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. 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 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. 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). 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. 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.