Tax Compliance: Better Compliance Data and Long-term Goals Would Support a More Strategic IRS Approach to Reducing the Tax Gap
Released: 2005-08-17T00:00:00

Letter

Background

IRS develops its tax gap estimate by measuring the rate of taxpayer compliance—the degree to which taxpayers fully complied with their tax obligations. IRS uses such compliance data, along with other data and assumptions, to estimate the dollar amount of taxes not paid accurately and on time. For tax year 2001, IRS estimated that from 83.4 percent to 85 percent of owed taxes were paid voluntarily and on time, and that from $312 billion to $353 billion in taxes were not paid that should have been. IRS also estimates the amount of the gross tax gap that it will recover through enforcement and other actions and subtracts that to estimate the net annual tax gap. For tax year 2001, IRS estimated that it would eventually recover about $55 billion for a net tax gap from $257 billion to $298 billion. As we have reported in the past, closing the entire gap may not be feasible since it could entail more intrusive recordkeeping or reporting than the public is willing to accept or more resources than IRS is able to commit. However, given the size of the tax gap, even modest reductions would yield very significant financial benefits.

IRS has estimated the tax gap on multiple occasions, beginning in 1979. IRS’s earlier tax gap estimates relied on the Taxpayer Compliance Measurement Program (TCMP), through which IRS periodically performed line-by-line examinations of randomly selected tax returns. TCMP started with tax year 1963 and examined individual returns most frequently— generally every 3 years—through tax year 1988. IRS contacted all taxpayers selected for TCMP studies. IRS did not implement any TCMP studies after 1988 because of concerns about costs and burdens on taxpayers.

Under NRP, a program that we have encouraged, IRS recently completed its initial review of about 46,000 randomly selected individual tax returns from tax year 2001 (see app. I for a list of conducted TCMP and NRP surveys). Unlike with TCMP studies, IRS did not need to contact taxpayers for every tax return selected under NRP, handled some taxpayer contacts through correspondence rather than face-to-face examinations, and generally only asked taxpayers to explain information that it was otherwise unable to verify through IRS and third-party databases. In addition, unlike operational examinations, NRP examinations were randomly selected and used to measure compliance rather than target suspected noncompliance.

IRS has a strategic planning process through which it supports decisions about strategic goals, program development, and resource allocation. Under GPRA, agencies are to develop strategic plans as the foundation for results-oriented management. GPRA requires that agency strategic plans identify long-term goals, outline strategies to achieve the goals, and describe how program evaluations were used to establish or revise the goals. GPRA requires federal agencies to establish measures to determine the results of their activities.

Scope and Methodology

To provide information on the estimated amount that each major type of noncompliance contributed to the 2001 tax gap, we reviewed IRS’s tax gap estimate for 2001. To determine IRS’s views on the certainty of its estimate, we reviewed IRS studies about tax gap estimation and interviewed IRS research officials to understand the data and methodologies used. We also spoke with IRS officials regarding planned changes to the data sources and estimation methodologies for the tax gap estimate. We determined that the tax gap estimates presented in this report are sufficiently reliable for the specific purposes of our engagement, particularly since IRS already has publicly released its tax gap estimates and disclosed their weaknesses. These purposes include discussing the major tax gap components and the orders of magnitude for various components, IRS’s concerns about the certainty of its estimates, and our recommendations on IRS’s compliance data and efforts.

We reviewed IRS, academic, and our own reports and interviewed IRS officials to identify the various reasons for noncompliance. We talked with IRS officials to determine the extent and reliability of data and coding on the reasons for noncompliance, and reviewed IRS’s Examination Operational Automation Database, which is a database of tax return examination results that includes examiners’ determinations of the reasons for any noncompliance. We also talked with IRS officials to determine any plans to develop better data on reasons for noncompliance.

To determine IRS’s approach to reducing the tax gap and whether the approach incorporates established results-oriented planning principles, we reviewed IRS strategic and performance plans and interviewed IRS strategic planning officials at the agency and operating division levels. We asked IRS to identify its key efforts to reduce the tax gap as well as the related rationales, goals, and results. As part of our work on whether the approach incorporates established results-oriented planning principles, we used what we learned about IRS’s approach to determine the extent to which it incorporated selected planning principles consistent with GPRA’s requirements. For purposes of this review, we focused on elements of results-oriented planning that, previously, we found common to leading organizations successfully pursuing results-oriented management–defining desired results, measuring performance, and using performance information to support agency missions.

IRS Lacks Approved Plans to Regularly Measure Compliance, Including Underreporting Which Accounts for the Largest Portion of the Tax Gap

IRS estimates that underreporting of taxes accounted for about $250 billion to $292 billion of the $312 billion to $353 billion tax gap for 2001, while underpayment and nonfiling accounted for about $32 billion and $30 billion, respectively. The actual tax gap could be higher or lower due to various factors that affect the certainty of the estimate, such as old compliance data. IRS is taking some steps designed to improve portions of its compliance measurement efforts and its preliminary tax gap estimate and plans to release a revised tax gap estimate by the end of 2005. While IRS has proposed a schedule for NRP studies over the next several years, IRS has no approved plans to regularly measure tax compliance, which it could use to update the tax gap estimate and guide its compliance efforts.

Underreporting Accounted for Most of the Tax Gap Estimate

As table 1 indicates, underreporting of individual income taxes represented about half of the tax gap for 2001 (the estimate ranges from $150 billion to $187 billion out of a gross tax gap estimate that ranges from $312 billion to $353 billion).

Within the underreporting estimate, IRS attributed about $150 billion to $187 billion, or about 50 percent of the total tax gap, to individual income tax underreporting, including underreporting of business income, such as sole proprietor, informal supplier, and farm income (about $83 billion to $99 billion); nonbusiness income, such as wages, interest and capital gains (about $42 billion to $57 billion); overstated income adjustments, deductions, and exemptions (about $14 billion to $16 billion); and overstated credits (about $11 billion to $14 billion). Underreporting of corporate income tax contributed an estimated $30 billion, or about 10 percent, to the 2001 tax gap, which included both small corporations (those reporting assets of $10 million or less) and large corporations (those reporting assets of over $10 million). (For a more detailed table of IRS’s estimates for the various components of the 2001 tax gap, see app. II).

Employment tax underreporting accounted for an estimated $66 billion to $71 billion, or about 20 percent, of the 2001 tax gap and included several taxes that must be paid by self-employed individuals and employers. Self- employed individuals are generally required to calculate and remit Social Security and Medicare taxes to the U.S. Treasury each quarter. Employers are required to withhold these taxes from their employees’ wages, match these amounts, and remit withholdings to Treasury at least quarterly. Underreported self-employment and employer-withheld employment taxes respectively contributed an estimated $51 billion to $56 billion and $14 billion to IRS’s tax gap estimate. The employment tax underreporting estimate also includes underreporting of federal unemployment taxes (about $1 billion).

IRS’s 2001 Tax Gap Estimate Is Inexact Due to Incomplete and Old Data, Outdated Methodologies, and Inherent Measurement Difficulties

Although a significant portion of IRS’s new tax gap estimate is based on recent compliance data, IRS has concerns with the certainty of the overall tax gap estimate in part because of incomplete and old data, outdated methodologies, and measurement difficulties. Table 2 shows IRS’s certainty level in the estimates, as well as the underlying data sources.

As table 2 shows, IRS’s estimate for the 2001 tax gap does not include estimates of excise tax underreporting and nonfiling. According to IRS, the reason for this omission is that numerous federal excise taxes, many of which have specific exclusions or varying applications, complicate excise tax computations. Further, data on excise tax transactions are typically maintained at the state level and are often incomplete. Also, according to an IRS research official, the estimate does not include corporate income tax and employment tax nonfiling because IRS lacks good, representative data for corporate and employment tax nonfilers. Further, data from IRS’s operational programs to identify nonfilers exclude those whom IRS does not know about and do not include the full tax liability of nonfilers whom IRS has identified.

The 2001 tax gap estimate also does not include any estimates for taxes due from illegal source income, as the magnitude of such income is difficult to estimate. Moreover, the federal government seeks to eliminate most illegal activities altogether, rather than derive revenue from these activities.

Estimates for Some Components of the Tax Gap Are Based on Old Data

Old data also contribute to IRS’s “weaker” level of certainty for certain segments of the underreporting portion of its 2001 tax gap estimate. For example, IRS used data from the 1970s and 1980s to estimate underreporting of corporate income taxes and employer-withheld employment taxes. For large corporate income tax underreporting, IRS based its estimate on the amount of tax recommended from operational examinations rather than the tax ultimately assessed as part of the total tax liability. According to IRS officials, IRS relies on the amount of tax recommended because it is difficult to determine the true tax liability of large corporations due to complex and ambiguous tax laws that create opportunities for differing interpretations and that complicate the determination. These officials further stated that because these examinations are not randomly selected and are not focused on identifying all tax noncompliance, the estimate produced from the examination data is not representative of the tax gap for all large corporations. They also explained that due to these complexities and the costs and burdens of collecting complete and accurate data, IRS has not systematically measured large corporation tax compliance through statistically valid studies, even though the officials acknowledged that such studies would be useful in estimating the related tax gap.

Tax Gap Estimates Are Affected by Outdated Methodologies

Further, some methodologies IRS used to estimate the tax gap are based on older data and contribute to the uncertainty surrounding the tax gap estimate. For example, because IRS knew that it would not detect all underreporting noncompliance, IRS multiplied the detected amounts of underreporting to help calculate a total estimate for underreported individual income tax. IRS officials explained that they used a number of “multipliers,” including one derived from the 1976 TCMP study of individual tax returns, which was before IRS expanded and improved its computer matching programs to better detect various types of underreported income. In addition, IRS estimated individual income tax nonfiling based on the assumption that the relationship between individual income nonfiling and underreporting has been constant since the 1988 TCMP survey was conducted.

Tax Gap Is Inherently Difficult to Estimate

Finally, it is inherently difficult for IRS to observe and measure some types of underreporting or nonfiling. For example, underreporting of income or nonfiling of tax returns by informal suppliers can be hard for IRS to detect because the tax laws generally do not require third parties to withhold income tax or file information returns on payments made to informal suppliers, as are required with other types of individuals such as wage earners. Similarly, academic studies have discussed the difficulty in tracking cash payments that businesses make to their employees, as businesses may not report these payments to IRS in order to avoid paying employment taxes and employees may not report these payments on their income tax return to avoid paying income taxes.

IRS Plans to Issue a Revised Tax Gap Estimate but Has No Approved Plans to Regularly Collect Compliance Data

IRS is taking several steps that could improve the preliminary tax gap estimate for tax year 2001. IRS intends to publish a revised tax gap estimate by the end of 2005 based on the results of these steps.

For example, IRS officials stated that IRS plans to further analyze the preliminary NRP results in an attempt to improve the certainty of the estimate. NRP is a significant achievement and its data should be valuable in improving IRS operations and for other uses. However, those officials added that because IRS is still assessing the quality of the NRP data, it has not yet finalized the certainty levels for the preliminary estimates for individual income tax and self-employment tax underreporting. Likewise, we cannot yet be certain about the quality of the NRP data collected because IRS is still assessing the data.

IRS plans to implement three changes to its estimation methodology for its revised tax gap estimate. Although it is too soon to know whether these changes will improve the estimate, IRS expects that the changes will help address known methodological weaknesses. According to IRS, these changes include the following: IRS plans to replace the multiplier it derived in the 1970s and used to estimate individual income tax underreporting. IRS is developing a new methodology, known as detection controlled estimation (DCE). DCE is a regression-based model that will use 2001 NRP data and control for variables that could affect the amount of underreporting detected.

IRS plans to develop a new technique as well as replace the data from the 1981 and 1985-1986 University of Michigan surveys to estimate the individual income tax underreporting portion of the tax gap attributable to informal suppliers.

IRS intends to update its estimate of individual income tax nonfiling, which is currently based on 1988 nonfiler TCMP data, by using “Exact Match” data provided by the U.S. Census Bureau. Census will match data from its Current Population Survey against the IRS Master Files to identify the extent of nonfiling by individual taxpayers. The Census data to be provided to IRS will be aggregated and not contain information on specific individuals.

In addition, IRS research officials are planning a compliance measurement study that will allow IRS to update underreporting estimates involving flow-through entities. This study, which IRS intends to begin in October 2005, would take 2 to 3 years to complete. Because individual taxpayers or corporations may be recipients of income (or losses) from flow-through entities, this study could affect IRS’s underreporting estimates for individual and corporate income tax.

While these data and methodology updates could improve the tax gap estimates, IRS has no approved plans to periodically collect more and better compliance data over the long term beyond the study of flow- through entities. IRS Research officials said that they recently proposed a schedule for additional NRP studies over the next several years. However, these officials also said this proposal is under consideration but has not been finalized. IRS has indicated that given its current research priorities, it could not begin another NRP study of individual income tax returns before 2008, at the earliest, and would not complete such a study until at least 2010.

According to IRS officials, IRS has not committed to regularly collecting compliance data because of the associated costs and burdens. Taxpayers whose returns are examined through compliance studies such as NRP bear costs in terms of time and money. Also, IRS incurs costs, including direct costs and opportunity costs (or revenue that IRS potentially forgoes by examining randomly selected returns, which are more likely to include returns from compliant taxpayers than returns selected because they are likely to contain noncompliance that would produce additional tax assessments).

Regularly Measuring Compliance Can Be Beneficial, but Determining the Frequency of Measurement Involves Considering Several Factors

Regularly measuring compliance can offer many benefits, including helping IRS identify new or growing types of noncompliance, identify changes in tax laws and regulations that may improve compliance, more effectively target examinations of tax returns, understand the effectiveness of its programs to promote and enforce compliance, and determine its resource needs and allocations. For example, by analyzing 1979 and 1982 TCMP data, IRS identified significant noncompliance with the number of dependents claimed on tax returns and justified a legislative change to address the noncompliance. As a result, for tax year 1987, taxpayers claimed about 5 million fewer dependents on their returns than would have been expected without the change in law.

Tax compliance data are useful outside of IRS as well. Other federal agencies and offices use compliance data for tax policy analysis, revenue estimating, and research. For example, the Department of Commerce’s Bureau of Economic Analysis had used TCMP data to adjust its national income and product accounts. Additionally, state tax authorities have used IRS compliance data to develop state compliance programs and estimate state tax gaps. Also, policy makers in the executive branch and Congress can use the results from compliance measurement studies to help decide on appropriate funding levels for IRS.

As we have reported in the past, the longer the time between compliance measurement surveys, the less useful they become given changes in the economy and tax law. According to IRS, without current compliance data, it has limited capability to determine key areas of noncompliance to address and actions to take to maximize the use of its limited resources. For example, the formulas that IRS creates from compliance data to select returns for examination have enabled IRS to focus examination resources on noncompliant returns rather than burdening compliant taxpayers. When IRS updated the formulas in the early 1990s with compliance data from the 1988 TCMP, IRS selected a lower percentage of compliant tax returns for examination. However, after 3 years of using formulas based on the 1988 data, the percentage of compliant tax returns examined increased each year through 1998, placing additional burdens on compliant taxpayers and leaving less time for IRS to examine noncompliant returns that resulted in an additional tax assessment.

Historically, IRS has varied how frequently it measured compliance for particular types of taxpayers and taxes. As appendix I shows, the period between measurements of individual income tax reporting compliance, which consistently has accounted for the largest portion of the tax gap, never exceeded 4 years between 1963 and 1988. In planning the 2001 NRP to measure individual income tax compliance, IRS envisioned doing the NRP on a 3-year cycle. Appendix I also shows that IRS measured compliance less frequently for other types of taxpayers and taxes, such as for small corporation income taxes, and that IRS never measured compliance for large corporations or for excise taxes.

Although regularly measuring tax compliance can be beneficial, how often measurements should be made is a judgment that depends on many potential criteria including (1) the amount that a particular type of noncompliance is thought to contribute to the tax gap, (2) whether IRS has reason to believe that compliance may have changed (e.g., due to tax law changes), and (3) costs, particularly when IRS officials said that resources to conduct operational examinations are already limited. Using these criteria, IRS would likely vary the frequency of compliance measurement studies. Based on these criteria as well as our previous reports, decisions about compliance measurement would also be affected by the following factors.

Precision. The costs and benefits of measuring compliance can vary with how precisely IRS wishes to measure compliance to achieve an intended use (e.g., tax gap estimation or examination return selection). Obtaining more precise and more detailed compliance data for more detailed populations of taxpayers or tax issues (e.g., types of income or deductions) would likely be more costly but potentially more useful.

Capacity. Each compliance measurement study requires having enough resources such as staffing, training, tools, and systems to capture the data. Regular compliance measurement through smaller efforts targeted at particular types of taxpayers or taxes and sampling designs that collect data across consecutive tax years rather than for one year could help reduce costs and sustain long-term compliance measurement.

IRS Has Concerns with Its Data on Reasons for Noncompliance but Does Not Have Firm or Specific Plans to Develop Better Data

Several factors concern IRS about its data on the reasons for noncompliance, which can be unintentional or intentional. Although IRS is developing a system intended to capture better examination data, IRS does not have firm or specific plans to develop better data on the reasons for noncompliance, even though the lack of such data makes it harder to decide whether it should address specific areas of noncompliance through nonenforcement efforts, such as designing clearer forms or publications, or enforcement efforts.

IRS Has Concerns with Its Data on Reasons for Noncompliance

IRS has concerns with its data on the unintentional and intentional reasons for noncompliance. Various types of unintentional or intentional reasons could explain why taxpayers fail to comply with the tax laws. Unintentional reasons can include being unaware of recordkeeping requirements, accidentally entering an item on the wrong line of a tax return, or following inaccurate advice from a tax practitioner. Intentional reasons for noncompliance can include intentionally omitting income from a tax return or interpreting vague tax laws to evade tax liability.

IRS collects data on the reasons for noncompliance for specific tax issues during its operational examinations of tax returns. In many of these cases, it is difficult for examiners to determine a taxpayer’s intent– whether the noncompliance is unintentional or intentional. Unless the evidence clearly points to the reason, the examiner would have to make subjective judgments about why the noncompliance occurred. IRS has a number of other concerns with the data: The database is incomplete because not all examination results, including data on reasons for noncompliance, were being entered into the database.

IRS has not tested the adequacy of the controls for data entry or the reliability of the data being collected. IRS has found instances where examiners close examinations without assigning a reason for noncompliance or by assigning the same reason to all instances of noncompliance, regardless of the situation.

IRS has not trained all examiners to ensure consistent understanding and use of the various codes to indicate the reason for noncompliance.

The data do not represent the population of noncompliant taxpayers but rather only those who had their tax returns examined.

IRS Does Not Have Firm or Specific Plans to Develop Better Data on Reasons for Noncompliance, which Could Help IRS’s Efforts to Address Tax Noncompliance

According to IRS officials, the agency does not have firm or specific plans to develop better data on the reasons for noncompliance. One official explained that IRS decided not to improve the consistency of its current reason data because it is devoting its limited resources to other efforts, such as developing the Examination Desktop Support System (EDSS). Although this system is intended to allow examiners to capture better examination data, specific system features have not yet been identified to improve examiners’ selection of reason codes. IRS officials said that the system could be enhanced in the future to improve the reason data and that they plan to consider such enhancements.

As the National Taxpayer Advocate recently testified, data on whether taxpayers are unintentionally or intentionally noncompliant with specific tax provisions are critical to IRS for deciding whether its efforts to address specific areas of noncompliance should focus on nonenforcement activities, such as improved forms or publications, or enforcement activities to pursue intentional noncompliance. For example, taxpayers may unintentionally claim the Earned Income Tax Credit (EITC) because they do not understand the child residency requirements for this credit (i.e., a dependent must live with the taxpayer for more than half of the year). This type of unintentional noncompliance may require IRS to more clearly explain the EITC requirements within related forms and publications. However, other taxpayers may file false EITC claims with the intent of evading tax liability, which may suggest a strategy that relies on IRS’s enforcement programs and tools. Similar situations could exist for other tax code provisions.

If IRS is to develop better data on the reasons for noncompliance, it will be important for IRS to consider factors in data collection such as the following.

Data reliability. To minimize examiner subjectivity and ensure that the data are complete and accurate, IRS would need to refine the reason categories, provide adequate training, establish system and data entry controls, and provide supervisory oversight.

Scope. IRS would need to decide whether the reason categories are to be captured for selected types of noncompliance or all types of noncompliance.

Examination selection. IRS currently collects reason data annually through hundreds of thousands of operational examinations. IRS also collected reason data through NRP. In the future, IRS would need to decide whether to collect reason data (1) during all operational examinations, (2) for a statistical sample of operational examinations, or (3) for examinations performed through periodic compliance studies such as NRP. Collecting data for a sample of examinations or through periodic compliance studies might be done with a smaller cadre of examiners specially trained and overseen to maximize consistency of decisions about the reasons why taxpayers are noncompliant. Also, data from samples of examinations could be used to generalize reasons for noncompliance for all examinations, and data from compliance studies of all taxpayers could be used to generalize these reasons for the population of taxpayers.

Our past reports have supported the concept of rigorously researching the causes of noncompliance. Recognizing the benefits of better compliance data, the National Taxpayer Advocate has also urged IRS to consider performing additional research into causes of noncompliance.

IRS’s Approach to Reducing the Tax Gap Focuses on Service and Enforcement but Lacks Long-term, Quantitative Compliance Goals and Measures That Are Consistent with Results-Oriented Management Principles

IRS approaches tax gap reduction through improving service to taxpayers and enforcing tax laws and has established two broad strategic goals and related key efforts that are intended to support this approach. However, IRS has not established long-term, quantitative compliance goals and regularly collected data to track progress in reducing the tax gap, which would complement its current important compliance efforts. Establishing clear compliance goals and measuring progress towards them benefits both IRS and external stakeholders and are consistent with the results- oriented performance management principles set forth in GPRA. Although IRS has lacked such data in the past and faces other challenges, NRP and EITC data provide an improved base for setting compliance goals and reexamining existing programs intended to reduce the tax gap.

IRS Approaches Tax Gap Reduction through Broad Goals and Numerous Efforts to Improve Taxpayer Service and Enforce Tax Laws

IRS’s overall approach to reducing the tax gap consists of improving service to taxpayers and enhancing enforcement of the tax laws. Through efforts such as education and outreach programs, IRS seeks to improve voluntary compliance with the tax system by helping people understand their tax obligations. In addition, IRS attempts to simplify the tax process, such as by revising forms and publications to make them more easily understood by diverse taxpayer communities and electronically accessible. In conjunction with taxpayer service, IRS uses its enforcement authority to ensure that taxpayers are reporting and paying the proper amount of taxes. Through efforts such as examining tax returns and collaborating with state governments to share leads on abusive tax avoidance transactions, IRS seeks to detect and deter noncompliance.

Two of IRS’s three strategic goals, along with their associated objectives and strategies, are intended to directly support this approach.

Goal 1—Improve Taxpayer Service—is intended to promote voluntary compliance. This goal has three objectives (1) improve service options for the tax paying public (2) facilitate participation in the tax system by all sectors of the public and (3) simplify the tax process.

Goal 2—Enhance Enforcement of the Tax Law—is intended to ensure, through IRS’s enforcement authority, that taxpayers are meeting their tax obligations. The four objectives for this goal are (1) discourage and deter noncompliance with emphasis on corrosive activity by corporations, high- income individual taxpayers, and other contributors to the tax gap; (2) ensure that attorneys, accountants, and other tax practitioners adhere to professional standards and follow the law; (3) detect and deter domestic and off-shore-based tax and financial criminal activity; and (4) deter abuse within tax-exempt and governmental entities and misuse of such entities by third parties for tax avoidance or other unintended purposes. To achieve these objectives, IRS has 15 strategies, such as “re-examine and adjust audit processes to target likely areas of noncompliance.”

In addition to these goals, IRS’s service and enforcement efforts outlined in its strategic plan are also intended to support tax gap reduction. IRS’s strategic plan mentions over 60 service and enforcement efforts targeted at improving taxpayer compliance. Because the plan did not prioritize these efforts, we asked IRS officials to identify the key efforts in reducing the tax gap. In response, IRS provided over 40 key efforts. Enforcement efforts included pursuing high income nonfilers (taxpayers with income over $100,000 who have not filed a tax return) through direct enforcement actions and identifying higher priority collection cases through analytical models. Service, or nonenforcement, efforts included a taxpayer education program on tip reporting. (See app. III for a summary of the key efforts provided.)

IRS’s Tax Gap Reduction Approach Does Not Establish Long-term, Quantitative Compliance Goals or Regular Data Collection to Measure Progress

IRS has developed a strategic planning and budgeting process to help the agency comply with GPRA requirements. However, IRS’s strategies for improving compliance generally lack a clear focus on long-term, quantitative goals and results measurement. IRS has established broad qualitative goals and strategies for improving taxpayer service and enhancing enforcement of the tax laws. IRS has also identified measures, such as compliance rates for tax reporting, filing, and payment as well as the percentage of Americans who think it is acceptable to cheat on their taxes, which are intended to gauge the progress of its strategies toward its broad goals. However, IRS does not collect recent data to update all of these compliance measures and has not established quantitative goals against which to compare the measures and judge any progress made through its compliance strategies.

Although IRS has not focused on quantitative, results-oriented goals for improving voluntary compliance, IRS has established many output-related goals and measures that track activity level, such as the number of taxpayers contacted, collection cases closed, or returns examined. In contrast, IRS has fewer outcome-related goals and measures that track results, such as refund timeliness or examination quality.

In the past, IRS had set a long-term goal of improving overall compliance to 90 percent by 2001. This goal was to be achieved through a research approach rooted in IRS’s Compliance 2000 philosophy. The Compliance 2000 philosophy envisioned using nonenforcement efforts to correct unintentional noncompliance and reserving enforcement efforts for intentional noncompliance. To carry out this philosophy, in the early 1990s, IRS initiated many research projects across IRS’s 63 district offices to identify noncompliant market segments, root causes for the noncompliance, and innovative ways to improve compliance. However, the lack of objective compliance data, among other factors, limited the success of this approach. Recently, external stakeholders, such as the IRS Oversight Board, have supported the concept of setting a numeric, long- term goal for increasing the voluntary compliance rate.

In response to a President’s Management Agenda initiative to better integrate budget and performance information, IRS officials said that they are considering various long-term goals for the agency. IRS has not yet set a time frame for publicly releasing the goals. Nor have IRS officials indicated whether any goals will be related to improving taxpayer compliance or whether they will be quantitative and results-oriented.

Long-term, Quantitative Compliance Goals and Measures Are Beneficial and Consistent with Results-Oriented Management Principles

Focusing on outcome-oriented goals and establishing measures to assess the actual results, effects, or impact of a program or activity compared to its intended purpose can help agencies improve performance and stakeholders determine whether programs have produced desired results. As such, long-term, quantitative compliance goals offer several benefits for IRS, as discussed below.

Perhaps most important, compliance goals coupled with periodic measurements of compliance levels would provide IRS with a better basis for determining to what extent its various service and enforcement efforts contribute to compliance. Additionally, long-term, quantitative goals may help IRS consider new strategies to improve compliance, especially since these strategies could take several years to implement. For example, IRS’s progress toward the goal of having 80 percent of all individual tax returns electronically filed by 2007 has required enhancement of its technology, development of software to support electronic filing, education of taxpayers and practitioners, and other steps that could not be completed in a short time frame. Focusing on intended results can also promote strategic and disciplined management decisions that are more likely to be effective because managers who use fact-based performance analysis are better able to target areas most in need of improvement and select appropriate interventions. Likewise, agency accountability can be enhanced when both agency management and external stakeholders such as Congress can assess an agency’s progress toward meeting its goals. Finally, setting long-term, quantitative goals would be consistent with results-oriented management principles that are associated with high- performing organizations and incorporated into the statutory management framework Congress has adopted through GPRA.

Updated Compliance Data Provide Opportunities for IRS to Establish a More Results-Oriented Tax Gap Reduction Approach

Not unlike other agencies we have reported on in the past, IRS faces challenges in implementing a results-oriented management approach, such as identifying and collecting the necessary data to make informed judgments about what goals to set and to subsequently measure its progress in reaching its goals. However, having completed the NRP review of income underreporting by individuals, IRS now has an improved foundation for setting goals for improving taxpayers’ compliance.

IRS’s effort to address noncompliance with the EITC provides an example of how a more data-driven planning approach can help IRS become more results-oriented over time. IRS’s most recent EITC compliance study estimated that between $8.5 billion and $9.9 billion, or between 27 percent and 32 percent, respectively, of the EITC claims filed for tax year 1999 should not have been paid. Following the release of this study, a task force of IRS and Treasury officials determined the three leading types of errors that accounted for about $7 billion annually in overclaims. On the basis of compliance data and other research, IRS started an initiative to improve service, fairness, and compliance and designed specific corrective actions targeting the three types of errors. IRS is evaluating these actions to determine their effectiveness at reducing the overclaim rate in each of the three errors. Because IRS targeted its EITC effort based on data on the sources and extent of taxpayer errors, it was better able to determine what actions to take and how well, using systematic data collection and program evaluation, the effort is meeting its intended purpose.

Measuring progress toward any goals that may be set could be challenging. For example, IRS researchers have found it difficult to determine the extent to which its enforcement actions deter noncompliance or its services improve compliance among taxpayers who want to comply. Although widespread agreement exists that IRS enforcement programs generally increase voluntary tax compliance, challenges such as collecting reliable compliance data, developing reasonable assumptions about taxpayer behavior, and accounting for factors outside of IRS’s actions that can affect taxpayer compliance, such as changes in tax law, make it difficult to estimate the effect of IRS’s enforcement and service activities. Even if IRS is unable to empirically estimate the extent to which its actions directly affected compliance rates, periodic measurements of compliance levels can indicate the extent to which compliance is improving or declining and provide a basis for reexamining existing programs and triggering corrective actions if necessary.

Recently, several research studies have offered insights to better understand the direct tax revenue effects of IRS’s activities as well as the indirect effects on voluntary tax compliance. IRS researchers have hypothesized that the indirect effect of an examination varies among taxpayer segments. Further, a recent study concluded that criminal investigations have positive direct and indirect tax effects. Although these studies generally indicate that IRS activities have positive tax effects, the magnitude of these effects is not yet known with a high level of confidence given compliance measurement challenges, as mentioned earlier. According to IRS, these studies serve as a valuable baseline for further research, but it has not yet determined how it will use these studies to make operational decisions.

Conclusions

As discussed in our recent testimony on the tax gap before the Senate Committee on Finance, and underscored by IRS, periodic tax compliance measurement is critically important to IRS’s ability to estimate the tax gap and design compliance programs intended to reduce the tax gap. Without current, reliable compliance data, it can be difficult for IRS to monitor trends or identify new types of noncompliance, determine its compliance resource needs and how to allocate such resources, and justify budget and staffing requests to policy makers in Congress and the executive branch. Consequently, completion of NRP, which covered the largest portion of the tax gap and was designed and implemented with an eye to reducing the costs and burdens of data collection, is a substantial achievement. However, although IRS has recently proposed a schedule for future NRP studies, it has no approved plans to repeat this study or periodically measure compliance across the various components of the tax gap. Doing periodic compliance studies in areas that have previously been measured, such as individual income tax underreporting, would provide valuable information to support a more data-driven and risk-based approach towards improving compliance and reducing the tax gap. Although it may not be feasible or necessary to measure compliance for all components of the tax gap at the same frequency or with the same level of investment, where practical methodologies exist, periodic measurements should be taken. Where practical methodologies do not yet exist, such as for excise tax or for large corporations, looking for ways to overcome challenging compliance measurement difficulties would be worthwhile.

The tax gap is both a measure of the burden and frustration of taxpayers who want to comply but are tripped by tax code complexity and of willful tax cheating by a minority who do not wish to pay their fair share to support government programs. As such, collecting data on the reasons why noncompliance occurs can help IRS more effectively tailor its efforts to improve compliance. It can be difficult for IRS examiners to consistently determine the reasons why taxpayers have failed to comply with the tax laws. However, IRS has no specific plans to address this issue and, as a result, is missing opportunities to gather better data than it already collects. Certain immediate steps, like improving reason codes, better training examiners in applying the codes, and possibly reducing the number of examiners who would be responsible for making judgments on the reasons taxpayers are noncompliant may improve the data IRS currently collects. Nevertheless, given the difficulty of consistently determining why taxpayers are noncompliant, sustained research on these reasons also would be needed to develop a better understanding.

Reducing the tax gap will be a challenging task given persistent levels of noncompliance and will not likely be achieved through a single solution. Rather, the tax gap must be attacked on multiple fronts and with multiple strategies over a sustained period of time. Without long-term, quantitative voluntary compliance goals and related performance measures, 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. Having compliance goals, coupled with recently collected NRP data, would provide a solid base upon which IRS can develop a more strategic, results-oriented approach to reducing the tax gap.

Taken together, these steps—periodically measuring compliance, determining the reason taxpayers are noncompliant, and setting results- oriented long-term goals—can help IRS build a foundation to understand how its taxpayer service and enforcement efforts affect compliance, improve its efforts, and make progress on reducing the tax gap.

Recommendations for Executive Action

To establish a stronger foundation for improving IRS’s efforts to reduce the tax gap, the Commissioner of Internal Revenue should do the following.

Develop plans to periodically measure tax compliance for areas that have been previously measured, such as for individual income tax underreporting, and study ways to cost effectively measure compliance for other components of the tax gap that have not been measured, such as for excise tax and large corporations. Those plans and that study should take into account risk management factors such as the amount the component contributes to the gap, changes that may have affected compliance levels since a measurement was last taken, and the cost of measuring compliance.

Take steps to ensure that IRS regularly collects complete, accurate, and consistent data, to the extent possible, on the reasons taxpayers are noncompliant and that sufficient broader research is undertaken to continue learning about the reasons why noncompliance occurs.

Establish a long-term, quantitative voluntary compliance goal for individual income tax underreporting and for tax underpayment, as well as for other areas of noncompliance as data become available.

Agency Comments and Our Evaluation

The Commissioner of Internal Revenue provided written comments on a draft of this report in a letter dated July 6, 2005, which is reprinted in appendix IV. In the letter, the Commissioner agreed with our recommendations. In response to the recommendation that IRS develop plans to periodically measure tax compliance, the Commissioner recognized the need for and value of developing and regularly updating compliance measures for various taxpayer populations and said that IRS will continue to consult with stakeholders to develop and refine its compliance measurement plans. In response to our recommendation that IRS take steps to regularly collect complete, accurate, and consistent data on the reasons for noncompliance, the Commissioner agreed that a better understanding of taxpayer noncompliant behavior would be useful in shaping strategic priorities and defining efforts to improve compliance. He further said that the operating divisions will continue to partner with the IRS research community to identify and better understand specific reasons for noncompliance and that IRS will ensure that auditors are trained to properly apply reason codes in the new report-writing system IRS is developing. In response to the recommendation that IRS develop long- term quantitative compliance goals, the Commissioner agreed with the concept of developing such goals and discussed factors that make goal- setting challenging. We appreciate IRS’s current actions related to our recommendations and recognize the challenges involved in balancing a number of complex issues related to obtaining and using tax compliance data.

As agreed with your offices, unless you publicly announce its contents earlier, we plan no further distribution of this report until 30 days from its issue date. At that time, we will send copies to the Chairman and Ranking Minority Member, House Committee on Ways and Means; the Secretary of the Treasury; the Commissioner of Internal Revenue; the Director, Office of Management and Budget; and other interested parties. We will make copies available to others on request. In addition, the report will be available at no charge on the GAO Web site at http://www.gao.gov/.

If you or your staff have any questions, please contact me at (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 report. Key contributors to this report are listed in appendix V.

Appendix I: IRS Compliance Measurement Surveys

The following table summarizes the Internal Revenue Service’s (IRS) efforts to measure voluntary compliance using TCMP surveys and the National Research Program (NRP) survey of individual income tax returns for tax year 2001. Years provided for individual income tax surveys refer to tax years. Years provided for surveys for all other types of tax refer to return processing years.

Appendix II: Detailed Tax Gap Estimates, Data Sources, and Level of Certainty

The following table shows estimates for the various portions of the preliminary 2001 tax gap, the sources, including the age, of the data the Internal Revenue Service (IRS) used for these estimates, IRS’s level of certainty for each estimate, and areas for which IRS could not develop an estimate because of insufficient data.

Appendix III: IRS Key Efforts to Reduce the Tax Gap

The Internal Revenue Service’s (IRS) strategic plan outlines, but does not prioritize, service and enforcement efforts to improve compliance. Therefore, we asked IRS officials to identify IRS’s key efforts to reduce the tax gap. IRS’s divisions provided lists that totaled 47 efforts, which are described in the following examples.

The Small Business/Self-Employed Division identified 15 efforts such as models to identify higher priority collection cases to pursue, a computer matching program to identify underreported income, initiatives on high income nonfilers, attempts to improve tip income reporting, and efforts to identify abusive tax avoidance transactions.

The Wage and Investment Division identified 7 efforts including various initiatives on tax collection, Earned Income Tax Credit, and using private contractors to collect certain types of tax debts.

The Large and Mid-Sized Business Division identified 5 efforts such as identifying compliance risks, starting examinations sooner and doing them faster, and improving the treatment of abusive tax avoidance transactions.

The Tax Exempt and Government Entities Division identified 8 efforts including abusive tax avoidance transactions in employee plans, abuses in tax-exempt bond financing, pension plan noncompliance, and abuses by credit counseling organizations.

The Criminal Investigation Division identified 12 efforts including those involving questionable refunds, nonfilers, employment tax evasion, corporation fraud, and offshore abusive tax schemes.

Appendix IV: Comments from the Internal Revenue Service

Appendix V: GAO Contact and Staff Acknowledgments

GAO Contact

Acknowledgments

In addition to the contact named above, Jeff Arkin, Ralph Block, Elizabeth Curda, Elizabeth Fan, Evan Gilman, Shannon Groff, George Guttman, Michael Rose, Sam Scrutchins, and Tom Short made key contributions to ithis report.