The federal government’s financial condition and long-term fiscal outlook present enormous challenges to the nation’s ability to respond to emerging forces reshaping American society, the United States’ place in the world, and the future role of the federal government. Over the next few decades as the baby boom generation retires and health care costs continue to rise, federal spending on retirement and health programs—Social Security, Medicare, Medicaid, and other federal pension, health, and disability programs—will grow dramatically. Absent policy changes on the spending and/or revenue sides of the budget, a growing imbalance between expected federal spending and tax revenues will mean escalating and eventually unsustainable federal deficits and debt that will threaten our future economy, standard of living, and, ultimately, our national security. Ultimately, the nation will have to decide what level of federal benefits and spending it wants and how it will pay for these benefits. GAO’s long-term simulations illustrate the magnitude of the fiscal challenges associated with an aging society and the significance of the related challenges the government will be called upon to address. Indeed, the nation’s long-term fiscal outlook is daunting under many different policy scenarios and assumptions. For instance, under a fiscally restrained scenario, if discretionary spending grew only with inflation over the next 10 years and all existing tax cuts expire when scheduled under current law, spending for Social Security and health care programs would grow to consume over 80 percent of federal revenue by 2040. (See fig. 1.) On the other hand, if discretionary spending grew at the same rate as the economy in the near term and if all tax cuts were extended, by 2040 federal revenues may just be adequate to pay only some Social Security benefits and interest on the growing federal debt. (See fig. 2.) Addressing the projected fiscal gaps shown here will require policymakers to examine the advisability, affordability, and sustainability of existing programs, policies, functions, and activities throughout the entire federal budget—spanning discretionary spending, mandatory spending, including entitlements, and tax policies and programs. Neither slowing the growth of discretionary spending nor allowing tax cuts to expire—nor both options combined—would by themselves eliminate our long-term fiscal imbalance. Additional economic growth is critical and will help to ease the burden, but the projected fiscal gap is so great that it is wholly unrealistic to expect that we will grow our way out of the problem. The President’s 2007 budget released last week included some proposals to reduce the growth in Medicare spending. Whether or not these proposals are adopted, they should serve to raise public awareness of the importance of health care costs to both today’s budget and tomorrow’s. This could also serve to jump start discussion about appropriate ways to control a major driver of our long-term fiscal outlook—health care spending. Clearly, tough choices will be required. Changes in existing budget processes and financial, fiscal, and performance metrics will be necessary to facilitate these choices. Early action to change existing programs and policies would yield the highest fiscal dividends and provide a longer period for prospective beneficiaries to make adjustments in their own planning. The longer we wait, the more painful and difficult the choices will become and the less transition time we will have. By waiting, an important window is lost during which today’s relatively large workforce can increase saving and begin preparing for the necessary changes in fiscal policy, Social Security, and health care as well as other reforms that may be necessary parts of the solution to this coming fiscal crunch. However, the long-term challenge is fast becoming a short-term one as the retirement of the baby boomers’ generation will begin as early as 2008 and since overall workforce growth has already begun to slow. While our long-term fiscal imbalance cannot be eliminated with a single strategy, reducing the tax gap is one approach that could help address the looming fiscal challenges facing the nation. The 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 timely and accurately paid and what was actually paid for a specific year. 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 timely. Estimates for each type of noncompliance include estimates for some or all of the five types of taxes that IRS administers. IRS develops its tax gap estimates by measuring the rate of taxpayer compliance—the degree to which taxpayers fully and timely complied with their tax obligations. That rate is then used, along with other data and assumptions, to estimate the dollar amount of taxes not timely and accurately paid. For instance, IRS most recently estimated that for tax year 2001, 83.7 percent of owed taxes were paid voluntarily and timely, which translated into an estimated gross tax gap of $345 billion. IRS developed these estimates using compliance data collected through the National Research Program (NRP). Using its recently collected compliance data, IRS has estimated that underreporting of income represented over 80 percent of the tax gap for 2001 (an estimated $285 billion out of a gross tax gap estimate of $345 billion), as indicated in table 1. Within the underreporting estimate, IRS attributed about $197 billion, or about 57 percent of the total tax gap, to individual income tax underreporting, including underreporting of business income, such as sole proprietor, informal supplier, and farm income (about $109 billion); nonbusiness income, such as wages, interest, and capital gains (about $56 billion); overstated credits (about $17 billion); and overstated income adjustments, deductions, and exemptions (about $15 billion). Underreporting of corporate income tax contributed an estimated $30 billion, or about 10 percent, to the 2001 tax gap, which included both small corporations (those reporting assets of $10 million or less) and large corporations (those reporting assets of over $10 million). Employment tax underreporting accounted for an estimated $54 billion, or about 16 percent, of the 2001 tax gap and included several taxes that must be paid by self-employed individuals and employers. Self-employed individuals are generally required to calculate and remit Social Security and Medicare taxes to the U.S. Treasury each quarter. Employers are required to withhold these taxes from their employees’ wages, match these amounts, and remit withholdings to Treasury at least quarterly. Underreported self-employment and employer-withheld employment taxes, respectively, contributed an estimated $39 billion and $14 billion to IRS’s tax gap estimate. The employment tax underreporting estimate also includes underreporting of federal unemployment taxes (about $1 billion). Taxpayers who do not file their tax returns on time or at all and otherwise do not pay their tax liabilities accounted for the remainder of the 2001 tax gap—around $61 billion. For example, nonfiling and underpayment noncompliance by individual taxpayers alone contributed an estimated $48 billion to this portion of the tax gap. IRS has concerns with the certainty of the overall tax gap estimate in part because some areas of the estimate rely on old data and IRS has no estimates for other areas of the tax gap. For example, IRS used data from the 1970s and 1980s to estimate underreporting of corporate income taxes and employer-withheld employment taxes. For large corporate income tax underreporting, IRS based its estimate on the amount of tax recommended from operational examinations rather than the tax ultimately assessed as part of the total tax liability. According to IRS officials, IRS relies on the amount of tax recommended because it is difficult to determine the true tax liability of large corporations due to complex and ambiguous tax laws that create opportunities for differing interpretations and that complicate the determination. These officials further stated that because these examinations are not randomly selected and are not focused on identifying all tax noncompliance, the estimate produced from the examination data is not representative of the tax gap for all large corporations. They also explained that due to these complexities and the costs and burdens of collecting complete and accurate data, IRS has not systematically measured large corporation tax compliance through statistically valid studies, even though the officials acknowledged that such studies would be useful in estimating the related tax gap. IRS has no estimates for corporate income, employment, and excise tax nonfiling or for excise tax underreporting. For these types of noncompliance, IRS maintains that the data are either difficult to collect, imprecise, or unavailable. In addition, it is inherently difficult for IRS to observe and measure some types of underreporting or nonfiling, such as tracking cash payments that businesses make to their employees, as businesses and employees may not report these payments to IRS in order to avoid paying employment and income taxes, respectively. IRS’s overall approach to reducing the tax gap consists of improving service to taxpayers and enhancing enforcement of the tax laws. Recently, IRS has taken a number of steps that may improve its ability to reduce the tax gap. Favorable trends in staffing of IRS enforcement personnel; examinations performed through correspondence, as opposed to more complex face-to-face examinations; and the use of some enforcement sanctions such as liens and levies are encouraging. Also, IRS has made progress with respect to abusive tax shelters through a number of initiatives and recent settlement offers that have resulted in billions of dollars in collected taxes, interest, and penalties. In addition, IRS has successfully prosecuted a number of taxpayers who have committed criminal violations of the tax laws. Given its persistence and size, we need not only to consider expanding current approaches but also explore new legislation to help IRS in reducing the tax gap. Although IRS has made a number of changes in its methodologies for measuring the tax gap over the past three decades, which makes comparisons difficult, regardless of methodology the voluntary compliance rate that underpins the gap has tended to range from around 81 percent to around 84 percent.