and growing  structural deficits, it is nevertheless important that the government  continues to seek out potential causes and solutions. This is in keeping  with another theme that we have emphasized: that fundamental  reexamination of government programs, policies, and priorities is  necessary to assure that they match the needs of the 21st century. While  we do not know the extent to which tax code complexity contributes to  the tax gap, this hearing is an important step as Congress considers the  role played by tax code complexity in either contributing to the tax gap or  impeding progress towards solutions.
My statement today will cover (1) how complexity adds to taxpayer  burden and economic efficiency costs; (2) how complexities in reporting  income contribute to the tax gap; (3) how tax expenditures add  complexity and contribute to the tax gap; and (4) possible strategies for  addressing the tax gap. It is based mostly on our work from 2005 through  2011 on tax compliance issues affecting individual taxpayers. Those  performance audits 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 provided a  reasonable basis for our findings and conclusions based on our audit  objectives.
We have also updated our analyses from our previous work on the number  and sum of tax expenditure provisions. To determine the reliability of this  data, we reviewed related documentation and tested data for obvious  errors. We determined that the data were sufficiently reliable for the  purposes of this testimony.
subsections: section_title: Background
subsections: section_title: Tax Gap
paragraphs: The gross 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 paid voluntarily and on time and  what was actually paid for a specific year. Of the estimated $345 billion  tax gap for tax year 2001, IRS estimated that it would eventually recover  about $55 billion of that through late payments and enforcement actions,  for a net tax gap of $290 billion. 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 on time. We have made many recommendations over time  that could address the tax gap.
IRS’s tax gap estimates for each type of noncompliance include estimates  for some or all of the five types of taxes that IRS administers.  Underreporting of tax liabilities can occur when a taxpayer underreports  income earned or overclaims deductions from income. As shown in table  1, underreporting of tax liabilities—particularly for the individual income  tax—accounted for most of the tax gap estimate for tax year 2001. We  have encouraged regular tax gap measurements, and IRS officials have  indicated that they will be updating their tax gap estimates later in 2011 or  early 2012. We believe that these estimates are important to gauge  progress in addressing the tax gap and because analyzing the data used to  estimate it can help identify ways to improve tax compliance.
Taxpayers who underreported the amount of individual income tax they  owed represented an estimated $197 billion of the 2001 tax gap, and $165  billion of that amount was due to individual tax filers underreporting their  income. As shown in table 2, underreporting of individuals’ business  income and nonbusiness income accounted for $109 billion and $56  billion, respectively, of the 2001 tax gap.
IRS has concerns with the certainty of the tax gap estimate for tax year  2001 in part because some areas of the 2001 estimate rely on data  originally gathered in the 1970s and 1980s. IRS has no estimates for other  areas of the tax gap, and it is inherently difficult to measure some types of  noncompliance. Some analysts believe the 2001 estimate likely  underestimated the tax gap and that in absolute dollars it is likely larger  now than in 2001.
IRS’s overall approach to reducing the tax gap consists of improving  service to taxpayers and enhancing enforcement of the tax laws. IRS seeks  to improve voluntary compliance through efforts such as education and  outreach programs and tax form simplification. It also uses its  enforcement authority to ensure that taxpayers are reporting and paying  the proper amounts of taxes through efforts such as examining tax returns  and matching the amount of income taxpayers report on their tax returns  to the income amounts reported on information returns it receives from  third parties. In spite of IRS’s efforts to improve taxpayer compliance, the  rate at which taxpayers pay their taxes voluntarily and on time has tended  to range from around 81 percent to around 84 percent over the past three  decades.
section_title: Tax Expenditures
paragraphs: The sum of the estimated revenue loss due to tax expenditures was over  $1 trillion in 2010. Tax expenditures are often aimed at policy goals  similar to those of federal spending programs. Existing tax expenditures,  for example, help students and families finance higher education and  provide incentives for people to save for retirement. Because tax  expenditures result in forgone revenue for the government, they have a  significant effect on overall tax rates—all else equal, for any given level of  revenue, tax expenditures mean that overall tax rates must be higher than  a tax system with no tax expenditures. In 2005, we recommended that the  federal government take several steps to ensure greater transparency of  and accountability for tax expenditures by reporting better information on  tax expenditure performance and more fully incorporating tax  expenditures into federal performance management and budget review  processes.
section_title: Complexity Can Have Value, but Adds to Compliance and Efficiency Costs
paragraphs: The federal tax system contains complex rules.  These rules may be  necessary, for example, to ensure proper measurement of income, target  benefits to specific taxpayers, and address areas of noncompliance.  However, these complex rules also impose a wide range of record keeping,  planning, computational, and filing requirements upon businesses and  individuals. Complying with these requirements costs taxpayers time and  money. As shown in figure 1, these costs to taxpayers are above and  beyond what they pay to the government in taxes.
Estimating total compliance costs is difficult because neither the  government nor taxpayers maintain regular accounts of these costs, and  federal tax requirements often overlap with record keeping and reporting  that taxpayers do for other purposes. Although available estimates are  uncertain, taken together, they suggest that total compliance costs are  large. For example, in 2005 we reviewed existing studies and reported that  even using the lowest available compliance cost estimates for the personal  and corporate income tax, combined compliance costs would total $107  billion (roughly 1 percent of gross domestic product ) per year;  other studies estimate costs 1.5 times as large.
The tax system also results in economic efficiency costs, which are  reductions in economic well-being caused by changes in behavior due to  taxes, government benefits, monopolies, and other forces that interfere in  the market. Efficiency costs can take the form of lost output or  consumption opportunities. For example, economists generally agree that  the favorable tax treatment of owner-occupied housing distorts investment  in the economy, resulting in too much investment in housing and too little  business investment. Estimating efficiency costs associated with the tax  system is challenging because it has extensive and diverse effects on  behavior. In fact, in a 2005 report, we found no comprehensive estimates  of the efficiency costs of the current federal tax system. The two most  comprehensive studies we found suggest that these costs are large—on  the order of magnitude of 2 to 5 percent of GDP each year (as of the mid- 1990s). However, the actual efficiency costs of the current tax system may  not fall within this range because of uncertainty surrounding taxpayers’  behavioral responses, changes in the tax code and the economy since the  mid-1990s, and the fact that the two studies did not cover the full scope of  efficiency costs.
Tax software and the use of paid tax return preparers may mitigate the  need for taxpayers to understand complexities of the tax code. In 2010,  IRS processed about 137 million returns. As we have previously reported,  about 90 percent of returns are prepared by individual taxpayers or paid  preparers using professional or commercial software. Software companies  and paid preparers often act as surrogate tax administrators in that they  keep abreast of tax law changes. A participant at the 2007 Joint Forum on  Tax Compliance stated that taxpayers receiving assistance in preparing  their individual tax returns, either from paid preparers or tax preparation  software, are somewhat insulated from tax code complexity.
However, while many paid tax preparers help taxpayers by using their  expertise to help ensure that complex laws are understood, others may  introduce their own mistakes. For example, in a limited investigation in  2006, all 19 of the tax return preparers who prepared returns for our  undercover investigators produced errors, some with substantial  consequences. IRS’s review of 2001 tax returns also found that tax  returns prepared by paid preparers contained a significant level of errors.
IRS audits of returns prepared by a paid preparer showed a higher error  rate—56 percent—than audits of returns prepared by the taxpayer—47  percent.
section_title: Complexities in Reporting Income Contribute to the Tax Gap by Providing Opportunities for Taxpayers to Misreport
paragraphs: Income measurement is straightforward for a large proportion of the  individual taxpayer population: those who earn only labor and interest  income and capital income within a retirement account generally have  their income reported to them (and to the IRS) by the source of the  income. However, substantial numbers of taxpayers who receive income  from capital gains, rents, self-employment, and other sources often deal  with complex tax laws, complicated calculations, and detailed record  keeping. While complexities lead some taxpayers to make mistakes when  reporting their income, some misreporting is due to intentional acts of tax  evasion.
For example, IRS studies show that the majority of capital asset  transactions and capital gains and losses were for securities transactions  such as sales of corporate stock, mutual funds, bonds, options, and capital  gain distributions from mutual funds. Taxpayers are required to report  securities transactions on their federal income tax returns. To accurately  report securities sales, the taxpayer must have records of the dates they  acquired and sold the asset; sales price, or gross proceeds from the sale;  cost or other basis of the sold asset; and resulting gains or losses. They  must report this information separately for short-term transactions and  long-term transactions. Further, before taxpayers can determine any gains  or losses from securities sales, they must determine if and how the original  cost basis of the securities must be adjusted to reflect certain events, such  as stock splits, nontaxable dividends, or nondividend distributions.
Complex income-reporting requirements for securities transactions may  contribute to taxpayers’ misreporting their income. In 2006, we estimated  that 8.4 million of the estimated 21.9 million taxpayers with securities  transactions misreported their gains or losses for tax year 2001. A greater  estimated percentage of taxpayers misreported gains or losses from  securities sales (36 percent) than capital gain distributions from mutual  funds (13 percent), and most of the misreported securities transactions  exceeded $1,000 of capital gain or loss. This may be because taxpayers  must determine the taxable portion of securities sales’ income whereas  they need only add up their capital gain distributions. Furthermore, about  half of these taxpayers who misreported failed to accurately report the  securities’ basis, sometimes because they did not know the basis or failed  to adjust the basis appropriately. Although we were not able to estimate  the capital gains tax gap for securities, we were able to determine the  direction of the misreporting. For securities sales, an estimated 64 percent  of taxpayers underreported their income from securities (i.e., they  understated gains or overstated losses) compared to an estimated 33  percent of taxpayers who overreported income (i.e., they overstated gains  or understated losses). For both underreported and overreported  income, some taxpayers misreported over $400,000 in gains or losses.
Small businesses—which include sole proprietorships and S corporations,  among other entities—are subject to multiple layers of filing, reporting,  and deposit requirements. These requirements reflect IRS’s administration  of a variety of tax and other policies, including income, employment, and  excise taxes, as well as pension and other employee benefit programs. In  considering the number of requirements, it is important to note that the  requirements reflect many decisions and compromises made by Congress  and administrations to accomplish their policy goals, including those that  may benefit small businesses and other taxpayers.
Sole proprietors face significant complexities in reporting income. This  complexity may contribute to the estimated $68 billion of the tax gap  caused by sole proprietors underreporting their net business income,  which can stem either from understated receipts or overstated expenses.  For example, sole proprietors report their business-related profit or loss  on their individual income tax return, and they can use their losses to  offset other categories of income on their returns in the year that they  incur the loss. Identifying which of a sole proprietor’s payments qualify as  business expenses and the amount to be deducted can be complex. For  example, two types of payments—costs of goods sold and capital  improvements—must be distinguished from other types of payments  because they are treated differently under tax rules. Expenses that are  used partly for business and personal purposes can be deducted only to  the extent they are used for business.
Individual taxpayers who are shareholders in S corporations may also  experience difficulty because of complexity in income measurement. An S  corporation is a federal business type that provides tax benefits and  limited liability protection to shareholders. S corporations are not  generally taxed at the entity level: income, losses, and deduction items  pass through to the individual shareholders’ income tax returns, and the  shareholders are taxed on any net income. S corporations are to provide  their shareholders and IRS with information on the allocation of income,  losses, and other items.
As we have previously reported, one source of complexity for S  corporation shareholders may arise when calculating basis—their  ownership share of the corporation—in order to claim losses and  deductions to offset other earned income. Shareholders generally can  only claim losses and deductions up to the amount of basis the  shareholder has in the S corporation’s stock and debt. While the S  corporation is required to send shareholders some information that can be  used to calculate basis, S corporations are not required to report any basis  calculations to shareholders. IRS officials and S corporation stakeholder  representatives told us that calculating and tracking basis was one of the  biggest challenges in complying with S corporation rules. In 2009, we  recommended that Congress require S corporations to calculate  shareholder’s stock and debt basis as completely as possible and report  the calculation to shareholders and IRS. In an analysis of IRS’s annual  examinations of individual tax returns that closed for fiscal years 2006  through 2008, we found the amount of the misreported losses that  exceeded basis limitations was over $10 million, or about $21,600 per  taxpayer.
section_title: Tax Expenditures Add Complexity and Contribute to the Tax Gap by Providing Opportunities for Taxpayers to Make Mistakes or Evade Taxes
paragraphs: The growing number of tax expenditures is among the causes of tax code  complexity. Between 1974 and 2010, tax expenditures reported by the  Department of the Treasury more than doubled in overall number from 67  to 173. Tax expenditures are an important means the government uses to  address a wide variety of social objectives, from supporting educational  attainment, to providing low-income housing, to ensuring retirement  income, and many others. However, tax expenditures add to tax code  complexity in part because they require taxpayers to learn about,  determine their eligibility for, and choose between tax expenditures that  have similar purposes. Tax expenditures also complicate tax planning, as  taxpayers must predict their own future circumstances as well as future  tax rules to make the best choice among provisions.
Savings incentives within the tax code illustrate how tax expenditures add  to complexity. While the tax code includes numerous types of savings  incentives—including those for healthcare and higher education—my  statement will focus on retirement savings as a key example. Taxpayers  can choose between traditional Individual Retirement Arrangements (IRA)  and Roth IRAs for retirement savings. Although the tax rules for  distributions diverge for traditional and Roth IRAs, taxpayers may not  know that a 10 percent early withdrawal penalty, with some exceptions,  applies to both IRA types. Taxpayers also get confused over which IRA  early withdrawals are not subject to penalties, in part because the  exceptions differ for employer pension plans. Additionally, both types of  IRAs have rules governing eligibility to contribute, and contributions to  each are subject to an annual limit. However, taxpayers may not  understand that the annual contribution limit applies across traditional  IRAs and Roth IRAs in combination, which may lead them to  overcontribute. With regard to record-keeping burden, taxpayers with  traditional or Roth IRAs must track the total amount of contributions in a  given year and reasons for distributions to accurately report this  information on their tax returns. Frequent changes to IRA rules (such as  increasing contribution limits and allowing workers to tap IRA assets for  certain nonretirement purposes without an early withdrawal penalty) have  also made tax planning more difficult for taxpayers.
As we reported in 2008, IRS research and enforcement data show that—in  the aggregate—many taxpayers misreported millions of dollars in  traditional IRA contributions and distributions on their tax returns. We  reported that in tax year 2001 the following occurred:    Of the taxpayers who made deductible traditional IRA contributions,  an estimated 14.8 percent (554,657 taxpayers) did not accurately  report the IRA deduction on their individual tax returns—10.4 percent  overstated their deductible contributions (that is, exceeded the  applicable limit) and 4.4 percent underreported their deductible  contributions (that is, reported less on their returns than they actually  could deduct). The understated net income due to these misreported  traditional IRA contribution deductions was $392 million, including  both taxpayers who either overstated or understated their contribution  deductions to a traditional IRA.
Of the taxpayers who had taxable traditional IRA distributions, an  estimated 14.6 percent (1.5 million taxpayers) misreported  withdrawals from their traditional IRA distributions—13.7 percent  understated (that is, reported an amount less than what the taxpayer  withdrew) and 0.9 percent overstated IRA distributions (that is,  reported an amount greater than what the taxpayer withdrew). The  underreported net income due to misreported IRA distributions was  $6.3 billion, including taxpayers who failed to report early  distributions and the associated tax.
Taxpayers also make costly mistakes when choosing higher-education tax  incentives. In a 2008 testimony, we reported that among tax filers who  appeared to be eligible for a tax credit or tuition deduction in tax year  2005, about 19 percent, representing about 412,000 returns, failed to claim  any of them. The amount by which these tax filers failed to reduce their  tax averaged $219; 10 percent of this group could have reduced their tax  liability by over $500. In total, including both those who failed to claim a  tax credit or tuition deduction and those who chose a credit or a  deduction that did not maximize their benefit, we found that in 2005, 28  percent, or nearly 601,000 tax filers, did not maximize their potential tax  benefit.
Some tax expenditures also provide taxpayers who intend to evade taxes  with opportunities to do so. For example, the Treasury Inspector General  for Tax Administration (TIGTA) reported in 2011 that the First-time  Homebuyer Credit (FTHBC) and the subsequent changes made to the  credit have confused taxpayers and allowed individuals to make  fraudulent claims for the refundable credit. For example, TIGTA reported  many taxpayers claiming the credit appeared not to be first-time  homebuyers because tax information indicated they had owned homes  within 3 years prior to their new home purchase. The 2008 FTHBC  provided taxpayers a refundable credit of up to $7,500 that must be repaid  in $500 increments each year over 15 years beginning in the 2011 filing  season. According to recent IRS data, the total amount to be repaid by  taxpayers is $7 billion. The American Recovery and Reinvestment Act of  2009 increased the maximum FTHBC credit to $8,000, with no payback  required unless the home ceases to be the taxpayer’s principal residence  within 3 years. In 2009, we testified that IRS faced significant challenges in  determining if taxpayers were complying with the numerous conditions  for the credit. For example, to determine eligibility, IRS had to verify that  taxpayers had not owned a house in the previous 3 years and verify the  closing date on home purchases. Other challenges included enforcing the  $500 per year payback provision in the 2008 credit.
section_title: Strategies to Reduce the Tax Gap Present Challenges and Trade- offs
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 could require actions by  Congress or IRS.
subsections: section_title: Enhancing Information Reporting
paragraphs: Enhancing information reporting can reduce complexity for taxpayers. It  can also reduce the opportunities available for taxpayers to evade taxes  by, for example, underreporting business income or filing fraudulent  claims for tax credits. Generally, new requirements on third parties to  submit information returns would require statutory changes, whereas  improvements to existing information-reporting forms may be done  administratively by IRS.
The extent to which individual taxpayers accurately report the income  they earn has been shown to be 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, 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. For types of income for  which there is little or no information reporting, individual taxpayers tend  to misreport over half of their income.
One area where improved information reporting could help is higher- education expenses. Eligible educational institutions are required to report  information on qualified tuition and related expenses for higher education  to both taxpayers and IRS so that taxpayers can determine the amount of  educational tax benefits that can be claimed. However, the information  currently reported by educational institutions on tuition statements sent to  IRS and taxpayers (on Form 1098-T) may be confusing for taxpayers who  use the form to prepare their tax returns and not very useful to IRS. IRS  requires institutions to report on Form 1098-T either the (1) amount of  payments received, or (2) amount billed for qualified expenses. IRS  officials stated that most institutions report the amount billed and do not  report payments. However, the amount billed may not equal the amount  that can be claimed as a credit. In order to reduce taxpayer confusion  and enhance compliance with the eligibility requirements for higher- education benefits, in 2009 we recommended that IRS revise Form 1098-T  to improve the usefulness of information on qualifying education  expenses.
Another area where improved information reporting could improve  compliance is rental income. In 2008, we estimated that at least 53 percent  of individual taxpayers with rental real estate misreported their rental real  estate activities for tax year 2001, resulting in an estimated $12.4 billion of  net misreported income. IRS enforcement officials cited limited  information reporting as a major challenge in ensuring compliance  because without third-party information reporting, it is difficult for IRS to  systematically detect taxpayers who fail to report any rent or determine  whether the rent and expense amounts taxpayers report are accurate. In  2008, we recommended that IRS require third parties to report mortgaged  property addresses to help IRS identify who may have misreported their  rental real estate activity, but IRS did not adopt our recommendation  because of third-party burden and a lack of an IRS compliance program to  use such information. We made a similar recommendation in a 2009  report, which IRS is still evaluating as of December 2010.
While information reporting reduces the complexity of reporting income  for individual taxpayers, this tool can create costs for the third parties  responsible for reporting the income to the taxpayer and IRS. For  example, we previously reported that expanding information reporting on  securities sales to include basic information would involve challenges for  brokers and the IRS. In particular, brokers would bear costs and  burdens—even as taxpayers’ costs and burdens decrease somewhat—and  many issues would arise about how to calculate adjusted basis, which  securities would be covered, and how information would be transferred  among brokers.
In some cases it is difficult to identify third parties for whom a reporting  requirement could be enforced without an undue burden on both the third  parties and IRS. In a 2009 report, we found that a major reason why little  information reporting on sole proprietor expenses exists is because of the  difficulty identifying third parties. For example, there is no third party  who could verify the business use of cars or trucks by sole proprietors.
section_title: Ensuring High-Quality Services to Taxpayers
paragraphs: Ensuring high-quality services is a necessary foundation for voluntary  compliance, so action by IRS to improve the quality of services provided to  taxpayers would be beneficial. High-quality services can help taxpayers  who wish to comply but do not understand their obligations. IRS taxpayer  services include education and outreach programs, simplifying the tax  process, and revising forms and publications to make them electronically  accessible and more easily understood by diverse taxpayer communities.  For example, if tax forms and instructions are unclear, taxpayers may be  confused and make unintentional errors. Ensuring high-quality taxpayer  services would also be a key consideration in implementing any of the  approaches for tax gap reduction. For example, expanding enforcement  efforts would increase interactions with taxpayers, requiring processes to  efficiently communicate with taxpayers. Changing tax laws and  regulations would also require educating taxpayers about the new  requirements in a clear, timely, and accessible manner. For example, we  previously reported that while taxpayers’ access to telephone assistance in  tax year 2009 was better than the previous year, it remained lower than in  2007, in part because of calls about tax law changes. Despite heavy call  volume, the accuracy of IRS responses to taxpayers’ questions remained  above 90 percent.
section_title: Simplifying the Tax Code or Fundamental Tax Reform
paragraphs: Congressional 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 businesses to understand and voluntarily comply with their tax  obligations. One way to simplify the tax code is to eliminate or combine  tax expenditures, thereby helping reduce taxpayers’ unintentional errors  and limiting opportunities for tax evasion. As we have previously testified,  the Government Performance and Results Act (GPRA) Modernization Act  of 2010 (GPRAMA) could help inform reexamination or restructuring  efforts and lead to more efficient and economical executive-branch service  delivery in overlapping program areas. The act is intended to identify the  various agencies and federal activities—including spending programs,  regulations, and tax expenditures—that contribute to crosscutting  outcomes.
While simplification can have benefits, it can also have drawbacks.  Eliminating tax expenditures would reduce the incentives for the activities  that were encouraged. Also, in 2005, we stated that changes to the tax  system can create winners and losers. The government may attempt to  mitigate large gains and losses by implementing transition rules. Deciding  if transition relief is necessary involves how to trade off between equity,  efficiency, simplicity, transparency, and administrability.
Similar trade-offs exist with possible fundamental tax reforms that would  move away from an income tax system to some other system, such as a  consumption tax, national sales tax, or value-added tax. Fundamental tax  reform would most likely result in a smaller tax gap if the new system has  few tax preferences or complex tax code provisions and if taxable  transactions are transparent. However, these characteristics are difficult  to achieve in any system and experience suggests that simply adopting a  fundamentally different tax system, whatever the economic merits, may  not by itself eliminate any tax gap. For example, in 2008, we reported that  some available data indicate a value-added tax may be less expensive to  administer than an income tax. However, we found that like other systems,  even a simple value-added tax—one that exempts few goods or services— has compliance risks and, largely as a consequence, generates  administrative costs and compliance burden. Similar to other taxes,  adding complexity through exemptions or reduced rates for some goods  or services generally decreases revenue and increases compliance risks  because of the incentive to misclassify purchases and sales. Such  complexity also increases the record-keeping burden on businesses and  increases the government resources devoted to enforcement.
Any tax system could be subject to noncompliance, and its design and  operation, including the types of tools made available to tax  administrators, will affect the size of any corresponding tax gap. Further,  the motivating forces behind tax reform include factors beyond tax  compliance, such as economic effectiveness, equity, and burden, which  could in some cases carry greater weight in designing an alternative tax  system than ensuring the highest levels of compliance.
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, and Questions, may be useful  in guiding policymakers as they consider tax reform proposals.
section_title: Devoting Additional Resources to Enforcement
paragraphs: Devoting additional resources to enforcement has the potential to help  reduce the tax gap by billions of dollars. 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. If Congress were to provide IRS more enforcement  resources, the amount that the tax gap could be reduced depends in part  on factors such as the size of budget increases, how IRS manages any  additional resources, and the indirect increase in taxpayers’ voluntary  compliance resulting from expanded enforcement. Providing IRS with  additional funding would enable it to contact millions of potentially  noncompliant taxpayers it currently identifies but cannot contact given  resource constraints.
However, devoting additional resources to enforcement will not  completely close the tax gap. For example, in a 2009 report, we reported  that IRS’s compliance programs focused on sole proprietors’  underreporting of income addressed only a small portion of sole  proprietor expense noncompliance. 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. These exams are  costly and yielded less revenue than exams 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. In April 2011, the Commissioner of Internal  Revenue 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 move to matching those information returns to tax returns during tax  return processing. IRS currently matches data provided on over 2 billion  information returns to tax returns only after the normal filing season.  Matching during the filing season would allow IRS to detect and correct  errors before it sends taxpayers their refunds, thereby avoiding the costs  of trying to recover funds from taxpayers later. This approach 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. One prerequisite would be a major reworking of some  fundamental IRS computer systems. To the extent that implementing this  vision would require additional budgetary resources or changes in tax  policies, Congress would play a key role.
section_title: Using Consistent Definitions
paragraphs: If Congress changed the law to include more consistent definitions across  tax provisions, then taxpayers could more easily understand and comply  with their obligations. Higher-education tax preferences provide an  example of inconsistent definitions for qualified education expenses.   What tax filers are allowed to claim as a qualified higher-education  expense varies between some of the various savings and credit provisions  in the tax code. For example, while Coverdell education savings accounts  and qualified tuition programs under section 529 of the Internal Revenue  Code permit tax filers to include room and board as qualified expenses if  the student is enrolled at least half time, the American Opportunity Credit  and the Lifetime Learning Credit do not. These dissimilar definitions  require that tax filers keep track of expenses separately, applying some  expenses to some tax preferences, but not others.
There are no easy solutions to the tax gap, but addressing the tax gap is as  important as ever before in the face of the nation’s fiscal challenges.  Innovative thinking and the combined efforts of IRS and Congress will be  needed now and in the years to come.
Chairman Baucus, Ranking Member Hatch, and Members of the  Committee, this completes my prepared statement. I would be happy to  respond to any questions you may have at this time.
section_title: Contact and Acknowledgments
paragraphs: For further information on this testimony, please contact Michael Brostek  at (202) 512-9110 or brostekm@gao.gov. In addition to the individual  named above, David Lewis, Assistant Director; Shannon Finnegan, analyst- in-charge; Sandra Beattie; Amy Bowser; Barbara Lancaster; John Mingus;  Erika Navarro; Melanie Papasian; and Jonathan Stehle made key  contributions to this report. Contact points for our Offices of  Congressional Relations and Public Affairs may be found on the last page  of this statement.
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