Tax Gap: Multiple Strategies, Better Compliance Data, and Long-Term Goals Are Needed to Improve Taxpayer Compliance
Published: 2005-10-26T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: Long-term budget simulations by GAO and others show that we face large and growing structural deficits due primarily to known demographic trends and rising health care costs. Reducing the annual tax gap--the difference between what taxpayers timely and accurately pay in taxes and what they should pay under the law--could help the nation cope with these long-term fiscal challenges. The tax gap arises through the underreporting of tax liabilities, underpayment of taxes due or "nonfiling" of required tax returns. This testimony discusses the findings of GAO's recent tax gap report. It addresses the significance of reducing the tax gap, measuring the extent of the tax gap, collecting data on reasons why noncompliance occurs, and the Internal Revenue Service's (IRS) strategies for reducing the tax gap.
section_title: What GAO Found
paragraphs: IRS's recent estimate of the tax gap in 2001 ranged from $312 billion to $353 billion. IRS estimates it will eventually recover some of this tax gap, resulting in a net tax gap of $257 billion to $298 billion. Reducing the tax gap will be challenging given persistent levels of noncompliance. Still, given its size, even small or moderate reductions in the net tax gap could yield substantial returns, which could improve the government's fiscal position. 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. The tax gap must be attacked on multiple fronts and with multiple strategies over a sustained period of time. These strategies could include simplifying the tax code, providing quality service to taxpayers, and enhancing enforcement of tax laws by using tools such as tax withholding and information reporting. Regularly measuring compliance is also critical to IRS's ability to reduce the tax gap. A significant part of IRS's tax gap estimate is based on recently collected data on individual income tax reporting compliance. However, other areas of the tax gap rely on old data and outdated methodologies. IRS does not have approved plans, with one exception, to collect more current compliance data covering the various components of the tax gap. Although it can be challenging to develop, data on the reasons why taxpayers do not comply with the tax laws could help IRS more effectively tailor its efforts to reduce noncompliance. IRS has begun to capture data on the reasons for noncompliance, but it has concerns with the data. Although IRS is developing a system intended to capture better examination data, it does not have specific plans to develop better data on the reasons for noncompliance. IRS's strategies for reducing the tax gap involve improving taxpayer service and enforcing tax laws, but do not have a clear focus on quantitative long-term goals or results measurement. Establishing clear goals and measuring progress toward them would be consistent with results-oriented management principles and would provide IRS with a solid base upon which to develop a more strategic approach to reducing the tax gap.

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  intentionally or unintentionally fail to comply with the tax laws. Their  failure to pay taxes increases the burden of funding the nation’s  commitments on those taxpayers who voluntarily pay their taxes.
Mr. Chairman, as I know you and the Comptroller General have discussed  in the past, confronting the nation’s long-term 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. Simply put, our nation’s fiscal  policy is on an imprudent and unsustainable course. 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. While our long-term fiscal imbalance cannot be eliminated  with a single strategy, reducing the tax gap should be one part of a broader  effort to repair the nation’s fiscal health.
My remarks are based on our previous work on a variety of issues, in  particular the Comptroller General’s recent testimony and our 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:    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 but must be done with multiple strategies  over a sustained period.
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, but IRS does not have approved plans, with one exception, for  obtaining and maintaining more current compliance data covering the  various components of the tax gap beyond tax year 2001.
Collecting data on the reasons why noncompliance occurs can help IRS  more effectively tailor its efforts to improve compliance. However, IRS has  no specific plans to gather better data than it already collects.
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 the statutory management framework Congress has adopted.
In our July 2005 report on reducing the tax gap, we made  recommendations that IRS develop plans to periodically measure tax  compliance, take steps to improve its data on the reasons why taxpayers  do not comply, and establish long-term, quantitative goals for voluntary  compliance levels with an initial focus on individual income tax  underreporting and total tax underpayment. Taken together, these steps  can help IRS build a foundation to understand how its taxpayer service  and enforcement efforts affect compliance, improve the efforts, and make  progress on reducing the tax gap. The Commissioner of Internal Revenue  agreed with our recommendations, highlighted challenges associated with  them, and commented on various steps IRS would take to implement each  recommendation.
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 ranging from  $312 billion to $353 billion.
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 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.
section_title: Reducing the Tax Gap Could Improve the Nation’s Fiscal Position but Will Require Multiple Strategies
paragraphs: Given its size, even small or moderate reductions in the net tax gap could  yield substantial returns, which could improve the government’s fiscal  position. 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.
However, reducing the tax gap will be challenging given persistent levels  of noncompliance. 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 businesses to  understand and voluntarily comply with their tax obligations. For  instance, the multiple tax preferences for education assistance might  increase taxpayers’ burden in understanding and complying with the rules  associated with these options. In our July 2005 report on postsecondary  tax preferences, we found that hundreds of thousands of taxpayers do not  appear to make optimal decisions when selecting education-related tax  preferences. One explanation of these taxpayers’ choices may be the  complexity of postsecondary tax preferences, which experts have  commonly identified as difficult for tax filers to use. 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.
Providing quality services to taxpayers is an important part of any overall  strategy to improve compliance and thereby reduce the tax gap. 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.
In terms of enforcement, IRS will need to use multiple strategies and  techniques to find noncompliant taxpayers and bring them into  compliance. In particular, as figure 1 shows, a pair of tools have been  shown to lower levels of noncompliance: 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 specific areas where additional  withholding or information reporting requirements could serve to improve  compliance:    Requiring tax withholding and more or better information return reporting  by organizations that make payments to independent contractors for  services provided.
Requiring information return reporting on payments made to corporations  for services provided.
Require that information returns dealing with capital gain income report  the purchase price, or other cost basis data, as well as the sales price for  stocks and bonds.
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 examination of opportunities to expand information reporting  and tax withholding has the potential to increase the transparency of the  tax system and the level of compliance.
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, we 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.
section_title: Regular Compliance Measurement Can Support Informed Decisions to Reduce the Tax Gap, but IRS Lacks Approved Plans for Such Measurement
paragraphs: Regularly measuring compliance can offer many benefits, including  helping IRS identify new or growing types of noncompliance, identify  changes in tax laws and regulations that may improve compliance, more  effectively target examinations of tax returns, 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.
Tax compliance data are also useful outside of IRS. Other federal agencies  and offices use compliance data for tax policy analysis, revenue  estimating, and research. Further, the longer the time between compliance  measurement surveys, the less useful they become given changes in the  economy and tax law. Without current compliance data, IRS has limited  capability to determine key areas of noncompliance to address and actions  to take to maximize the use of its limited resources.
subsections: section_title: Underreporting Accounted for Most of the Tax Gap Estimate
paragraphs: Using its recently collected compliance data, IRS has estimated that  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), as  indicated in table 1.
Within the underreporting estimate, IRS attributed about $150 billion to  $187 billion, or about 50 percent of the total tax gap, to individual income  tax underreporting, including underreporting of business income, such as  sole proprietor, informal supplier, and farm income (about $83 billion to  $99 billion); nonbusiness income, such as wages, interest and capital gains  (about $42 billion to $57 billion); overstated income adjustments,  deductions, and exemptions (about $14 billion to $16 billion); and  overstated credits (about $11 billion to $14 billion). Underreporting of  corporate income tax contributed an estimated $30 billion, or about 10  percent, to the 2001 tax gap, which included both small corporations  (those reporting assets of $10 million or less) and large corporations  (those reporting assets of over $10 million).
Employment tax underreporting accounted for an estimated $66 billion to  $71 billion, or about 20 percent, of the 2001 tax gap and included several  taxes that must be paid by self-employed individuals and employers. Self- employed individuals are generally required to calculate and remit Social  Security and Medicare taxes to the U.S. Treasury each quarter. Employers  are required to withhold these taxes from their employees’ wages, match  these amounts, and remit withholdings to Treasury at least quarterly.  Underreported self-employment and employer-withheld employment  taxes respectively contributed an estimated $51 billion to $56 billion and  $14 billion to IRS’s tax gap estimate. The employment tax underreporting  estimate also includes underreporting of federal unemployment taxes  (about $1 billion).
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 outdated  methodologies. For example, IRS used data from the 1970s and 1980s to  estimate underreporting of corporate income taxes and employer-withheld  employment taxes. IRS has no estimates for other areas of the tax gap,  such as 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. 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.
section_title: IRS Plans to Issue a Revised Tax Gap Estimate, but Has No Approved Plans to Regularly Collect Compliance Data
paragraphs: 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 has begun a compliance measurement study that will allow IRS to  update underreporting estimates involving S corporations. This study,  which IRS began in July 2005, is scheduled to take 2 to 3 years to  complete. Because individual taxpayers may be recipients of income (or  losses) from S corporations, this study could affect IRS’s estimates for the  underreporting gap for individual income tax.
Beyond this study of S corporations, IRS has no approved plans to  periodically collect more or better compliance data over the long term.  Also, IRS has indicated that given its current research priorities, it would  not begin another NRP study of individual income tax returns before 2008,  and would not complete such a study until at least 2010. When IRS initially  proposed the tax year 2001 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 both direct costs  and opportunity costs—revenue that IRS potentially forgoes by using its  resources to examine randomly selected returns, which are more likely to  include returns from compliant taxpayers and less likely to produce  additional tax assessments compared to traditional examinations. One IRS  official also emphasized that IRS has fewer resources than in the past to  conduct examinations as well as compliance studies.
Although the costs and burdens of compliance measurement are legitimate  concerns, we believe compliance studies to be good investments. 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. Any plans for obtaining and  maintaining reasonably current information on compliance levels for all  portions of the tax gap would 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. For example, taxpayers may unintentionally claim the  Earned Income Tax Credit (EITC) because they do not understand the  child residency requirements for this credit (i.e., a qualifying child must  live with the taxpayer for more than half of the year). This type of  unintentional noncompliance may require IRS to more clearly explain the  EITC requirements within related forms and publications. However, other  taxpayers may file false EITC claims with the intent of evading tax  liability, which may suggest a strategy that relies on IRS’s enforcement  programs and tools. Similar situations could exist for other tax code  provisions. Recognizing the benefits of better compliance data, we, as well  as the National Taxpayer Advocate, have urged IRS to consider performing  additional research into causes of noncompliance.
IRS collects data on the reasons for noncompliance for specific tax issues  during its operational examinations of tax returns. In many of these cases,  it is difficult for examiners to determine a taxpayer’s intent—whether the  noncompliance is unintentional or intentional. Unless the evidence clearly  points to the reason, the examiner would have to make subjective  judgments about why the noncompliance occurred. IRS has a number of  other concerns with the data:    The database is incomplete because not all examination results, including  data on reasons for noncompliance, were being 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 ensure consistent understanding and  use of the various codes to indicate the reason for noncompliance.
The data do not represent the population of noncompliant taxpayers but  rather only those who had their tax returns examined.
According to IRS officials, the agency does not have firm or specific plans  to develop better data on the reasons for noncompliance. One official  explained that IRS decided not to improve the consistency of its current  reason data because it is devoting its limited resources to other efforts,  such as developing the Examination Desktop Support System. Although  this system is intended to allow examiners to capture better examination  data, specific system features have not yet been identified to improve  examiners’ selection of reason codes. IRS officials said that the system  could be enhanced in the future to improve the data on reasons for  noncompliance and that they plan to consider such enhancements. If IRS  enhances the data on reasons for noncompliance, it will be important to  consider factors such as how complete and reliable such data need to be,  and whether to collect the data for all types of noncompliance or for all  examinations (as opposed to a targeted random sample).
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 of a program compared to its intended purpose can help  agencies improve performance and stakeholders determine whether  programs have produced desired results. Furthermore, 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. As such, establishing long-term, quantitative  compliance goals coupled with periodic measurements of compliance  levels offers several benefits for IRS. These benefits include providing a  better basis for determining to what extent its various service and  enforcement efforts contribute to compliance, considering new strategies  to improve compliance over time, and promoting strategic and  disciplined management decisions that target areas most in need of  improvement.
IRS’s strategies for improving compliance, which involve improving  taxpayer service and enhancing enforcement of the tax laws, generally  lack a clear focus on long-term, quantitative goals and results  measurement. 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. However,  IRS has not yet set a time frame for publicly releasing the goals or  indicated how many goals will be related to improving taxpayer  compliance or whether they will be quantitative and results-oriented.   According to IRS officials, developing long-term, results-oriented goals is a  complex process that requires sustained management commitment. These  factors contribute to IRS’s uncertainty about when it will publicly release  its goals.
Like other agencies, IRS faces challenges in implementing a results- oriented management approach. For example, collecting reliable  compliance data, 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, make it difficult to  estimate the effect of IRS’s enforcement and service activities. However,  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. Moreover, having completed the NRP review of individual  income tax underreporting, IRS now has an improved foundation for  setting a goal or goals for improving taxpayers’ compliance.
section_title: Concluding Observations
paragraphs: Reducing the tax gap is one approach that would help address the looming  fiscal challenges facing the nation. 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. Toward that end, in our July 2005  report on reducing the tax gap, we made recommendations to IRS to  develop plans to periodically measure tax compliance, take steps to  improve its data on the reasons why taxpayers do not comply, and  establish long-term, quantitative goals for voluntary compliance levels  with an initial focus on individual income tax underreporting and total tax  underpayment. Taken together, these steps can help IRS build a  foundation to understand how its taxpayer service and enforcement  efforts affect compliance, improve the efforts, and make progress on  reducing the tax gap. The Commissioner of Internal Revenue agreed with  our recommendations, highlighted challenges associated with them, and  commented on various steps IRS would take to implement each  recommendation.
Mr. Chairman and Members of the Subcommittee, this concludes my  testimony. 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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