Tax Compliance: Multiple Approaches Are Needed to Reduce the Tax Gap
Published: 2007-02-16T00:00:00

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, various approaches to reduce it, and what the proposed budget for fiscal year 2008 says about it. This testimony discusses the need for taking multiple approaches and to what extent the tax gap could be reduced through three overall approaches--simplifying or reforming the tax system, providing IRS with additional enforcement tools, and devoting additional resources to enforcement. This statement is based on prior GAO work.
section_title: What GAO Found
paragraphs: Multiple approaches are needed to reduce the tax gap. No single approach is likely to fully and cost-effectively address noncompliance since, for example, it has multiple causes and spans different types of taxes and taxpayers. Simplifying or reforming the tax code, providing IRS more enforcement tools, and devoting additional resources to enforcement are three major approaches. Moreover, providing quality services to taxpayers is a necessary foundation for voluntary compliance. Such steps as periodically measuring noncompliance and its causes, setting tax gap reduction goals, optimizing the allocation of IRS's resources, and leveraging technology to enhance IRS's efficiency would also contribute to tax gap reduction. 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 most likely 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 make underreported income transparent to IRS. These tools have led to high, sustained levels of taxpayer compliance and improved IRS resource allocation by helping 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, underreporting exists in many forms, 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 IRS enforcement resources requires considering such factors as how well IRS uses its resources and the proper balance between taxpayer service and enforcement activities. If Congress provides IRS more enforcement resources, the amount of tax gap reduction would depend on factors such as the size of budget increases and the indirect increase in taxpayers' voluntary compliance resulting from expanded enforcement. The recent budget request for fiscal year 2008 proposes legislation and new initiatives to reduce the tax gap but expected dollar gains are modest. Further reductions likely would require many more such changes.

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 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. First I will discuss the need for multiple approaches  toward reducing the tax gap. Then I will discuss three specific tax gap  reduction approaches: (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. 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:    Multiple approaches are needed to reduce the tax gap. No single approach  is likely to fully and cost-effectively address noncompliance since, for  example, it has multiple causes and spans different types of taxes and  taxpayers. Simplifying or reforming the tax code, providing IRS more  enforcement tools, and devoting additional resources to enforcement are  three major approaches discussed below, but providing quality services to  taxpayers also is a necessary foundation for voluntary compliance. Quality  services can help taxpayers who wish to comply but do not understand  their obligations, whereas enforcement actions may be needed for those  who intentionally evade their tax obligations. Such steps as periodically  measuring noncompliance and its causes, setting tax gap reduction goals,  considering the costs and benefits of initiatives to reduce the gap,  evaluating the results of such initiatives undertaken, optimizing the  allocation of IRS’s resources, and leveraging technology to enhance IRS’s  efficiency would also contribute to tax gap reduction.
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 to be contacted. 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,  underreporting exists in many forms, 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 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 identifies but currently cannot contact given  resource constraints.
The administration’s budget request for fiscal year 2008 recognizes the  need for multiple approaches to tax gap reduction. It offers 16 legislative  proposals and hundreds of millions of dollars for new IRS initiatives to  reduce the tax gap. Among other things, these proposals address taxpayer  services as well as two other approaches—expanded information  reporting and additional enforcement resources for IRS. Even with these  efforts, however, the dollar amounts expected to be raised are quite small  compared to the size of the tax gap. This underscores the likelihood that  more significant reductions in the tax gap will require many additional  actions under a multiple approaches strategy given the variety of taxes,  taxpayers, and types of noncompliance that contribute to 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 tax form simplification. 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 $48 billion in fiscal year 2006  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.
Congress has been encouraging IRS to develop an overall tax gap  reduction plan or strategy that could include a mix of approaches like  simplifying code provisions, increased enforcement, and reconsidering the  level of resources devoted to enforcement. Some progress has been made  toward laying out the broad elements of a plan or strategy for reducing the  tax gap. On September 26, 2006, the U.S. Department of the Treasury  (Treasury), Office of Tax Policy, released “A Comprehensive Strategy for  Reducing the Tax Gap.” However, the document generally does not  identify specific steps that Treasury and IRS will undertake to reduce the  tax gap, the related time frames for such steps, or explanations of how  much the tax gap would be reduced. Furthermore, the document  mentioned the importance of establishing benchmarks against which  progress on each step under the strategy could be measured. It said that  after the fiscal year 2008 budget request was released, Treasury and IRS  would issue more details in March or April 2007 about the steps they  would take to reduce opportunities for evasion and address the tax gap.
The 2008 budget request issued on February 5, 2007, suggested 16  legislative changes to expand or improve information reporting, improve  compliance by businesses, strengthen tax administration, and expand  penalties. It also proposed additional funding for new initiatives aimed at  reducing the tax gap.
section_title: Multiple Approaches Are Needed to Reduce the Tax Gap
paragraphs: No single approach is likely to fully and cost-effectively address  noncompliance and therefore multiple approaches are likely to be needed.  The tax gap has multiple causes; spans five types of taxes; and is spread  over several types of taxpayers including individuals, corporations, and  partnerships. Thus, for example, while simplifying laws should help when  noncompliance is due to taxpayers’ confusion, enforcement may be  needed for taxpayers who understand their obligations but decline to  fulfill them. Similarly, while devoting more resources to enforcement  should increase taxes assessed and collected, too great an enforcement  presence likely would not be tolerated.
Simplifying or reforming the tax code, providing IRS more enforcement  tools, and devoting additional resources to enforcement are three major  tax gap reduction approaches discussed in more detail below, but  providing quality services to taxpayers plays an important role in  improving compliance and reducing the tax gap. 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. 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. Also, changing tax laws and regulations  would require educating taxpayers about the new requirements in a clear,  timely, and accessible manner. In 2006, we reported that IRS improved its  two most commonly used services—telephone and Web site assistance— for the 2006 filing season. Increased funding financed some of the  improvements, but a significant portion has been financed internally by  efficiencies gained from increased electronic filing of tax returns and  other operational improvements.
Although quality service helps taxpayers comply, showing a direct  relationship between quality service and compliance levels is very  challenging. As required by Congress, IRS is in the midst of a study that is  to result in a 5-year plan for taxpayer service activities, which is to include  long-term quantitative goals and to balance service and enforcement. Part  of the study focuses on the effect of taxpayer service on compliance. A  Phase I report was issued in April 2006 and a Phase II report should be  completed in fiscal year 2007, which is to include, among other things, a  multiyear plan for taxpayer service activities and improvement initiatives.
However, in deciding on the appropriate mix of approaches to use in  reducing the tax gap, 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 and setting long-term  goals. A data-based plan is one key to closing the tax gap. To the extent  that IRS can develop better compliance data, it can develop more effective  approaches for reducing the gap. 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. Furthermore, we have  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 1 tax year, to  allow IRS to track compliance trends annually. The administration’s fiscal  year 2008 budget proposal offers this idea by requesting funds to annually  study compliance based on a smaller sample size than the 2001 NRP study.
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. For example, withholding and  information reporting requirements impose some costs and burdens on  those who track and report information. These costs and burdens need to  be reasonable in relation to the improvements expected to arise from new  compliance strategies.
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.
Optimizing resource allocation. 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. In general though, the  effects of tax gap reduction by improving voluntary tax compliance can be  quite large. For example, if the estimated 83.7 percent voluntary  compliance rate that produced a gross tax gap of $345 billion in tax year  2001 had been 85 percent, this tax gap would have been about $28 billion  less; if it had been 90 percent, the gap would have been about $133 billion  less.
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. The administration’s fiscal year 2008 budget  proposal requests additional funds under its Business Systems  Modernization initiatives.
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 three  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. The administration’s fiscal year  2008 budget proposes legislative language to simplify eligibility  requirements for the credit as well as to clarify the uniform definition of a  qualifying child.
Another form of simplification could be to broaden the tax base while  reducing tax rates, which could minimize incentives for not complying.  This base-broadening could include a review of whether existing tax  expenditures are achieving intended results at a reasonable cost in lost  revenue and added burden and eliminating or consolidating those that are  not. 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 67 in 1974 to 161 in 2006, and the sum of tax expenditure estimates  rose to nearly $847 billion. 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. Nevertheless, 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.
Despite the potential benefits that simplification may yield, 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 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 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 taxes  owed from a taxpayer’s income and remit them to IRS. Information  reporting tends to lead to high levels 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, withholding and  information reporting help IRS to better identify noncompliant taxpayers  and prioritize contacting them, which enables 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, underreporting exists in varied  forms, and the requirements could impose costs and burdens on third  parties.
Figure 1 shows how much voluntary reporting compliance improves for  income subject to withholding or information reporting. Once withholding  or information reporting requirements are in place for particular types of  income, compliance tends to remain 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  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.
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.
Information reporting helps 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.
Withholding and information reporting lead to high levels of compliance.  Designing new requirements to address underreporting would need to  address the challenge 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, challenges arise in establishing new  withholding or information reporting requirements for certain other types  of income that are extensively underreported. Such underreporting may be  difficult to determine because of complex tax laws or transactions or the  lack of a practical and reliable third-party source to provide information  on the taxable income.
For example, while withholding or information reporting mechanisms on  nonfarm sole proprietor and informal supplier income would likely  improve their compliance, comprehensive mechanisms that are practical  and effective are difficult to identify. 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. 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.
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 who 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.
The administration’s proposed budget for fiscal year 2008 has 16 legislative  proposals on tax gap reduction of which 7 relate to expanded information  reporting. Two of these proposals involve information reporting on  payments to corporations and on the cost basis of security sales, which we  discussed earlier in this section of the testimony. The administration also  proposes requiring a certified tax identification number from  nonemployee service providers (contractors), increased information  reporting for certain government payments for property and services, and  increased information return penalties. We have done past work related to  these proposals and suggested them as options for reducing the tax gap.  The remaining 2 proposals would expand broker information reporting  and require information reporting on merchant card payment  reimbursements.
The 7 proposals relating to information reporting account for virtually all  the revenue that the budget request’s 16 tax gap legislative proposals are  projected to raise. The 16 proposals are expected to raise about $29 billion  over 10 years, or about 1 percent per year of the 2001 net tax gap amount  of $290 billion. About 98 percent of the $29 billion would come from the  information reporting proposals. About 85 percent would come from 3 of  them—those relating to payments to corporations, basis reporting on  security sales, and merchant payment card reimbursements.
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, as 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.
Given resource constraints, IRS is unable to contact millions of additional  taxpayers for whom it has evidence of 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. 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 amount of additional resources. The degree to which  revenues would increase from expanded enforcement depends on many  variables, such as how quickly IRS can ramp up efforts, how well IRS  selects the best cases to be worked, and how taxpayers react to  enforcement efforts. Estimating those revenue increases would require  assumptions about these and other variables. Because actual experience is  likely to diverge from those assumptions, the actual revenue increases are  likely to differ from the estimates. The lack of reliable key data  compounds the difficulty of estimating the likely revenues. To the extent  possible, obtaining better data on key variables would provide a better  understanding of the likely results with any increased enforcement  resources.
With additional resources for enforcement, IRS would be able to assess  and collect additional taxes, but the related tax gap reductions may not be  immediate. If IRS uses the resources to hire more enforcement staff, the  reductions may occur gradually as IRS is able to hire and train the staff.  Also, several years can elapse after IRS assesses taxes before it actually  collects these taxes.
Similarly, the amounts of taxes actually collected can vary substantially  from the related tax amounts assessed through enforcement actions by the  type of tax or taxpayer involved. In a 1998 report, we found that 5 years  after taxes were assessed against individual taxpayers with business  income, 48 percent of the assessed taxes had been collected, whereas for  the largest corporate taxpayers, 97 percent of assessed taxes had been  collected.
These various factors need to be taken into account in estimating revenue  to be obtained from increased funding. In doing such estimates for its  fiscal year 2007 budget, IRS accounted for several factors, 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 first year after  expanding enforcement activities, the additional revenue to be collected is  less than half the amount to be collected 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 also depends on how well IRS can use information about  noncompliance to manage the additional resources. Because IRS does not  have compliance data for some segments of the tax gap and others are  based on old data, IRS cannot easily track the extent to which compliance  is improving or declining. IRS also has concerns with its information on  whether taxpayers unintentionally or intentionally fail to comply with the  tax laws. Knowing the reasons for taxpayer noncompliance 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. To the extent that compliance data are outdated and IRS  does not know the reason for taxpayer noncompliance, IRS may be less  able to target resources efficiently to achieve the greatest tax gap  reduction at the least taxpayer burden.
IRS has taken important steps to better ensure efficient allocation and use.  For example, the NRP study has provided better data on which taxpayers  are most likely to be noncompliant. IRS is using the data to improve its  audit selection processes in hopes of reducing the number of audits that  result in no change, which should reduce unnecessary burden on  compliant taxpayers and increase enforcement staff productivity (as  measured by direct enforcement revenue).
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. In addition to returns on investment estimates being rough, IRS  lacks information on the incremental returns on investment from pursuing  the “next best case” for some enforcement programs. It is the marginal  revenue gain from these cases that matters in estimating the direct  revenue from expanded enforcement. 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  different enforcement efforts is subject to uncertainty.
Given the variation in estimated returns on investment for different 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 how IRS  allocates the increase. Although it might be tempting to allocate resources  heavily toward 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.
Beyond direct tax revenue collection, expanded enforcement efforts could  reduce the tax gap even more, 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.
As table 2 shows, the administration’s budget request for fiscal year 2008  proposes additional revenue-producing initiatives, legislative proposals,  and non-revenue-producing initiatives. The revenue-producing initiatives  generally would fund additional staff to enforce tax laws; the legislative  proposals include, for example, new information return requirements that  would increase revenue; and the non-revenue-producing initiatives  generally would fund infrastructure and Business Systems Modernization  changes to support IRS operations.
Over the 3 years, the requested funding decreases while the estimated  resulting revenue increases. About $410 million is requested for fiscal year  2008 to fund all of these initiatives, which are estimated to bring in about  $695 million in increased revenue that year. The estimated cost for the  initiatives declines to $355 million in fiscal years 2009 and 2010 and the  projected revenues increase to about $2.6 billion in 2010. Costs decline  due to start up costs applying only in fiscal year 2008. Revenues increase  in part due to improved annual returns from the hiring, training, and  deployment of additional staff, but more so due to the phase in of the  legislative proposals, particularly the information reporting requirements.  The legislative proposals alone are estimated to produce $1.9 billion of the  $2.6 billion total additional revenues expected to come from the  administration’s budget proposals in fiscal year 2010. The revenue effects  of the revenue-producing initiatives exclude the likely deterrent effect  from IRS enforcement programs as well as any improvement in voluntary  compliance due to improved taxpayer services.
The revenues expected from these initiatives are small compared to the  estimated $290 billion net tax gap for tax year 2001. For instance, all of the  revenue-producing initiatives coming largely from additional enforcement  staffing are expected to yield about $699 million in fiscal year 2010, or  about one-quarter of 1 percent of the tax year 2001 net tax gap. In 2010, the  total estimated increased revenues from both the revenue-producing and  legislative initiatives, or about $2.6 billion, is about 0.9 percent of the 2001  net tax gap.
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 single 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. The various proposals in the  administration’s budget request raise modest dollar amounts compared to  the size of the tax gap. This underscores the likelihood that a wide variety  of efforts will be needed to make significant progress in addressing the tax  gap. We look forward to seeing the administration’s expanded outline of  steps it will be taking.
Mr. Chairman and Members of the Committee, 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 Thomas Short, Assistant Director; Jeffrey Arkin; Elizabeth Fan;  Ronald Jones; Lawrence Korb; and Ellen Rominger.
This is a work of the U.S. government and is not subject to copyright protection in the  United States. It may be reproduced and distributed in its entirety without further  permission from GAO. However, because this work may contain copyrighted images or  other material, permission from the copyright holder may be necessary if you wish to  reproduce this material separately.