Of the 36 countries with alternative filing systems, only Denmark and Sweden have tax agency reconciliation systems. The remaining 34 countries have final withholding filing systems. There are several potential barriers to adopting a final withholding system in the United States. Specifically, before a final withholding system could be instituted in the United States, the law would have to be changed to require employers to calculate employees’ tax liability and adjust employees’ last paychecks so that total yearly withholdings would equal employees’ tax liability. Also, unlike many countries with final withholding systems, the United States tax system does not exempt or limit taxes on interest and dividend income, nor does it require married couples to file separately. (Appendix I lists these 34 countries and describes how final withholding systems generally operate in those countries.) A tax agency reconciliation system would be easier to implement in the United States because it would not require statutory changes. In general, under a tax agency reconciliation type system, the tax agency is to calculate the tax liability on the basis of information returns or income reports received from payers, such as wage reports prepared by employers and interest income reports prepared by financial institutions. The tax agency then is to send the taxpayer a printed tax return or reconciliation statement. Upon receipt of the tax return, the taxpayer is to review and correct its contents, add information if any is missing, and return the completed return to the tax agency. After the tax agency receives and reviews the tax return, it is to send the taxpayer either a refund or tax bill. In 1994, Denmark prepared tax returns for 85 percent of its 4.5 million taxpayers, and Sweden prepared returns for 74 percent of its 7.3 million taxpayers. In 1987, in response to a provision in the Tax Reform Act of 1986, IRS studied the feasibility of a tax agency reconciliation filing system. IRS estimated that 55 million individual taxpayers would be eligible to use such an alternative filing system. This estimate included all taxpayers who were filing Form 1040EZ, most taxpayers who were filing Form 1040A, and a few who were filing Form 1040. Under the system IRS studied, employers and payers would be required to submit wage statements (Form W-2) and information returns (Form 1099) by the end of January, instead of the end of February as is now required. IRS would spend the next 4 to 6 weeks processing these documents. Some taxpayers would receive their returns in early March, but most taxpayers would start receiving theirs in early April. IRS concluded that the tax agency reconciliation filing system it studied was not feasible primarily because it would be very difficult to receive, verify, and post over 900 million wage and information documents in time to generate tax returns. IRS determined that checking all of the documents for accuracy and correcting them in time to generate returns was beyond its capabilities. Our objectives in describing the potential benefits and impediments of a voluntary tax agency reconciliation type filing system were to (1) estimate how many taxpayers would not have to prepare returns under this kind of system, (2) identify the operational characteristics such a system might have, (3) identify the pros and cons of such a system to taxpayers and IRS, and (4) identify any major impediments to or costs in establishing such a system under the current federal tax laws. It is important to note that we focused our work on the impact that an alternative filing system might have for individual taxpayers and IRS. We recognize that establishing such a system would affect other stakeholders such as (1) some employers and financial institutions that would probably incur additional costs to modify existing systems or establish new systems for information reporting and (2) tax preparers who might lose revenue from reduced demand for their services or might have to change the services they offer to meet any new type of demand from taxpayers. However, we did not attempt to quantify the benefits and costs to them of implementing such a system. Rather, we viewed the approach to considering the feasibility and desirability of devising an alternative filing system as encompassing two levels of efforts: first, an initial look using readily available data to determine whether additional research by IRS might be warranted and second, a more detailed effort that might involve gathering and analyzing additional data, including specific impacts on third party stakeholders. While we restricted our effort to the first of these two levels of effort, we did make a presentation, on how a tax agency reconciliation system would work, to IRS’ Information Reporting Program Advisory Committee, which is composed of representatives from third-party stakeholders, such as financial institutions, employers, and other payers. We also discussed a tax agency reconciliation system with officials of the American Institute of Certified Public Accountants and H&R Block, Inc., which is a national tax return preparation company. To estimate the number of taxpayers that would be eligible for a tax agency reconciliation system, we used IRS’ tax year 1992 Statistics of Income (SOI) file to extract records that met the income and deduction criteria we established for a hypothetical tax agency reconciliation system. These criteria were that taxpayers would only have income that was reported on information returns and that taxpayers would not itemize deductions. To identify the operational characteristics a tax agency reconciliation type system might have, we reviewed IRS’ 1987 return-free filing study. We also interviewed officials at the Department of the Treasury and IRS to determine what administrative changes would have to be made to the federal tax system to have a voluntary tax agency reconciliation type system. We also reviewed the literature on how the tax agency reconciliation systems worked in Denmark and Sweden. We compared information on the operations of tax systems in these countries with the operations of our federal income tax system to determine how they differed. We also interviewed representatives from local consulates to Denmark’s and Sweden’s foreign embassies about how their tax agency reconciliation filing systems worked. To determine potential pros and cons of a tax agency reconciliation type system for taxpayers, we reviewed the return preparation tasks IRS published in its 1994 individual income tax booklets. We compared these tasks with the type of tasks taxpayers would have under a tax agency reconciliation type system. We also reviewed literature on costs to taxpayers to have paid preparers complete their tax returns. To determine any potential benefits and costs to IRS under a tax agency reconciliation system, we applied IRS’ methodology for estimating its cost to process tax returns to the filing population eligible for tax agency reconciliation to estimate the cost to process documents under such a system. We also used IRS’ costing methodology to estimate the cost to process tax returns under the current system for the population eligible for tax agency reconciliation. To identify the impediments to establishing a tax agency reconciliation type system, we reviewed IRS’ procedures for processing information returns and obtained IRS officials’ views on potential impediments. To determine the effect of a tax agency reconciliation system on taxpayers’ ability to file state income tax returns, we discussed a hypothetical system with representatives of the Federation of Tax Administrators and state tax officials who attended the federation’s national conference held in Cleveland, Ohio, in June 1995. We also reviewed an IRS document on taxpayers’ opinion of a tax agency reconciliation system and discussed the conclusions with IRS officials. Our work was done from November 1994 through April 1996 in accordance with generally accepted government auditing standards. We requested comments on a draft of this report from the Commissioner of Internal Revenue, and on August 19, 1996, we received written comments from the Deputy Commissioner. His comments are discussed on pages 21 to 22 and a copy of the comments appear in appendix III. We also requested and received comments on a draft of this report from the American Institute of Certified Public Accountants and IRS’ Information Reporting Program Advisory Committee. These comments are discussed on pages 22 to 24. To determine how many taxpayers potentially could be covered by a tax agency reconciliation system, we used income and deduction criteria that would maximize the number of taxpayers that could be included in the system, while minimizing administrative changes. Taxpayers who met these criteria included those who had taxable income from wages, interest, dividends, pensions, and did not itemize deductions and, instead, took the standard deduction; and did not take any tax credits except the earned income tax credit. We estimated that about 51 million taxpayers who filed tax year 1992 returns, which was the latest year that data were available to make our estimate, met these conditions. The 51 million taxpayers accounted for about 45 percent of the 113.6 million taxpayers who filed tax year 1992 returns and had about 14 percent of the total individual income tax liability reported that year. Also, the majority of these taxpayers, about 28.7 million or 56 percent, had taxable income from wages only. We limited eligibility for the system to taxpayers with taxable income from wages, interest, dividends, pensions, and unemployment compensation because IRS receives information returns on these income types, which could be used to calculate taxpayers’ tax liabilities. Taxpayers with other types of income, such as rents, royalties, capital gains, and self-employment (i.e., nonemployee compensation), were excluded from eligibility because the information returns with these types of income showed gross income amounts and needed to be reduced by taxpayers’ costs to determine the net taxable amounts. IRS does not receive information returns on taxpayers’ costs to produce income. Similarly, taxpayers who itemized deductions were excluded from the eligible population because some itemized deductions, such as medical expenses and charitable contributions, are not reported on information returns. Regarding tax credits, the earned income tax credit was the only individual tax credit that could be calculated with the income and entity information that would be available to IRS. The following sections describe one way a tax agency reconciliation system might work. This version of a tax agency reconciliation system would consist of four operational characteristics. Taxpayer information needed by IRS: To calculate taxpayer tax liability and the earned income tax credit, if applicable, some of the information IRS would need on each taxpayer would include the following: name and address, Social Security Number (SSN), name and SSN of spouse, name and SSN of dependents and qualifying children, relationship of dependents and qualifying children to taxpayer, and number of months dependents and qualifying children lived with taxpayer during the year.