The EIC is a refundable tax credit available to low-income working taxpayers. Congress established the EIC in 1975 to offset the impact of Social Security taxes on low-income families and to encourage low-income individuals with families to seek employment rather than welfare. EIC coverage and benefit amounts have expanded significantly since 1975. For example, provisions in the Omnibus Budget Reconciliation Act of 1993 (1) raised the maximum credit for families with two or more EIC-qualifying children to $2,528 for tax year 1994 and (2) made certain taxpayers without qualifying children eligible for the credit starting in tax year 1994. For tax year 1994, about 18.9 million taxpayers received about $20.8 billion in EIC benefits. Almost all of those benefits ($20.1 billion) went to families with EIC-qualifying children. Other families who qualify for the EIC may not be claiming it. In that regard, researchers have estimated that between 75 and 86 percent of all eligible families actually claimed the EIC in 1990. IRS data show high noncompliance rates associated with EIC claims. Some noncompliance involves mathematical errors and other obvious mistakes made by taxpayers or their representatives in preparing the returns. Staff in IRS’ 10 service centers are to review each paper return when it is received to make sure it is accurate and complete (e.g., includes required supporting schedules) and, for returns claiming the EIC, contains basic eligibility information, such as the age of qualifying children. Information is then entered into computers. The computers check for math and qualifying errors, some of which could affect EIC eligibility or the size of the EIC claim. EIC claims have for years been the source of many errors identified during processing. In 1995, for example, IRS identified 1.6 million EIC-related errors involving about 8 percent of all returns with EIC claims. Of the 1.6 million errors, about 600,000 involved situations where the taxpayer claimed the EIC but was found not to qualify and about 1 million involved cases where the taxpayer erred in computing the EIC. Other noncompliance involves mistakes that can be detected only through an audit of the return. In the past, IRS measured this kind of noncompliance through its Taxpayer Compliance Measurement Program (TCMP). The last TCMP, involving audits of tax year 1988 returns, found that about 42 percent of EIC recipients were not entitled to some or all of the credit that they claimed—representing about 34 percent of the EIC dollars paid that year. However, these TCMP results may not represent current compliance levels because the EIC has changed substantially since 1988. For example, changes enacted in 1990 included a major redesign and simplification of the EIC eligibility rules that had accounted for many of the errors found in the 1988 TCMP. More recently, IRS sampled EIC returns filed electronically during a 2-week period in January 1994. Although the results can be generalized only to returns filed in that 2-week period, IRS’ analysis of this limited EIC data showed that 39 percent of the returns involved overstated EIC claims that represented 26 percent of the dollars claimed. IRS conducted a broader, more statistically reliable study of EIC returns filed electronically and on paper in 1995. As of August 26, 1996, IRS had not released the results of that study. The most serious form of noncompliance involves deliberate attempts to defraud the government through, for example, phony refund claims. The Questionable Refund Program, established in the 1970s, is IRS’ primary effort to identify fraudulent refund claims, including those involving the EIC. An IRS computer program analyzes all returns to identify those that are potentially fraudulent. Then, fraud detection teams in the 10 service centers perform more in-depth reviews and, if a return is considered fraudulent, attempt to stop any refund before it is issued. The number of returns identified by IRS as containing fraudulent refund claims and the total dollar amount of stopped refunds have increased significantly since 1990. From January 1 through December 31, 1995, the fraud detection teams had identified about 62,000 fraudulent returns and stopped about $83 million in refunds. About 72 percent of the returns had EIC claims. We do not know whether that large percentage reflects (1) the level of EIC-related fraud compared with other types of fraud, (2) IRS’ emphasis on EIC-related fraud, or (3) the comparative ease of identifying EIC-related fraud versus other types of fraud. Over the past few years, more attention has been placed on determining whether the EIC is being paid to ineligible taxpayers. In 1995, IRS expanded its efforts to identify and stop incorrect refunds. Much of what IRS did involved verifying SSNs, with an emphasis on returns claiming the EIC. IRS was looking for SSNs that did not match the Social Security Administration’s records or that had been used on another return filed that year, and returns that were missing one or more required SSNs. IRS warned taxpayers that their refunds could be delayed if they submitted a return with a missing or incorrect SSN. On the cover of the instructions accompanying Form 1040, for example, IRS warned taxpayers to check their SSNs and explained that “incorrect or missing SSNs for you, your spouse, or dependents may delay your refund.” IRS also issued several public service announcements to alert taxpayers to the need for correct SSNs. Another important step IRS took in preparing for the 1995 filing season was to eliminate the direct deposit indicator. In conjunction with the electronic filing program, the private sector offers what is commonly referred to as a refund anticipation loan (RAL). These loans enable taxpayers, for a fee, to get their money more quickly than if they were to wait for IRS to issue their refunds. A taxpayer repays the loan by arranging to have the refund deposited directly to an account specified for repayment of the loan. Although RALs are contracts between the financial institution and the borrower, IRS facilitated the process in the past by providing the direct deposit indicator to the electronic return transmitter after the return was received, acknowledging that the taxpayer’s direct deposit request would be honored. IRS would not honor a request if the taxpayer had a debt, such as unpaid child support or unpaid federal taxes, that would be offset against the taxpayer’s refund. Because the opportunity to get money quickly through RALs was seen as encouraging electronic filing fraud and because a large number of EIC fraud schemes identified by IRS in the past involved RALs, IRS did not provide the direct deposit indicator in 1995. Our objective was to provide information on and our analysis of IRS’ efforts to reduce EIC noncompliance in 1995. To achieve our objective, we reviewed studies on EIC noncompliance, reviewed IRS’ initiatives and procedures for preventing and detecting EIC analyzed IRS data on the results of its efforts to reduce EIC noncompliance, interviewed IRS National Office officials responsible for various EIC compliance initiatives, and interviewed Cincinnati and Fresno Service Center officials responsible for EIC-related studies or investigations. IRS took several steps in 1995 to address a growing problem with refund fraud in general. In March 1996, we reported on those efforts. Unlike that report, this report focuses, to the extent possible, on IRS’ efforts and results as they relate specifically to EIC noncompliance. As discussed later, our attempt to focus specifically on EIC-related results was limited by the nature of IRS’ data. We relied on data provided in IRS’ reports and did not verify the data. We did our work from January 1995 through June 1996 in accordance with generally accepted government auditing standards. You also asked us to determine the extent of EIC noncompliance. Although this letter contains some data on noncompliance, a critical piece of information needed to respond to that portion of your request—the results of IRS’ study of EIC returns filed in 1995—was unavailable at the time we prepared this report. That study was designed to provide current and projectable data on the extent of EIC noncompliance. IRS said that it would provide a report on the results of this study after completing its analysis of the data. After we receive the report, we will analyze the results and issue a separate product. We requested comments on a draft of this report from the Commissioner of Internal Revenue or her designee. On July 30, 1996, we met with the Assistant Commissioner for Criminal Investigations and other IRS officials, who provided us with oral comments. Those comments were generally reiterated and expanded upon in an August 12, 1996, letter from the Acting Chief Compliance Officer. IRS’ comments are summarized and evaluated beginning on page 12 and the Acting Chief’s letter is reprinted in the appendix. IRS took several steps in 1995 to combat a growing problem with refund fraud in general and, more specifically, EIC noncompliance. Most significantly, IRS (1) expanded the up-front controls in its Electronic Filing System, (2) placed increased emphasis on its efforts to verify SSNs on paper returns, and (3) held up the refunds on millions of EIC returns with valid SSNs to allow IRS time to check for duplicate SSN usage. IRS’ efforts had some positive results (e.g., over $800 million in reduced refunds and additional tax assessments) but also had some problems (e.g., an inability to follow through on plans to check for duplicate SSNs) that limited their effectiveness. IRS’ efforts and the publicity surrounding them also may have had a sizable deterrent effect. For example, they may have contributed to the receipt of many fewer EIC claims in 1995 than IRS had expected. For the past several years, IRS has included up-front controls (filters) in its Electronic Filing System to identify submissions that had data problems, such as missing or invalid SSNs or an SSN that had already been used on another return filed for the same tax year. If a problem was identified, IRS refused to accept the electronic submission until the problem was corrected.