Tax Administration: Alternative Strategies to Obtain Compliance Data
Released: 1996-04-26T00:00:00

Letter

Background

For over 30 years, TCMP has been IRS’ primary program for gathering comprehensive and reliable taxpayer compliance data. It has been IRS’ only program for making statistically reliable estimates of compliance nationwide. It has also been used to identify areas where tax law needs to be changed to improve voluntary compliance and to estimate the tax gap and its components. TCMP data are also used outside IRS, including by Congress to make revenue estimates for new legislation and by the Department of Commerce’s Bureau of Economic Analysis to adjust national income accounts such as the gross domestic product.

The 1994 TCMP survey, which was to consist of over 150,000 income tax returns, was to be the most comprehensive TCMP effort ever undertaken. By auditing the tax returns of individuals (Form 1040), small corporations with $10 million or less in assets (Form 1120), Partnerships (Form 1065), and S corporations (Form 1120S), IRS planned to obtain comprehensive compliance data. Most sample results were to be sufficiently precise to be reliable at the national level as well as at smaller geographic areas across the country. The 1994 TCMP was designed to fulfill the information needs for several compliance areas expected to be important to IRS’ functions over the next decade. The more important uses were to include development of audit selection formulas, validation of IRS’ revised approach to categorizing returns for audit, and development of new approaches to researching compliance across specific geographic areas. Each of these uses is discussed in more detail below.

Since 1969, IRS has used TCMP data to update its Discriminant Function (DIF) formulas, which are mathematical formulas used to select tax returns with the greatest probability of change for audit. The current formulas for individuals are based on 1988 tax returns, IRS’ most recent individual TCMP audits. Formulas for small corporations are based on returns that were processed in 1987. IRS does not use DIF scores for partnerships and S corporations because of the age of the underlying TCMP audits.

TCMP data were also to be used to test new compliance strategies. IRS planned to change the way it categorized returns for audit by adopting the market segment approach. Market segments represent groups of taxpayers with similar characteristics, such as those in manufacturing. IRS assumes that because these taxpayers have similar external characteristics, their tax compliance behavior will exhibit similar attributes.

Finally, the 1994 TCMP was to provide compliance research data. IRS recently reorganized its compliance research function, establishing a National Office of Research and Analysis (NORA) and 31 District Office of Research and Analysis (DORA) sites. The 1994 TCMP was to be large enough to provide reliable compliance data for field and National Research Offices. IRS’ researchers planned to use TCMP data to identify national and geographically specific areas of noncompliance and, by focusing on key compliance issues, develop programs to improve voluntary compliance. It is through these research efforts that IRS planned to improve overall voluntary compliance.

Noncompliance represents a major source of lost revenue for the nation. IRS’ most recent tax-gap estimates indicate that over $127 billion was lost to noncompliance in 1992. In an attempt to reduce this lost revenue, IRS established an objective of collecting at least 90 percent of the taxes owed through voluntary compliance and enforcement measures by the year 2001. However, this overall compliance rate has remained at about 87 percent since 1973. The 1994 TCMP was intended to provide data from which other programs could be developed to improve this rate and increase revenue.

This nation’s tax system is based on individuals and businesses voluntarily paying the taxes they owe. To the extent that this system works, it improves the efficiency of tax collection. Measuring the extent to which the tax system works and identifying areas in which it does not is the job of compliance measurement. TCMP has been IRS’ only tool for measuring voluntary compliance and determining compliance issues. The postponed TCMP for 1994 tax returns was to establish the voluntary compliance benchmark to carry IRS into the next century.

Objectives, Scope, and Methodology

The objectives of this assignment were to (1) determine the possible effects on IRS’ compliance programs of postponing the 1994 TCMP and (2) identify some potential short- and long-term alternatives to the planned TCMP for collecting this data.

To determine the possible effects of postponing the 1994 TCMP, we talked to responsible officials in IRS’ Research Division and the Examination Division. We obtained information on how these officials planned to use TCMP data and what will likely be affected now that TCMP has been postponed.

To identify alternatives to the planned TCMP, we talked to IRS officials responsible for planning TCMP. We discussed alternative sampling methodologies with officials from IRS’ Statistics of Income (SOI) Branch who were responsible for preparing the original TCMP sample and asked them to determine sample sizes on the basis of revised requirements. We developed the revised requirements on the basis of our discussions with IRS’ Research Division staff as well as officials outside IRS, including congressional staff.

Some of the observations in this report are based on the work we have done over the years on IRS’ compliance programs as well as our specific work on TCMP in recent years.

We requested comments from you on a draft of this report. On February 23, 1996, we obtained oral comments from IRS’ Director of Research and the National Director of Compliance Specialization. We also obtained commented from you in a March 18, 1996, letter. These comments are discussed on page 13 of this report.

We did our work in San Francisco, Dallas, and Washington, D.C., between August and December 1995 in accordance with generally accepted government auditing standards.

Loss of TCMP Data Could Disrupt IRS’ Compliance Strategies

The planned TCMP for 1994 tax returns was to establish the voluntary compliance benchmark to carry IRS into the next century. While agency officials said that postponing TCMP will help resolve budget problems, our work suggests that the loss of these or comparable data is also likely to disrupt IRS’ efforts to increase the total collection percentage to 90 percent by 2001. For example, without these data, IRS will have difficulty updating the formulas it uses to select returns for audit and, thus, it would be more likely that a higher percentage of the returns IRS selects for audit would not result in changes to the amount of tax owed by the taxpayer. Additionally, without such data IRS will be unlikely to have sufficient data to validate its market segment approach to audits or to be used by the DORA research functions to identify programs to improve voluntary compliance. It is not clear whether IRS will replace the data it had planned to obtain from TCMP. However, updated compliance data will be needed in the short term if IRS still plans to update the audit selection formulas and in the long term to validate and improve IRS’ compliance efforts.

Updated Compliance Data Were Needed to Update Return Selection Formulas

The primary system that will be disrupted by postponing TCMP is the one used by IRS to select returns for audit. Since 1969, IRS has used DIF formulas to select returns for audit. New DIF formulas are developed periodically from TCMP data and applied to all individual and small corporation income tax returns. IRS then selects returns for audit with the highest DIF scores. In 1992, over 55 percent of the audited returns of individuals were selected using the DIF score. The DIF selection system replaced programs that were largely dependent on auditor’s judgment. The DIF system has not only improved the efficiency of IRS’ audit efforts but also the consistency and objectivity of the selection process. The use of the DIF selection process has also resulted in fewer “no-change” audits, which not only waste IRS’ resources but unnecessarily burden compliant taxpayers. According to IRS, use of the DIF scoring system reduced the no-change rate from over 46 percent in 1969 to about 15 percent in 1992.

IRS officials believe the DIF process is dependent on periodically updating the formulas used to score returns. Formulas are updated so that they will more accurately identify the returns with the greatest probability for change. Until 1988, data from TCMP had been used to update formulas for individual returns every 3 years. However, the most recent TCMP was conducted on 1988 individual returns. For small corporations, partnerships, and S corporations, IRS has updated formulas much less frequently. TCMPs were conducted on corporate returns filed in 1987, and partnership and S corporation returns filed in 1982 and 1985, respectively.

IRS is not certain how well the DIF scores will continue to perform if not updated. IRS officials believe that by 1998, the year IRS planned to have TCMP data available, the DIF scores may become less effective at identifying returns with the greatest potential for change. They said this decrease in effectiveness may occur because of changes in tax laws and taxpayer behavior—resulting in an increased no-change rate for DIF selected returns and potentially lower revenue yields. This would mean greater burden on compliant taxpayers if more of them are selected for audit. IRS officials indicated that they plan to monitor the performance of DIF over time.

Compliance Data Needed to Validate Market Segment Approach

The 1994 TCMP was also intended to provide information on IRS’ new market segment approach for grouping tax returns. IRS initiated the market segment approach on the basis of work done in its Western Region, which indicated that compliance rates and audit issues were likely to be similar for taxpayers with similar characteristics, such as businesses in the same industry (e.g., manufacturing or retail sales). Accordingly, IRS concluded that grouping taxpayers by market segments might result in selecting returns for audit that have a higher potential for change and might allow auditors to specialize in market segments.

The 1994 TCMP was designed to provide data to test this hypothesis as well as to develop DIF scores by market segment rather than by audit class, as had been done in the past. Without TCMP or some alternative to provide similar information, IRS will not have data to show whether market segments are better for return selection purposes than traditional audit classes or be able to determine the compliance rate or compliance issues of the market segments. Because of these concerns, IRS no longer plans to test a selection of returns for audit by using the market segment approach. Instead, IRS plans to continue selecting returns for audit using the DIF score within audit classes.

TCMP Was Designed to Support IRS’ Research Function

Finally, the 1994 TCMP was designed to provide compliance data for IRS’ National and District Research Offices. IRS established these offices to research taxpayer compliance at the national and local levels. These researchers were to identify programs to improve compliance not only through audits but also through larger scale nonaudit programs, such as improved guidance and assistance to taxpayers and tax-law changes. TCMP also was to be used to develop benchmark compliance data for measuring future progress and determine how effectively managers were meeting their objectives of improving compliance.

Without TCMP or an alternative data source, IRS’ new research function would still be able to analyze noncompliance in filing returns and paying taxes. However, research on reporting compliance, the area where most of IRS’ compliance dollars are spent, would be very limited. Thus, researchers would have inadequate data to identify emerging trends in reporting compliance, to develop solutions, and to test the effectiveness of these solutions. As a result, IRS would likely continue its reliance on enforcement to improve compliance. However, enforcement has proven to be a costly and ineffective way to increase overall voluntary compliance.

Possible Short-Term Approaches to Collect Compliance Data

According to IRS officials, because of criticisms of TCMP and budget concerns, the 1994 TCMP is unlikely to be conducted. Although IRS officials told us they planned to use an alternative method to obtain TCMP data, they currently have no short-term proposal on how to obtain these data. Regardless of how IRS plans to mitigate the loss of 1994 TCMP data, it would have to start soon in order to minimize the adverse effects of not updating its compliance programs.

According to IRS officials, a number of alternative sampling strategies could fill the short-term data gap created by postponing TCMP indefinitely. From these strategies, we identified several alternative samples that met three basic objectives we considered important: (1) reducing the sample size to make data collection less costly for IRS and less burdensome to taxpayers, (2) maintaining IRS’ ability to update the DIF scoring system, and (3) maximizing use of the work already completed to identify returns and collect data for the 1994 TCMP sample.

One alternative sample would be for IRS to reduce the planned TCMP sample size and still provide some of the same data, although with less precision. This smaller sample could also be used to update the DIF score with little loss in accuracy. On the basis of our discussions with SOI officials, it appears IRS could reduce the sample size in any one of several ways, including decreasing the level of acceptable statistical precision for individual and corporate returns; selecting a sample with only businesses (sole proprietors, corporations, partnerships, and S corporations), with reduced precision; classifying TCMP sample returns and eliminating returns that past audit experience indicates are not likely to result in an audit adjustment; and selecting a sample that includes only sole proprietor and corporation returns.

Numerous other alternatives to the sampling methodology and characteristics may give slightly different sample sizes. For example, by eliminating the requirement for updating the DIF formula, the sample size for the corporation and individual business option is reduced by about 12 percent, to 28,275. However, such an approach would lessen the value of TCMP because it would limit IRS’ ability to update the DIF score, a primary purpose of TCMP audits.

Reducing the sample size would reduce the cost of TCMP audits. IRS’ cost estimates for the 1994 TCMP were divided into two types, (1) staffing costs and (2) opportunity costs. Staffing costs reflect IRS’ cost estimates for auditors to conduct the TCMP audits. Opportunity costs reflect IRS’ estimates of the difference between revenue generated through the regular audit program and revenue generated by TCMP audits. According to IRS officials, TCMP audits generate less revenue because the returns are randomly selected rather than identified by using the DIF score or as part of a special project and because the returns take longer to audit.

Table 1 shows how the variations in sampling methodology and characteristics change the sample size and cost estimates.

Changing the sample characteristics not only reduces the size but affects the usefulness of data from the sample. Each of the changes shown in table 1 has its own set of strengths and weaknesses that relate primarily to reliability and coverage. For example, reducing the sample to businesses only and reducing the precision would provide no information on nonbusiness individuals. Also, this sample would be of little use at the DORA level because it would not provide statistically reliable estimates of compliance below the national level. This sample could, however, provide some information on market segment compliance and be used to update the DIF formula for businesses and the return types where voluntary compliance is the lowest. Also, a business-only approach could be combined with a multiyear sample where the compliance of nonbusiness individual returns is evaluated in a future year. Although we did not fully evaluate the alternatives, the table in appendix I summarizes some of the more obvious trade-offs inherent in the alternatives discussed above.

Deciding how to change the sampling strategy to reduce the sample size would require careful evaluation of the tradeoffs. It seems reasonable, however, to consider that any new sample should, at a minimum, allow some updating of the DIF formulas, since this was to be the primary purpose of the original TCMP. To the extent that other purposes can also be met through one of these alternative sampling strategies, the sample would be more valuable.

Long-Term Compliance Measurement Considerations

Because a significant portion of IRS’ workload and future revenue depends on compliance programs, it is important that IRS determine how to measure compliance. Such measurements are an on-going need for any tax system that depends on voluntary compliance. It is also important that any long-term solution to obtaining compliance measurement information address the issue of sustainability so that long-term consistent measurement data are available. Sustainability means that the program’s costs, in terms of IRS’ budget and perceived burden on the taxpayer, must be clearly defensible. Additionally, to be efficient and effective, it would be necessary to design a program that provides timely data and clearly identifies the objectives and uses of these compliance data.

We identified several alternatives to the traditional TCMP that would meet some of the data needs that were lost when TCMP was postponed, including (1) conducting multiyear TCMP audits on smaller samples and combining the results; (2) using operational audit data; and (3) conducting a mini TCMP to identify compliance issues, with a more focused TCMP audit on the identified issues. We discuss these three options below.

Using Multiyear TCMP Audits

The multiyear TCMP alternative envisions annual TCMP-type audits on a smaller sample of tax returns which, over the course of several years, could be combined to obtain the required statistical precision. For example, IRS could disaggregate an entity type, such as individual taxpayers, into separate market segments or audit classes and conduct the audits of each segment on a 3-year cycle. Table 2 below shows an example of how such a program might operate.

One benefit of such an approach to IRS would be that after the initial 3-year period, new and current data would become available for one of the segments every year, making it easier to fine-tune the compliance system. Such an approach, however, would require considerable effort from IRS’ statisticians to ensure that the sample design was statistically sound. Also, it would require a long-term commitment from IRS managers to ensure that returns were audited regularly.

Using Operational Audit Data

A second option is to use data from operational audits already being done. Using data from operational audits would provide a large amount of compliance data. This option is also probably the most sustainable of the three we discuss because it would be less burdensome on compliant taxpayers and have no marginal staffing and opportunity costs. However, there are weaknesses. IRS currently has no system to track operational audit issues. While such a system is currently being developed, it is not yet operational and testing is not planned to begin until later in 1996. According to IRS officials, this database is to identify audit issues as well as provide codes to identify the causes of noncompliance. Also, IRS officials believe that using a database of operational audit results could not be used for updating the DIF formulas, determining ways to improve voluntary compliance, or systematically identifying emerging audit issues because the audited returns would not be randomly selected.

Using a Mini TCMP

A third option is to periodically conduct a very small TCMP that covers all taxpayers and follow up with mini TCMP audits on specific issues identified as concerns. Using this approach, IRS may be able to reduce the sample size and focus the majority of the audits on less compliant taxpayers, thus reducing cost and taxpayer burden. This approach may also provide IRS with insight into the areas of greatest noncompliance because efforts would be more focused. IRS officials said that this approach, however, would probably not provide sufficient data to update the DIF formulas and may be of little use at DORA sites because too few randomly selected returns would likely be examined.

Conclusions

A significant proportion of IRS’ present and future compliance programs have been predicated on the information obtained from TCMP. Benchmarking current compliance, validating the market segment approach, updating return selection formulas, researching noncompliance issues and developing programs to address them, and estimating the tax gap all depend on TCMP information. Without updated compliance data, increasing voluntary compliance, as envisioned by IRS, is less likely to occur.

IRS has options to replace at least some of the data that would have been available from the 1994 TCMP audits. Auditing a smaller sample size by eliminating some return types and accepting a decrease in precision, is a factor in such options. While each of these alternatives has limitations, they would meet some of the data needs that were lost when TCMP was postponed. It is important for IRS to make a decision soon on how to replace TCMP data because it will take some time to implement a replacement, and IRS projects that the currently available 1988 data will be less effective by 1998.

If IRS does not develop a sustainable compliance measurement program, IRS’ compliance programs may be disrupted as the proportion of audits that result in no-changes increases and IRS’ access to information on emerging compliance issues decreases. In the long term, such disruptions are likely to result in increased burdens on compliant taxpayers as more of them are selected for audit.

Recommendations

To provide the data necessary to help meet the objectives of IRS’ compliance strategies, we recommend that you identify a short-term alternative strategy to minimize the negative effects of the compliance information that is likely to be lost because TCMP was postponed, and develop a cost-effective, long-term strategy to ensure the continued availability of reliable compliance data.

Agency Comments and Our Evaluation

We requested comments from you on a draft of this report. Responsible IRS officials, including the National Director, Compliance, Research and National Director, Compliance Specialization, provided comments in a February 23, 1996, meeting. These officials agreed with our recommendations and provided some technical comments, which we have incorporated where appropriate. In a March 18, 1996, letter, you restated those agreement and indicated that over the next several months IRS would devote substantial effort to investigating all potential options for capturing reliable compliance information as an alternative to TCMP.

We believe the actions that IRS proposes, if properly implemented, will be responsive to our recommendations.

This report contains recommendations to you. The head of a federal agency is required by 31 U.S.C. 720 to submit a written statement on actions taken on these recommendations to the Senate Committee on Governmental Affairs and the House Committee on Government Reform and Oversight not later than 60 days after the date of this letter. A written statement also must be sent to the House and Senate Committees on Appropriations with the agency’s first request for appropriations made more than 60 days after the date of this letter.

We are sending copies of this report to pertinent congressional committees with responsibilities related to IRS, the Secretary of the Treasury, and other interested parties. Copies will be made available to others upon request.

The major contributors to this report are listed in appendix II. If you have any questions, please contact me on (202) 512-9044.

Trade-Offs With Alternative Sampling Strategies

Useable to update DIF scores, provides baseline compliance for market segments, useable at the DORA level for most market segments, very precise compared with other options.

Large sample size requiring significant resource and cost commitment.

Useable to update DIF scores, provides baseline data for national market segments, reduces the sample size and burden.

Not useable at the DORA level.

Useable to update DIF formula for businesses, where the most noncompliance occurs, provides baseline data for national market segments, reduces the sample size and burden.

Not usable to update the DIF score for individual returns, not useable at the DORA level.

Possibly useable to update DIF formulas, would provides some national market segment information, reduces the sample size and burden.

Not useable at the DORA level, problems identifying no-change returns.

Useable to update DIF formulas for selected classes of business return, provides national market segment compliance data, reduces the burden on individual taxpayers.

Not useable to update the DIF score or identify compliance issues for nonbusiness individuals, partnerships, and S corporations not useable at the DORA level.

Major Contributors to This Report

General Government Division, Washington, D.C.

San Francisco Regional Office

Ralph T. Block, Assistant Director Louis G. Roberts, Evaluator-in-Charge The first copy of each GAO report and testimony is free. Additional copies are $2 each. Orders should be sent to the following address, accompanied by a check or money order made out to the Superintendent of Documents, when necessary. VISA and MasterCard credit cards are accepted, also. Orders for 100 or more copies to be mailed to a single address are discounted 25 percent.

U.S. General Accounting Office P.O. Box 6015 Gaithersburg, MD 20884-6015 Room 1100 700 4th St. NW (corner of 4th and G Sts. NW) U.S. General Accounting Office Washington, DC Orders may also be placed by calling (202) 512-6000 or by using fax number (301) 258-4066, or TDD (301) 413-0006.

Each day, GAO issues a list of newly available reports and testimony. To receive facsimile copies of the daily list or any list from the past 30 days, please call (202) 512-6000 using a touchtone phone. A recorded menu will provide information on how to obtain these lists.