The gross tax gap has grown in dollar terms since IRS’s previous estimate for tax year 2001, increasing from $345 billion to $450 billion for tax year 2006. However, given the growth of the economy and total federal tax liability over that period, the percentage of taxes owed that taxpayers paid voluntarily and on time, known as the voluntary compliance rate, has remained relatively constant—83.7 percent in 2001 and 83.1 percent in 2006. The tax gap estimate is an aggregate of estimates for the three primary types of noncompliance: (1) underreporting of tax liabilities on tax returns; (2) underpayment of taxes due from filed returns; and (3) nonfiling, which refers to the failure to file a required tax return altogether or on time. The estimate also covers the five types of taxes that IRS administers— individual income, corporate income, employment, estate, and excise taxes. The tax gap includes unintentional errors as well as intentional evasion, such as intentionally underreporting income, intentionally over-reporting expenses, and engaging in abusive tax shelters or frivolous tax schemes. It does not include legal tax avoidance activities (legally lowering tax liability), taxes due from illegally derived income, or various forms of fraud. For example, in general, refund fraud related to identity theft would not be included in the tax gap estimate because it does not involve evading a tax liability. Nevertheless, as discussed later in the testimony, actions taken to improve overall compliance and reduce the tax gap could also potentially address identity theft related fraud. A critical step toward reducing the tax gap is to understand the sources and nature of taxpayer noncompliance. As shown in table 1, noncompliance does not come from a single source but rather occurs across different types of taxes and taxpayers. For example, individual income tax accounted for most of the tax gap estimate for tax year 2006. However, corporate income tax and employment tax also contributed a significant portion. As shown in table 2, individual income tax underreporting includes both nonbusiness income tax and business income tax underreporting. Business income for individuals includes income from a variety of business types, including sole proprietors, partnerships, and S corporations, many of which are small businesses. Nearly 40 percent, or $179 billion, of the 2006 gross tax gap can be attributed to these types of business taxpayers who underreport their business income tax, and by extension their self-employment tax, on their individual income tax returns. Further, the misreporting of business income tax can take on a variety of forms. For example, misreporting of non-corporate business income tax can be largely attributed to sole proprietors who understated receipts or overstated expenses. A key reason for this misreporting is well known. Unlike wage and some investment income, sole proprietors’ income is not subject to withholding and only a portion is subject to information reporting to IRS by third parties. As shown in figure 1, the extent to which individual taxpayers accurately report their income is related to the extent to which the income is reported to them and IRS by third parties or taxes on the income are withheld. For example, for types of income for which there is little or no information reporting, such as business income, individual taxpayers tend to misreport over half of their income. In contrast, employers report most wages, salaries, and tip compensation to employees and IRS through Form W-2. Also, banks and other financial institutions provide information returns (Forms 1099) to account holders and IRS showing the taxpayers’ annual income from some types of investments. Findings from IRS’s study of individual tax compliance indicate that nearly 99 percent of these types of income are accurately reported on individual tax returns. Taxpayers misreport income and expenses for a variety of reasons. Some misreporting is intentional; some is unintentional. Often it is impossible to tell from a tax return whether errors are intentional or unintentional or even who made the error. For example, paid tax return preparers could make errors or taxpayers could fail to share relevant information with their preparers. Our past reports shed some light on the extent of unintentional errors. In our report on securities cost basis reporting, we found that among individual taxpayers who misreported securities sales, roughly one-third over-reported income (i.e., they overstated gains or understated losses). For sole proprietors, we reported that 9 percent over-reported their net income, while 61 percent underreported their net income in 2001.instances of over-reporting could be due to unintentional errors. We have long encouraged regular tax gap measurement because these estimates are important to gauge progress in addressing the tax gap and, perhaps more importantly, because analyzing the data used to estimate it can help identify ways to improve tax compliance. One source of such data is the National Research Program (NRP), which uses audits of a stratified, random sample of tax returns to produce statistically valid estimates of noncompliance for the entire population of tax return filers. IRS uses the NRP sample results to better target its enforcement examinations of noncompliant taxpayers. Better targeting examinations to taxpayers who are noncompliant reduces burden on compliant taxpayers. Updated compliance data can also help identify changes in tax laws and regulations that may improve compliance. For example, we analyzed NRP data on individual taxpayer compliance and reported that, among other things, Congress could consider requiring brokers to report to both taxpayers and IRS the adjusted basis of securities that taxpayers sell. Congress enacted this provision,Taxation estimated would raise $6.7 billion in revenue through 2018. which the Joint Committee on 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. We have made numerous recommendations over time that could address the tax gap, as follows. Multiple approaches are needed to reduce the tax gap. No single approach is likely to fully and cost-effectively address noncompliance since the noncompliance has multiple causes and spans different types of taxes and taxpayers. While the tax gap will remain a challenge into the future, the following strategies could help. These strategies would require actions by Congress or IRS. Information reporting is a powerful tool that reduces tax evasion and helps taxpayers comply voluntarily. Several major new information requirements have recently taken effect, based at least in part on our work and recommendations. Brokers are required to report their clients’ basis for securities sales, starting in 2012. Banks and other third parties are required to report businesses’ credit card and similar receipts, starting in 2011. Under the Foreign Account Tax Compliance Act, starting in 2014, U.S. financial institutions and other entities are required to withhold a portion of certain payments made to foreign financial institutions that have not entered into an agreement with IRS to report details on U.S. account holders to IRS. As these three sets of information reporting requirements have only recently taken effect, it is too soon to tell the actual impact they are having on taxpayer compliance. We have identified other options for information reporting. GAO, Tax Administration: Costs and Uses of Third-Party Information Returns, GAO-08-266 (Washington, D.C.: Nov. 20, 2007). Service payments to corporations. Currently, businesses must report to IRS payments for services they make to unincorporated persons or businesses, but payments to corporations generally do not have to be reported. Service payments made by landlords. Taxpayers who rent out real estate are required to report to IRS expense payments for certain services, such as payments for property repairs, only if their rental activity is considered a trade or business. However, the law does not clearly spell out how to determine when rental real estate activity is considered a trade or business. Broader requirements for these two forms of information reporting, covering goods in addition to services, were enacted into law in 2010 but were later repealed. We believe the more narrow extensions of information reporting to include services, but not goods, remain important options for improving compliance. Additionally, we have identified existing information reporting requirements that could be enhanced. Higher education expenses. Eligible educational institutions are currently required to report information on qualified tuition and related expenses for higher education so that taxpayers can determine the amount of educational tax benefits they can claim. IRS revising the information reporting form could improve the usefulness of reported information. Mortgaged properties. Requiring third parties, such as mortgage lenders, to report mortgaged property addresses in addition to information they are already required to report on mortgaged properties would help IRS identify potential noncompliance. Identifying additional third-party reporting opportunities is challenging. Considerations include whether any third parties have accurate information available in a timely manner, the burden of reporting on the third parties, and whether IRS can enforce the reporting requirement. To illustrate, in a 2009 report, we found that a major reason why little information reporting on sole proprietor expenses exists is because of the For example, there is no third party that difficulty identifying third parties.could verify the business use of cars or trucks by sole proprietors. Ensuring high-quality taxpayer services, such as by telephone and correspondence or online, can help taxpayers who wish to comply with tax laws but do not understand their obligations. However, in recent years and continuing this year, IRS’s service performance has seen declines. Tax law changes and other funding priorities have affected IRS’s ability to provide quality taxpayer services. For example, we recently reported that call volume has increased nearly 35 percent from the same time period last year, which IRS attributed, in part, to taxpayer questions about tax law changes. Concurrently, taxpayers’ ability to get through to IRS telephone assistors has declined.percent of callers seeking to talk to an IRS telephone assistor got through, compared to 70 percent for 2011.