oversight

Tax Gap: Sources of Noncompliance and Strategies to Reduce It

Published by the Government Accountability Office on 2012-04-19.

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

                             United States Government Accountability Office

GAO                          Testimony before the Subcommittee on
                             Government Organization, Efficiency, and
                             Financial Management, Committee on
                             Oversight and Government Reform, House
                             of Representatives

                             TAX GAP
For Release on Delivery
Expected at 10:00 a.m. EDT
Thursday, April 19, 2012



                             Sources of Noncompliance
                             and Strategies to Reduce It
                             Statement of James R. White, Director
                             Strategic Issues




GAO-12-651T
                                               April 19, 2012

                                               TAX GAP
                                               Sources of Noncompliance and Strategies to Reduce
                                               It
Highlights of GAO-12-651T, a testimony
before the Subcommittee on Government
Organization, Efficiency, and Financial
Management, Committee on Oversight and
Government Reform, House of
Representatives

Why GAO Did This Study                         What GAO Found
In January 2012, IRS estimated that            Noncompliance does not have a single source but occurs across different types
the gross tax gap—the difference               of taxes and taxpayers. For example, individual income tax accounts for the
between taxes owed and taxes paid on           largest portion of the tax gap, but corporate income tax and employment tax are
time—was $450 billion for tax year             also significant. Further, misreporting by individuals involves business income,
2006. IRS estimated that it would              non-business income, deductions, and credits. The extent of misreporting
collect $65 billion through enforcement        depends on the extent to which income tax is withheld or reported to the Internal
actions and late payments, leaving a           Revenue Service (IRS) by third parties. For example, nearly 40 percent, or $179
net tax gap of $385 billion. From 2001         billion, of the 2006 gross tax gap is due to misreporting of non-corporate
to 2006, IRS estimated that the gross
                                               business income and related self-employment taxes. Much of this misreporting
tax gap increased by $105 billion.
                                               can be attributed to sole proprietors underreporting receipts or over-reporting
However, the percentage of taxes
owed that were paid on time remained
                                               expenses. Unlike wage and some investment income, sole proprietors’ income is
relatively constant at 83.1 percent in         not subject to withholding and only a portion is reported to IRS by third parties.
2006, compared to 83.7 percent in              Because noncompliance has multiple causes and spans different types of taxes
2001.                                          and taxpayers, multiple approaches are needed to reduce the tax gap. The
Given persistent levels of                     following strategies could help and will require actions by Congress or IRS.
noncompliance and large and growing            Enhancing information reporting by third parties to IRS could reduce tax
structural deficits, it will be important to   evasion and help taxpayers comply voluntarily. However, identifying additional
understand the causes of tax
                                               reporting opportunities can be challenging because third parties may not have
noncompliance and develop new
                                               accurate information available in a timely manner. Also, adding reporting
approaches to minimize it.
                                               requirements creates burden for both third parties and IRS.
This testimony addresses two
questions: (1) What types of taxpayers         Ensuring high-quality services to taxpayers, such as by telephone and
are responsible for the tax gap, and           correspondence or online, can help taxpayers who wish to comply with tax laws
what is the nature of their                    but do not understand their obligations. However, tax law changes and funding
noncompliance? (2) What are                    priorities have recently affected IRS’s ability to provide quality taxpayer services.
strategies for reducing the tax gap?           Devoting additional resources to enforcement would enable IRS to contact
The statement also discusses potential
                                               millions of potentially noncompliant taxpayers it identifies but cannot contact. To
long-term strategies to prevent refund
                                               determine the appropriate level of enforcement resources, policymakers would
fraud related to identity theft. This
statement is based largely on GAO’s
                                               need to consider how to balance taxpayer service and enforcement activities and
recent reports and recommendations             how effectively and efficiently IRS currently uses its resources.
on tax noncompliance and updates               Expanding compliance checks before IRS issues refunds would involve
GAO’s 2011 testimony on the tax gap.           matching information returns to tax returns during, rather than after, the tax filing
What GAO Recommends                            season. This approach would require a major reworking of some fundamental
                                               IRS computer systems but could help address identity theft-related fraud and
GAO has made numerous prior                    allow IRS to use enforcement resources on other compliance problems.
recommendations regarding actions to
close the tax gap. Congress and IRS            Leveraging external resources, such as paid tax return preparers and
have acted on some, while others are           whistleblowers, can help improve tax compliance because paid preparers’
reflected in the strategies presented in       actions have an enormous impact on IRS’s ability to effectively administer tax
this testimony.                                laws, and whistleblowers provide IRS information on suspected noncompliance.
                                               Modernizing information systems would allow IRS to post more
                                               comprehensive tax return information to its computer systems, which could
                                               facilitate the examination process and expedite taxpayer contacts for faster
View GAO-12-651T. For more information,        resolution.
contact James R. White at (202) 512-9110 or
whitej@gao.gov.                                Simplifying the tax code could help taxpayers understand and voluntarily
                                               comply with their tax obligations and limit opportunities for tax evasion.
                                                                                         United States Government Accountability Office
Chairman Platts, Ranking Member Towns, and Members of the
Subcommittee:

I am pleased to be here to discuss the tax gap and related fraud, such as
identity theft based refund fraud, and how to reduce it. In January 2012,
the Internal Revenue Service (IRS) estimated that the gross tax gap—the
difference between taxes owed and taxes paid on time—was $450 billion
in tax year 2006. IRS estimated that it would eventually recover about $65
billion of this amount through late payments and enforcement actions,
leaving a net tax gap of $385 billion. 1 The tax gap has been a persistent
problem in spite of a myriad of congressional and IRS efforts to reduce it,
as the rate at which taxpayers voluntarily comply with United States tax
laws has changed little over the past three decades. In past testimonies,
we have said that there are no easy fixes to this problem, and given
persistent levels of noncompliance, reducing the tax gap will not likely be
achieved through a single solution. Rather, the tax gap must be attacked
on multiple fronts and with multiple strategies over a sustained period of
time. Whether mistakes are intentional or unintentional, misreporting is
unfair to compliant taxpayers and undermines the equity of the tax
system. Moreover, in the face of large and growing structural deficits, it
will be especially important to understand the causes of tax
noncompliance today and continue to develop new approaches to
minimize it.

My testimony today will answer two questions: (1) What types of
taxpayers are responsible for the tax gap, and what is the nature of their
noncompliance? (2) What are strategies for reducing the tax gap? As
requested, we will also provide information on potential long-term
strategies to prevent refund fraud related to identity theft. My testimony is
based largely on our recent reports on tax noncompliance and updates
our 2011 testimonies on the tax gap and identity theft. 2 Additional
information on our scope and methodology is available in our published
products.




1
 Throughout this statement, references to the tax gap refer to the gross tax gap unless
otherwise noted.
2
 GAO, Tax Gap: Complexity and Taxpayer Compliance, GAO-11-747T (Washington,
D.C.: June 28, 2011), and Taxes and Identity Theft: Status of IRS Initiatives to Help
Victimized Taxpayers, GAO-11-721T (Washington, D.C.: June 2, 2011).




Page 1                                                                        GAO-12-651T
                             This testimony and the reports and testimonies upon which it is based
                             were conducted in accordance with generally accepted government
                             auditing standards. Those standards require that we plan and perform the
                             audit to obtain sufficient, appropriate evidence to provide a reasonable
                             basis for our findings and conclusions based on our audit objectives. We
                             believe that the evidence obtained provides a reasonable basis for our
                             findings and conclusions based on our audit objectives.

                             For this hearing, we updated prior reported information about the
                             estimated amounts for various components of the 2006 tax gap, the data
                             and methodology used to estimate the 2006 tax gap, and actions IRS has
                             taken to address our recommendations to improve taxpayer compliance.
                             We confirmed the new information with IRS officials.



The Tax Gap Is
Spread across Various
Types of Taxpayers
and Taxes
Characteristics of the Tax   The gross tax gap has grown in dollar terms since IRS’s previous
Gap                          estimate for tax year 2001, increasing from $345 billion to $450 billion for
                             tax year 2006. 3 However, given the growth of the economy and total
                             federal tax liability over that period, the percentage of taxes owed that
                             taxpayers paid voluntarily and on time, known as the voluntary
                             compliance rate, has remained relatively constant—83.7 percent in 2001
                             and 83.1 percent in 2006. 4



                             3
                             These amounts have not been adjusted for inflation.
                             4
                               This 30 percent increase in the size of the gross tax gap from 2001 to 2006 is similar to
                             the increase in the size of the United States economy (gross domestic product) over the
                             time period. Likewise, total tax liabilities increased nearly 26 percent, from about $2.1
                             trillion to about $2.7 trillion, from tax years 2001 to 2006. (Dollar amounts for total tax
                             liabilities do not match percentage increase because of rounding.) IRS also estimated that
                             corporate income tax underreporting increased by $37 billion during this time. However,
                             this growth may not indicate increased corporate noncompliance. According to IRS, the
                             2001 estimate of this portion of the tax gap was estimated based on old empirical data
                             and was likely understated. In addition, from 2001 to 2006, corporation income tax
                             liabilities more than doubled, while individual income tax liabilities grew by 15 percent.




                             Page 2                                                                        GAO-12-651T
The tax gap 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. 5 The
estimate also covers the five types of taxes that IRS administers—
individual income, corporate income, employment, estate, and excise
taxes.

The tax gap includes unintentional errors as well as intentional evasion,
such as intentionally underreporting income, intentionally over-reporting
expenses, and engaging in abusive tax shelters or frivolous tax schemes.
It does not include legal tax avoidance activities (legally lowering tax
liability), taxes due from illegally derived income, or various forms of
fraud. For example, in general, refund fraud related to identity theft would
not be included in the tax gap estimate because it does not involve
evading a tax liability. Nevertheless, as discussed later in the testimony,
actions taken to improve overall compliance and reduce the tax gap could
also potentially address identity theft related fraud.

A critical step toward reducing the tax gap is to understand the sources
and nature of taxpayer noncompliance. As shown in table 1,
noncompliance does not come from a single source but rather occurs
across different types of taxes and taxpayers. For example, individual
income tax accounted for most of the tax gap estimate for tax year 2006.
However, corporate income tax and employment tax also contributed a
significant portion.




5
 Taxpayers who receive filing extensions, pay their full tax liability by payment due dates,
and file returns prior to extension deadlines are considered to have filed on time.




Page 3                                                                          GAO-12-651T
Table 1: IRS’s Tax Year 2006 Gross Tax Gap Estimates by Type of Noncompliance and Type of Tax

Dollars in billions
                                                                           Type of tax
                             Individual             Corporate        Employment
Type of noncompliance       income tax             income tax               tax            Estate tax           Excise tax            Total
Underreporting                    $235                    $67                   $72                 $2        No estimate             $376
Underpayment                         36                     4                      4                 2                  0.1              46
Nonfiling                            25            No estimate         No estimate                   3        No estimate                28
Total                             $296                    $71                   $76                 $7                 $0.1           $450
                                          Source: IRS.



                                          As shown in table 2, individual income tax underreporting includes both
                                          nonbusiness income tax and business income tax underreporting.
                                          Business income for individuals includes income from a variety of
                                          business types, including sole proprietors, 6 partnerships, and S
                                          corporations, 7 many of which are small businesses. Nearly 40 percent, or
                                          $179 billion, of the 2006 gross tax gap can be attributed to these types of
                                          business taxpayers who underreport their business income tax, and by
                                          extension their self-employment tax, on their individual income tax
                                          returns. 8 Further, the misreporting of business income tax can take on a
                                          variety of forms. For example, misreporting of non-corporate business
                                          income tax can be largely attributed to sole proprietors who understated
                                          receipts or overstated expenses. 9 A key reason for this misreporting is



                                          6
                                           Sole proprietors are self-employed individuals who should file a Schedule C with their
                                          individual tax returns to report profits and losses from their businesses. Sole proprietors
                                          include those who provide services, such as doctors or accountants; produce goods, such
                                          as manufacturers; and sell goods at fixed locations, such as car dealers and grocers.
                                          7
                                           S corporations provide limited liability protection to shareholders and “pass through”
                                          gains and losses to shareholders’ individual tax returns without generally paying taxes at
                                          the entity level. Limited liability protection means that a shareholder’s financial liability for a
                                          company is limited to the amount of their investment in the company. Owners of S
                                          corporations are referred to as shareholders.
                                          8
                                           Self-employed individuals are generally required to calculate and remit Social Security
                                          and Medicare taxes to the U.S. Treasury each quarter. As employment taxes and income
                                          taxes for self-employed taxpayers are largely assessed on the same income, self-
                                          employed individuals who underreport their income consequently underreport the
                                          employment tax due on that income.
                                          9
                                           GAO, Tax Gap: A Strategy for Reducing the Gap Should Include Options for Addressing
                                          Sole Proprietor Noncompliance, GAO-07-1014 (Washington, D.C.: July 13, 2007).




                                          Page 4                                                                               GAO-12-651T
                                           well known. Unlike wage and some investment income, sole proprietors’
                                           income is not subject to withholding and only a portion is subject to
                                           information reporting to IRS by third parties.

Table 2: Underreporting Portion of IRS’s Tax Year 2006 Gross Tax Gap Estimates

Dollars in billions
Tax gap component                                                                       Estimated underreporting amount
Individual income tax                                                                                             $235
 Nonbusiness income                                                                                                 68
 Business income                                                                                                   122
 Adjustments, deductions, and exemptions                                                                            17
 Credits                                                                                                            28


Corporate income tax                                                                                               $67
 Small corporations                                                                                                 19
 Large corporations                                                                                                 48


Employment tax                                                                                                     $72
 Self-employment tax                                                                                                57
 FICA and unemployment tax                                                                                          15


Estate tax                                                                                                          $2


Total underreporting                                                                                              $376
                                           Source: IRS.



                                           As shown in figure 1, the extent to which individual taxpayers accurately
                                           report their income is related to the extent to which the income is reported
                                           to them and IRS by third parties or taxes on the income are withheld. For
                                           example, for types of income for which there is little or no information
                                           reporting, such as business income, individual taxpayers tend to
                                           misreport over half of their income. In contrast, employers report most
                                           wages, salaries, and tip compensation to employees and IRS through
                                           Form W-2. Also, banks and other financial institutions provide information
                                           returns (Forms 1099) to account holders and IRS showing the taxpayers’
                                           annual income from some types of investments. Findings from IRS’s
                                           study of individual tax compliance indicate that nearly 99 percent of these
                                           types of income are accurately reported on individual tax returns.




                                           Page 5                                                           GAO-12-651T
Figure 1: Effect of Information Reporting on Taxpayer Compliance, Tax Year 2006




Taxpayers misreport income and expenses for a variety of reasons.
Some misreporting is intentional; some is unintentional. Often it is
impossible to tell from a tax return whether errors are intentional or
unintentional or even who made the error. For example, paid tax return
preparers could make errors or taxpayers could fail to share relevant
information with their preparers. Our past reports shed some light on the
extent of unintentional errors. In our report on securities cost basis
reporting, 10 we found that among individual taxpayers who misreported
securities sales, roughly one-third over-reported income (i.e., they


10
  Generally, a taxpayer’s gain or loss from a securities sale is simply the difference
between the gross proceeds from the sale and the original purchase price, or original cost
basis. However, 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.




Page 6                                                                       GAO-12-651T
                        overstated gains or understated losses). 11 For sole proprietors, we
                        reported that 9 percent over-reported their net income, while 61 percent
                        underreported their net income in 2001. 12 It seems likely that such
                        instances of over-reporting could be due to unintentional errors.


Measuring the Tax Gap   We have long encouraged regular tax gap measurement because these
                        estimates are important to gauge progress in addressing the tax gap and,
                        perhaps more importantly, because analyzing the data used to estimate it
                        can help identify ways to improve tax compliance. One source of such
                        data is the National Research Program (NRP), which uses audits of a
                        stratified, random sample of tax returns to produce statistically valid
                        estimates of noncompliance for the entire population of tax return filers.
                        IRS uses the NRP sample results to better target its enforcement
                        examinations of noncompliant taxpayers. Better targeting examinations to
                        taxpayers who are noncompliant reduces burden on compliant taxpayers.

                        Updated compliance data can also help identify changes in tax laws and
                        regulations that may improve compliance. For example, we analyzed
                        NRP data on individual taxpayer compliance and reported that, among
                        other things, Congress could consider requiring brokers to report to both
                        taxpayers and IRS the adjusted basis of securities that taxpayers sell. 13
                        Congress enacted this provision, 14 which the Joint Committee on
                        Taxation estimated would raise $6.7 billion in revenue through 2018.

                        As we have reported in the past, closing the entire gap may not be
                        feasible since it could entail more intrusive recordkeeping or reporting
                        than the public is willing to accept or more resources than IRS is able to
                        commit. 15 However, given the size of the tax gap, even modest reductions



                        11
                          GAO, Capital Gains Tax Gap: Requiring Brokers to Report Securities Cost Basis Would
                        Improve Compliance if Related Challenges Are Addressed, GAO-06-603 (Washington,
                        D.C.: June 13, 2006).
                        12
                             GAO-07-1014.
                        13
                         GAO-06-603.
                        14
                          Energy Improvement and Extension Act of 2008, Pub. L. No 110-343, § 403, 122 Stat.
                        3768, 3854 (Oct. 3, 2008).
                        15
                         GAO, Taxpayer Compliance: Analyzing the Nature of the Income Tax Gap,
                        GAO/T-GGD-97-35 (Washington, D.C.: Jan. 9, 1997).




                        Page 7                                                                    GAO-12-651T
                             would yield very significant financial benefits. We have made numerous
                             recommendations over time that could address the tax gap, as follows.


                             Multiple approaches are needed to reduce the tax gap. No single
Various Strategies Are       approach is likely to fully and cost-effectively address noncompliance
Required to Reduce           since the noncompliance has multiple causes and spans different types of
                             taxes and taxpayers. While the tax gap will remain a challenge into the
the Tax Gap                  future, the following strategies could help. These strategies would require
                             actions by Congress or IRS.


Enhancing Information        Information reporting is a powerful tool that reduces tax evasion and
Reporting by Third Parties   helps taxpayers comply voluntarily. Several major new information
to IRS                       requirements have recently taken effect, based at least in part on our
                             work and recommendations.

                             •     Brokers are required to report their clients’ basis for securities sales,
                                   starting in 2012. 16
                             •     Banks and other third parties are required to report businesses’ credit
                                   card and similar receipts, starting in 2011. 17
                             •     Under the Foreign Account Tax Compliance Act, starting in 2014, U.S.
                                   financial institutions and other entities are required to withhold a
                                   portion of certain payments made to foreign financial institutions that
                                   have not entered into an agreement with IRS to report details on U.S.
                                   account holders to IRS. 18

                             As these three sets of information reporting requirements have only
                             recently taken effect, it is too soon to tell the actual impact they are
                             having on taxpayer compliance.

                             We have identified other options for information reporting.




                             16
                                 GAO-06-603.
                             17
                              GAO, Tax Administration: Costs and Uses of Third-Party Information Returns,
                             GAO-08-266 (Washington, D.C.: Nov. 20, 2007).
                             18
                               GAO, Reporting Foreign Accounts to IRS: Extent of Duplication Not Currently Known,
                             but Requirements Can Be Clarified, GAO-12-403 (Washington, D.C.: Feb 28, 2012).




                             Page 8                                                                    GAO-12-651T
•     Service payments to corporations. Currently, businesses must
      report to IRS payments for services they make to unincorporated
      persons or businesses, but payments to corporations generally do not
      have to be reported. 19
•     Service payments made by landlords. Taxpayers who rent out real
      estate are required to report to IRS expense payments for certain
      services, such as payments for property repairs, only if their rental
      activity is considered a trade or business. However, the law does not
      clearly spell out how to determine when rental real estate activity is
      considered a trade or business. 20

Broader requirements for these two forms of information reporting,
covering goods in addition to services, were enacted into law in 2010 but
were later repealed. We believe the more narrow extensions of
information reporting to include services, but not goods, remain important
options for improving compliance.

Additionally, we have identified existing information reporting
requirements that could be enhanced.

•     Higher education expenses. Eligible educational institutions are
      currently required to report information on qualified tuition and related
      expenses for higher education so that taxpayers can determine the
      amount of educational tax benefits they can claim. 21 IRS revising the
      information reporting form could improve the usefulness of reported
      information. 22
•     Mortgaged properties. Requiring third parties, such as mortgage
      lenders, to report mortgaged property addresses in addition to




19
  GAO, Tax Gap: IRS Could Do More to Promote Compliance by Third Parties with
Miscellaneous Income Reporting Requirements, GAO-09-238 (Washington, D.C.: Jan. 28,
2009).
20
 GAO, Tax Gap: Actions That Could Improve Rental Real Estate Reporting Compliance,
GAO-08-956 (Washington, D.C.: Aug. 28, 2008).
21
    26 U.S.C. § 6050S.
22
  GAO, 2009 Tax Filing Season: IRS Met Many 2009 Goals, but Telephone Access
Remained Low, and Taxpayer Service and Enforcement Could Be Improved, GAO-10-225
(Washington, D.C.: Dec. 10, 2009).




Page 9                                                                 GAO-12-651T
                             information they are already required to report on mortgaged
                             properties would help IRS identify potential noncompliance. 23

                        Identifying additional third-party reporting opportunities is challenging.
                        Considerations include whether any third parties have accurate
                        information available in a timely manner, the burden of reporting on the
                        third parties, and whether IRS can enforce the reporting requirement. To
                        illustrate, in a 2009 report, we found that a major reason why little
                        information reporting on sole proprietor expenses exists is because of the
                        difficulty identifying third parties. 24 For example, there is no third party that
                        could verify the business use of cars or trucks by sole proprietors.


Ensuring High-Quality   Ensuring high-quality taxpayer services, such as by telephone and
Services to Taxpayers   correspondence or online, can help taxpayers who wish to comply with
                        tax laws but do not understand their obligations. However, in recent years
                        and continuing this year, IRS’s service performance has seen declines.
                        Tax law changes and other funding priorities have affected IRS’s ability to
                        provide quality taxpayer services. For example, we recently reported that
                        call volume has increased nearly 35 percent from the same time period
                        last year, which IRS attributed, in part, to taxpayer questions about tax
                        law changes. 25 Concurrently, taxpayers’ ability to get through to IRS
                        telephone assistors has declined. 26 Through late February of this year, 65
                        percent of callers seeking to talk to an IRS telephone assistor got
                        through, compared to 70 percent for 2011. To improve service, we have
                        recommended that IRS determine the costs and benefits of creating
                        additional automated telephone applications and finalize a more


                        23
                          GAO, Home Mortgage Interest Deduction: Despite Challenges Presented by Complex
                        Tax Rules, IRS Could Enhance Enforcement and Guidance, GAO-09-769 (Washington,
                        D.C.: July 29, 2009); Tax Administration: Expanded Information Reporting Could Help IRS
                        Address Compliance Challenges with Forgiven Mortgage Debt, GAO-10-997
                        (Washington, D.C.: Aug 31, 2010); and GAO-08-956.
                        24
                          GAO, Tax Gap: Limiting Sole Proprietor Loss Deductions Could Improve Compliance
                        but Would Also Limit Some Legitimate Losses, GAO-09-815 (Washington, D.C.: Sept. 10,
                        2009).
                        25
                          GAO, 2011 Filing Season: Processing Gains, but Assistance Could Be Enhanced by
                        More Self-Service Tools, GAO-12-176 (Washington, D.C.: Dec. 15, 2011).
                        26
                          GAO, Internal Revenue Service: Interim Results of 2012 Tax Filing Season and
                        Summary of the Fiscal Year 2013 Budget Request, GAO-12-566 (Washington, D.C.: Mar.
                        20, 2012).




                        Page 10                                                                    GAO-12-651T
                           comprehensive plan for online services, including an assessment of
                           granting taxpayers the ability to update their account information online.


Devoting Additional        Devoting additional resources to enforcement would enable IRS to
Resources to Enforcement   contact millions of potentially noncompliant taxpayers that it currently
                           identifies but cannot contact given resource constraints. However,
                           determining the appropriate level of enforcement resources to provide
                           IRS requires taking into account factors such as how effectively and
                           efficiently IRS is currently using its resources, how to strike the proper
                           balance between IRS’s taxpayer service and enforcement activities, and
                           competing federal funding priorities. For example, in a 2009 report, we
                           found that despite investing nearly a quarter of all revenue agent time in
                           2008, IRS was able to examine (audit) about 1 percent of estimated
                           noncompliant sole proprietors. Not only are these exams burdensome for
                           businesses, they are also costly for IRS and yield less revenue than
                           examinations of other categories of taxpayers, in part because most sole
                           proprietorships are small in terms of receipts. 27


Expanding Compliance       IRS could reduce the tax gap by expanding compliance checks before
Checks Before IRS Issues   issuing refunds to taxpayers. The Commissioner of Internal Revenue has
Refunds                    talked about a long-term vision to increase compliance activities before
                           refunds are sent to taxpayers. In one example, IRS is exploring a
                           requirement that third parties send information returns to IRS and
                           taxpayers at the same time as opposed to the current requirement that
                           some information returns go to taxpayers before going to IRS. The intent
                           is to allow IRS to match those information returns to tax returns during tax
                           return filing season rather than after the filing season is complete. 28 As
                           will be discussed later, this approach could also help IRS address identity
                           theft-related fraud and could also allow IRS to use its enforcement
                           resources on other significant compliance problems. However, the
                           Commissioner made clear that his vision for more prerefund compliance
                           checks will take considerable time to implement, will require a major
                           reworking of some fundamental IRS computer systems, and could impose
                           some additional burden on third parties.



                           27
                            GAO-09-815.
                           28
                            GAO, Taxpayer Account Strategy: IRS Should Finish Defining Benefits and Improve
                           Cost Estimates, GAO-11-168 (Washington, D.C.: Mar. 24, 2011).




                           Page 11                                                                 GAO-12-651T
Leveraging External        Another way IRS may be able to reduce the tax gap is by leveraging
Resources Such as Paid     external resources.
Tax Return Preparers and
                           •     Paid tax return preparers prepare approximately 60 percent of all tax
Whistleblowers                   returns filed, and IRS has acknowledged that paid preparers’ actions
                                 have an enormous impact on its ability to administer tax laws
                                 effectively. Based in part on our work and recommendations, IRS
                                 recently developed new requirements for paid preparers, such as
                                 competency testing, which it has concluded will increase tax
                                 compliance. 29 IRS’s goals for the program include leveraging
                                 relationships with paid preparers and improving the accuracy of the
                                 tax returns they prepare.
                           •     Tax whistleblowers can help improve tax compliance by providing
                                 information to IRS on others’ suspected tax noncompliance. We have
                                 made several recommendations for IRS to improve its whistleblower
                                 program through enhanced data collection and whistleblower claim
                                 processing timeliness. 30 According to IRS, it is in the process of
                                 implementing these recommendations.

Modernizing Information    Modernization of IRS’s information systems could improve taxpayer
Systems                    compliance. IRS is engaged in a multiyear effort to replace the systems it
                           uses to process individual tax returns and receive electronically filed tax
                           returns. 31 IRS had identified various compliance benefits to replacing the
                           system it uses to process individual tax returns, including increasing
                           taxpayer and paid preparer voluntary compliance and examination case
                           selection. 32 Among other benefits, replacing its electronic filing system will
                           allow IRS to accept taxpayers’ prior-year returns and portable document
                           format (PDF) files attached to their tax returns. According to IRS officials,


                           29
                             GAO, Tax Preparer Regulation: IRS Needs a Documented Framework to Achieve Goal
                           of Improving Taxpayer Compliance, GAO-11-336 (Washington, D.C.: Mar. 31, 2011); Tax
                           Preparers: Oregon’s Regulatory Regime May Lead to Improved Federal Tax Return
                           Accuracy and Provides a Possible Model for National Regulation, GAO-08-781
                           (Washington, D.C.: Aug. 15, 2008); and Internal Revenue Service: Fiscal Year 2009
                           Budget Request and Interim Performance Results of IRS’s 2008 Tax Filing Season,
                           GAO-08-567 (Washington, D.C.: Mar. 13, 2008).
                           30
                             GAO, Tax Whistleblowers: Incomplete Data Hinders IRS’s Ability to Manage Claim
                           Processing Time and Enhance External Communication, GAO-11-683 (Washington, D.C.:
                           Aug. 10, 2011).
                           31
                               GAO-12-176.
                           32
                               GAO-11-168.




                           Page 12                                                                 GAO-12-651T
                           posting more comprehensive information from individual income tax
                           returns to its computer systems could facilitate the examination process,
                           expedite taxpayer contacts for faster resolution, and potentially better
                           define specific tax gap issues. 33


Simplifying the Tax Code   Tax code complexity can lead to noncompliance. Efforts to simplify or
or Fundamental Tax         reform the tax code may help reduce the tax gap by making it easier for
Reform                     individuals and businesses to understand and voluntarily comply with
                           their tax obligations. For example, eliminating or combining tax
                           expenditures, such as exemptions, deductions, and credits, could help
                           taxpayers reduce unintentional errors and limit opportunities for tax
                           evasion.

                           Policymakers may find it useful to compare any proposed changes to the
                           tax code based on a set of widely accepted criteria for assessing
                           alternative tax proposals. These criteria include the equity, or fairness, of
                           the tax system; the economic efficiency, or neutrality, of the system; and
                           the simplicity, transparency, and administrability of the system. These
                           criteria can sometimes conflict, and the weight one places on each
                           criterion will vary among individuals. Our publication, Understanding the
                           Tax Reform Debate: Background, Criteria, & Questions, may be useful in
                           guiding policymakers as they consider tax reform proposals. 34

                           Our recent reports show how changing tax laws to include more
                           consistent definitions across tax provisions could help taxpayers more
                           easily understand and comply with their obligations.

                           •    For example, higher education expenses that qualify for some of the
                                savings and credit provisions in the tax code differ by provision. These
                                dissimilar definitions require that taxpayers keep track of expenses




                           33
                             GAO, Tax Administration: 2007 Filing Season Continues Trend of Improvement, but
                           Opportunities to Reduce Costs and Increase Tax Compliance Should be Evaluated,
                           GAO-08-38 (Washington, D.C.: Nov. 15, 2007).
                           34
                            GAO, Understanding the Tax Reform Debate: Background, Criteria, & Questions,
                           GAO-05-1009SP (Washington, D.C.: September 2005).




                           Page 13                                                                  GAO-12-651T
                           separately, applying some expenses to some tax preferences but not
                           others. 35
                      •    Likewise, more clarity would help taxpayers determine how to treat
                           certain financial derivative products for tax purposes. Unique
                           characteristics of financial derivatives make them particularly difficult
                           for the tax code and IRS to address. Deferring gains or accelerating
                           losses, changing ordinary income into capital gains or vice versa for
                           losses, and altering the source of gains to avoid withholding taxes are
                           examples of inconsistent tax rules for financial derivatives resulting in
                           equivalent economic outcomes being taxed differently. 36

                      Identity theft creates problems for both taxpayers and IRS. In refund fraud
Challenges to         cases, an identity thief uses a legitimate taxpayer’s identity to fraudulently
Addressing Identity   file a tax return and claim a refund during the filing season. In these
                      cases, the identity thief typically uses a stolen Social Security Number
Theft                 (SSN) to file a forged tax return and obtain a refund early in the filing
                      season. The legitimate owner of the SSN may not be aware that this has
                      occurred until he or she files a tax return later in the filing season and IRS
                      discovers that two returns have been filed using the same SSN. In this
                      instance, the legitimate taxpayer’s refund will likely be frozen until IRS
                      can determine the legitimate owner of the SSN. 37

                      In our June 2011 testimony before this subcommittee, we reported that
                      IRS faced various challenges in resolving, detecting, and preventing
                      identity theft. These challenges included limitations in coordinating with
                      other agencies and taxpayers because of privacy and other laws, inability




                      35
                        GAO, Student Aid and Postsecondary Tax Preferences: Limited Research Exists on
                      Effectiveness of Tools to Assist Students and Families through Title IV Student Aid and
                      Tax Preferences, GAO-05-684 (Washington, D.C.: July 29, 2005).
                      36
                        GAO, Financial Derivatives: Disparate Tax Treatment and Information Gaps Create
                      Uncertainty and Potential Abuse, GAO-11-750 (Washington, D.C.: Sept. 20, 2011).
                      37
                        Identity theft may also involve employment fraud. This occurs when an identity thief uses
                      someone else’s name and SSN to obtain a job. In this instance, IRS would receive a Form
                      W-2 or a Form 1099 reporting income on the taxpayer’s account, which the rightful owner
                      of the SSN had not earned and does not report as income to IRS. As a result, the
                      taxpayer may be subject to enforcement action when, during the filing process, IRS
                      matches what the employer and the taxpayer report and it appears that he or she earned
                      more income than was reported on his or her tax return.




                      Page 14                                                                       GAO-12-651T
                   to detect suspicious cases until after fraud has occurred, and the lack of
                   resources and authority to investigate and prosecute identity thieves. 38

                   Addressing these challenges will require significant, long-term changes in
                   IRS’s operations and systems. As previously discussed, the
                   Commissioner’s long-term vision to increase up-front compliance
                   activities could help. For example, matching employer information with tax
                   returns before refunds are issued could prevent identity thieves from
                   using phony W-2s to claim fraudulent refunds. However, significant
                   changes would be needed before this matching could occur. Third-party
                   information returns would need to be filed with IRS earlier in the filing
                   season. 39 IRS would also need to improve its automated processing
                   systems; IRS’s current Customer Account Data Engine (CADE 2) effort is
                   one key step. 40


                   Chairman Platts, Ranking Member Towns, and Members of the
                   Subcommittee, this completes my prepared statement. I would be
                   pleased to respond to any questions that you may have at this time.


                   If you or your staff have any questions about this testimony, please
GAO Contacts and   contact me at (202) 512-9110 or whitej@gao.gov. Contact points for our
Staff              Offices of Congressional Relations and Public Affairs may be found on
                   the last page of this statement. GAO staff who made key contributions to
Acknowledgements   this testimony are listed in appendix II.




                   38
                    GAO, Tax Administration: IRS Has Implemented Initiatives to Prevent, Detect, and
                   Resolve Identity Theft-Related Problems, but Needs to Assess Their Effectiveness,
                   GAO-09-882 (Washington, D.C.: Sept. 8, 2009), and GAO-11-721T.
                   39
                     Many information returns, such as forms W-2 filed by employers, are not due to the
                   government until the end of February.
                   40
                    GAO-11-18.




                   Page 15                                                                     GAO-12-651T
Appendix I: 2006 Tax Gap Estimate Data and
              Appendix I: 2006 Tax Gap Estimate Data and
              Methodology



Methodology

              The Internal Revenue Service’s (IRS) tax gap estimates are based on a
              variety of data sources and methodologies. For example, IRS studied
              individual taxpayer compliance through the National Research Program
              (NRP) and used the resulting compliance data to estimate the tax gap for
              individual income tax underreporting and the portion of employment tax
              underreporting attributed to self-employment taxes for tax year 2006.

              The 2006 Individual NRP involved auditing a random selection of about
              13,000 to 14,000 individual tax returns and is much smaller than the tax
              year 2001 Individual NRP of approximately 45,000 returns. Starting with
              the 2006 Individual NRP compliance study, IRS is using a rolling sample,
              which will combine samples across three years. According to IRS, this
              change will reduce cost and provide more up to date compliance data.
              The sample design for the 2006 Individual NRP included 11 primary
              strata, which were based on the examination classes used in audit
              workload selection. Also, the 2006 Individual NRP was designed to
              oversample returns with business income reported on Schedule C, E, or
              F or Form 2106.

              The individual underreporting gap for tax year 2006 was based on
              findings from the 2006 Individual NRP and from an econometric analysis
              of tax year 2001 NRP data. This econometric analysis, called Detection-
              Controlled Estimation (DCE), attempts to account for income that
              taxpayers do not report on their tax returns and that NRP auditors could
              not detect. Because insufficient NRP data has been accumulated for tax
              year 2006 and later years for full DCE analysis, an improved DCE was
              undertaken using tax year 2001 NRP data and adjusted using other
              information to estimate undetected income for tax year 2006 NRP returns.

              We have not verified the accuracy of IRS’s estimate of the tax gap.
              According to IRS, a significant portion of IRS’s 2006 tax gap estimate is
              based on recent compliance data and improved estimation methods.
              However, the tax gap estimate continues to be incomplete and partly
              based on older data. For example, the underreporting estimates for both
              FICA and unemployment taxes are projections based on applying the
              estimated compliance rates for 1984 to currently reported taxes.

              To estimate the 2006 individual nonfiling gap, IRS used tax year 2005
              third-party information returns, rather than the Census Exact Match study,
              as it did for the tax year 2001 estimate. The underpayment component of
              the tax gap is not an estimate but rather represents the actual tax
              amounts that taxpayers reported on time, but did not pay on time.



              Page 16                                                         GAO-12-651T
Appendix II: GAO Contact and Staff
                  Appendix II: GAO Contact and Staff
                  Acknowledgments



Acknowledgments

                  James R. White, (202) 512-9110 or whitej@gao.gov
GAO Contact
                  In addition to the contact named above, Jeff Arkin, Assistant Director;
Staff             Elizabeth Fan, Analyst-in-Charge; David Lewis; Karen O’Conor; and
Acknowledgments   Sonya Vartivarian made key contributions to this report. Gregory Borecki,
                  Shannon Finnegan, Tom Gilbert, Lois Hanshaw, Ed Nannenhorn, Jeff
                  Niblack, Jeff Schmerling, and Joanna Stamatiades also provided valuable
                  assistance.




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                  Page 17                                                        GAO-12-651T
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