Tax Compliance: Opportunities Exist to Reduce the Tax Gap Using a Variety of Approaches
Published: 2006-07-26T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: The tax gap--the difference between the tax amounts taxpayers pay voluntarily and on time and what they should pay under the law--has been a long-standing problem in spite of many efforts to reduce it. Most recently, the Internal Revenue Service (IRS) estimated a gross tax gap for tax year 2001 of $345 billion and estimated it would recover $55 billion of this gap, resulting in a net tax gap of $290 billion. When some taxpayers fail to comply, the burden of funding the nation's commitments falls more heavily on compliant taxpayers. Reducing the tax gap would help improve the nation's fiscal stability. For example, each 1 percent reduction in the net tax gap would likely yield $3 billion annually. GAO was asked to discuss the tax gap and various approaches to reduce it. This testimony discusses to what extent the tax gap could be reduced through three approaches--simplifying or reforming the tax system, providing IRS with additional enforcement tools, and devoting additional resources to enforcement--as well as various factors that could guide decision-making when devising a strategy to reduce the tax gap. This statement is based on prior GAO work.
section_title: What GAO Found
paragraphs: Simplifying the tax code or fundamental tax reform has the potential to reduce the tax gap by billions of dollars. IRS has estimated that errors in claiming tax credits and deductions for tax year 2001 contributed $32 billion to the tax gap. Thus, considerable potential exists. However, these provisions serve purposes Congress has judged to be important and eliminating or consolidating them could be complicated. Fundamental tax reform would be most likely to result in a smaller tax gap if the new system has few, if any, exceptions (e.g., few tax preferences) and taxable transactions are transparent to tax administrators. These characteristics are difficult to achieve, and any tax system could be subject to noncompliance. Withholding and information reporting are particularly powerful tools to reduce the tax gap. They could help reduce the tax gap by billions of dollars, especially if they can make currently underreported income transparent to IRS. These tools have been shown to lead to high, sustained levels of taxpayer compliance. Using these tools can also help IRS better allocate its resources to the extent they help IRS identify and prioritize its contacts with noncompliant taxpayers. As GAO previously suggested, reporting the cost, or basis, of securities sales is one option to improve taxpayers' compliance. However, designing additional withholding and information reporting requirements may be challenging given that many types of income are already subject to reporting, there are many forms of underreporting, and withholding and reporting requirements impose costs on third parties. 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 for IRS requires taking into account many factors such as how well 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 decides to provide IRS more enforcement resources, the amount the tax gap could be reduced would depend 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. Increasing IRS's funding would enable it to contact millions of potentially noncompliant taxpayers it identifies but does not have resources to contact. Finally, using multiple approaches may be the most effective strategy to reduce the tax gap, as no one approach is likely to fully and cost effectively address noncompliance. Key factors to consider in devising a tax gap reduction strategy include periodically measuring noncompliance and its causes, setting reduction goals, leveraging technology, optimizing IRS's allocation of resources, and evaluating the results of any initiatives.

section_title: Letter
paragraphs: I appreciate this opportunity to discuss the tax gap—the difference  between what taxpayers pay in taxes voluntarily and on time and what  they should pay under the law—and what is achievable in reducing the  gap. Most recently, the Internal Revenue Service (IRS) estimated that for  tax year 2001, taxpayers paid about 84 percent of the taxes that should  have been paid on time under the law, resulting in an estimated gross tax  gap of $345 billion. IRS estimated that it would eventually recover around  $55 billion of the 2001 tax gap through late payments and IRS enforcement  actions, leaving a net tax gap of $290 billion. Because of taxpayer  noncompliance, the burden of funding the nation’s commitments falls  more heavily on taxpayers who willingly and accurately pay their taxes.  Reducing the tax gap would help improve the nation’s fiscal stability. For  example, based on IRS’s estimate, each 1 percent reduction in the net tax  gap would likely yield nearly $3 billion annually. However, the tax gap has  been a persistent problem in spite of a myriad of congressional and IRS  efforts to reduce it, as the rate at which taxpayers voluntarily comply with  our tax laws has changed little over the past three decades. Likewise,  factors such as globalization and the ever-increasing complexity of the tax  code further challenge IRS’s ability to administer the tax code.
My remarks focus on what is achievable in reducing the tax gap through a  variety of approaches, specifically by (1) simplifying or reforming the tax  system; (2) providing IRS additional enforcement authority and tools, such  as information reporting and tax withholding, through changes to the tax  laws; and (3) devoting additional resources to enforcement under the  existing tax laws. I will also discuss various factors that could guide  decision making when devising a strategy to reduce the tax gap. My  remarks are based on our previous work on a variety of issues, in  particular, recent testimonies and a report on reducing the tax gap. These  efforts were conducted in accordance with generally accepted government  auditing standards.
Let me begin by highlighting four major points:    Simplifying the tax code or fundamental tax reform has the potential to  reduce the tax gap by many billions of dollars. For example, IRS estimated  that errors in claiming tax credits and deductions for tax year 2001  contributed $32 billion to the tax gap. Reducing the number of such credits  and deductions therefore has some direct potential to reduce the tax gap.  However, these credits and deductions serve purposes Congress has  judged to be important, and eliminating them likely would be complicated.  Fundamental tax reform, such as shifting to a consumption tax system,  would most likely result in a smaller tax gap if the new system has few, if  any, exceptions (e.g., few or no tax preferences) and taxable transactions  are transparent to tax administrators. These characteristics are difficult to  achieve in any system, and any tax system could be subject to  noncompliance.
Providing IRS with more enforcement tools, particularly withholding and  information reporting, also has the potential to reduce the tax gap by  billions of dollars, especially if those tools help IRS deal with the largest  contributor to the tax gap—underreported income. Tax withholding and  information reporting have been shown to lead to high, sustained levels of  taxpayer compliance because the income taxpayers earn is transparent to  them and IRS. Also, using these tools can help IRS better allocate its  resources by improving its ability to identify and prioritize noncompliant  taxpayers it contacts. For example, we found that having third parties  report to taxpayers and IRS the cost, or basis, of stocks and mutual funds  that taxpayers sell could help taxpayers improve their voluntary  compliance and help IRS allocate its enforcement efforts concerning these  transactions. However, designing withholding or information reporting  requirements to address underreporting may be challenging given that  many types of income are already subject to such requirements, there are  many forms of underreporting, and any requirements could impose costs  and burdens on the third parties that withhold or report.
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 of the tax gap that 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 identifies but currently cannot contact given  resource constraints.
Each approach to reducing the tax gap—simplifying or reforming the tax  code, providing IRS with more enforcement tools, or devoting additional  resources to enforcement—has the potential to reduce the tax gap,  although using multiple approaches may be the most effective strategy  since no one approach is likely to fully and cost effectively address  noncompliance. Some key factors to consider in designing a strategy to  reduce the tax gap include periodically measuring noncompliance and its  causes, setting tax gap reduction goals and measuring progress against the  goals, leveraging technology to enhance IRS’s efficiency, identifying and  considering the costs and benefits of possible approaches, optimizing the  allocation of IRS’s resources, and evaluating the results of any initiatives  to reduce the tax gap.
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 paid voluntarily and on time 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 on time. 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. As shown in table 1, underreporting of tax liabilities  accounted for most of the tax gap estimate for tax year 2001.
IRS has estimated the tax gap on multiple occasions, beginning in 1979,  relying on its Taxpayer Compliance Measurement Program (TCMP). 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 for tax year  2001 while minimizing taxpayer burden.
IRS has concerns with the certainty of the tax gap estimate for tax year  2001 in part because some areas of the estimate rely on old data, IRS has  no estimates for other areas of the tax gap, and it is inherently difficult to  measure some types of noncompliance. IRS used data from NRP to  estimate individual income tax underreporting and the portion of  employment tax underreporting attributed to self-employed individuals.  The underpayment segment of the tax gap is not an estimate, but rather  represents the tax amounts that taxpayers reported on time but did not  pay on time. Other areas of the estimate, such as corporate income tax and  employer-withheld employment tax underreporting, rely on decades-old  data. Also, IRS has no estimates for corporate income, employment, and  excise tax nonfiling or for excise tax underreporting. In addition, it is  inherently difficult for IRS to observe and measure some types of  underreporting or nonfiling, such as tracking cash payments that  businesses make to their employees, as businesses and employees may not  report these payments to IRS in order to avoid paying employment and  income taxes, respectively.
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 by attempting to simplify the tax process, such as  by revising forms and publications to make them electronically accessible  and more easily understood by diverse taxpayer communities. IRS 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. IRS reports that it collected over $47 billion in 2005 from  noncompliant taxpayers it identified through its various enforcement  programs.
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. Any  significant reduction of the tax gap would likely depend on an  improvement in the level of taxpayer compliance.
section_title: Reducing the Tax Gap through Tax Simplification or Tax System Reform Depends on Their Design and May Have Effects Beyond Tax Compliance
paragraphs: Tax law simplification and reform both have the potential to reduce the  tax gap by billions of dollars. The extent to which the tax gap would be  reduced depends on which parts of the tax system would be simplified and  in what manner as well as how any reform of the tax system is designed  and implemented. Neither approach, however, will eliminate the gap.  Further, changes in the tax laws and system to improve tax compliance  could have unintended effects on other tax system objectives, such as  those involving economic behavior or equity.
Simplification has the potential to reduce the tax gap for at least 3 broad  reasons. First, it could help taxpayers to comply voluntarily with more  certainty, reducing inadvertent errors by those who want to comply but  are confused because of complexity. Second, it may limit opportunities for  tax evasion, reducing intentional noncompliance by taxpayers who can  misuse the complex code provisions to hide their noncompliance or to  achieve ends through tax shelters. Third, tax code complexity may erode  taxpayers’ willingness to comply voluntarily if they cannot understand its  provisions or they see others taking advantage of complexity to  intentionally underreport their taxes.
Simplification could take multiple forms. One form would be to retain  existing laws but make them simpler. For example, in our July 2005 report  on postsecondary tax preferences, we noted that the definition of a  qualifying postsecondary education expense differed somewhat among  some tax code provisions, for instance with some including the cost to  purchase books and others not. Making definitions consistent across code  provisions may reduce taxpayer errors. Although we cannot say the errors  were due to these differences in definitions, in a limited study of paid  preparer services to taxpayers, we found some preparers claiming  unallowable expenses for books. Further, the Joint Committee on  Taxation suggested that such dissimilar definitions may increase the  likelihood of taxpayer errors and increase taxpayer frustration.
Another tax code provision in which complexity may have contributed to  the individual tax gap involves the earned income tax credit, for which IRS  estimated a tax loss of up to about $10 billion for tax year 1999. Although  some of this noncompliance may be intentional, we and the National  Taxpayer Advocate have previously reported that confusion over the  complex rules governing eligibility for claiming the credit could cause  taxpayers to fail to comply inadvertently.
Although retaining but simplifying tax code provisions may help reduce  the tax gap, doing so may not be easy, may conflict with other policy  decisions, and may have unintended consequences. The simplification of  the definition of a qualifying child across various code sections is an  example. We suggested in the early 1990s that standardizing the definition  of a qualifying child could reduce taxpayer errors and reduce their  burden. A change was not made until 2004. However, some have  suggested that the change has created some unintended consequences,  such as increasing some taxpayers’ ability to reduce their taxes in ways  Congress may not have intended.
Another form of simplification could be to eliminate or consolidate tax  expenditures. Among the many causes of tax code complexity is the  growing number of preferential provisions in the code, defined in statute  as tax expenditures, such as tax exemptions, exclusions, deductions,  credits, and deferrals. The number of these tax expenditures has more  than doubled from 1974 through 2005. Tax expenditures can contribute to  the tax gap if taxpayers claim them improperly. For example, IRS’s recent  tax gap estimate includes a $32 billion loss in individual income taxes for  tax year 2001 because of noncompliance with these provisions.  Simplifying these provisions of the tax code would not likely yield $32  billion in revenue because even simplified provisions likely would have  some associated noncompliance. However, the estimate suggests that  simplification could have important tax gap consequences, particularly if  simplification also accounted for any noncompliance that arises because  of complexity on the income side of the tax gap for individuals.
However, these credits and deductions serve purposes that Congress has  judged to be important to advance federal goals. Eliminating them or  consolidating them likely would be complicated, and would likely create  winners and losers. Elimination also could conflict with other objectives  such as encouraging certain economic activity or improving equity.
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 may not by itself eliminate any tax  gap. Any tax system could be subject to noncompliance, and their design  and operation, including the types of tools made available to tax  administrators affect the size of any corresponding tax gap. Further, the  motivating forces behind tax reform likely 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.
section_title: Providing IRS with Additional Enforcement Tools Potentially Could Improve Compliance Significantly, but Identifying and Designing Such Tools Can Be Challenging
paragraphs: Changing the tax laws to provide IRS with additional enforcement tools,  such as expanded tax withholding and information reporting, could also  reduce the tax gap by many billions of dollars, particularly with regard to  underreporting—the largest segment of the tax gap. Tax withholding  promotes compliance because employers or other parties subtract some  or all of the taxes owed from a taxpayer’s income and remit them to IRS.  Information reporting tends to lead to high of compliance because income  taxpayers earn is transparent to them and IRS. In both cases, high levels of  compliance tend to be maintained over time. Also, because through  withholding and information reporting IRS can better identify  noncompliant taxpayers and prioritize contacting them by the potential for  additional revenue, these tools can enable IRS to better allocate its  resources. However, designing new withholding or information reporting  requirements to address underreporting can be challenging given that  many types of income are already subject to at least some form of  withholding or information reporting, there are varied forms of  underreporting, and the requirements could impose costs and burdens on  third parties.
Taxpayers tend to report income subject to tax withholding or information  reporting with high levels of compliance, as shown in figure 1, because the  income is transparent to the taxpayers as well as to IRS. Additionally, once  withholding or information reporting requirements are in place for  particular types of income, compliance tends to remains high over time.  For example, for wages and salaries, which are subject to tax withholding  and substantial information reporting, the percentage of income that  taxpayers misreport report has consistently been measured at around 1  percent over time.
In the past, we have identified a few specific areas where additional  withholding or information reporting requirements could serve to improve  compliance:    Require more data on information returns dealing with capital  gains income from securities sales. Recently, we reported that an  estimated 36 percent of taxpayers misreported their capital gains or losses  from the sale of securities, such as corporate stocks and mutual funds.
Further, around half of the taxpayers who misreported did so because  they failed to report the securities’ cost, or basis, sometimes because they  did not know the securities’ basis or failed to take certain events into  account that required them to adjust the basis of their securities. When  taxpayers sell securities like stock and mutual funds through brokers, the  brokers are required to report information on the sale, including the  amount of gross proceeds the taxpayer received; however, brokers are not  required to report basis information for the sale of these securities. We  found that requiring brokers to report basis information for securities  sales could improve taxpayers’ compliance in reporting their securities  gains and losses and help IRS identify noncompliant taxpayers. However,  we were unable to estimate the extent to which a basis reporting  requirement would reduce the capital gains tax gap because of limitations  with the compliance data on capital gains and because neither IRS nor we  know the portion of the capital gains tax gap attributed to securities sales.
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 report separately on their tax  returns the total amount of payments to independent contractors. IRS’s  Taxpayer Advocate Service recently recommended allowing independent  contractors to enter into voluntary withholding agreements.
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.  The Taxpayer Advocate Service has recommended requiring information  reporting on payments made to corporations, and the administration’s  fiscal year 2007 budget has proposed requiring additional information  reporting on certain good and service payments by federal, state, and local  governments.
In addition to improving taxpayer compliance, information reporting can  help IRS to better allocate its resources to the extent that it helps IRS  better identify noncompliant taxpayers and the potential for additional  revenue that could be obtained by contacting these taxpayers. For  example, IRS officials told us that receiving information on basis for  taxpayers’ securities sales would allow IRS to determine more precisely  taxpayers’ income for securities sales through its document matching  programs and would allow it to identify which taxpayers who misreported  securities income have the greatest potential for additional tax  assessments. Similarly, IRS could use basis information to improve both  aspects of its examination program—examinations of tax returns through  correspondence and examinations of tax returns face-to-face with the  taxpayer. Currently, capital gains issues are too complex and time  consuming for IRS to examine through correspondence. However, IRS  officials told us that receiving cost basis information might enable IRS to  examine noncompliant taxpayers through correspondence because it  could productively select tax returns to examine. Also, having cost basis  information could help IRS identify the best cases to examine face-to-face,  making the examinations more productive while simultaneously reducing  the burden imposed on compliant taxpayers who otherwise would be  selected for examination. As a result of all these benefits, basis reporting  would allow IRS to better allocate its resources that focus on securities  misreporting across its enforcement programs.
Although withholding and information reporting lead to high levels of  compliance, designing new requirements to address underreporting could  be challenging given that many types of income, including wages and  salaries, dividend and interest income, and income from pensions and  Social Security are already subject to withholding or substantial  information reporting. Also, there are challenges involved with  establishing new withholding or information reporting requirements for  certain other types of income where there is extensive underreporting of  income. Challenges exist because taxable income may be difficult to  determine because of complex tax laws, complex transactions, or the lack  of a practical and reliable third-party source to provide the information.  For example, with regard to reporting securities basis information, we  reported that it would be difficult for brokers to report information for  some types of transactions because of complex tax laws and that  representatives from the securities industry told us that a set of rules  would need to be developed to establish clearly what types of transactions  would be subject to any reporting requirement.
Likewise, a persistent and large part of the tax gap relates to nonfarm sole  proprietor and informal supplier income. As shown in figure 1, this  income is not subject to information reporting, and these taxpayers  misreported about half of the income they earned for tax year 2001.  Although establishing withholding or information reporting requirements  for these forms of income would likely improve taxpayers’ compliance,  practical and effective information reporting mechanisms are difficult to  identify. For example, informal suppliers by definition receive income in  an informal manner through services they provide to a variety of individual  citizens or small businesses. Whereas businesses may have the capacity to  perform withholding and information reporting functions for their  employees, it may be challenging to extend withholding or information  reporting responsibilities to the individual citizens that receive services,  who may not have the resources or knowledge to comply with such  requirements. Consequently, innovative approaches likely will be needed if  tools like withholding and information returns are to be extended to cover  more sources of the tax gap.
Finally, implementing tax withholding and information reporting  requirements generally imposes costs and burdens on the businesses that  must implement them, and, in some cases, on taxpayers. For example,  expanding information reporting on securities sales to include basis  information will impose costs on the brokers that would track and report  the information. Further, trying to close the entire tax gap with these  enforcement tools could entail more intrusive recordkeeping or reporting  than the public is willing to accept. Considering these costs and burdens  should be part of any evaluation of additional withholding or information  reporting requirements.
Although I have focused on information reporting and tax withholding, I  want to mention one other enforcement tool that can potentially deter  noncompliance, which is the use of penalties for filing inaccurate or late  tax and information returns. Congress has placed a number of civil penalty  provisions in the tax code. However, as with civil penalties related to other  federal agencies, inflation may have weakened the deterrent effect of IRS  penalties. For example, the Treasury Inspector General for Tax  Administration has noted that the $50 per partner per month penalty for a  late-filed partnership tax return, established by Congress in 1978, would  equate to $17.22 in 2004 dollars. In its fiscal year 2007 budget, the  administration has proposed expanding penalty provisions applicable to  paid tax return preparers to include non-income tax returns and related  documents. In addition, Congress recently increased certain penalties  related to tax shelters and other tax evasion techniques. Given Congress’s  recent judgment that some tax penalties were too low and concerns that  inflation may have weakened the effectiveness of the civil penalty  provisions in the tax code, additional increases may need to be considered  to ensure that all penalties are of sufficient magnitude to deter tax  noncompliance.
section_title: Devoting Additional Resources to Enforcement Likely Could Reduce the Tax Gap, but to What Extent Is Difficult to Predict
paragraphs: Devoting more resources to enforcement has the potential to help reduce  the tax gap by billions of dollars in that IRS would be able to expand its  enforcement efforts to reach a greater number of potentially noncompliant  taxpayers. However, determining the appropriate level of enforcement  resources to provide IRS requires taking into account many 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 of  the tax gap that could be reduced depends in part on the size of any  increase in IRS’s budget, how IRS would manage any additional resources,  and the indirect increase in taxpayers’ voluntary compliance that would  likely result from expanded IRS enforcement.
As I previously mentioned, IRS is able to secure tens of billions of dollars  in tax revenue from noncompliant taxpayers it identifies through its  various enforcement programs. However, given resource constraints, IRS  is unable to contact millions of additional taxpayers for whom it has  evidence on potential noncompliance. With additional resources, IRS  would be able to assess and collect additional taxes and further reduce the  tax gap. In 2002, IRS estimated that a $2.2 billion funding increase would  allow it to take enforcement actions against potentially noncompliant  taxpayers it identifies but cannot contact and would yield an estimated $30  billion in revenue. For example, IRS estimated that it contacted about 3  million of the over 13 million taxpayers it identified as potentially  noncompliant through its matching of tax returns to information returns.  IRS estimated that contacting the additional 10 million potentially  noncompliant taxpayers it identified, at a cost of about $230 million, could  yield nearly $7 billion in potentially collectible revenue. However, we did  not evaluate the accuracy of the estimate, and as will be discussed below,  many factors suggest that it is difficult to estimate reliably net revenue  increases that might come from additional enforcement efforts.
Although additional enforcement funding has the potential to reduce the  tax gap, the extent to which it would help depends on several factors.  First, and perhaps most obviously, the amount of tax gap reduction would  depend in part on the size of any budget increase. Generally, larger budget  increases should result in larger reductions in the tax gap. IRS prioritizes  the cases of potentially noncompliant taxpayers it reviews through its  enforcement programs based on factors, such as the likelihood that a  taxpayer is noncompliant, the potential amount of additional taxes that  could be assessed, and collection potential. As such, it is likely that IRS  would begin to experience diminishing returns as it began to review  additional, lower priority cases of potentially noncompliant taxpayers.  Given the diminishing returns IRS would likely experience as it moves to  working less and less productive cases, the amount of expected reduction  in the tax gap for each additional dollar of funding would decline. Further,  reductions in the tax gap that could be derived from additional  enforcement funding may not be immediate. The reductions may occur  gradually as IRS is able to hire and train enforcement personnel.
Recently, IRS obtained some additional funding targeted for enforcement  activities that it estimated will result in additional revenue. In its fiscal  year 2006 budget request, IRS requested millions of dollars to expand its  tax return examination and tax collection activities with the goal of  increasing individual taxpayer compliance and addressing concerns raised  by GAO and others regarding the erosion of IRS’s enforcement presence  and the continued growth in noncompliance. In estimating the revenue  that it would obtain from the increased funding, IRS took several factors  into account, including opportunity costs because of training, which draws  experienced enforcement personnel away from the field; differences in  average enforcement revenue obtained per full-time employee by  enforcement activity; and differences in the types and complexity of cases  worked by new hires and experienced hires. IRS forecasted that in the  initial year after expanding enforcement activities, the additional revenue  it expects to collect is less than half the amount it expects to collect  annually in later years. This example underscores the logic that if IRS is to  receive a relatively large funding increase, it likely would be better to  provide it in small but steady amounts.
The amount of tax gap reduction likely to be achieved from any budget  increase Congress may choose to provide also depends on how well IRS  can manage the additional resources. As previously mentioned, IRS does  not have compliance data for some segments of the tax gap and others are  based on old data. 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. Also, regardless of the type of  noncompliance, IRS has concerns with its information on whether  taxpayers unintentionally or intentionally fail to comply with the tax laws.  Knowing the reasons why taxpayers are noncompliant can help IRS decide  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. For those portions of the tax gap that rely on old data and  where IRS does not know the reason for taxpayers’ noncompliance, IRS  may be less able to target resources efficiently to achieve the greatest tax  gap reduction at the least burden to taxpayers.
As part of an effort to make the best use of its enforcement resources, IRS  has developed rough measures of return on investment in terms of tax  revenue that it assesses from uncovering noncompliance. Generally, IRS  cites an average return on investment for enforcement of 4:1, that is, IRS  estimates that it collects $4 in revenue for every $1 of funding. Where IRS  has developed return on investment estimates for specific programs, it  finds substantial variation depending on the type of enforcement action.  For instance, the ratio of estimated tax revenue gains to additional  spending for pursuing known individual tax debts through phone calls is  13:1 versus a ratio of 32:1 for matching the amount of income taxpayers  report on their tax returns to the income amounts reported on information  returns. However, in addition to current returns on investment estimated  being rough, IRS also lacks information on the incremental returns on  investment for some enforcement programs. Developing such measures is  difficult because of incomplete information on all the costs and all the tax  revenue ultimately collected from specific enforcement efforts. Because  IRS’s current estimates of the revenue effects of additional funding are  imprecise, the actual revenue that might be gained from expanding  differing enforcement efforts is subject to uncertainty.
Given the variation in estimated returns on investment for differing types  of IRS compliance efforts, the amount of tax gap reduction that may be  achieved from an increase in IRS’s resources would depend on IRS’s  decisions about how to allocate the increase. Although it might be  tempting to allocate resources heavily toward those areas with the highest  estimated return, allocation decisions must take into account diverse and  difficult issues. For instance, although one enforcement activity may have  a high estimated return, that return may drop off quickly as IRS works its  way through potential noncompliance cases. In addition, IRS dedicates  examination resources across all types of taxpayers so that all taxpayers  receive some signal that noncompliance is being addressed. Further,  issues of fairness can arise if IRS focuses its efforts only on particular  groups of taxpayers.
Importantly, expanded enforcement efforts could reduce the tax gap more  than through direct tax revenue collection, as widespread agreement  exists that IRS enforcement programs have an indirect effect through  increases in voluntary tax compliance. The precise magnitude of the  indirect effects of enforcement is not known with a high level of  confidence given challenges in measuring compliance; developing  reasonable assumptions about taxpayer behavior; and accounting for  factors outside of IRS’s actions that can affect taxpayer compliance, such  as changes in tax law. However, several research studies have offered  insights to help better understand the indirect effects of IRS enforcement  on voluntary tax compliance and show that they could exceed the direct  effect of revenue obtained.
section_title: Various Factors Should Be Considered in Devising Strategies to Reduce the Tax Gap
paragraphs: Although closing the entire tax gap is neither feasible nor desirable due to  costs and intrusiveness, reducing the tax gap is worthwhile for many  reasons, including fairness to those who are compliant and also because it  is a means to improve our nation’s fiscal position. Each of the three  approaches I have discussed could make a contribution to reducing the  tax gap, although using multiple approaches may be the most effective  strategy since no one approach is likely to address noncompliance fully  and cost effectively. However, in deciding on one or more of the three  broad approaches to use, many factors or issues could affect strategic  decisions. Among the broad factors to consider are the likely effectiveness  of any approach, fairness, enforceability, and sustainability. Beyond these,  our work points to the importance of the following:    Measuring compliance levels periodically. Regularly measuring the  magnitude of, and the reasons for, noncompliance provides insights on  how to reduce the gap through potential changes to tax laws and IRS  programs. In July 2005, we recommended that IRS periodically measure  tax compliance, identify reasons for noncompliance, and establish  voluntary compliance goals. IRS agreed with the recommendations and  established a voluntary tax compliance goal of 85 percent by 2009. In  terms of measuring tax compliance, we have also identified alternative  ways to measure compliance, including conducting examinations of small  samples of tax returns over multiple years, instead of conducting  examinations for a larger sample of returns for one tax year, to allow IRS  to track compliance trends annually.
Leveraging technology. Better use of technology could help IRS be more  efficient in reducing the tax gap. IRS is modernizing its technology, which  has paid off in terms of telephone service, resource allocation, electronic  filing, and data analysis capability. However, this ongoing modernization  will need strong management and prudent investments to maximize  potential efficiencies.
Considering the costs and burdens. Any action to reduce the tax gap  will create costs and burdens for IRS; taxpayers; and third parties, such as  those who file information returns. As discussed earlier, for example,  withholding and information reporting requirements impose some costs  and burdens on those that track and report information. These costs and  burdens need to be reasonable in relation to the improvements expected  to arise from new compliance strategies.
Optimizing resource allocation. As previously discussed, developing  reliable measures of the return on investment for strategies to reduce the  tax gap would help inform IRS resource allocation decisions. IRS has  rough measures of return on investment based on the additional taxes it  assesses. Developing such measures is difficult because of incomplete  data on the costs of enforcement and collected revenues. Beyond direct  revenues, IRS’s enforcement actions have indirect revenue effects, which  are difficult to measure. However, indirect effects could far exceed direct  revenue effects and would be important to consider in connection with  continued development of return on investment measures.
Evaluating the results. Evaluating the actions taken by IRS to reduce  the tax gap would help maximize IRS’s effectiveness. Evaluations can be  challenging because it is difficult to isolate the effects of IRS’s actions  from other influences on taxpayers’ compliance. Our work has discussed  how to address these challenges, for example by using research to link  actions with the outputs and desired effects.
section_title: Concluding Observations
paragraphs: When taxpayers do not pay all of their taxes, honest taxpayers carry a  greater burden to fund government programs and the nation is less able to  address its long-term fiscal challenges. Thus, reducing the tax gap is  important, even though closing the entire tax gap is neither feasible nor  desirable because of costs and intrusiveness. All of the approaches I have  discussed have the potential to reduce the tax gap alone or in  combination, and no one approach is clearly and always superior to the  others. As a result, IRS needs a strategy to attack the tax gap on multiple  fronts with multiple approaches.
Mr. Chairman and Members of the Subcommittee, this concludes my  testimony. I would be happy to answer any question 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. Contact points for our Offices of  Congressional Relations and Public Affairs may be found on the last page  of this testimony. Individuals making key contributions to this testimony  include Tom Short, Assistant Director; Jeff Arkin; Cheryl Peterson; and  Jeff Procak.
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