For fiscal year 2004, IRS is requesting $10.4 billion, an increase of 5.3 percent over fiscal year 2003 requested levels, and 100,043 FTEs. IRS’s 2004 budget request is its second in a row to propose increased spending for higher priority areas that would be funded, in part, with internal savings redirected from other areas. Specifically, IRS proposes to devote an additional $454 million and 3,033 more FTEs to enhance programs, primarily in compliance and some customer service areas. As shown in figure 1, $166 million of the enhancements would be funded from internal savings with the remainder funded from the budget increase. As we did in last year’s testimony on IRS’s 2003 budget request, we commend IRS for identifying savings to be reinvested in operations to improve IRS performance. This approach implements a key principal of IRS’s long-term modernization effort. Under this approach, the reengineering of IRS’s work processes—much of which is dependent on investments in computer modernization—would automate or eliminate work, improve productivity, and free staff time that could then be redirected to higher priority customer service and compliance activities. We provide some context for understanding the 2004 budget request in figures 2 and 3 as shown in appendix I. In those figures, we illustrate how IRS allocated expenditures and staff resources in fiscal year 2002, the most recently completed year. Revised projections developed since the 2004 budget request was prepared raise questions about IRS’s ability to achieve all the savings projected and shift resources to compliance as planned. In addition, some projected savings are based on reengineering efforts that are not well defined. Further, IRS’s recent history also shows that it has been unable to increase resources in the compliance area despite having made it a priority in past budget requests. In fact, for the most recent 3 full fiscal years—2000, 2001, and 2002—compliance resources have declined slightly. Reasons for this decline include unfunded expenses consuming budget increases and workload increases in other essential operations. IRS has revised the savings associated with several reengineering efforts identified in the 2004 budget request. Revisions this far in advance of the start of the fiscal year are not a surprise. They do indicate that there is some uncertainty associated with the budget request’s savings projections. Four of the seven most significant reengineering efforts—in terms of FTEs and dollars to be saved—will not achieve all of their projected savings because the efforts were based on assumptions that will not be realized, according to IRS data and officials. IRS now projects that the seven most significant efforts will save 1,073 FTEs and $60.5 million, down from original projections of 1,356 FTEs and $77.7 million. IRS provided different reasons for why all savings will not be achieved for the following individual efforts: IRS’s effort to improve the efficiency of compliance support activities— the single most significant effort—was partially dependent on IRS implementing individual compliance savings projects in 2003. This effort was projected to save 394 FTEs and almost $26 million. However, due in part to delays until 2004 to allow for additional testing, this effort is now expected to save about 30 percent of the original projections through the end of fiscal year 2004. IRS’s effort to improve the efficiency of personnel services—the second most significant effort—depended in part on the functions of a new computer system to achieve most of its savings. This effort was originally projected to save 222 FTEs and $14.6 million. According to IRS officials, these functions will not be delivered on time due to schedule delays. IRS officials have not determined the impact of this delay and are currently assessing other potential approaches to achieve savings in this area. IRS officials said the remaining three of the seven most significant efforts will achieve all or more of their projected savings. For example, the effort to improve the efficiency of handling payments and returns, originally projected to save 121 FTEs and $4.6 million, is now expected to have more than double the savings, or 235 FTEs and $11.9 million, due to greater than expected productivity. However, according to IRS officials, even when their savings are combined, these three efforts will not save enough to offset the reduced savings from the other four. Reengineering efforts may not achieve all of their savings goals, in part, because of the long time lag between when IRS begins developing its budget request and when the fiscal year begins. As with most other federal agencies, IRS usually begins formulating its budget request about 18 months before the start of the fiscal year and about 10 months before the President submits his budget to Congress. With planning beginning so far ahead of the budget’s actual execution, there are inevitably intervening events, such as implementation delays with computer systems, that make the assumptions upon which projections are based no longer realistic. Some of the reengineering efforts listed in the 2004 budget request are not well defined, thus raising questions about whether they will achieve their savings goals. For example: IRS still is reviewing its procedures to identify ways to make tax return processing more efficient. Although IRS projected this effort to save 203 FTEs and $6.9 million, it has not yet identified the operational areas that will be reengineered. IRS officials said that the projected savings are based on a 2 percent efficiency increase, but they are currently determining how to achieve that goal. The effort to improve the efficiency of personnel services noted above also included numerous competitive outsourcing assessments affecting several program areas that, according to the budget request, would result in a significant reduction of staffing. However, in response to our request for more information, IRS was unable to provide details on the type or number of specific assessments, program areas that would be affected, how this effort would lead to reduced staffing, or the amount of net savings expected. According to IRS budget officials, IRS uses its budget formulation process to establish productivity goals, although the responsible business units may not know specifically how savings will be achieved. Officials said that this approach encourages innovation in meeting performance goals while identifying ways to save FTEs and budget dollars. Since 2001, IRS’s budget requests have made increasing compliance staff one of several key priorities. For example, in its 2001 budget request IRS asked for funding for the Staffing Tax Administration for Balance and Equity (STABLE) initiative, which was designed to provide additional staffing for examination, collections, and the new Tax Exempt and Government Entities Division. However, TIGTA recently reported data that showed an over 7 percent decline in compliance staff between 2000 and 2002. There are several reasons for the decline, including increased workload and unfunded costs. In September 2002, the Commissioner attributed the decline in compliance staffing to increases in workload in other essential operations such as processing returns, issuing refunds, and answering taxpayer mail. In the most recently completed fiscal year, 2002, IRS faced unbudgeted cost increases, such as rent and pay increases, in the amount of about $106 million. As a result, IRS had to delay hiring revenue agents and officers, tax compliance officers, and tax specialists. As shown in appendix I, in 2002 figure 2 shows about 69 percent of IRS’s spending was for labor costs. IRS noted in its budget request that any major negative changes in the agency’s financial posture, such as unfunded salary increases, will have a negative effect on staffing levels. IRS’s experience with last year’s budget request illustrates the difficulty of projecting and realizing savings and investing resources in higher priority areas. As part of its 2003 budget request, IRS identified internal savings of almost $197 million and 2,287 FTEs to be accomplished through various reengineering efforts and workload decreases. IRS planned to reinvest those savings in higher priority areas—compliance and customer service program enhancements, including efforts to stabilize audit rates, improve telephone assistance level of service, and target highest priority collection cases. However, IRS now estimates that about $75 million, or 38 percent, of the dollar savings and about 1,280, or 56 percent, of the FTE savings will be achieved by the specific reengineering efforts and workload decreases as identified in the 2003 budget request. IRS officials provided several reasons why some savings for these particular reengineering efforts will not be realized, including delays in modernization projects and less-than- anticipated workload decreases. For example, IRS received more innocent spouse cases than anticipated, and the cases received were more complex, causing the hours spent per case to increase. While savings associated with a particular effort listed in the 2003 budget request may not materialize, IRS officials said that business unit managers have identified other ways to increase productivity and did more work with fewer staff—therefore achieving productivity increases through efforts not identified in the 2003 budget request. As an example, officials provided an analysis showing increased telephone collections cases closed with significantly fewer staff than in the previous year. While GAO did not verify these savings, IRS officials were confident that this and other similar productivity increases were being achieved. Furthermore, IRS budget officials said the results of productivity increases not listed in the 2003 budget request should be included in any tally of IRS’s savings. We agreed that productivity increases generate savings. IRS was unable to quantify the gains from productivity increases in time for this hearing. IRS officials also said that most of the savings generated by the productivity increases would be used to handle workload increases in the same area where savings were generated. They said the savings would not be available for reallocation to other areas. As was the case in 2002, cost increases not included in the 2003 budget request are also limiting IRS’s ability to fund new investments. According to IRS officials, IRS will need to fund a total of about $388 million out of existing resources, including about $128 million for pay increases. IRS is requesting about $2.1 billion and 7,986 staff years in information technology (IT) resources for fiscal year 2004.