oversight

Compliance and Collection: Challenges for IRS in Reversing Trends and Implementing New Initiatives

Published by the Government Accountability Office on 2003-05-07.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

                          United States General Accounting Office

GAO                       Testimony
                          Before the Subcommittee on Transportation, Treasury, and
                          Independent Agencies, Committee on Appropriations,
                          House of Representatives


For Release on Delivery
Expected at 2 p.m. EDT
Wednesday, May 7, 2003
                          COMPLIANCE AND
                          COLLECTION
                          Challenges for IRS in
                          Reversing Trends and
                          Implementing New
                          Initiatives
                          Statement of Michael Brostek, Director
                          Strategic Issues




GAO-03-732T
                          A
                                               May 7, 2003


                                               COMPLIANCE AND COLLECTION

                                               Challenges for IRS in Reversing Trends
Highlights of GAO-03-732T, a testimony         and Implementing New Initiatives
before the Subcommittee on
Transportation, Treasury, and
Independent Agencies, Committee on
Appropriations, House of Representatives




Taxpayers’ willingness to                      From fiscal years 1993 through 2002, IRS’s four major compliance programs for
voluntarily comply with tax laws               individual taxpayers had mixed trends in the portion of taxpayers they contacted
depends in part on their confidence            with two declining, one increasing, and one staying relatively the same. Among
that friends, neighbors, and                   the programs, IRS’s often-cited audit rate declined about 38 percent. From fiscal
business competitors are paying                years 1996 through 2001, IRS’s collection program experienced almost universal
their fair share of taxes. The                 declines in workload coverage, cases closed, direct staff time used, productivity,
Internal Revenue Service’s (IRS)               and dollars of unpaid taxes collected. Many parties have expressed concern
programs to ensure compliance                  about the compliance—especially audit—and collections trends for their
and to collect delinquent taxes are            potential to undermine taxpayers’ motivation to fulfill their tax obligations.
viewed by many as critical for
maintaining the public’s confidence
                                               Since 2001 IRS has sought more resources including increased staffing for
in our tax system.
                                               compliance and collections. Despite receiving requested budget increases,
                                               staffing levels in key occupations were lower in 2002 than in 2000. These
The Subcommittee asked GAO to
present information on trends in               declines occurred for reasons such as unbudgeted expenses consuming budget
IRS’s compliance and collection                increases and other operational workload increases. Based on past experience
programs and to discuss issues                 and uncertainty regarding some expected internal savings, fiscal year 2004
related to IRS’s efforts to increase           anticipated staff increases might not fully materialize.
staffing for these programs. GAO
was also asked to discuss IRS’s                IRS’s 2004 budget proposes a substantial initiative to address known sources of
plans to launch new initiatives to             EIC noncompliance. IRS intends to ramp up the initiative rapidly with planning
reduce noncompliance with the                  and implementation proceeding simultaneously. If it is to succeed, the initiative
Earned Income Tax Credit (EIC)                 will require careful planning and close management attention.
and to use private collection
agencies to assist in collecting               IRS also proposes to use private collection agencies to assist in collecting
delinquent taxes.                              certain delinquent tax debt. IRS is seeking authority to retain some tax receipts
                                               in a revolving fund to pay the private collectors. A pilot effort to use private
                                               collectors in 1996 was unsuccessful, in part because IRS was unable to identify
                                               and channel appropriate collection cases to the private collectors. Key
GAO is not making any                          implementation details for this proposal must be worked out and it too will
recommendations. GAO is                        require careful planning and close management attention.
currently working with members of
Congress to define the scope of                Proposed EIC Initiative Caseloads by Fiscal Year and Initiative Type, 2004-08
work they would like GAO to do to                  Thousands of filers
assess IRS’s proposed initiative to                                                                                   Fiscal year
address EIC noncompliance.
                                                   Initiative                                     2004        2005        2006        2007        2008
                                                   Qualifying child       Relationship
                                                                                                         a
                                                                          certification             45        2,000       1,500        800         100
                                                                          Residency
                                                                                                         a
                                                                          certification                           0       1,000      1,000        1,000
                                                   Filing status                                      5         450         450        450         450
                                                                      b
                                                   Income reporting                                 175         470         470        470         470
                                               Source: IRS.

                                               Note: Projections are based on receiving an initiative-specific annual appropriation of $100 million.
www.gao.gov/cgi-bin/getrpt?GAO-03-732T.        a
                                                In 2004, a total of 45,000 claimants will be asked to certify both their relationship and their
                                               residency.
To view the full report, including the scope
and methodology, click on the link above.      b
                                               Also known as the “underreporter” initiative.
For more information, contact Michael
Brostek at (202) 512-9110 or
brostekm@gao.gov.
Mr. Chairman and Members of the Subcommittee:

I am pleased to participate in the Subcommittee’s hearing today focusing
on compliance issues and initiatives in the Internal Revenue Service’s (IRS)
fiscal year 2004 budget request. Specifically, my statement today will cover
recent trends in IRS’s compliance and collection programs, IRS’s staffing
for these programs, and its initiatives to expand compliance efforts for the
Earned Income Credit (EIC) and to use private collection agencies to assist
in the collection of delinquent tax debt.

From fiscal years 1993 through 2002, IRS’s compliance programs for
individual taxpayers—audits, document matching, nonfiler identification,
and math error corrections—had mixed trends in the rate at which they
contact potentially noncompliant taxpayers with two declining, one
increasing, and one staying relatively the same.1 Among the four programs,
IRS’s often-cited audit rate declined approximately 38 percent comparing
1993 to 2002. In the collection area, comparing fiscal years 1996 to 2001
IRS’s collection program experienced almost universal declines in
workload coverage, cases closed, direct staff time used, productivity, and
dollars of unpaid taxes collected.2 Many parties have expressed concern
about the compliance program--especially audit—and collection program
trends for their potential to undermine taxpayers’ motivation to fulfill their
tax obligations.

Concerned about these trends, IRS has sought additional resources,
including increased staffing levels for compliance and collection since
fiscal year 2001. However, despite receiving requested budget increases,
staffing levels in key occupations were lower in 2002 than in 2000. Reasons
for this decline include unbudgeted expenses consuming budget increases
and workload increases in other essential operations. The 2004 budget
again proposes funding increases in part to augment staffing for
compliance and collection activities. Also, as it did last year, IRS projects
that savings from more efficient operations will enable it to shift more
staffing into these activities in 2004. Current savings projections since the
budget was prepared, as well as the past history of unrealized staffing




1
    IRS and others sometimes refer to the four programs as enforcement programs.
2
  The collection of delinquent taxes is also considered to be a compliance program by IRS.
For purposes of this testimony, it is discussed separately.




Page 1                                                                       GAO-03-732T
                       increases, raise questions about whether IRS will realize the full staffing
                       increases it expects.

                       In the compliance area, IRS’s 2004 budget proposes a new initiative to
                       address noncompliance in the EIC. The EIC initiative is a substantial new
                       effort to target known sources of EIC noncompliance that IRS intends to
                       ramp up rapidly. Planning and implementation for this initiative will
                       proceed simultaneously. The success of the initiative will depend on
                       careful planning and close management attention as IRS’s implementation
                       progresses.

                       In the collection area, IRS has proposed using private collection agencies
                       to assist it with a portion of the collection activities for some delinquent tax
                       debt. IRS is requesting authority to retain some tax collection receipts in a
                       revolving fund that would be used to pay the private collectors. A pilot
                       effort to use private debt collectors in 1996 was unsuccessful, in part
                       because IRS was unable to identify and channel appropriate collection
                       cases to the private debt collectors. Various key details for implementing
                       this proposal must be worked out and it, like the EIC initiative, will require
                       careful planning and close management attention if Congress authorizes
                       the effort.

                       Our assessment of IRS compliance and collection trends, and budget issues
                       is based on recently issued GAO products. We updated certain trends for
                       IRS’s fiscal year 2002 operations by analyzing IRS management reports. We
                       also used data reported by the Treasury Inspector General for Tax
                       Administration. To assess the status of IRS’s EIC initiative and plans to use
                       the assistance of private collection agencies, we interviewed IRS officials
                       and reviewed documents prepared to justify both initiatives.

                       I will now discuss these issues in more detail, turning first to trends in IRS’s
                       compliance and collection programs.



Trends in Compliance   In recent years, steep declines have occurred in some of IRS’s compliance
                       programs for individual taxpayers, as have broad declines in its efforts to
and Collection         collect delinquent taxes. These trends have triggered concerns that
Programs Have          taxpayers’ motivation to voluntarily comply with their tax obligations could
                       be adversely affected.
Triggered Concern



                       Page 2                                                              GAO-03-732T
Compliance Trends Are          Taxpayers’ willingness to voluntarily comply with the tax laws depends in
Mixed; the Often Cited Audit   part on their confidence that their friends, neighbors, and business
                               competitors are paying their fair share of taxes. IRS’s compliance
Rate Has Declined Steeply      programs, including audits, document matching, and other efforts, are
                               viewed by many as critical to maintaining the public’s confidence in our tax
                               system.

                               Looking across all four of IRS’s major enforcement programs between
                               fiscal years 1993 and 2002 reveals a somewhat mixed picture, as shown in
                               figure 1. The four programs and their trends are as follows:

                               • The math error program that identifies obvious errors such as
                                 mathematical errors, omitted data, or other inconsistencies on the filed
                                 tax return. Using only the math error count, which is consistent
                                 throughout the 10 years, the math error contact rate rose 33 percent
                                 (from 3.59 to 4.79 percent).

                               • The document matching program that identifies unreported income
                                 using information returns filed by third parties such as employers and
                                 banks. Document matching rates went up and down at various times but
                                 ended 45 percent lower (from 2.37 percent to 1.30 percent) in 2002
                                 compared to 1993.

                               • The nonfiler program that identifies potential nonfilers of tax returns by
                                 using information return and historical filing data. The nonfiler rates
                                 also went up and down but ended in 2002 about where they were in
                                 1993.

                               • The audit program that checks compliance in reporting income,
                                 deductions, credits and other issues on tax returns through
                                 correspondence or in face-to-face meetings with an IRS auditor.
                                 Comparing 1993 to 2002, the audit contact rate dropped 38 percent
                                 (from 0.92 to 0.57 percent) even though it rose significantly between
                                 1993 and 1995.




                               Page 3                                                           GAO-03-732T
Figure 1: IRS Compliance Contact Rates, Fiscal Years 1993-2002
8    Rate (percent)


7


6


5


4


3


2


1


0

1993          1994          1995       1996   1997   1998      1999       2000      2001       2002
Year

                Math error (revised)
                Math error
                Nonfiler
                Document matching
                Audit
Source: GAO analysis of IRS data.

Note: The revised math error contact rate includes roughly 2 million contacts that IRS had been
making but had not been reporting as math errors for fiscal years 1997 through 2002. IRS had not
collected data on these math errors prior to fiscal year 1997.


Figure 2 shows compliance program trends based on income ranges.
Although audit rates for individual taxpayers in higher and middle-income
ranges rose slightly in 2002, overall they were significantly lower in 2002
than in 1993, while the rate for the lowest income range was virtually the
same in 2002 as in 1993. The audit contact rates for the highest and lowest
income individuals essentially converged at around .8 percent in fiscal
years 2001 and 2002. Most of the audits of the lowest income individuals
dealt with EIC claims. Document matching contact for all three income
ranges rose somewhat between 2001 and 2002. However, rates for all three
income ranges ended significantly lower in 2002 than 1993 following similar
patterns of change over the years. Data on contact rates by income level
were not available for the math error and nonfiler programs.




Page 4                                                                              GAO-03-732T
Figure 2: IRS Individual Audit and Document Matching Contact Rates by Income Level, Fiscal Years 1993-2002
5 Audit rates (percentage)                                                            5 Document matching rates (percentage)



4                                                                                     4



3                                                                                     3



2                                                                                     2



1                                                                                     1



0                                                                                     0
 1993    1994     1995     1996     1997   1998   1999   2000     2001   2002          1993    1994   1995   1996   1997   1998   1999   2000   2001   2002
Year                                                                                    Year

                                                                  $100,000 and over
                                                                  $25,000 to under $100,000
                                                                  Under $25,000

Source: GAO analysis of IRS data.




Collection Trends Have                                   As we reported in May 2002, between fiscal years 1996 and 2001 trends in
Declined                                                 the collection of delinquent taxes showed almost universal declines in
                                                         collection program performance, in terms of coverage of workload, cases
                                                         closed, direct staff time used, productivity, and dollar of unpaid taxes
                                                         collected.3 Although IRS’s workload generally declined for two of those
                                                         indicators, workload and cases closed, the collection work it completed
                                                         declined more rapidly creating an increasing gap as show in figure 3.4
                                                         During that 6-year period, the gap between the new collection workload
                                                         and collection cases closed grew at an average annual rate of about 31
                                                         percent.


                                                         3
                                                           U.S. General Accounting Office, Tax Administration: Impact of Compliance and
                                                         Collection Program Declines on Taxpayers, GAO-02-674 (Washington, D.C.: May 22, 2002).
                                                         4
                                                           Workload is the number of delinquent accounts assigned to field and telephone collection.
                                                         Work completed is the number of delinquent accounts worked to closure, excluding
                                                         accounts for which collection work has been deferred.




                                                         Page 5                                                                                 GAO-03-732T
Figure 3: Percentage Gap between Collection Workload and Work Completed, Fiscal
Years 1996-2002
40 Percentage of workload


35


30


25


20


15


10


 5


 0


 -5 1996                1997        1998   1999          2000           2001         2002
Source: GAO analysis of IRS data.



The increasing gap between collection workload and collection work
completed led IRS in March 1999 to start deferring collection action on
billions of dollars in delinquencies. IRS’s inventory of delinquent accounts
was growing and aging and the gap between its workload and capacity to
complete work was increasing. Officials recognized that they could not
work all collection cases, and they believed that they needed to be able to
deal with taxpayers more quickly, particularly taxpayers who were still in
business and owed employment taxes.5

By the end of fiscal year 2002, after the deferral policy had been in place for
about 3 and one-half years, IRS had deferred taking collection action on
about $15 billion in unpaid taxes, interest, and penalties. IRS’ deferral of
collection action has declined somewhat since the deferral policy was
adopted. Although the rate has declined from 45 percent in 2000 to about



5
  IRS considers employment tax compliance to be among the most challenging issues for
small business, since delinquent tax can rapidly compound beyond the employer’s ability to
pay. See U.S. General Accounting Office, Tax Administration: IRS’s Efforts to Improve
Compliance with Employment Tax Requirements Should Be Evaluated, GAO-02-92
(Washington, D.C.: Jan. 15, 2002).




Page 6                                                                         GAO-03-732T
                            32 percent in 2002, IRS is still deferring collection action on about one out
                            of three collection cases.



Concerns Regarding the      Many parties have expressed concern about these trends in IRS’s
Compliance and Collection   compliance and collection programs. Since the mid-1990s, we have issued
                            six reports on IRS compliance and collection trends in response to
Trends                      congressional concerns.6 During annual oversight hearings on IRS,
                            Congress often raises questions about the declining audit rate and possible
                            effects on compliance. In recent years, congressional concerns as well as
                            IRS’s requests have resulted in efforts to augment IRS’s staffing levels.

                            In fact, the former IRS Commissioner’s report to the IRS Oversight Board
                            during September 2002 made what was perhaps the most explicit case for
                            additional staffing to address IRS’s compliance and collection
                            performance. Although the Commissioner recognized that IRS needed to
                            improve the productive use of its current resources, he cited a need for an
                            annual 2 percent staffing increase on top of planned productivity increases
                            over 5 years to help reverse the trends. In terms of the collection of tax
                            debts, the IRS Commissioner estimated that an almost 60 percent gap
                            exists between IRS’s collection workload and the work it has completed.
                            Closing this gap, according to the Commissioner, would require 5,450 new
                            full-time staff.7 IRS also has been looking for ways to free resources for
                            compliance programs by boosting productivity or reducing workload in
                            other areas.




                            6
                              U.S. General Accounting Office, Tax Administration: Audit Trends and Results for
                            Individual Taxpayers, GAO/GGD-96-91 (Washington, D.C.: Apr. 26, 1996); Tax
                            Administration: IRS’ Audit and Criminal Enforcement Rates for Individual Taxpayers
                            Across the Country, GAO/GGD-99-19 (Washington, D.C.: Dec. 23, 1998); IRS Audit Rates:
                            Rate of Individual Taxpayers Has Declined With the Effect on Compliance Unknown,
                            GAO-01-484 (Washington, D.C.: Apr. 25, 2001); Tax Administration: Use of Nonaudit
                            Contacts, GAO/GGD-00-7 (Washington, D.C.: Mar. 16, 2001); Tax Administration: Impact of
                            Compliance and Collection Program Declines on Taxpayers, GAO-02-674 (Washington,
                            D.C.: May 22, 2002); and Tax Administration: IRS Should Continue to Expand Reporting
                            on Its Enforcement Efforts, GAO-03-378 (Washington, D.C.: Jan. 31, 2003).
                            7
                              Internal Revenue Service, Report to the IRS Oversight Board: Assessment of the IRS and
                            the Tax System, September 2002.




                            Page 7                                                                      GAO-03-732T
                          In our recent Performance and Accountability Series report on the
                          Treasury Department, we cite the collection of unpaid taxes as one of the
                          management challenges facing IRS.8 In that report, we state that IRS is in
                          various stages of planning and implementing management improvements,
                          including reengineering compliance and collection practices. However, as
                          of September 30, 2002, IRS’s inventory of known unpaid taxes totaled
                          $249 billion, of which $112 billion has some collection potential, and is at
                          risk.9



Increasing Compliance     Since 2001, IRS's budget requests have made increasing its compliance and
                          collection staff one of several key priorities. For example, in its 2001
and Collection Staffing   budget request IRS asked for funding for the Staffing Tax Administration
Has Been and Remains      for Balance and Equity initiative, which was designed to provide additional
                          staff for examination, collection, and other enforcement activities.
an IRS Priority, but      However, as shown in figures 4 and 5, staffing in two key compliance and
Declines Have             collection occupations were lower in 2002 than in 2000. This continues a
Continued                 general trend of declining staffing in these occupations for a number of
                          years.




                          8
                            U.S. General Accounting Office, Major Management Challenges and Program Risks:
                          Department of the Treasury, GAO-03-109 (Washington, D.C.: January 2003).
                          9
                            Known unpaid taxes consist of (1) taxes due from taxpayers for which IRS can support the
                          existence of a receivable with a taxpayer agreement or a favorable court ruling (federal
                          taxes receivable), (2) compliance assessments in which neither the taxpayer nor the court
                          has affirmed that the amounts are owed, and (3) write-offs, which are unpaid assessments
                          for which IRS does not expect collections due to such factors as the taxpayer's death,
                          bankruptcy, or insolvency. The $112 billion only includes the first two categories.




                          Page 8                                                                       GAO-03-732T
Figure 4: Number of Revenue Agents, Fiscal Years 1996-2002
16,000 Number of revenue agents



15,000



14,000



13,000



12,000



11,000
         1996               1997                1998         1999   2000   2001          2002
          Fiscal year ended
Source: Treasury Inspector General for Tax Administration.




Figure 5: Number of Revenue Officers, Fiscal Years 1996-2002
6,000 Number of revenue officers



5,500



5,000



4,500



4,000



3,500



3,000
        1996              1997                1998           1999   2000   2001         2002
        Fiscal year
Source: Treasury Inspector General for Tax Administration.



The declines in compliance and collection staffing occurred for several
reasons, including increased workload and unbudgeted costs. In
September 2002, the Commissioner attributed the decline in compliance



Page 9                                                                            GAO-03-732T
                                staffing to increases in workload in other essential operations, such as
                                processing returns, issuing refunds, and answering taxpayer mail. In the
                                most recently completed fiscal year, 2002, IRS faced unbudgeted cost
                                increases, such as rent and pay increases, of about $106 million. As a result,
                                IRS had to delay hiring revenue agents and officers. IRS noted in its 2002
                                budget request that any major negative changes in the agency's financial
                                posture, such as unbudgeted salary increases, will have a negative effect on
                                staffing levels.



Fully Realizing a Fiscal Year   For fiscal year 2004, IRS is requesting $10.4 billion, an increase of 5.3
2004 Staffing Increase May      percent over fiscal year 2003 requested levels, and 100,043 full-time
                                equivalents (FTE). Also, IRS's 2004 budget request is its second in a row to
Be Challenging
                                propose increased spending for higher priority areas that would be funded,
                                in part, with internal savings redirected from other areas. Specifically, IRS
                                proposes to devote an additional $454 million and 3,033 more FTEs to
                                enhance programs, including compliance and some customer service areas.
                                As shown in figure 6, $166 million of the enhancements would be funded
                                from internal savings with the remainder funded from the budget increase.



                                Figure 6: IRS's Proposed Funding for Program Enhancements
                                                                 $10.4 billion budget request
                                 $10 billion for current operations


                                                                                        $166 million
                                                                                        from internal   $454 million
                                                                                        savings         in proposed
                                                                                                        program
                                                                                       $288 million     enhancements
                                                                                       from budget
                                                                                       increase



                                Source: GAO analysis IRS data.



                                We commend IRS for identifying savings to be reinvested in operations to
                                improve IRS performance. This approach implements a key principle of
                                IRS's long-term modernization effort. Under this approach, the
                                reengineering of IRS's work processes, much of which depends on
                                investments in computer modernization, would automate or eliminate



                                Page 10                                                                     GAO-03-732T
work, improve productivity, and free staff time that could then be
redirected to higher priority customer service and compliance activities.

Some caution is appropriate, however, in considering whether the
additional FTEs will be realized. In addition to the potential that some cost
increases may not be funded as in prior years, revised projections
developed since the 2004 budget request was prepared raise questions
about IRS's ability to achieve all the savings projected and shift resources
to compliance as planned.

IRS has revised the savings associated with several reengineering efforts
identified in the 2004 budget request. Revisions this far in advance of the
start of the fiscal year are not a surprise. They do indicate some
uncertainty associated with the budget request's savings projections.

For example, most significant reengineering efforts planned for fiscal year
2004, in terms of FTEs and dollars to be saved, will not achieve all of their
projected savings because the efforts were based on assumptions that will
not be realized, according to IRS data and officials. IRS's effort to improve
the efficiency of compliance support activities, the single most significant
effort, depended partially on IRS implementing individual compliance
savings projects in 2003. This effort was projected to save 394 FTEs and
almost $26 million. However, due in part to delays until 2004 to allow for
additional testing, this effort is now expected to save about 30 percent of
the original projections through the end of fiscal year 2004. IRS now
projects that the seven most significant efforts will save 1,073 FTEs and
$60.5 million, down from original projections of 1,356 FTEs and
$77.7 million.

Reengineering efforts may not achieve all of their savings goals, in part,
because of the long time lag between when IRS begins developing its
budget request and when the fiscal year begins. As with most other federal
agencies, IRS usually begins formulating its budget request about 18
months before the start of the fiscal year and about 10 months before the
President submits his budget to Congress. With planning beginning so far
ahead of the budget's actual execution, inevitable intervening events, such
as delays in implementing computer systems, make the assumptions upon
which projections are based no longer realistic.

In addition to lower current estimates of the potential savings from the
seven most significant reengineering estimates, some of the other
reengineering efforts listed in the 2004 budget request are not well defined.



Page 11                                                           GAO-03-732T
                          This raises questions about whether they will achieve their savings goals.
                          For example, IRS still is reviewing its procedures to identify ways to make
                          tax return processing more efficient. Although IRS projected this effort to
                          save 203 FTEs and $6.9 million, it has not yet identified the operational
                          areas that will be reengineered. IRS officials said that the projected savings
                          are based on a 2 percent efficiency increase, but they are currently
                          determining how to achieve that goal.

                          According to IRS budget officials, IRS uses its budget formulation process
                          to establish productivity goals, although the responsible business units may
                          not know specifically how savings will be achieved. Officials said that this
                          approach encourages innovation in meeting performance goals while
                          identifying ways to save FTEs and budget dollars.



EIC Initiative Is a       IRS’s 2004 budget submission requests $100 million and 650 FTEs for a new
                          initiative to improve compliance in one area in which noncompliance is
Substantial and           known to be a concern: EIC. Although Treasury and IRS have made
Challenging Strategy to   progress in defining the scope and nature of the initiative, many details
                          about its implementation are still to be settled as planning for and
Target Known              implementation of the initiative proceed simultaneously. IRS hopes that
Compliance Problems       this effort will reduce EIC noncompliance without unnecessarily burdening
                          or discouraging those who are eligible for and claim EIC. Given its scope,
                          potential effects on EIC claimants, and planned rapid expansion, the
                          success of the initiative will depend on careful planning and close
                          management attention as IRS implements the initiative.

                          Begun in 1975, the EIC is a refundable tax credit available to certain low-
                          income, working taxpayers. Two stated long-term objectives of Congress
                          have been: 1) to offset the impact of Social Security taxes on low-income
                          individuals; and 2) to encourage these same individuals to seek
                          employment, rather than depend on welfare benefits. Researchers have
                          reported that the EIC has been a generally successful incentive-based
                          antipoverty program, as was intended by Congress.10 For tax year 2001,
                          about $31 billion was paid to about 19 million EIC claimants.



                          10
                            The Council of Economic Advisers, Good News for Low Income Families: Expansions in
                          the Earned Income Tax Credit and the Minimum Wage, December, 1998. Congressional
                          Research Service, The Earned Income Tax Credit (EITC): An Overview, Updated report,
                          March 19, 2003.




                          Page 12                                                                 GAO-03-732T
However, in addition to its successes, the EIC program has historically
experienced high rates of noncompliance—including both overclaims and
underclaims of benefits. For over a decade we have reported on IRS’s
efforts to reduce EIC noncompliance. Due to persistently high
noncompliance rates, we have identified the EIC program as a high-risk
area for IRS since 1995.11 An IRS study of 1985 tax returns estimated that
the EIC overclaim in that year rate was 39.1 percent. The results of
subsequent EIC compliance studies conducted by IRS are shown in table 1.



Table 1: EIC Overclaim Rates for Selected Years

                                                 Overclaim rate estimates
Tax year                                         Lower-bound                             Upper-bound
1994                                                            --                                  23.5
1997                                                        23.8                                    25.6
1999                                                        27.0                                    31.7
Source: IRS reports.

Notes: All overclaim rates were adjusted by IRS to reflect dollars recovered from ineligible recipients.
For 1994 only a single estimate was available. In 1997 and 1999, because not all individuals
responded to the audit contacts, IRS used certain assumptions to estimate an overclaim rate range.
The lower bound assumes that the overclaim rate for the nonrespondents is the same as for the
respondents, while the upper bound assumes that all non-respondents are overclaims.


In 1997, Congress instructed IRS to improve EIC compliance through
expanded customer service and outreach, strengthened compliance, and
enhanced research efforts. For these efforts Congress authorized a 5-year,
EIC-specific appropriation of $716 million. Although the 5-year period
elapsed in fiscal year 2002, Congress appropriated $145 million specifically
for EIC compliance for fiscal year 2003. For fiscal year 2004, IRS is
requesting $153 million for this appropriation; the $100 million request for
the new EIC initiative is separate.

Early in 2002, when the results of IRS’s most recent study of EIC
compliance for tax year 1999 were released, the Assistant Secretary of the
Treasury and the IRS Commissioner established a joint task force to seek
new approaches to reduce EIC noncompliance. The task force sought to

11
  Prior to 2001, EIC was part of a broader IRS Tax Filing Fraud high-risk area. Beginning in
2001, the focus of that designation was narrowed to EIC specifically. See U.S. General
Accounting Office, High-Risk Series: An Update, GAO-01-263 (Washington, D.C.: January
2001).




Page 13                                                                                   GAO-03-732T
develop an approach to validate EIC claimants’ eligibility before refunds
are made, while minimizing claimants’ burden and any impact on EIC’s
relatively high participation rate. Through this initiative, administration of
the EIC program would become more like that of a social service program
such as Food Stamps or Social Security Disability, where proof of eligibility
is required prior to receipt of any benefit.

Based on its various studies of EIC noncompliance, IRS determined that
three specific areas account for a substantial portion of EIC
noncompliance. These three areas—qualifying child eligibility, improper
filing status, and income misreporting (also called “underreporter”)—
account for nearly 70 percent of all EIC refund errors, according to IRS.
The joint Treasury/IRS task force designed an initiative that would address
each of these sources of EIC noncompliance.

Filers that improperly claim qualified children represent the single largest
area of EIC overclaims, on a dollar basis. Under the proposed initiative,
IRS will attempt to verify all taxpayers’ claims for EIC-qualifying children
under two criteria: a residency and a relationship certification. IRS plans to
use third-party databases and other means to verify qualifying children for
an estimated 80 percent of EIC claimants. All other EIC claimants will be
asked to provide additional eligibility documentation prior to the filing
season. Those who do not respond and/or are unable to document their
eligibility will have the EIC portion of their returns frozen. If taxpayers do
not provide documentation before the filing season, IRS plans to require
them to provide it during or after the filing season. When and if they
document their eligibility, the EIC portion of their returns will be released.




Page 14                                                            GAO-03-732T
Initially, beginning in the summer of 2003, IRS intends to select 45,000 EIC
claimants whose qualifying child residency or relationship requirements
could not be verified from available databases. IRS plans under its
initiative to contact these taxpayers and give them the opportunity to
provide verifying documentation for the child (or children) that is (are)
claimed to qualify for the EIC. The two components of establishing
qualifying child eligibility—the claimant’s relationship to the child, and
residency with the claimant for more than 6 months—will be treated
somewhat differently. Taxpayers who establish their qualifying child
relationship will not have to do so in future years but all taxpayers will
have to show annually that the children lived with them for the required
time. IRS expects to expand the program in July 2004 by starting to contact
approximately 2 million taxpayers; in another planned expansion in July
2005, IRS would contact 2.5 million taxpayers.12

The other two parts of this initiative will cover an additional 180,000 high-
risk filers for tax year 2003—5,000 to verify their filing status and 175,000 to
verify their income. Criteria for selecting the 5,000 cases in the filing status
category have not yet been determined. They will be drawn from tax year
2003 cases. For the 175,000-case income verification initiative, IRS will use
document matching to identify EIC filers who have a history of
misreporting income in order to increase (or receive) the EIC.13 Based on
that history, these taxpayers’ returns are to be flagged when their 2003 EIC
claims are filed. Any EIC refund portion of each return is then to be frozen
until IRS can verify the taxpayers’ income through document matching or
audit procedures in the fall of 2003. These filers will be identified out of tax
year 2002 and 2003 cases. Table 2 shows IRS’s projections for future
casework in all three initiative areas.




12
  According to IRS, planned expansions are estimates that depend on its assessments of its
capacity to handle and the results the proposed 45,000 filer initiative.
13
  IRS’s automated underreporter system will be an important part of the income verification
initiative.




Page 15                                                                       GAO-03-732T
Table 2: Proposed EIC Initiative Caseloads by Fiscal Year and Initiative Type,
2004-08

Thousands of filers
                                                                 Fiscal Year
Initiative                                       2004         2005        2006         2007         2008
Qualifying child             Relationship
                             certification         45a       2,000        1,500          800          100
                             Residency
                                                      a
                             certification                        0       1,000        1,000        1,000
Filing status                                        5         450          450          450          450
                         b
Income reporting                                  175          470          470          470          470
Source: IRS documents.

Note: Projections are based on receiving an initiative-specific annual appropriation of $100 million and
estimates of how many cases IRS can adequately work.
a
In 2004, a total of 45,000 claimants will be asked to certify both their relationship and their residency.
b
Also known as the “underreporter” initiative.


Although the Treasury/IRS task force and now IRS have made progress in
defining the scope and nature of this initiative, many details about its
implementation are still to be settled. IRS expects to learn lessons from
initial sample cases it will work in 2003 that will be incorporated into
planned expansions of the effort later in 2003 and in 2004. IRS officials said
that estimates of the number of new employees that will be needed and
their training requirements are evolving. For example, although IRS’s 2004
budget submission identifies 650 FTEs for this initiative, current plans are
for a much lower staffing level at this point. In addition, cost and FTE
estimates are based on historical data that may not be directly comparable
to the staffing and technological demands of the initiative. Based on these
estimates, of the $100 million 2004 request, IRS has proposed budgeting
just under $55 million for direct casework in the three compliance areas.
The remaining $45 million is allocated to technology improvements and
management, development, and implementation costs related to the three
targeted compliance areas.

Fundamental to the precertification of qualifying children is the
development of clear forms that identify the specific types of
documentation IRS will accept to substantiate that a qualifying child meets
the relationship and residency tests for EIC. IRS is currently working with
others, like the Taxpayer Advocate, to develop these new forms, which are
to be used beginning this summer.



Page 16                                                                                    GAO-03-732T
Recently, concerns have been expressed about IRS’s intention to request
marriage certificates as proof of relationship to the qualifying child. We
have not looked at this specific issue. However, our 2002 report noted that
EIC forms and instructions that IRS used for similar attempts to determine
qualifying child eligibility could be confusing to taxpayers and required
documents that EIC claimants had difficulty obtaining. 14 When taxpayers
have been disallowed the EIC through an IRS audit, they are required to
substantiate their qualification for the EIC—that is, “recertify”—before
they can receive the credit again. As part of this process, IRS’s forms
indicated that EIC claimants could, for example, use medical records to
prove a child’s residency with them. However, EIC claimants faced
difficulty in providing such records. Low-income working families are less
likely to have stable relationships with medical service providers and their
children are less likely to have routine medical care.

IRS officials said that they plan to pretest the proposed precertification
forms both to determine whether they are clear and understandable to EIC
claimants but also to determine whether the claimants can provide the
required information. This is a critical step in implementing the initiative.
We recently reported that IRS seldom tests the new and revised individual
tax forms and instructions. 15

Ensuring consistent interpretation of documentation gathered in the new
initiative will also be important. In our 2002 report, we noted that IRS
examiners did not consistently assess documentation for qualifying
children. For example, we asked 21 examiners to examine five EIC
scenarios. The 21 examiners did not agree for any of the scenarios, and, in
some cases, the examiners reached widely varying judgments about
whether the evidence was sufficient to support an EIC claim.16 In order to
better ensure consistent and accurate decisions based on documentation
submitted, we recommended that IRS provide training to its examiners.




14
 U.S. General Accounting Office, Earned Income Credit: Opportunities to Make
Recertification Less Confusing and More Consistent, GAO-02-449 (Washington, D.C.:
Apr. 25, 2002).
15
  U.S. General Accounting Office, Tax Administration: IRS Should Reassess the Level of
Resources for Testing Forms and Instructions, GAO-03-486 (Washington, D.C.: Apr. 11,
2003).
16
     GAO-02-449.




Page 17                                                                    GAO-03-732T
                     Administering the EIC is not an easy task for IRS. IRS has to balance its
                     efforts to help ensure that all qualified persons claim the credit with its
                     efforts to protect the integrity of tax system and guard against fraud and
                     other forms of noncompliance associated with EIC. This initiative is a
                     substantial undertaking with a relatively aggressive implementation
                     schedule. Although it appears to be targeted to address known compliance
                     issues, its success will depend on careful planning and close management
                     attention. Any one of many challenges could put the initiative at risk.
                     These include whether, for instance, the proposed new forms will result in
                     evidence that IRS can use to verify relationship and residency
                     requirements. Further, IRS must determine whether lessons from the first
                     attempts to verify the eligibility of relatively small numbers of EIC
                     claimants can be learned and incorporated before the substantial
                     expansion of the initiative in fiscal years 2004 and 2005.



Challenges Must Be   IRS’s 2004 budget requests $2 million and legislative authorization for use
                     of private collection agencies (PCA)17 to assist IRS in collecting certain
Met if IRS Is to     types of delinquent tax debt. IRS proposes to fund continuing use of PCAs
Successfully Use     from a to-be-established revolving fund that would receive a portion of
                     taxes collected through use of PCAs.
Private Collection
Agencies             As with its EIC initiative, IRS has defined the parameters for its use of
                     PCAs, but many key details for implementing the initiative remain to be
                     resolved. These implementation details, such as identifying delinquent
                     debt cases suitable for PCAs to pursue and protecting taxpayer rights, will
                     be critical if the initiative is to succeed. If the PCA initiative is authorized,
                     IRS will need to put focused management attention on planning and
                     monitoring the implementation of the PCA initiative to ensure proper
                     handling of these issues.

                     As previously noted, IRS’s inventory of delinquent debt is growing and
                     aging, with the gap between its workload and capacity to complete work
                     increasing. As a consequence, IRS has been deferring about one in three
                     new delinquency cases without pursuing any collection action. This
                     practice is contrary to the experience of Treasury and IRS, which indicates
                     that referring eligible debts for collection as early as possible greatly
                     enhances the success of collection efforts. The former IRS Commissioner


                     17
                          IRS is calling this initiative “Collection Contract Support.”




                     Page 18                                                               GAO-03-732T
estimated in 2002 that it would take 5,450 FTEs and $296.4 million for IRS
to bridge the gap between its workload and capacity to complete the
collection casework.

To help bridge this gap, Treasury has proposed an initiative to reach
taxpayers to obtain payment on delinquent debt through the assistance of
PCAs. Under this initiative, IRS would give PCAs specific, limited
information on outstanding tax liabilities, such as types of tax, amount of
the outstanding liabilities, tax years affected, and prior payments. Based
on the information provided by the IRS, PCAs would then be permitted to
locate and contact taxpayers, requesting payment of liabilities (i.e., tax,
interest, or penalty) in full or in installments (within 3 years, as specified by
IRS). If a taxpayer’s last known address is incorrect, the PCAs would
search public records for the correct address. PCAs are not to be
permitted to contact third parties to locate taxpayers. PCAs would not be
allowed to accept payments; all payments must be made to IRS. PCAs
would generally have 12 to 24 months to attempt collection. Afterwards,
uncollected accounts are to be redistributed to other PCAs for additional
collection efforts. Because PCAs would have no enforcement power, the
initiative would allow the IRS to focus its own enforcement resources on
more complex cases and issues.

Other procedural conditions under the proposal include requiring PCAs to
inform taxpayers of the availability of assistance from the Taxpayer
Advocate. Furthermore, PCAs would not be permitted to take any
enforcement action against a taxpayer, such as seizing assets to satisfy the
debt. To ensure that taxpayer rights and privacy would be safeguarded,
PCAs would be governed by the same rules by which IRS is governed.

Initially, IRS plans to stagger implementation of the initiative. For the first
6 months, IRS will place collection cases with no more than five PCAs, with
a total volume estimate not to exceed 50,000 cases per month for the first 3
months. IRS will contract with additional PCAs at a 6-month interval with
an anticipated rate of 2.6 million total cases annually by the time all
agencies have been operational for 1 full year. Assigned case inventory
rates will depend on a number of factors, including PCA performance,
ability to manage new inventory, quality control, volume of cases referred
to IRS for review, and readiness of IRS to supply cases. Based on this
implementation framework, Treasury has projected revenue estimates of
$46 million in 2004, and $476 million from 2004 through 2008.




Page 19                                                              GAO-03-732T
In order to implement the PCA initiative, IRS must ensure that it will have
the capacity to fulfill its responsibilities under the proposed contracts and
to oversee the PCAs. Further, it must make some difficult design decisions.
One significant capacity issue concerns whether IRS will be able to identify
those delinquent debts with the highest probability of resolution through
PCA contacts. Earlier pilot efforts to study use of PCAs in 1996 and 1997
were hindered, in part, because IRS was unable to do this. For example,
we reported that the numbers and types of collection cases sent to PCAs
during those pilots were significantly different from those anticipated in
the pilot program’s original design. This resulted in substantially fewer
collection cases than PCAs could productively work to make the effort
cost-effective. IRS realizes that identifying appropriate cases for referral to
PCAs is a key issue. While IRS proposes using “case selection analytics” to
identify appropriate cases, the analytical model has not been developed.

Another IRS capacity issue relates to the cases that PCAs, for several
reasons, will refer back to IRS. For instance, under the proposed
arrangement, if a taxpayer was unable to fully pay the delinquent debt, the
case would be referred back to IRS. Some cases would then go to a
different PCA; therefore, the success of that PCA’s efforts in these cases
would depend on how well IRS reprocesses the cases. Until some
experience is gained under the proposed program, it will be difficult to
reliably estimate the number of cases that will be referred back to IRS and
the number of resources it will need to devote to the cases.

Other IRS capacity issues concern, for instance, how many resources it will
take to administer the contracts and to oversee the PCAs’ performance.
IRS expects to have up to 12 contractors, 2 of which would be small
businesses, and proposed procedures call for on-site visits and some direct
observation of PCAs’ collection efforts. IRS would also need to ensure
PCAs’ performance, such as having adequate procedures to safeguard
taxpayer information before and after the contracts are awarded, and that
it and the PCAs have secure computer systems to manage the work flow.

How the PCAs will be compensated is a key design decision that must be
finalized. On the one hand, IRS needs to provide the PCAs an incentive to
be efficient in collecting the delinquent debts and on the other hand, it must
ensure that the incentive does not lead to inappropriate performance
pressure on PCA staff. IRS intends to make part of PCAs' compensation
dependent on other factors, such as quality of service, taxpayer
satisfaction, and case resolution, in addition to collection results. Both the
law and IRS policy prohibit IRS managers from using records of tax



Page 20                                                             GAO-03-732T
               enforcement results, such as dollars collected and taxes assessed, to
               evaluate employee performance or set production goals. IRS and Treasury
               report that existing taxpayer protections would be fully preserved under
               the PCA initiative. Specifically, as with IRS employees, PCA employees
               could not be evaluated based on tax enforcement results. IRS is
               considering using a “balanced scorecard” to measure contractors’
               performance, but has not proposed specifically how this compensation
               balance will be struck.

               Finally, although the revolving fund mechanism presents potential
               advantages to IRS in better ensuring that it can pursue delinquent tax
               debts, IRS has not done a cost analysis on implementing the PCA initiative
               versus expanding the use of traditional IRS collection activities. We have
               not seen any plans to do so in the future. Some IRS officials believe that
               because IRS telephone collection staff have a broader scope of authority
               (e.g., the ability to levy a bank account to satisfy the debt) and greater
               experience with collecting delinquent taxes, IRS telephone staff are likely
               to be more effective and cost-efficient than PCAs. PCAs, however, may
               have advantages that IRS lacks. A number of factors would need to be
               considered in doing a cost analysis, and a comparison may not be possible
               without having some experience in using PCAs to collect this type of debt.



Concluding     Although IRS has received increases in its budgets since fiscal year 2001 in
               part to increase staffing to enhance in its compliance and collection
Observations   programs, IRS has been unable to achieve the desired staffing levels. Based
               on past experience and uncertainty regarding some expected internal
               savings that would enable IRS to reallocate staff to these programs, fiscal
               year 2004 staff increases might not fully materialize. Today’s hearing
               provides a useful venue for the Subcommittee to explore these funding
               issues and how IRS should prioritize its efforts.

               IRS has defined the scope and nature of its proposed new initiatives to
               address known sources of EIC noncompliance and to use private collection
               agencies to assist in collecting certain delinquent taxes. However, in both
               cases IRS faces significant challenges in moving forward to successfully
               implement the proposals. In commenting on a GAO report on IRS’s
               National Research Program—IRS’s ongoing effort to measure the level of
               taxpayers’ compliance while minimizing the burden on taxpayers selected
               for the study—the former Commissioner said that IRS would not
               compromise the quality of the program in order to meet the program’s
               target date. We believe this is a sound standard for these efforts as well.



               Page 21                                                          GAO-03-732T
                  Careful planning for and testing of key implementation steps can help
                  ensure the initiatives’ success.


                  This completes my prepared statement. I would be pleased to respond to
                  any questions.



Contact and       For further information on this testimony, please contact Michael Brostek
                  at (202) 512-9110 or brostekm@gao.gov. Individuals making key
Acknowledgments   contributions to this testimony include Leon Green, Demian Moore, Neil
                  Pinney, and Tom Short.




(450200)          Page 22                                                        GAO-03-732T
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