For over 30 years, TCMP has been IRS’ primary program for gathering comprehensive and reliable taxpayer compliance data. It has been IRS’ only program for making statistically reliable estimates of compliance nationwide. It has also been used to identify areas where tax law needs to be changed to improve voluntary compliance and to estimate the tax gap and its components. TCMP data are also used outside IRS, including by Congress to make revenue estimates for new legislation and by the Department of Commerce’s Bureau of Economic Analysis to adjust national income accounts such as the gross domestic product. The 1994 TCMP survey, which was to consist of over 150,000 income tax returns, was to be the most comprehensive TCMP effort ever undertaken. By auditing the tax returns of individuals (Form 1040), small corporations with $10 million or less in assets (Form 1120), Partnerships (Form 1065), and S corporations (Form 1120S), IRS planned to obtain comprehensive compliance data. Most sample results were to be sufficiently precise to be reliable at the national level as well as at smaller geographic areas across the country. The 1994 TCMP was designed to fulfill the information needs for several compliance areas expected to be important to IRS’ functions over the next decade. The more important uses were to include development of audit selection formulas, validation of IRS’ revised approach to categorizing returns for audit, and development of new approaches to researching compliance across specific geographic areas. Each of these uses is discussed in more detail below. Since 1969, IRS has used TCMP data to update its Discriminant Function (DIF) formulas, which are mathematical formulas used to select tax returns with the greatest probability of change for audit. The current formulas for individuals are based on 1988 tax returns, IRS’ most recent individual TCMP audits. Formulas for small corporations are based on returns that were processed in 1987. IRS does not use DIF scores for partnerships and S corporations because of the age of the underlying TCMP audits. TCMP data were also to be used to test new compliance strategies. IRS planned to change the way it categorized returns for audit by adopting the market segment approach. Market segments represent groups of taxpayers with similar characteristics, such as those in manufacturing. IRS assumes that because these taxpayers have similar external characteristics, their tax compliance behavior will exhibit similar attributes. Finally, the 1994 TCMP was to provide compliance research data. IRS recently reorganized its compliance research function, establishing a National Office of Research and Analysis (NORA) and 31 District Office of Research and Analysis (DORA) sites. The 1994 TCMP was to be large enough to provide reliable compliance data for field and National Research Offices. IRS’ researchers planned to use TCMP data to identify national and geographically specific areas of noncompliance and, by focusing on key compliance issues, develop programs to improve voluntary compliance. It is through these research efforts that IRS planned to improve overall voluntary compliance. Noncompliance represents a major source of lost revenue for the nation. IRS’ most recent tax-gap estimates indicate that over $127 billion was lost to noncompliance in 1992. In an attempt to reduce this lost revenue, IRS established an objective of collecting at least 90 percent of the taxes owed through voluntary compliance and enforcement measures by the year 2001. However, this overall compliance rate has remained at about 87 percent since 1973. The 1994 TCMP was intended to provide data from which other programs could be developed to improve this rate and increase revenue. This nation’s tax system is based on individuals and businesses voluntarily paying the taxes they owe. To the extent that this system works, it improves the efficiency of tax collection. Measuring the extent to which the tax system works and identifying areas in which it does not is the job of compliance measurement. TCMP has been IRS’ only tool for measuring voluntary compliance and determining compliance issues. The postponed TCMP for 1994 tax returns was to establish the voluntary compliance benchmark to carry IRS into the next century. The objectives of this assignment were to (1) determine the possible effects on IRS’ compliance programs of postponing the 1994 TCMP and (2) identify some potential short- and long-term alternatives to the planned TCMP for collecting this data. To determine the possible effects of postponing the 1994 TCMP, we talked to responsible officials in IRS’ Research Division and the Examination Division. We obtained information on how these officials planned to use TCMP data and what will likely be affected now that TCMP has been postponed. To identify alternatives to the planned TCMP, we talked to IRS officials responsible for planning TCMP. We discussed alternative sampling methodologies with officials from IRS’ Statistics of Income (SOI) Branch who were responsible for preparing the original TCMP sample and asked them to determine sample sizes on the basis of revised requirements. We developed the revised requirements on the basis of our discussions with IRS’ Research Division staff as well as officials outside IRS, including congressional staff. Some of the observations in this report are based on the work we have done over the years on IRS’ compliance programs as well as our specific work on TCMP in recent years. We requested comments from you on a draft of this report. On February 23, 1996, we obtained oral comments from IRS’ Director of Research and the National Director of Compliance Specialization. We also obtained commented from you in a March 18, 1996, letter. These comments are discussed on page 13 of this report. We did our work in San Francisco, Dallas, and Washington, D.C., between August and December 1995 in accordance with generally accepted government auditing standards. The planned TCMP for 1994 tax returns was to establish the voluntary compliance benchmark to carry IRS into the next century. While agency officials said that postponing TCMP will help resolve budget problems, our work suggests that the loss of these or comparable data is also likely to disrupt IRS’ efforts to increase the total collection percentage to 90 percent by 2001. For example, without these data, IRS will have difficulty updating the formulas it uses to select returns for audit and, thus, it would be more likely that a higher percentage of the returns IRS selects for audit would not result in changes to the amount of tax owed by the taxpayer. Additionally, without such data IRS will be unlikely to have sufficient data to validate its market segment approach to audits or to be used by the DORA research functions to identify programs to improve voluntary compliance. It is not clear whether IRS will replace the data it had planned to obtain from TCMP. However, updated compliance data will be needed in the short term if IRS still plans to update the audit selection formulas and in the long term to validate and improve IRS’ compliance efforts. The primary system that will be disrupted by postponing TCMP is the one used by IRS to select returns for audit. Since 1969, IRS has used DIF formulas to select returns for audit. New DIF formulas are developed periodically from TCMP data and applied to all individual and small corporation income tax returns. IRS then selects returns for audit with the highest DIF scores. In 1992, over 55 percent of the audited returns of individuals were selected using the DIF score. The DIF selection system replaced programs that were largely dependent on auditor’s judgment. The DIF system has not only improved the efficiency of IRS’ audit efforts but also the consistency and objectivity of the selection process. The use of the DIF selection process has also resulted in fewer “no-change” audits, which not only waste IRS’ resources but unnecessarily burden compliant taxpayers. According to IRS, use of the DIF scoring system reduced the no-change rate from over 46 percent in 1969 to about 15 percent in 1992. IRS officials believe the DIF process is dependent on periodically updating the formulas used to score returns. Formulas are updated so that they will more accurately identify the returns with the greatest probability for change. Until 1988, data from TCMP had been used to update formulas for individual returns every 3 years. However, the most recent TCMP was conducted on 1988 individual returns. For small corporations, partnerships, and S corporations, IRS has updated formulas much less frequently. TCMPs were conducted on corporate returns filed in 1987, and partnership and S corporation returns filed in 1982 and 1985, respectively. IRS is not certain how well the DIF scores will continue to perform if not updated. IRS officials believe that by 1998, the year IRS planned to have TCMP data available, the DIF scores may become less effective at identifying returns with the greatest potential for change. They said this decrease in effectiveness may occur because of changes in tax laws and taxpayer behavior—resulting in an increased no-change rate for DIF selected returns and potentially lower revenue yields. This would mean greater burden on compliant taxpayers if more of them are selected for audit. IRS officials indicated that they plan to monitor the performance of DIF over time. The 1994 TCMP was also intended to provide information on IRS’ new market segment approach for grouping tax returns. IRS initiated the market segment approach on the basis of work done in its Western Region, which indicated that compliance rates and audit issues were likely to be similar for taxpayers with similar characteristics, such as businesses in the same industry (e.g., manufacturing or retail sales). Accordingly, IRS concluded that grouping taxpayers by market segments might result in selecting returns for audit that have a higher potential for change and might allow auditors to specialize in market segments. The 1994 TCMP was designed to provide data to test this hypothesis as well as to develop DIF scores by market segment rather than by audit class, as had been done in the past. Without TCMP or some alternative to provide similar information, IRS will not have data to show whether market segments are better for return selection purposes than traditional audit classes or be able to determine the compliance rate or compliance issues of the market segments. Because of these concerns, IRS no longer plans to test a selection of returns for audit by using the market segment approach. Instead, IRS plans to continue selecting returns for audit using the DIF score within audit classes.