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

Letter

Background

Tax Gap

The gross tax gap is an estimate of the difference between the taxes— including individual income, corporate income, employment, estate, and excise taxes—that should have been paid voluntarily and on time and what was actually paid for a specific year. Of the estimated $345 billion tax gap for tax year 2001, IRS estimated that it would eventually recover about $55 billion of that through late payments and enforcement actions, for a net tax gap of $290 billion. The estimate is an aggregate of estimates for the three primary types of noncompliance: (1) underreporting of tax liabilities on tax returns; (2) underpayment of taxes due from filed returns; and (3) nonfiling, which refers to the failure to file a required tax return altogether or on time. We have made many recommendations over time that could address the tax gap.

IRS’s tax gap estimates for each type of noncompliance include estimates for some or all of the five types of taxes that IRS administers. Underreporting of tax liabilities can occur when a taxpayer underreports income earned or overclaims deductions from income. As shown in table 1, underreporting of tax liabilities—particularly for the individual income tax—accounted for most of the tax gap estimate for tax year 2001. We have encouraged regular tax gap measurements, and IRS officials have indicated that they will be updating their tax gap estimates later in 2011 or early 2012. We believe that these estimates are important to gauge progress in addressing the tax gap and because analyzing the data used to estimate it can help identify ways to improve tax compliance.

Taxpayers who underreported the amount of individual income tax they owed represented an estimated $197 billion of the 2001 tax gap, and $165 billion of that amount was due to individual tax filers underreporting their income. As shown in table 2, underreporting of individuals’ business income and nonbusiness income accounted for $109 billion and $56 billion, respectively, of the 2001 tax gap.

IRS has concerns with the certainty of the tax gap estimate for tax year 2001 in part because some areas of the 2001 estimate rely on data originally gathered in the 1970s and 1980s. IRS has no estimates for other areas of the tax gap, and it is inherently difficult to measure some types of noncompliance. Some analysts believe the 2001 estimate likely underestimated the tax gap and that in absolute dollars it is likely larger now than in 2001.

IRS’s overall approach to reducing the tax gap consists of improving service to taxpayers and enhancing enforcement of the tax laws. IRS seeks to improve voluntary compliance through efforts such as education and outreach programs and tax form simplification. It also uses its enforcement authority to ensure that taxpayers are reporting and paying the proper amounts of taxes through efforts such as examining tax returns and matching the amount of income taxpayers report on their tax returns to the income amounts reported on information returns it receives from third parties. In spite of IRS’s efforts to improve taxpayer compliance, the rate at which taxpayers pay their taxes voluntarily and on time has tended to range from around 81 percent to around 84 percent over the past three decades.

Tax Expenditures

The sum of the estimated revenue loss due to tax expenditures was over $1 trillion in 2010. Tax expenditures are often aimed at policy goals similar to those of federal spending programs. Existing tax expenditures, for example, help students and families finance higher education and provide incentives for people to save for retirement. Because tax expenditures result in forgone revenue for the government, they have a significant effect on overall tax rates—all else equal, for any given level of revenue, tax expenditures mean that overall tax rates must be higher than a tax system with no tax expenditures. In 2005, we recommended that the federal government take several steps to ensure greater transparency of and accountability for tax expenditures by reporting better information on tax expenditure performance and more fully incorporating tax expenditures into federal performance management and budget review processes.

Complexity Can Have Value, but Adds to Compliance and Efficiency Costs

The federal tax system contains complex rules. These rules may be necessary, for example, to ensure proper measurement of income, target benefits to specific taxpayers, and address areas of noncompliance. However, these complex rules also impose a wide range of record keeping, planning, computational, and filing requirements upon businesses and individuals. Complying with these requirements costs taxpayers time and money. As shown in figure 1, these costs to taxpayers are above and beyond what they pay to the government in taxes.

Estimating total compliance costs is difficult because neither the government nor taxpayers maintain regular accounts of these costs, and federal tax requirements often overlap with record keeping and reporting that taxpayers do for other purposes. Although available estimates are uncertain, taken together, they suggest that total compliance costs are large. For example, in 2005 we reviewed existing studies and reported that even using the lowest available compliance cost estimates for the personal and corporate income tax, combined compliance costs would total $107 billion (roughly 1 percent of gross domestic product ) per year; other studies estimate costs 1.5 times as large.

The tax system also results in economic efficiency costs, which are reductions in economic well-being caused by changes in behavior due to taxes, government benefits, monopolies, and other forces that interfere in the market. Efficiency costs can take the form of lost output or consumption opportunities. For example, economists generally agree that the favorable tax treatment of owner-occupied housing distorts investment in the economy, resulting in too much investment in housing and too little business investment. Estimating efficiency costs associated with the tax system is challenging because it has extensive and diverse effects on behavior. In fact, in a 2005 report, we found no comprehensive estimates of the efficiency costs of the current federal tax system. The two most comprehensive studies we found suggest that these costs are large—on the order of magnitude of 2 to 5 percent of GDP each year (as of the mid- 1990s). However, the actual efficiency costs of the current tax system may not fall within this range because of uncertainty surrounding taxpayers’ behavioral responses, changes in the tax code and the economy since the mid-1990s, and the fact that the two studies did not cover the full scope of efficiency costs.

Tax software and the use of paid tax return preparers may mitigate the need for taxpayers to understand complexities of the tax code. In 2010, IRS processed about 137 million returns. As we have previously reported, about 90 percent of returns are prepared by individual taxpayers or paid preparers using professional or commercial software. Software companies and paid preparers often act as surrogate tax administrators in that they keep abreast of tax law changes. A participant at the 2007 Joint Forum on Tax Compliance stated that taxpayers receiving assistance in preparing their individual tax returns, either from paid preparers or tax preparation software, are somewhat insulated from tax code complexity.

However, while many paid tax preparers help taxpayers by using their expertise to help ensure that complex laws are understood, others may introduce their own mistakes. For example, in a limited investigation in 2006, all 19 of the tax return preparers who prepared returns for our undercover investigators produced errors, some with substantial consequences. IRS’s review of 2001 tax returns also found that tax returns prepared by paid preparers contained a significant level of errors.

IRS audits of returns prepared by a paid preparer showed a higher error rate—56 percent—than audits of returns prepared by the taxpayer—47 percent.

Complexities in Reporting Income Contribute to the Tax Gap by Providing Opportunities for Taxpayers to Misreport

Income measurement is straightforward for a large proportion of the individual taxpayer population: those who earn only labor and interest income and capital income within a retirement account generally have their income reported to them (and to the IRS) by the source of the income. However, substantial numbers of taxpayers who receive income from capital gains, rents, self-employment, and other sources often deal with complex tax laws, complicated calculations, and detailed record keeping. While complexities lead some taxpayers to make mistakes when reporting their income, some misreporting is due to intentional acts of tax evasion.

For example, IRS studies show that the majority of capital asset transactions and capital gains and losses were for securities transactions such as sales of corporate stock, mutual funds, bonds, options, and capital gain distributions from mutual funds. Taxpayers are required to report securities transactions on their federal income tax returns. To accurately report securities sales, the taxpayer must have records of the dates they acquired and sold the asset; sales price, or gross proceeds from the sale; cost or other basis of the sold asset; and resulting gains or losses. They must report this information separately for short-term transactions and long-term transactions. Further, before taxpayers can determine any gains or losses from securities sales, they must determine if and how the original cost basis of the securities must be adjusted to reflect certain events, such as stock splits, nontaxable dividends, or nondividend distributions.

Complex income-reporting requirements for securities transactions may contribute to taxpayers’ misreporting their income. In 2006, we estimated that 8.4 million of the estimated 21.9 million taxpayers with securities transactions misreported their gains or losses for tax year 2001. A greater estimated percentage of taxpayers misreported gains or losses from securities sales (36 percent) than capital gain distributions from mutual funds (13 percent), and most of the misreported securities transactions exceeded $1,000 of capital gain or loss. This may be because taxpayers must determine the taxable portion of securities sales’ income whereas they need only add up their capital gain distributions. Furthermore, about half of these taxpayers who misreported failed to accurately report the securities’ basis, sometimes because they did not know the basis or failed to adjust the basis appropriately. Although we were not able to estimate the capital gains tax gap for securities, we were able to determine the direction of the misreporting. For securities sales, an estimated 64 percent of taxpayers underreported their income from securities (i.e., they understated gains or overstated losses) compared to an estimated 33 percent of taxpayers who overreported income (i.e., they overstated gains or understated losses). For both underreported and overreported income, some taxpayers misreported over $400,000 in gains or losses.

Small businesses—which include sole proprietorships and S corporations, among other entities—are subject to multiple layers of filing, reporting, and deposit requirements. These requirements reflect IRS’s administration of a variety of tax and other policies, including income, employment, and excise taxes, as well as pension and other employee benefit programs. In considering the number of requirements, it is important to note that the requirements reflect many decisions and compromises made by Congress and administrations to accomplish their policy goals, including those that may benefit small businesses and other taxpayers.

Sole proprietors face significant complexities in reporting income. This complexity may contribute to the estimated $68 billion of the tax gap caused by sole proprietors underreporting their net business income, which can stem either from understated receipts or overstated expenses. For example, sole proprietors report their business-related profit or loss on their individual income tax return, and they can use their losses to offset other categories of income on their returns in the year that they incur the loss. Identifying which of a sole proprietor’s payments qualify as business expenses and the amount to be deducted can be complex. For example, two types of payments—costs of goods sold and capital improvements—must be distinguished from other types of payments because they are treated differently under tax rules. Expenses that are used partly for business and personal purposes can be deducted only to the extent they are used for business.

Individual taxpayers who are shareholders in S corporations may also experience difficulty because of complexity in income measurement. An S corporation is a federal business type that provides tax benefits and limited liability protection to shareholders. S corporations are not generally taxed at the entity level: income, losses, and deduction items pass through to the individual shareholders’ income tax returns, and the shareholders are taxed on any net income. S corporations are to provide their shareholders and IRS with information on the allocation of income, losses, and other items.

As we have previously reported, one source of complexity for S corporation shareholders may arise when calculating basis—their ownership share of the corporation—in order to claim losses and deductions to offset other earned income. Shareholders generally can only claim losses and deductions up to the amount of basis the shareholder has in the S corporation’s stock and debt. While the S corporation is required to send shareholders some information that can be used to calculate basis, S corporations are not required to report any basis calculations to shareholders. IRS officials and S corporation stakeholder representatives told us that calculating and tracking basis was one of the biggest challenges in complying with S corporation rules. In 2009, we recommended that Congress require S corporations to calculate shareholder’s stock and debt basis as completely as possible and report the calculation to shareholders and IRS. In an analysis of IRS’s annual examinations of individual tax returns that closed for fiscal years 2006 through 2008, we found the amount of the misreported losses that exceeded basis limitations was over $10 million, or about $21,600 per taxpayer.

Tax Expenditures Add Complexity and Contribute to the Tax Gap by Providing Opportunities for Taxpayers to Make Mistakes or Evade Taxes

The growing number of tax expenditures is among the causes of tax code complexity. Between 1974 and 2010, tax expenditures reported by the Department of the Treasury more than doubled in overall number from 67 to 173. Tax expenditures are an important means the government uses to address a wide variety of social objectives, from supporting educational attainment, to providing low-income housing, to ensuring retirement income, and many others. However, tax expenditures add to tax code complexity in part because they require taxpayers to learn about, determine their eligibility for, and choose between tax expenditures that have similar purposes. Tax expenditures also complicate tax planning, as taxpayers must predict their own future circumstances as well as future tax rules to make the best choice among provisions.

Savings incentives within the tax code illustrate how tax expenditures add to complexity. While the tax code includes numerous types of savings incentives—including those for healthcare and higher education—my statement will focus on retirement savings as a key example. Taxpayers can choose between traditional Individual Retirement Arrangements (IRA) and Roth IRAs for retirement savings. Although the tax rules for distributions diverge for traditional and Roth IRAs, taxpayers may not know that a 10 percent early withdrawal penalty, with some exceptions, applies to both IRA types. Taxpayers also get confused over which IRA early withdrawals are not subject to penalties, in part because the exceptions differ for employer pension plans. Additionally, both types of IRAs have rules governing eligibility to contribute, and contributions to each are subject to an annual limit. However, taxpayers may not understand that the annual contribution limit applies across traditional IRAs and Roth IRAs in combination, which may lead them to overcontribute. With regard to record-keeping burden, taxpayers with traditional or Roth IRAs must track the total amount of contributions in a given year and reasons for distributions to accurately report this information on their tax returns. Frequent changes to IRA rules (such as increasing contribution limits and allowing workers to tap IRA assets for certain nonretirement purposes without an early withdrawal penalty) have also made tax planning more difficult for taxpayers.

As we reported in 2008, IRS research and enforcement data show that—in the aggregate—many taxpayers misreported millions of dollars in traditional IRA contributions and distributions on their tax returns. We reported that in tax year 2001 the following occurred: Of the taxpayers who made deductible traditional IRA contributions, an estimated 14.8 percent (554,657 taxpayers) did not accurately report the IRA deduction on their individual tax returns—10.4 percent overstated their deductible contributions (that is, exceeded the applicable limit) and 4.4 percent underreported their deductible contributions (that is, reported less on their returns than they actually could deduct). The understated net income due to these misreported traditional IRA contribution deductions was $392 million, including both taxpayers who either overstated or understated their contribution deductions to a traditional IRA.

Of the taxpayers who had taxable traditional IRA distributions, an estimated 14.6 percent (1.5 million taxpayers) misreported withdrawals from their traditional IRA distributions—13.7 percent understated (that is, reported an amount less than what the taxpayer withdrew) and 0.9 percent overstated IRA distributions (that is, reported an amount greater than what the taxpayer withdrew). The underreported net income due to misreported IRA distributions was $6.3 billion, including taxpayers who failed to report early distributions and the associated tax.

Taxpayers also make costly mistakes when choosing higher-education tax incentives. In a 2008 testimony, we reported that among tax filers who appeared to be eligible for a tax credit or tuition deduction in tax year 2005, about 19 percent, representing about 412,000 returns, failed to claim any of them. The amount by which these tax filers failed to reduce their tax averaged $219; 10 percent of this group could have reduced their tax liability by over $500. In total, including both those who failed to claim a tax credit or tuition deduction and those who chose a credit or a deduction that did not maximize their benefit, we found that in 2005, 28 percent, or nearly 601,000 tax filers, did not maximize their potential tax benefit.

Some tax expenditures also provide taxpayers who intend to evade taxes with opportunities to do so. For example, the Treasury Inspector General for Tax Administration (TIGTA) reported in 2011 that the First-time Homebuyer Credit (FTHBC) and the subsequent changes made to the credit have confused taxpayers and allowed individuals to make fraudulent claims for the refundable credit. For example, TIGTA reported many taxpayers claiming the credit appeared not to be first-time homebuyers because tax information indicated they had owned homes within 3 years prior to their new home purchase. The 2008 FTHBC provided taxpayers a refundable credit of up to $7,500 that must be repaid in $500 increments each year over 15 years beginning in the 2011 filing season. According to recent IRS data, the total amount to be repaid by taxpayers is $7 billion. The American Recovery and Reinvestment Act of 2009 increased the maximum FTHBC credit to $8,000, with no payback required unless the home ceases to be the taxpayer’s principal residence within 3 years. In 2009, we testified that IRS faced significant challenges in determining if taxpayers were complying with the numerous conditions for the credit. For example, to determine eligibility, IRS had to verify that taxpayers had not owned a house in the previous 3 years and verify the closing date on home purchases. Other challenges included enforcing the $500 per year payback provision in the 2008 credit.

Strategies to Reduce the Tax Gap Present Challenges and Trade- offs

Multiple approaches are needed to reduce the tax gap. No single approach is likely to fully and cost-effectively address noncompliance since the noncompliance has multiple causes and spans different types of taxes and taxpayers. While the tax gap will remain a challenge into the future, the following strategies could help. These strategies could require actions by Congress or IRS.

Enhancing Information Reporting

Enhancing information reporting can reduce complexity for taxpayers. It can also reduce the opportunities available for taxpayers to evade taxes by, for example, underreporting business income or filing fraudulent claims for tax credits. Generally, new requirements on third parties to submit information returns would require statutory changes, whereas improvements to existing information-reporting forms may be done administratively by IRS.

The extent to which individual taxpayers accurately report the income they earn has been shown to be related to the extent to which the income is reported to them and IRS by third parties or taxes on the income are withheld. For example, employers report most wages, salaries, and tip compensation to employees and IRS through Form W-2. Also, banks and other financial institutions provide information returns (Forms 1099) to account holders and IRS showing the taxpayers’ annual income from some types of investments. Findings from IRS’s study of individual tax compliance indicate that nearly 99 percent of these types of income are accurately reported on individual tax returns. For types of income for which there is little or no information reporting, individual taxpayers tend to misreport over half of their income.

One area where improved information reporting could help is higher- education expenses. Eligible educational institutions are required to report information on qualified tuition and related expenses for higher education to both taxpayers and IRS so that taxpayers can determine the amount of educational tax benefits that can be claimed. However, the information currently reported by educational institutions on tuition statements sent to IRS and taxpayers (on Form 1098-T) may be confusing for taxpayers who use the form to prepare their tax returns and not very useful to IRS. IRS requires institutions to report on Form 1098-T either the (1) amount of payments received, or (2) amount billed for qualified expenses. IRS officials stated that most institutions report the amount billed and do not report payments. However, the amount billed may not equal the amount that can be claimed as a credit. In order to reduce taxpayer confusion and enhance compliance with the eligibility requirements for higher- education benefits, in 2009 we recommended that IRS revise Form 1098-T to improve the usefulness of information on qualifying education expenses.

Another area where improved information reporting could improve compliance is rental income. In 2008, we estimated that at least 53 percent of individual taxpayers with rental real estate misreported their rental real estate activities for tax year 2001, resulting in an estimated $12.4 billion of net misreported income. IRS enforcement officials cited limited information reporting as a major challenge in ensuring compliance because without third-party information reporting, it is difficult for IRS to systematically detect taxpayers who fail to report any rent or determine whether the rent and expense amounts taxpayers report are accurate. In 2008, we recommended that IRS require third parties to report mortgaged property addresses to help IRS identify who may have misreported their rental real estate activity, but IRS did not adopt our recommendation because of third-party burden and a lack of an IRS compliance program to use such information. We made a similar recommendation in a 2009 report, which IRS is still evaluating as of December 2010.

While information reporting reduces the complexity of reporting income for individual taxpayers, this tool can create costs for the third parties responsible for reporting the income to the taxpayer and IRS. For example, we previously reported that expanding information reporting on securities sales to include basic information would involve challenges for brokers and the IRS. In particular, brokers would bear costs and burdens—even as taxpayers’ costs and burdens decrease somewhat—and many issues would arise about how to calculate adjusted basis, which securities would be covered, and how information would be transferred among brokers.

In some cases it is difficult to identify third parties for whom a reporting requirement could be enforced without an undue burden on both the third parties and IRS. In a 2009 report, we found that a major reason why little information reporting on sole proprietor expenses exists is because of the difficulty identifying third parties. For example, there is no third party who could verify the business use of cars or trucks by sole proprietors.

Ensuring High-Quality Services to Taxpayers

Ensuring high-quality services is a necessary foundation for voluntary compliance, so action by IRS to improve the quality of services provided to taxpayers would be beneficial. High-quality services can help taxpayers who wish to comply but do not understand their obligations. IRS taxpayer services include education and outreach programs, simplifying the tax process, and revising forms and publications to make them electronically accessible and more easily understood by diverse taxpayer communities. For example, if tax forms and instructions are unclear, taxpayers may be confused and make unintentional errors. Ensuring high-quality taxpayer services would also be a key consideration in implementing any of the approaches for tax gap reduction. For example, expanding enforcement efforts would increase interactions with taxpayers, requiring processes to efficiently communicate with taxpayers. Changing tax laws and regulations would also require educating taxpayers about the new requirements in a clear, timely, and accessible manner. For example, we previously reported that while taxpayers’ access to telephone assistance in tax year 2009 was better than the previous year, it remained lower than in 2007, in part because of calls about tax law changes. Despite heavy call volume, the accuracy of IRS responses to taxpayers’ questions remained above 90 percent.

Simplifying the Tax Code or Fundamental Tax Reform

Congressional efforts to simplify the tax code and otherwise alter current tax policies may help reduce the tax gap by making it easier for individuals and businesses to understand and voluntarily comply with their tax obligations. One way to simplify the tax code is to eliminate or combine tax expenditures, thereby helping reduce taxpayers’ unintentional errors and limiting opportunities for tax evasion. As we have previously testified, the Government Performance and Results Act (GPRA) Modernization Act of 2010 (GPRAMA) could help inform reexamination or restructuring efforts and lead to more efficient and economical executive-branch service delivery in overlapping program areas. The act is intended to identify the various agencies and federal activities—including spending programs, regulations, and tax expenditures—that contribute to crosscutting outcomes.

While simplification can have benefits, it can also have drawbacks. Eliminating tax expenditures would reduce the incentives for the activities that were encouraged. Also, in 2005, we stated that changes to the tax system can create winners and losers. The government may attempt to mitigate large gains and losses by implementing transition rules. Deciding if transition relief is necessary involves how to trade off between equity, efficiency, simplicity, transparency, and administrability.

Similar trade-offs exist with possible fundamental tax reforms that would move away from an income tax system to some other system, such as a consumption tax, national sales tax, or value-added tax. Fundamental tax reform would most likely result in a smaller tax gap if the new system has few tax preferences or complex tax code provisions and if taxable transactions are transparent. However, these characteristics are difficult to achieve in any system and experience suggests that simply adopting a fundamentally different tax system, whatever the economic merits, may not by itself eliminate any tax gap. For example, in 2008, we reported that some available data indicate a value-added tax may be less expensive to administer than an income tax. However, we found that like other systems, even a simple value-added tax—one that exempts few goods or services— has compliance risks and, largely as a consequence, generates administrative costs and compliance burden. Similar to other taxes, adding complexity through exemptions or reduced rates for some goods or services generally decreases revenue and increases compliance risks because of the incentive to misclassify purchases and sales. Such complexity also increases the record-keeping burden on businesses and increases the government resources devoted to enforcement.

Any tax system could be subject to noncompliance, and its design and operation, including the types of tools made available to tax administrators, will affect the size of any corresponding tax gap. Further, the motivating forces behind tax reform include factors beyond tax compliance, such as economic effectiveness, equity, and burden, which could in some cases carry greater weight in designing an alternative tax system than ensuring the highest levels of compliance.

Policymakers may find it useful to compare any proposed changes to the tax code based on a set of widely accepted criteria for assessing alternative tax proposals. These criteria include the equity, or fairness, of the tax system; the economic efficiency, or neutrality, of the system; and the simplicity, transparency, and administrability of the system. These criteria can sometimes conflict, and the weight one places on each criterion will vary among individuals. Our publication, Understanding the Tax Reform Debate: Background, Criteria, and Questions, may be useful in guiding policymakers as they consider tax reform proposals.

Devoting Additional Resources to Enforcement

Devoting additional resources to enforcement has the potential to help reduce the tax gap by billions of dollars. However, determining the appropriate level of enforcement resources to provide IRS requires taking into account factors such as how effectively and efficiently IRS is currently using its resources, how to strike the proper balance between IRS’s taxpayer service and enforcement activities, and competing federal funding priorities. If Congress were to provide IRS more enforcement resources, the amount that the tax gap could be reduced depends in part on factors such as the size of budget increases, how IRS manages any additional resources, and the indirect increase in taxpayers’ voluntary compliance resulting from expanded enforcement. Providing IRS with additional funding would enable it to contact millions of potentially noncompliant taxpayers it currently identifies but cannot contact given resource constraints.

However, devoting additional resources to enforcement will not completely close the tax gap. For example, in a 2009 report, we reported that IRS’s compliance programs focused on sole proprietors’ underreporting of income addressed only a small portion of sole proprietor expense noncompliance. Despite investing nearly a quarter of all revenue agent time in 2008, IRS was able to examine (audit) about 1 percent of estimated noncompliant sole proprietors. These exams are costly and yielded less revenue than exams of other categories of taxpayers, in part because most sole proprietorships are small in terms of receipts.

Expanding Compliance Checks Before IRS Issues Refunds

IRS could reduce the tax gap by expanding compliance checks before issuing refunds to taxpayers. In April 2011, the Commissioner of Internal Revenue talked about a long-term vision to increase compliance activities before refunds are sent to taxpayers. In one example, IRS is exploring a requirement that third parties send information returns to IRS and taxpayers at the same time as opposed to the current requirement that some information returns go to taxpayers before going to IRS. The intent is to move to matching those information returns to tax returns during tax return processing. IRS currently matches data provided on over 2 billion information returns to tax returns only after the normal filing season. Matching during the filing season would allow IRS to detect and correct errors before it sends taxpayers their refunds, thereby avoiding the costs of trying to recover funds from taxpayers later. This approach could also allow IRS to use its enforcement resources on other significant compliance problems. However, the Commissioner made clear that his vision for more prerefund compliance checks will take considerable time to implement. One prerequisite would be a major reworking of some fundamental IRS computer systems. To the extent that implementing this vision would require additional budgetary resources or changes in tax policies, Congress would play a key role.

Using Consistent Definitions

If Congress changed the law to include more consistent definitions across tax provisions, then taxpayers could more easily understand and comply with their obligations. Higher-education tax preferences provide an example of inconsistent definitions for qualified education expenses. What tax filers are allowed to claim as a qualified higher-education expense varies between some of the various savings and credit provisions in the tax code. For example, while Coverdell education savings accounts and qualified tuition programs under section 529 of the Internal Revenue Code permit tax filers to include room and board as qualified expenses if the student is enrolled at least half time, the American Opportunity Credit and the Lifetime Learning Credit do not. These dissimilar definitions require that tax filers keep track of expenses separately, applying some expenses to some tax preferences, but not others.

There are no easy solutions to the tax gap, but addressing the tax gap is as important as ever before in the face of the nation’s fiscal challenges. Innovative thinking and the combined efforts of IRS and Congress will be needed now and in the years to come.

Chairman Baucus, Ranking Member Hatch, and Members of the Committee, this completes my prepared statement. I would be happy to respond to any questions you may have at this time.

Contact and Acknowledgments

For further information on this testimony, please contact Michael Brostek at (202) 512-9110 or brostekm@gao.gov. In addition to the individual named above, David Lewis, Assistant Director; Shannon Finnegan, analyst- in-charge; Sandra Beattie; Amy Bowser; Barbara Lancaster; John Mingus; Erika Navarro; Melanie Papasian; and Jonathan Stehle made key contributions to this report. Contact points for our Offices of Congressional Relations and Public Affairs may be found on the last page of this statement.

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