The gross tax gap is an estimate of the difference between the taxes— including individual income, corporate income, employment, estate, and excise taxes—that should have been paid voluntarily and on time and what was actually paid for a specific year. Of the estimated $345 billion tax gap for tax year 2001, IRS estimated that it would eventually recover about $55 billion of that through late payments and enforcement actions, for a net tax gap of $290 billion. The 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. We have made many recommendations over time that could address the tax gap. IRS’s tax gap estimates for each type of noncompliance include estimates for some or all of the five types of taxes that IRS administers. Underreporting of tax liabilities can occur when a taxpayer underreports income earned or overclaims deductions from income. As shown in table 1, underreporting of tax liabilities—particularly for the individual income tax—accounted for most of the tax gap estimate for tax year 2001. We have encouraged regular tax gap measurements, and IRS officials have indicated that they will be updating their tax gap estimates later in 2011 or early 2012. We believe that these estimates are important to gauge progress in addressing the tax gap and because analyzing the data used to estimate it can help identify ways to improve tax compliance. Taxpayers who underreported the amount of individual income tax they owed represented an estimated $197 billion of the 2001 tax gap, and $165 billion of that amount was due to individual tax filers underreporting their income. As shown in table 2, underreporting of individuals’ business income and nonbusiness income accounted for $109 billion and $56 billion, respectively, of the 2001 tax gap. IRS has concerns with the certainty of the tax gap estimate for tax year 2001 in part because some areas of the 2001 estimate rely on data originally gathered in the 1970s and 1980s. IRS has no estimates for other areas of the tax gap, and it is inherently difficult to measure some types of noncompliance. Some analysts believe the 2001 estimate likely underestimated the tax gap and that in absolute dollars it is likely larger now than in 2001. IRS’s overall approach to reducing the tax gap consists of improving service to taxpayers and enhancing enforcement of the tax laws. IRS seeks to improve voluntary compliance through efforts such as education and outreach programs and tax form simplification. It also uses its enforcement authority to ensure that taxpayers are reporting and paying the proper amounts of taxes through efforts such as examining tax returns and matching the amount of income taxpayers report on their tax returns to the income amounts reported on information returns it receives from third parties. In spite of IRS’s efforts to improve taxpayer compliance, the rate at which taxpayers pay their taxes voluntarily and on time has tended to range from around 81 percent to around 84 percent over the past three decades. The sum of the estimated revenue loss due to tax expenditures was over $1 trillion in 2010. Tax expenditures are often aimed at policy goals similar to those of federal spending programs. Existing tax expenditures, for example, help students and families finance higher education and provide incentives for people to save for retirement. Because tax expenditures result in forgone revenue for the government, they have a significant effect on overall tax rates—all else equal, for any given level of revenue, tax expenditures mean that overall tax rates must be higher than a tax system with no tax expenditures. In 2005, we recommended that the federal government take several steps to ensure greater transparency of and accountability for tax expenditures by reporting better information on tax expenditure performance and more fully incorporating tax expenditures into federal performance management and budget review processes. The federal tax system contains complex rules. These rules may be necessary, for example, to ensure proper measurement of income, target benefits to specific taxpayers, and address areas of noncompliance. However, these complex rules also impose a wide range of record keeping, planning, computational, and filing requirements upon businesses and individuals. Complying with these requirements costs taxpayers time and money. As shown in figure 1, these costs to taxpayers are above and beyond what they pay to the government in taxes. Estimating total compliance costs is difficult because neither the government nor taxpayers maintain regular accounts of these costs, and federal tax requirements often overlap with record keeping and reporting that taxpayers do for other purposes. Although available estimates are uncertain, taken together, they suggest that total compliance costs are large. For example, in 2005 we reviewed existing studies and reported that even using the lowest available compliance cost estimates for the personal and corporate income tax, combined compliance costs would total $107 billion (roughly 1 percent of gross domestic product ) per year; other studies estimate costs 1.5 times as large. The tax system also results in economic efficiency costs, which are reductions in economic well-being caused by changes in behavior due to taxes, government benefits, monopolies, and other forces that interfere in the market. Efficiency costs can take the form of lost output or consumption opportunities. For example, economists generally agree that the favorable tax treatment of owner-occupied housing distorts investment in the economy, resulting in too much investment in housing and too little business investment. Estimating efficiency costs associated with the tax system is challenging because it has extensive and diverse effects on behavior. In fact, in a 2005 report, we found no comprehensive estimates of the efficiency costs of the current federal tax system. The two most comprehensive studies we found suggest that these costs are large—on the order of magnitude of 2 to 5 percent of GDP each year (as of the mid- 1990s). However, the actual efficiency costs of the current tax system may not fall within this range because of uncertainty surrounding taxpayers’ behavioral responses, changes in the tax code and the economy since the mid-1990s, and the fact that the two studies did not cover the full scope of efficiency costs. Tax software and the use of paid tax return preparers may mitigate the need for taxpayers to understand complexities of the tax code. In 2010, IRS processed about 137 million returns. As we have previously reported, about 90 percent of returns are prepared by individual taxpayers or paid preparers using professional or commercial software. Software companies and paid preparers often act as surrogate tax administrators in that they keep abreast of tax law changes. A participant at the 2007 Joint Forum on Tax Compliance stated that taxpayers receiving assistance in preparing their individual tax returns, either from paid preparers or tax preparation software, are somewhat insulated from tax code complexity. However, while many paid tax preparers help taxpayers by using their expertise to help ensure that complex laws are understood, others may introduce their own mistakes. For example, in a limited investigation in 2006, all 19 of the tax return preparers who prepared returns for our undercover investigators produced errors, some with substantial consequences. IRS’s review of 2001 tax returns also found that tax returns prepared by paid preparers contained a significant level of errors. IRS audits of returns prepared by a paid preparer showed a higher error rate—56 percent—than audits of returns prepared by the taxpayer—47 percent. Income measurement is straightforward for a large proportion of the individual taxpayer population: those who earn only labor and interest income and capital income within a retirement account generally have their income reported to them (and to the IRS) by the source of the income. However, substantial numbers of taxpayers who receive income from capital gains, rents, self-employment, and other sources often deal with complex tax laws, complicated calculations, and detailed record keeping. While complexities lead some taxpayers to make mistakes when reporting their income, some misreporting is due to intentional acts of tax evasion. For example, IRS studies show that the majority of capital asset transactions and capital gains and losses were for securities transactions such as sales of corporate stock, mutual funds, bonds, options, and capital gain distributions from mutual funds. Taxpayers are required to report securities transactions on their federal income tax returns. To accurately report securities sales, the taxpayer must have records of the dates they acquired and sold the asset; sales price, or gross proceeds from the sale; cost or other basis of the sold asset; and resulting gains or losses. They must report this information separately for short-term transactions and long-term transactions. Further, before taxpayers can determine any gains or losses from securities sales, they must determine if and how the original cost basis of the securities must be adjusted to reflect certain events, such as stock splits, nontaxable dividends, or nondividend distributions. Complex income-reporting requirements for securities transactions may contribute to taxpayers’ misreporting their income. In 2006, we estimated that 8.4 million of the estimated 21.9 million taxpayers with securities transactions misreported their gains or losses for tax year 2001. A greater estimated percentage of taxpayers misreported gains or losses from securities sales (36 percent) than capital gain distributions from mutual funds (13 percent), and most of the misreported securities transactions exceeded $1,000 of capital gain or loss. This may be because taxpayers must determine the taxable portion of securities sales’ income whereas they need only add up their capital gain distributions. Furthermore, about half of these taxpayers who misreported failed to accurately report the securities’ basis, sometimes because they did not know the basis or failed to adjust the basis appropriately. Although we were not able to estimate the capital gains tax gap for securities, we were able to determine the direction of the misreporting. For securities sales, an estimated 64 percent of taxpayers underreported their income from securities (i.e., they understated gains or overstated losses) compared to an estimated 33 percent of taxpayers who overreported income (i.e., they overstated gains or understated losses). For both underreported and overreported income, some taxpayers misreported over $400,000 in gains or losses.