Tax Gap: Multiple Strategies Are Needed to Reduce Noncompliance
Released: 2019-05-09T00:00:00

Letter

Background

In April 2016, IRS released its most recent tax gap estimate, stating that taxpayers should have paid an average of about $2.5 trillion dollars per year in federal taxes for tax years 2008 to 2010. Of this amount, IRS estimated that taxpayers voluntarily and timely paid about 81.7 percent, or $2.04 trillion, leaving $458 billion in unpaid taxes per year, as shown in figure 1.

The tax gap estimate is an aggregate estimate of the five types of taxes that IRS administers—individual income, corporation income, employment, estate, and excise taxes. For each tax type, IRS attempts to estimate the tax gap based on three types of noncompliance: (1) underreporting of tax liabilities on timely-filed tax returns; (2) underpayment of taxes due from timely-filed returns; and (3) nonfiling, when a taxpayer fails to file a required tax return altogether or on time.

Underreporting of tax liabilities accounted for most of the tax gap estimate for tax years 2008 to 2010, making up 84 percent of the entire estimated gross tax gap, as shown in figure 2.

Individual income taxes made up the largest portion ($264 billion) of underreporting. Underreporting of business income accounted for nearly half ($125 billion) of that amount, as shown in table 1. Business income underreporting includes income from sole proprietors, which accounted for the largest share ($78 billion) of individual income tax underreporting.

IRS uses various approaches to estimate the different components of the tax gap. A primary source of information IRS uses is its National Research Program (NRP) study of individual tax returns. Through NRP, IRS examines a stratified, random sample of tax returns, and uses statistical modeling to produce estimates of noncompliance for the population of individual income tax return filers. Other areas of the tax gap are estimated using payment data or other statistical models. In 2016, IRS completed examinations for an NRP study on employment tax returns filed from tax years 2008 to 2010. IRS employees reported that they plan to start analyzing the results by June 2019. However, IRS has not provided plans for how it will use the results to update the current state of the employment tax gap estimate, as we previously recommended. The tax gap includes unintentional errors as well as intentional evasion, such as intentionally underreporting income, intentionally overreporting expenses, and engaging in abusive tax shelters or frivolous tax schemes.

As we have previously reported, completely closing the tax gap is not feasible, as it would entail more intrusive enforcement and more burdensome recordkeeping or reporting than the public is willing to accept, and more resources than IRS is able to commit. However, even modest reductions would yield significant financial benefits and help improve the government’s fiscal position.

Tax noncompliance, even when unintentional, could discourage compliant taxpayers and undermines the integrity of the tax system and the public’s confidence in it. For example, consider two groups of taxpayers with similar tax situations—those who pay the full amount of tax due and those who do not. Those who do not pay taxes are not meeting their obligation to fund government services, which, in effect, shifts the fiscal burden to those who do pay. Further, IRS devotes resources to attempt to collect taxes due from noncompliant taxpayers—resources that could be used for other purposes.

In addition, noncompliance can create an unfair competitive advantage among businesses because those that do not pay tax debts are avoiding costs that tax-compliant businesses are incurring. For example, our past investigations identified instances in which federal contractors with tax debts won awards based on price differentials over tax compliant contractors.

Key Factors Contributing to the Tax Gap Include Limited Third-party Information Reporting, Resource Trade-offs, and Complexities in the Tax Code Limited Third-Party Information Reporting

Our past work has found that three important factors contributing to the tax gap are the extent to which income is reported to IRS by third parties, IRS’s resource trade-offs, and tax code complexity.

As we have previously reported, the extent to which individual income tax taxpayers accurately report their income is closely aligned with the amount of income that third parties report to them and to IRS. For example, according to 2008–2010 IRS data, taxpayers misreported more than half of the types of income for which there is little or no third-party information reporting, such as business income (see figure 3). In contrast, when employers both withheld taxes from, and reported information on, wages and salaries to employees and IRS (through Form W-2, Wage and Tax Statement), taxpayers misreported on only 1 percent of such income. Similarly, taxpayers misreported less than 10 percent of investment income that banks and other financial institutions reported to account holders and IRS (through Forms 1099).

For items subject to substantial third-party information reporting, IRS is able to use automated processes to address noncompliance. The automated underreporter program, through which IRS matches amounts reported on tax returns with amounts reported on information returns submitted by third parties, is one such process. This computer matching program allows IRS to identify discrepancies between tax returns and information returns, and propose automatic changes to taxpayers. For items with little to no third-party information reporting, IRS must rely on more resource-intensive methods, such as correspondence or face-to- face examinations, to address noncompliance. While these examinations may be started by reviewing specific tax return line items, they may also be expanded to cover other areas of the tax returns if there are indications of misreporting in areas of the return not previously identified. However, it is harder for IRS to detect noncompliance in areas with little third-party information reporting.

IRS Resource Trade-offs

IRS’s budget declined by about $2.6 billion (18.8 percent) from fiscal years 2011 through 2019, and IRS’s budget for fiscal year 2019 is less than its fiscal year 2000 budget, after adjusting for inflation (see figure 4).

Since fiscal year 2011, IRS staffing has fallen from 95,544 full-time equivalent employees to an estimated 75,676 in fiscal year 2019, a 20.8 percent reduction. At the same time, IRS faces increasing responsibilities, such as implementing relevant aspects of Public Law 115-97, which included significant changes to corporate and individual tax law. IRS also faces ever-evolving and significant challenges protecting taxpayer information, preventing identity theft and fraud, and modernizing an aging technology infrastructure.

We previously reported that available staff has been a key factor in IRS decisions to scale back a number of program activities, such as examining tax returns, according to IRS officials. Our analysis of IRS data shows the rate of individual returns audited has declined between fiscal years 2011 and 2018 (see figure 5). Reducing examinations can reduce revenues collected through such enforcement action, and may indirectly reduce voluntary compliance.

Tax Code Complexity

The federal tax system contains complex rules that may be necessary to appropriately target tax policy goals, such as providing benefits to specific groups of taxpayers. However, this complexity imposes a wide range of recordkeeping, planning, computing, and filing requirements upon taxpayers. For example, taxpayers who receive income from rents, self- employment, and other sources may be required to make complicated calculations and keep detailed records. This complexity can lead to errors and underpaid or overpaid taxes. Complexity, and the lack of transparency that it can create, can also exacerbate doubts about the tax system’s integrity.

Tax expenditures—tax credits, deductions, exclusions, exemptions, deferrals, and preferential tax rates estimated by the Department of the Treasury to reduce tax revenue by about $1.38 trillion in fiscal year 2018—can add to tax code complexity. In part, this is because taxpayers must learn about, determine their eligibility for, and choose between tax expenditures that may have similar purposes. For example, as we reported in 2012, about 14 percent of filers in 2009 (1.5 million of almost 11 million eligible returns) did not claim an education credit or deduction for which they appeared eligible.

The complexity involved with tax expenditures may be acceptable if they achieve their intended purposes. However, in many cases, their effectiveness is questionable or unknown. With some exceptions, tax expenditures generally are not subject to reauthorization and the annual congressional budget processes. We have recommended greater scrutiny of tax expenditures since 1994, as periodic reviews could help determine how well specific tax expenditures achieve their goals, and how their benefits and costs (including complexity) compare to those of other programs with similar goals. Such actions would help facilitate oversight and accountability of tax expenditures more in line with the performance management and reporting requirements of other federal programs.

Paid tax return preparers and tax software developers help taxpayers navigate the complexities of the tax code. However, some paid preparers may introduce their own mistakes. For example, in a limited study in 2014, we found that seven of 19 preparers who completed returns for our undercover investigators made errors with substantial tax consequences while, only two preparers calculated the correct refund amount. Likewise, using NRP data, which are statistically representative, we estimated that 60 percent of returns prepared by preparers contained errors.

Multiple Strategies Are Needed to Reduce the Tax Gap

IRS’s overall approach to reducing the tax gap consists of improving services to taxpayers, and enhancing enforcement of the tax laws. In spite of these efforts, the percentage at which taxpayers pay their taxes voluntarily and on time has remained relatively constant over the past three decades. Our past work has demonstrated that no single approach will fully and cost effectively address noncompliance since the problem has multiple causes and spans different types of taxes and taxpayers. In light of these challenges, we have made numerous recommendations to IRS that have not yet been implemented, as well as matters for congressional consideration. For example, in our most recent high-risk update, we highlighted various actions IRS should take to improve enforcement of tax laws and reduce the tax gap.

Strategy for using compliance data. Developing and documenting a strategy that outlines how IRS will use data to update compliance strategies could help address the tax gap. For example, a strategy that outlines how IRS plans to use NRP data to update compliance programs and approaches would help IRS determine resource trade- offs and more fully leverage the investment it makes in compliance research, while providing Congress with a better understanding of the merits of the research it is being asked to fund.

Voluntary compliance goal. A long-term, quantitative goal for improving voluntary compliance may provide IRS with a concrete target the agency can use in fulfilling its mission. Without a quantitative goal, it will be more difficult for IRS to determine the success of its strategies, adjust its approach when necessary, and remain focused on results, especially since factors that affect compliance change over time.

Analyzing employment tax NRP study results. Developing and documenting plans to assess its NRP employment tax study results would help IRS (1) identify areas of noncompliance, (2) devise actions to address such noncompliance, and (3) update its employment tax gap estimate. Without completed analysis of the NRP employment tax study results, IRS risks using outdated data to make decisions about compliance and areas of the tax gap to pursue.

Leveraging the Return Review Program. IRS’s Return Review Program (RRP) is a tool to detect and select potentially fraudulent returns to prevent the issuance of invalid refunds. Evaluating the costs and benefits of expanding RRP to analyze individual returns not claiming refunds could support other enforcement activities by streamlining the detection and treatment of other types of noncompliance and fraud.

Given that the tax gap has been a persistent issue, reducing it will also require targeted legislative actions, such as those we highlighted in our 2019 high-risk update.

Additional third-party information reporting. Expanding third-party information reporting to IRS could increase voluntary tax compliance. For example, reporting could be required for certain payments that rental real estate owners make to service providers, such as contractors who perform repairs on their rental properties, and for payments that businesses make to corporations for services.

Enhanced electronic filing. Requiring additional taxpayers to electronically file tax and information returns could help IRS improve compliance in a resource-efficient way. For example, expanding the mandate for corporations to electronically file their tax returns could help IRS reduce return processing costs, select the most productive tax returns to examine, and examine fewer compliant taxpayers.

Math error authority. Providing IRS with authority—with appropriate safeguards—to correct math errors and to correct errors in cases where information provided by a taxpayer does not match information in government databases, among other things, could help IRS correct errors and avoid burdensome audits and taxpayer penalties.

Paid preparer regulation. Providing IRS with the authority to regulate paid tax return preparers could improve the accuracy of the tax returns they prepare.

Chairman Neal, Ranking Member Brady, and Members of the Committee, this completes my prepared statement. I would be pleased to respond to any questions that you may have at this time.

GAO Contact and Staff Acknowledgements

If you or your staff have any questions about this testimony, please contact James R. McTigue, Jr. at (202) 512-9110 or mctiguej@gao.gov. Contact points for our Offices of Congressional Relations and Public Affairs may be found on the last page of this statement. Key contributors to this testimony include Jeff Arkin, Assistant Director; Robyn Trotter, Analyst-in-Charge; A.J. Stephens; and Alicia White. Other staff who made key contributions to the reports cited in the testimony are identified in the source products.

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