oversight

Tax Gap: IRS Could Significantly Increase Revenues by Better Targeting Enforcement Resources

Published by the Government Accountability Office on 2012-12-05.

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

                United States Government Accountability Office

GAO             Report to Congressional Requesters




                TAX GAP
December 2012




                IRS Could
                Significantly Increase
                Revenues by Better
                Targeting
                Enforcement
                Resources




GAO-13-151
                                           December 2012

                                           TAX GAP
                                           IRS Could Significantly Increase Revenues by Better
                                           Targeting Enforcement Resources
Highlights of GAO-13-151, a report to
congressional requesters




Why GAO Did This Study                     What GAO Found
Heightened attention to federal deficits   The Internal Revenue Service (IRS) spends most of its enforcement resources
has increased pressure on IRS to           on examinations. Correspondence exams of individual tax returns, which target
reduce the tax gap—the difference          fewer and simpler compliance issues, are significantly less costly on average
between taxes owed and taxes paid on       than the broader and more complex field exams. GAO estimated that the
time—and better enforce taxpayer           average cost (including overhead) of correspondence exams opened in 2007 and
compliance. Resource limitations and       2008 was $274, compared to an average of $2,278 for field exams. IRS spent
concern over taxpayer burden,              almost 20 percent of the $1.6 billion per year that it devoted to exams on returns
however, prevent IRS from auditing         from taxpayers with positive income of at least $200,000, even though such
more than a small fraction of individual
                                           returns accounted for only 3 percent of the 136 million individual returns filed per
income tax returns filed. How IRS
                                           year. (Positive income, a measure that IRS uses to classify returns for exam
allocates these limited resources
demands careful consideration.
                                           planning purposes, disregards losses that may offset this income).

As requested, this report (1) describes    GAO estimated that, for the 2 years of cases reviewed, correspondence exams
how IRS allocates resources across         were significantly more productive in terms of direct revenue produced per dollar
individual taxpayer compliance             of cost than field exams. As shown in the figure below, both types of exams of
enforcement programs and across            taxpayers with positive incomes of at least $200,000 were significantly more
types of taxpayers within each             productive than exams of lower-income taxpayers.
program; (2) estimates the direct
                                           Direct Revenue Return on Investment for Different Types of Exams and Groups of Individual
revenue return on investment for the
                                           Income Tax Returns Opened in 2007 and 2008
individual taxpayer enforcement
programs and the extent of variation
across those programs and across
types of taxpayers; and (3) determines
the potential for gains from shifting
resources from lower-yielding
programs and types of taxpayers to
higher-yielding ones.
To accomplish these objectives GAO
analyzed IRS data on 2007 and 2008
tax returns, reviewed IRS
documentation, and interviewed
appropriate IRS officials.

What GAO Recommends
GAO recommends that IRS review
disparities in the ratios of direct        Note: EITC is the earned income tax credit
revenue yield to costs across different    GAO demonstrated how these estimates could be used to inform resource
enforcement programs and across            allocation decisions. For example, a hypothetical shift of a small share of
different groups of cases and consider     resources (about $124 million) from exams of tax returns in less productive
this evidence as a potential basis for     groups shown in the figure to exams in the more productive groups could have
adjusting its allocation of enforcement    increased direct revenue by $1 billion over the $5.5 billion per year IRS actually
resources each year. IRS agreed with
                                           collected (as long as the average ratio of direct revenue to cost for each category
the recommendations.
                                           of returns did not change). These gains would recur annually, relative to the
                                           revenue that IRS would collect if it did not change its resource allocation. This
                                           particular resource shift would not reduce exam coverage rates significantly and,
View GAO-13-151. For more information,     therefore, should have little, if any, negative effect on voluntary compliance.
contact James White at (202) 512-9110 or
whitej@gao.gov

                                                                                        United States Government Accountability Office
Contents


Letter                                                                                 1
               Background                                                              3
               Examinations of Taxpayers with Less than $200,000 in Positive
                 Income Accounted for Most of the Total Cost of the Four
                 Enforcement Programs                                                  6
               Direct Revenue Return on Investment Was Highest for
                 Examinations of Taxpayers with at Least $200,000 in Positive
                 Income                                                                8
               Although Some Caution is Warranted, Exam Resource Reallocation
                 Could Produce Significant Direct Revenue Gains                       10
               Conclusions                                                            15
               Recommendations                                                        16
               Agency Comments                                                        16

Appendix I     Summary Methodology for Data Analysis                                 18



Appendix II    Detailed Tables                                                       21



Appendix III   Economic Guidelines for Enforcement Resource Allocation
               Decisions                                                             24



Appendix IV    Comments from the Internal Revenue Service                            26



Appendix V     GAO Contact and Staff Acknowledgments                                 28



Tables
               Table 1: Costs, Direct Revenue, Exam Coverage Rates and No-
                        Change Rates for Different Types and Groups of Exams
                        Opened In Fiscal Years 2007 and 2008 (Weighted Average
                        of the 2 Years)                                               21
               Table 2: Potential Changes in Direct Revenue and Exam Coverage
                        Rates Resulting from a Hypothetical Reallocation of Exam
                        Resources                                                     22


               Page i                                                  GAO-13-151 Tax Gap
          Table 3: Ratios of Direct Revenue to Cost for Field Exams Opened
                   in 2007 and 2008 after Accounting for Various Factors         23


Figures
          Figure 1: Cost Shares and Cost per Case for Four Exam and IRP
                   Programs for Cases Opened in Fiscal Years 2007 and 2008        7
          Figure 2: Number of Returns, Exam Costs, and Coverage Rates for
                   Different Categories of Individual Income Taxpayers            8
          Figure 3: Ratios of Direct Revenue to Costs for Different Types of
                   Exams and Groups of Individual Income Tax Returns for
                   Cases Opened in Fiscal Years 2007 and 2008                     9
          Figure 4: Changes in Resources and Direct Revenue for Different
                   Groups of Individual Income Tax Exams under a
                   Hypothetical Reallocation                                     11
          Figure 5: Coverage Rates for Different Types of Exams and Groups
                   of Individual Income Tax Returns Before and After
                   Hypothetical Reallocation                                     13




          Page ii                                                 GAO-13-151 Tax Gap
Abbreviations

AIMS              Audit Information Management System
ASFR              Automated Substitute for Return
AUR               Automated Underreporter
EITC              earned income tax credit
ERIS              Enforcement Revenue Information System
IFS               Integrated Financial System
IRP               Information Returns Processing
IRS               Internal Revenue Service
NRP               National Research Program
SB/SE             Small Business/Self-Employed
W&I               Wage and Investment



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Page iii                                                              GAO-13-151 Tax Gap
United States Government Accountability Office
Washington, DC 20548




                                   December 5, 2012

                                   The Honorable Max Baucus
                                   Chairman
                                   The Honorable Orrin Hatch
                                   Ranking Member
                                   Committee on Finance
                                   United States Senate

                                   The Honorable Charles Grassley
                                   Ranking Member
                                   Committee on the Judiciary
                                   United States Senate

                                   Heightened attention to federal deficits has increased pressure on the
                                   Internal Revenue Service (IRS) to reduce the tax gap—the difference
                                   between taxes owed and taxes paid on time—and better enforce taxpayer
                                   compliance. Resource limitations and interest in minimizing taxpayer
                                   burden, however, prevent IRS from auditing anything but a small fraction
                                   of the total number of individual income tax returns filed for a given tax
                                   year. Of the approximately 141 million individual tax returns filed in 2010,
                                   only 1.1 percent were formally audited. IRS has developed several
                                   compliance enforcement programs with the goal of increasing taxpayer
                                   compliance, using resources more efficiently, and minimizing taxpayer
                                   burden. These programs, which include computer-based matching
                                   systems and streamlined correspondence audits (which do not involve
                                   face-to-face meetings with taxpayers) designed for less complex issues,
                                   fill different roles in the compliance enforcement strategy. Every year IRS
                                   publishes information regarding the coverage rates and additional taxes
                                   assessed through these various programs, but relatively little information
                                   is available on how much revenue is actually collected as a result of these
                                   enforcement activities (called direct revenue). Even less information is
                                   available regarding program performance with respect to identifiable
                                   subpopulations (varying in terms of income levels, and types of income)
                                   covered by the enforcement programs.

                                   Given the importance of appropriately allocating limited resources, you
                                   asked us to assess the performance of IRS’s enforcement programs. In
                                   this report we (1) describe how IRS allocates resources across individual
                                   taxpayer compliance enforcement programs and across types of
                                   taxpayers within each program; (2) estimate the direct revenue return on
                                   investment for the individual taxpayer compliance enforcement programs


                                   Page 1                                                    GAO-13-151 Tax Gap
and the extent of variation across those programs and across types of
taxpayers; and (3) determine the potential for gains from shifting
resources from lower-yielding programs and types of taxpayers to higher-
yielding ones.

To describe how IRS allocates resources across individual taxpayer
compliance enforcement programs and across types of taxpayers within
each program, we compared the amounts of resources that IRS devotes
to each of four broad enforcement programs for individuals who file form
1040 tax returns—Automated Underreporter (AUR), Automated
Substitute for Return (ASFR), correspondence examination, and field
examination. 1 These programs are described below in the background
section. We also report the cost of cases worked and the percentage of
total returns covered by correspondence and field exam programs. For
the correspondence and field exam programs, we make these
comparisons across the principal groups of individual taxpayers (defined
in terms of positive income size and characteristics of their returns, such
as the presence of the earned income tax credit (EITC)) that IRS uses for
exam planning purposes. 2 We use program cost data obtained from IRS’s
Integrated Financial System (IFS) and data on the number of cases from
IRS’s Enforcement Revenue Information System (ERIS). We also use
data on coverage rates from IRS’s Data Book. 3 Our analyses to support
all three of our objectives cover enforcement cases opened in fiscal years
2007 and 2008 (the latest years of data available at the time of our
analysis in which the large majority of cases have worked their way
through the collection process). 4




1
 We exclude the Math Error program from our detailed review because it covers
100 percent of tax returns filed and, therefore, does not involve the same types of
resource allocation decisions that are relevant to the other programs.
2
 In general, total positive income is the sum of all positive amounts shown for the
various sources of income reported on the individual tax return and, thus,
excludes losses.
3
Internal Revenue Service, Data Book, 2009, Publication 55B, Washington, DC,
March 2010, and Data Book, 2008, March 2009.
4
 Although IRS typically reports enforcement data according to the fiscal year in
which cases are closed, we report our results according to the fiscal year in
which the cases were opened because that better reflects the populations of
cases that IRS targeted in their annual exam planning process.




Page 2                                                          GAO-13-151 Tax Gap
             To estimate the direct revenue return on investment for the individual
             taxpayer compliance enforcement programs, we obtained data from ERIS
             on collections of tax, interest, and penalties directly attributable to specific
             types of exams for different groups of taxpayers, as well as those
             attributable to AUR and ASFR cases. We also obtained cost data from
             IFS for these four programs. For the field exam program, available data
             allow us to incorporate differences in the length, difficulty, and location of
             audits into our cost comparisons. Our return on investment measure is
             computed as the ratio of revenues over costs with the value of the
             revenues discounted for any delays between the year in which IRS
             expended the money on the enforcement cases and the year in which the
             revenues were collected.

             To determine the potential for gains from shifting resources from lower-
             yielding programs and types of taxpayers to higher-yielding ones, we use
             our results from the second objective to demonstrate how modest
             reallocations of resources would affect total collections, assuming that
             additional cases examined in a particular group would be approximately
             as productive as the average case in that group. We also interviewed IRS
             officials and reviewed the technical literature on tax enforcement to
             identify factors beyond the direct revenue return on investment that IRS
             should consider when making adjustments to its resource allocations.

             We determined for the purposes of this review that the data used were
             reliable. (See app. I for additional information about our methodology.)
             We conducted this performance audit from November 2009 through
             December 2012 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.


             In January 2012, IRS estimated that the gross tax gap—the difference
Background   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. The tax gap has been a persistent problem in
             spite of extensive congressional and IRS efforts to reduce it. In past work
             we have said that 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. On the


             Page 3                                                        GAO-13-151 Tax Gap
                           enforcement front, IRS’s efforts to ensure compliance of individual
                           taxpayers combine several distinct programs that collectively monitor and
                           correct noncompliance with income tax filing, reporting, and payment
                           requirements. These programs fill different roles in the enforcement
                           process and vary in the number of taxpayers covered, the resources
                           used, and their level of automation.

Math Error Program:        IRS’s Math Error program electronically checks all filed tax returns for
                           obvious math errors as returns are processed. The Math Error program
                           reviews and adjusts items specifically listed in Internal Revenue Code
                           section 6213. The specific issues that the program has authority to review
                           include calculation errors, entries that are inconsistent with or exceed
                           statutory limits, various omissions, inclusions, and entries of information,
                           or incorrect use of an IRS table.

Automated Underreporter    IRS collects information on taxpayers from employers, financial
Program:                   institutions, and other third parties and compiles these data in the
                           Information Returns Processing (IRP) system. The Automated
                           Underreporter (AUR) program electronically matches the IRP data
                           against the information that taxpayers report on their forms 1040 as a
                           means of identifying potentially underreported income or unwarranted
                           deductions or tax credits. The matching process takes place months after
                           taxpayers have filed their tax returns. For tax year 2010, AUR identified
                           approximately 23.8 million potential discrepancies between taxpayer
                           income, deduction, and other information reported by third parties and the
                           information supplied by taxpayers on their individual income tax returns.
                           IRS officials said that resource constraints prevent them from contacting
                           taxpayers for all of the cases in which discrepancies are identified. If a
                           mismatch exceeds a certain tax threshold, AUR reviewers decide if it
                           warrants a notice to the taxpayer asking for an explanation of the
                           discrepancy or payment of any additional tax assessed. IRS guidance
                           directs reviewers to consider the reasonableness of the taxpayers’
                           responses, but reviewers generally do not examine the accuracy of the
                           information in the responses because they do not have examination
                           authority. For certain issues, AUR reviewers may refer cases for a
                           correspondence examination.

Automated Substitute for   The Automated Substitute for Return (ASFR) program uses data from the
Return Program:            IRP system to identify persons who did not file returns, construct tax
                           returns for certain nonfilers, and assess tax, interest, and penalties based
                           on those substitute returns. IRS does not pursue all of the constructed
                           returns. Potential cases fall into one of ten priority levels and are worked
                           highest-priority first. ASFR officials said they make budget decisions by


                           Page 4                                                     GAO-13-151 Tax Gap
                               taking into account the resources available to the program and determine
                               the level of new cases that will be worked over the following year. In fiscal
                               year 2011, the ASFR program closed nearly 1.4 million cases.

Correspondence Examinations:   Correspondence examinations are formal audits of individual taxpayers
                               but do not involve face-to-face meetings with taxpayers. Instead, these
                               examinations target specific issues that are limited in scope and
                               complexity, easily documented, and can be handled quickly and efficiently
                               through correspondence between the taxpayer and the IRS examiner.
                               Tax returns are selected as potential cases through automated business
                               rules that filter or select tax returns according to predetermined criteria.
                               These business rules can detect multiple potential issues, all of which can
                               be worked through a single correspondence exam. Examiners have the
                               authority to review additional issues on a return even if they were not
                               identified by the automatic filters.

Field Examinations:            Field examinations are conducted in face-to-face meetings between the
                               taxpayer and the IRS examiner. These audits are targeted at individual
                               returns with broader and more complex issues. Unlike correspondence
                               examinations, the field examination program has a classification process
                               where an experienced tax examiner will review a potential case to
                               determine which, if any, issues should be examined. Individual tax returns
                               are selected for field examination in a variety of ways. Some returns are
                               selected in the pursuit of specifically identified compliance issues, such as
                               abusive transactions or offshore compliance. Others are selected on the
                               basis of a statistical formula that attempts to predict the potential for
                               additional tax assessments, and yet others are selected randomly for
                               research purposes. Regardless of why the return was initially selected for
                               audit, an examiner will review the return in its entirety to determine if other
                               issues are present.

                               The responsibility for operating these individual taxpayer enforcement
                               programs largely rests with IRS’s Small Business/Self-Employed (SB/SE)
                               Division, which handles complex individual returns, and Wage and
                               Investment (W&I) Division, which handles simpler returns. SB/SE
                               operates parts of all four IRP and exam programs; W&I operates parts of
                               three programs, excluding field examinations.




                               Page 5                                                       GAO-13-151 Tax Gap
Examinations of
Taxpayers with Less
than $200,000 in
Positive Income
Accounted for Most of
the Total Cost of the
Four Enforcement
Programs

Most IRS Enforcement     Correspondence and field exams accounted for more than 80 percent of
Resources are Spent on   the total administrative costs of the four programs we reviewed over the
Examinations             2-year period we examined. (Total costs include direct examination time,
                         training and other offline activities of examiners, supervisory and
                         administrative support, and other overhead costs allocable to each
                         program.) Based on data for hourly costs and time spent on different
                         types of cases that IRS provided, we estimated that the cost per case for
                         field exams, $2,278, was many times greater than those for
                         correspondence exams, $274, AUR, $52, and ASFR, $72. (See fig. 1.)




                         Page 6                                                   GAO-13-151 Tax Gap
                            Figure 1: Cost Shares and Cost per Case for Four Exam and IRP Programs for
                            Cases Opened in Fiscal Years 2007 and 2008




                            Note: Dollar figures have been adjusted for inflation to 2011 dollars using the GDP deflator.



High-Income Taxpayers       IRS spent almost 20 percent of the $1.6 billion per year that it devoted to
Representing 3 Percent of   exams opened in 2007 and 2008 on returns with positive income of at
Returns Filed Accounted     least $200,000, even though such returns accounted for only 3 percent of
                            the 136 million individual income tax returns filed per year. 5 The share of
for Almost 20 Percent of    total cost for these returns was greater than their share of total returns
Total Exam Costs            because they were examined at above average rates and, compared to
                            lower-income returns, field exams were a greater proportion of their
                            examinations. (See fig. 2.)




                            5
                             Exams opened in 2007 and 2008 were generally filed in 2006 and 2007.




                            Page 7                                                                          GAO-13-151 Tax Gap
Figure 2: Number of Returns, Exam Costs, and Coverage Rates for Different Categories of Individual Income Taxpayers




                                        Note: Dollar figures have been adjusted for inflation to 2011 dollars using the GDP deflator.



                                        For the 2 years of cases we reviewed, exams (both correspondence and
Direct Revenue                          field) of taxpayers with positive incomes of at least $200,000 produced
Return on Investment                    significantly more direct revenue per dollar of cost than exams of lower-
                                        income taxpayers. Across income groups, correspondence exams were
Was Highest for                         significantly more productive than field exams in terms of discounted
Examinations of                         direct revenue per dollar of cost. (See fig. 3 and table 1 in app. II.) We
                                        estimated that the average direct revenue yield per dollar of cost across
Taxpayers with at                       all correspondence exams of individual taxpayers was $7. In contrast, the
Least $200,000 in                       average direct yield per dollar for field exams of individual taxpayers was
                                        $1.8. We also estimated that the direct revenue per dollar of cost was
Positive Income                         about $22 for AUR cases and about $31 for ASFR cases.




                                        Page 8                                                                          GAO-13-151 Tax Gap
Figure 3: Ratios of Direct Revenue to Costs for Different Types of Exams and Groups of Individual Income Tax Returns for
Cases Opened in Fiscal Years 2007 and 2008




                                         Note: Dollar figures have been adjusted for inflation to 2011 dollars using the GDP deflator. Direct
                                         revenue has been discounted over the gap between the year in which IRS incurred the exam costs
                                         and the year in which the revenue was collected.


                                         Exams that are more complicated than average are likely to require both
                                         more time to complete and more highly skilled examiners, who cost more
                                         per hour. In estimating the results for field exams in figure 3, we
                                         incorporated differences in the amount of time spent on each field exam,
                                         which is recorded in the ERIS database, but we did not account for
                                         differences in hourly costs relating to varying skill levels of examiners
                                         across cases because the data available for that purpose were limited. 6
                                         Nevertheless, to test the potential sensitivity of our results to this missing


                                         6
                                          According to IRS officials, the ERIS data relating to time spent on
                                         correspondence exams are not reliable for our purposes. On their advice, given
                                         that neither the time spent on 1040 correspondence exams nor the skill level of
                                         examiners typically vary significantly from case to case, we used the same cost
                                         estimate for all cases, which IRS provided to us.




                                         Page 9                                                                         GAO-13-151 Tax Gap
                               factor, we estimated an alternative set of field exam results, using an
                               ERIS data element that reflects the expected difficulty of an exam. We
                               also tested the effect of differences in locality pay for field examiners in
                               different geographic locations. (See app. I for further details.) We found
                               that adjusting for skill levels likely reduces some of the differences in
                               direct revenue per dollar of cost across field exam categories; adjusting
                               for location has a negligible effect. (See table 3 in app. II.) IRS would be
                               able to estimate ratios of direct revenue to cost that better incorporate
                               differences in the hourly costs across examiners with different skill levels
                               if data from IRS’s timekeeping system that records the number of hours
                               that each employee charged to specific exam cases were matched to
                               revenue data for the same cases.



Although Some
Caution is Warranted,
Exam Resource
Reallocation Could
Produce Significant
Direct Revenue Gains

Modest Reallocations           Our analysis of a hypothetical reallocation of IRS examination resources
Might Raise Billions of        for this 2-year period indicates that a shift of about $124 million in
Dollars in Direct Revenue      enforcement resources could have increased direct revenue by $1 billion
                               over the $5.5 billion per year IRS actually collected. This result is based
with Little, If Any, Decline   on shifting the $124 million from exams of lower-income returns with the
in Voluntary Compliance        earned income tax credit (EITC) and lower-income business returns
                               without EITC to exams of higher-income returns and lower-income
                               nonbusiness returns without EITC. The result holds true as long as the
                               average ratio of direct revenue to cost for each category of returns
                               remained unchanged. 7 (See fig. 4.) Similar gains would recur annually,



                               7
                                The results presented in figure 4 and table 2 in appendix II are based on our
                               estimates of direct revenue to cost from table 1. If, alternatively, we used the
                               ratios for field exams that incorporate the adjustments for difficulty (from table 3)
                               the direct revenue yield of our hypothetical reallocation would be about $900
                               million.




                               Page 10                                                           GAO-13-151 Tax Gap
                                        relative to the revenue that IRS otherwise would collect if it did not
                                        change its resource allocation and taxpayer behavior remained
                                        substantially the same.

Figure 4: Changes in Resources and Direct Revenue for Different Groups of Individual Income Tax Exams under a
Hypothetical Reallocation




                                        Notes: Negative amounts show resources taken away and corresponding revenue lost while positive
                                        amounts show increases. Dollar figures have been adjusted for inflation to 2011 dollars using the
                                        GDP deflator. Direct revenue has been discounted over the gap between the year in which IRS
                                        incurred the exam costs and the year in which the revenue was collected.


                                        We took account of several constraints when designing our hypothetical
                                        resource reallocation example. First, we did not want to suggest a large-
                                        scale change because some reallocations cannot be made quickly,
                                        particularly if they require a different distribution of examiner skills than
                                        exists in IRS’s current workforce. The $124 million that we shifted
                                        represents less than 8 percent of the $1.6 billion per year that IRS
                                        devoted to examinations of individual tax returns for the 2 years we
                                        studied and we shifted less than 5 percent of existing field exam




                                        Page 11                                                                     GAO-13-151 Tax Gap
resources ($1.1 billion per year) to correspondence exams. 8 Second, we
did not want to end up with extreme coverage rates (either high or low) in
any return category. Therefore, we did not reduce the combined coverage
rate for any category for which the coverage rate was already close to or
below 1 percent, and we kept the highest coverage rate (for returns with
positive incomes of $1 million or more) under 11 percent. 9 (Nevertheless,
that 11 percent rate is almost twice the current rate for that category.)
Finally, given that certain compliance issues can be reviewed effectively
only through a field exam, we did not decrease field exam resources in
any return category for which we increased correspondence exam
resources.

Exam resource reallocation can also affect tax collections indirectly by
influencing the voluntary compliance of nonexamined taxpayers. These
indirect effects are difficult to estimate and IRS has no empirical evidence
that would allow it to say whether overall voluntary compliance would
increase or decrease as a result of specific resource reallocations.
Changes in exam coverage rates are generally believed to affect
voluntary compliance by altering taxpayers’ perceived risks of being
audited. The higher the risk of being audited, the less inclined taxpayers
are to evade taxes. As shown in figure 5, our hypothetical reallocation
would have increased combined coverage rates in most of the tax return
categories we examined. For those categories in which coverage rates
declined, the declines were relatively modest. For these reasons we
believe that the direct revenue gains associated with our hypothetical
reallocation would not likely be offset by significant indirect revenue
losses. However, if larger resource allocations were considered, the lack
of empirical evidence on the potential changes in voluntary compliance
could leave IRS uncertain of the extent to which direct revenue gains
might be offset by negative indirect revenue effects. Although research on
this issue is challenging, IRS might be able to leverage its existing efforts
to study voluntary compliance through the National Research Program
(NRP) to get better information on the influence of enforcement activity on
voluntary compliance.




8
 See table 1 in appendix II for details of the existing allocation across groups and
table 2 for details on the reallocations.
9
 The combined coverage rate equals the number of correspondence and field
exams for a particular group, divided by the number of returns filed by that group.




Page 12                                                          GAO-13-151 Tax Gap
Figure 5: Coverage Rates for Different Types of Exams and Groups of Individual Income Tax Returns Before and After
Hypothetical Reallocation




Consideration of                        Our analysis focused upon ratios of average direct revenue to average
Additional Factors Could                cost. We did not incorporate other potentially important considerations
Improve Upon Allocation                 due to data constraints. One such consideration is the extent to which the
                                        ratio of direct revenue per dollar of cost may decline for a particular
Decisions that are Based                category of exams as additional resources are devoted to that category.
Solely on Ratios of                     The revenue yield of each additional return that IRS exams within a
Average Direct Revenue to               particular return category may be lower than the average revenue-
Costs                                   productivity rates we estimated, particularly if IRS’s return selection
                                        process for examinations results in returns with the greatest revenue
                                        potential being worked first and those with the least potential being
                                        worked last. Little is known about the relationship between marginal and
                                        average revenue and cost within specific return categories because IRS




                                        Page 13                                                        GAO-13-151 Tax Gap
currently does not identify the marginal cases worked each year. 10 Until
IRS collects some information on marginal cases, such as how the broad
characteristics of those returns that would likely be selected (or not
selected) in a modest program expansion (or contraction) would differ
from the average return actually audited now, planners would have to rely
solely upon ratios of average direct revenue to average cost—a less
accurate basis for estimating the direct revenue consequences of specific
exam resource allocations.

An analysis of the marginal revenue yields for specific categories of
returns might also enable IRS to reduce the number of audits that result
in no direct change in tax liability (although they may have beneficial
effects on voluntary compliance). These no-change cases impose
burdens on compliant taxpayers. Further, substantial variations across
return categories in the percentage of exams that result in no change
could be viewed as inequitable because compliant taxpayers in some
categories have a greater chance of being burdened than compliant
taxpayers in other categories. No-change rates in some higher-income
return categories are already relatively high, compared to rates for lower-
income categories. For example, the no-change rate for correspondence
exams of tax returns with positive income of $1 million or more was about
53 percent for fiscal years 2007 to 2008. (See table 1 in app. II.)
However, the highest no-change rates are associated with
correspondence exams, which should be less burdensome than field
exams. High no-change rates could also be associated with declining
revenue yields in marginal cases; however, without a specific study of
marginal cases, it is not possible to say whether no-change cases are
concentrated among the last cases examined in a particular category or
whether they are spread relatively evenly across exams worked
throughout the course of the year.



10
  Marginal revenue and cost are those associated with the marginal cases
worked in each return category. The marginal cases are those that would not
have been worked if the resources allocated to a particular category had been
slightly less, as well as those additional cases that would have been worked if the
resources for the category had been slightly greater. Some of IRS’s exam
priorities are related to potential revenue yield; however, IRS also gives high
priority to returns randomly selected for the National Research Program. This
random selection process is important to the research that identifies significant
areas of noncompliance, but it represents one reason to doubt that exam cases
worked lower down the list of IRS’s priorities always have lower returns than
those worked earlier.




Page 14                                                         GAO-13-151 Tax Gap
              Factors other than revenue yields and IRS budget costs also matter for
              purposes of an overall cost-benefit evaluation of IRS exam activities.
              These activities impose compliance costs on taxpayers and economic
              efficiency costs on society. Return categories with low ratios of direct
              revenue to IRS budget costs could have offsetting advantages in terms of
              lower efficiency and compliance costs; however, no empirical evidence of
              variations in these other effects or costs across the return categories
              exists, nor would it be easy to obtain. (See app. III for further discussion
              of these tradeoffs.)


              The results of our analyses suggest that there is potential for IRS to
Conclusions   increase the direct revenue yield of selected enforcement programs by
              hundreds of millions of dollars per year without significant (if any) adverse
              effect on the indirect effect that examinations have on revenues.
              However, our results are preliminary and limited in scope. The collection
              and analysis of additional data would help to both confirm our basic
              conclusion and assist IRS in more finely adjusting its resource allocation
              decisions. One priority would be to study the feasibility of estimating the
              marginal revenue and marginal costs within each program within each
              taxpayer group. It would be helpful, for example, to estimate at least how
              the broad characteristics of those returns that would likely be selected (or
              not selected) in a modest program expansion (or contraction) would differ
              from the average return actually audited now. Such information would
              help IRS assess the extent to which revenue productivity would likely
              decline, if at all, if more exam resources are devoted to a particular group
              of taxpayers. Another useful project would be to see if some linkage could
              be made between the amounts of time that specific examiners spend on
              each case and the revenue collection amounts for each case that are
              recorded in ERIS. Such a link would enable IRS to estimate ratios of
              direct revenue to cost that better incorporate differences in the hourly
              costs across examiners with different skill levels. The collection or
              estimation of other information that would be useful when allocating
              resources, such as the influence of enforcement activity on voluntary
              compliance, is challenging, which is why little is known about those topics
              to date. Nevertheless, IRS might be able to leverage its existing efforts to
              study voluntary compliance through the NRP to get better information on
              the influence of enforcement activity on voluntary compliance.

              In the absence of the additional data identified above, IRS planners can
              use the results of an analysis such as ours in combination with their
              professional judgment to decide whether the potential for direct revenue
              gains more than offsets the potential for reductions in indirect revenue or


              Page 15                                                    GAO-13-151 Tax Gap
                  in equity and any increases in compliance or efficiency costs. If the
                  answer is positive, they can adjust their allocation of resources
                  accordingly. Nevertheless, the better empirical basis IRS planners have
                  for making such judgments, the more confident they can be that they are
                  allocating their limited resources to the best effect.


                  To better ensure that IRS’s limited enforcement resources are allocated in
Recommendations   a manner that maximizes the revenue yield of the income tax, subject to
                  other important objectives of tax administration, such as minimizing
                  compliance costs and ensuring equitable treatment across different
                  groups of taxpayers, the Commissioner of Internal Revenue should:

                  •   review disparities in the ratios of direct revenue yield to costs across
                      different enforcement programs and across different groups of cases
                      within programs and determine whether this evidence provides a
                      basis for adjusting IRS’s allocation of enforcement resources each
                      year.
                  As part of this review, IRS should:

                  •   develop estimates of the marginal direct revenue and marginal direct
                      cost within each enforcement program and each taxpayer group;
                  •   compile data on the amount of time that specific grades of examiners
                      and downstream employees spend on specific categories of exams
                      that can be identified in ERIS; and
                  •   explore the potential of estimating the marginal influence of
                      enforcement activity on voluntary compliance, potentially taking
                      advantage of new NRP data.

                  We requested written comments from the Commissioner of Internal
Agency Comments   Revenue and received a letter from IRS Deputy Commissioner for
                  Services and Enforcement on November 29, 2012, (which is reprinted in
                  app. IV). IRS agreed with our recommendations and agreed that the
                  development of additional key data will require considerable work. In
                  recognition of the time it will take to obtain this information, IRS said it will
                  consider how to apply interim methods, findings, or approximations.


                  As agreed with your offices, unless you publicly announce the contents of
                  this report earlier, we plan no further distribution until 30 days from the
                  report date. At that time, we will send copies to interested congressional
                  committees, the Secretary of the Treasury, the Commissioner of Internal



                  Page 16                                                        GAO-13-151 Tax Gap
Revenue, and other interested parties. In addition, the report also will be
available at no charge on the GAO website at http://www.gao.gov.

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




James R. White
Director, Tax Issues
Strategic Issues




Page 17                                                    GAO-13-151 Tax Gap
Appendix I: Summary Methodology for Data
             Appendix I: Summary Methodology for Data
             Analysis



Analysis

             Our principal analysis compares the costs and direct revenues associated
             with correspondence and field exams that were opened during fiscal
             years 2007 and 2008 across the principal categories of individual
             taxpayers that the Internal Revenue Service (IRS) uses for exam planning
             purposes. These categories, defined in terms of income size and the
             nature of items reported on the returns, are shown in table 1 of
             appendix II.


Exam Costs   IRS provided us with total cost estimates for correspondence exams (with
             and without the earned income tax credit (EITC)) and field exams (with
             and without EITC) from its Integrated Financial System. These total cost
             estimates included all direct examiner costs, training and other off-line
             activities of examiners, supervisory and administrative support, and other
             overhead costs allocable to each program. We estimated hourly costs by
             dividing the total costs by the average examination hours per case, which
             IRS provided for correspondence exams (with and without the earned
             income tax credit (EITC)) and field exams (with and without EITC) from its
             Audit Information Management System (AIMS). 1 These hourly cost
             estimates are adequate for the relatively high-level comparisons we
             present in this report. IRS would be able to make more precise estimates
             for more detailed categories of exams if data from IRS’s timekeeping
             system that records the number of hours that each employee charged to
             specific exam cases were matched to revenue data for the same cases.

             To estimate the cost for each category of field exams we multiplied the
             hourly cost rates by the number of direct hours reported in the
             Enforcement Revenue Information System (ERIS) for each category of
             exam. 2 According to IRS officials the ERIS data relating to time spent on
             correspondence exams is not reliable for our purposes. 3 On their advice,
             given that neither the time spent on 1040 correspondence exams nor the



             1
              IRS provided six separate estimates for the total costs and the average examination
             hours per case—for Wage and Investment correspondence exams of returns with and
             without EITC, for Small Business/Self-Employed (SB/SE) correspondence exams of
             returns with and without EITC, and for SB/SE field exams of returns with and without
             EITC.
             2
              ERIS examination hours data originate in AIMS.
             3
              We determined that ERIS data were sufficiently reliable for other purposes identified in
             this report.




             Page 18                                                                GAO-13-151 Tax Gap
                  Appendix I: Summary Methodology for Data
                  Analysis




                  skill level of examiners typically vary significantly from case to case, we
                  used the same cost estimate for all cases, which IRS provided to us. We
                  restated the costs for each case in terms of 2011 dollars by adjusting for
                  inflation. Due to limitations of the ERIS data our cost estimates do not
                  include any downstream costs that IRS’s Collections function may have
                  devoted to these cases or any costs associated with examinations of
                  pass-through entities that could have improved the productivity of some of
                  these 1040 exams. We do not know whether the prevalence of these
                  missing costs varies significantly across our exam categories; however,
                  we do note that the one category we studied that specifically excluded
                  returns with pass-through income had ratios of revenue to costs that were
                  greater or equal to the ratios for the one category identified as likely to
                  include such returns. 4


Direct Revenues   We aggregated all of the tax, interest, and penalty collections recorded in
                  ERIS for the same fiscal years, exam types, and taxpayer categories
                  used for the cost side of our analysis. We also included amounts of
                  refunds disallowed due to examinations in our definition of revenues.
                  These amounts represent revenue saved for the government, even
                  though IRS does not have to collect it after the exams. 5 We compiled the
                  revenue data for each fiscal year in which the collections were made
                  (through the end of fiscal year 2011) and restated the revenue in terms of
                  2011 dollars by adjusting for inflation. 6 Then we discounted the value of
                  collections over the gap between the fiscal year in which IRS incurred the
                  exam costs (which we estimated as being the midpoint of the exam) and
                  the fiscal year in which the revenue was collected. The purpose of this
                  discounting, which is standard practice for cost-benefit analyses, is to



                  4
                   Returns without schedules C, E, F, or form 2106 contain no pass-through income; returns
                  with schedule E or form 2106 are the most likely to include such income.
                  5
                    One type of revenue savings that we could not include in our analysis due to data
                  limitations was that associated with disallowances of loss or credit carry forwards.
                  Additionally, corrections that IRS examiners make in taxpayers’ favor should also be
                  counted as social benefits arising from the exams because they improve the fairness of
                  the tax system’s application; however, such corrections were not identifiable in IRS’s
                  databases.
                  6
                   Additional collections from these 2007 and 2008 cases could continue to come in after
                  2011, which implies that our ratios of revenue to cost may be slightly understated;
                  however, the vast majority of collections typically are made within two years of exam
                  closures.




                  Page 19                                                             GAO-13-151 Tax Gap
                            Appendix I: Summary Methodology for Data
                            Analysis




                            account for the time-value of money between the time at which the
                            government bears the cost of an activity or investment and the time at
                            which it receives the related benefit. (We used a real discount rate for this
                            discounting because we had already adjusted all of our figures for
                            inflation.)


Incorporating Exam          The first set of estimates that we present in this report do not reflect
Difficulty and Location     potential differences in costs across exams due to the degree of
                            experience demanded of the examiner or the location at which the exam
                            was conducted. For a second set of estimates we adjusted the cost of
                            field exams for relative difficulty. To do this we used ERIS data on hours
                            by grade to compute a weighted average pay rate for all exams (for each
                            combination of EITC and non-EITC and field or correspondence for each
                            year). We then adjusted costs for each record by multiplying the cost by
                            the mid-point pay rate for the grade of the record, divided by the weighted
                            average difficulty pay rate for the relevant year and EITC status. For a
                            third set of estimates we made this difficulty adjustment for field exams
                            and then we also adjusted the costs of both correspondence and field
                            exams for location differences by using data on the location of exams,
                            hours, and locality pay for each location to compute a national average
                            locality pay rate (weighted by the number of hours in each location) for
                            each combination of field and correspondence exams of returns with and
                            without EITC and a locality pay rate for each location. We then multiplied
                            the cost estimate for each exam by the ratio of the national rate over the
                            relevant location-specific rate.


Effects of a Hypothetical   The columns labeled “Change in Resources” in table 2 of appendix II
Resource Reallocation       show the amounts of IRS budget resources we moved out of or into
                            specified exam categories for our hypothetical reallocation. These shifts
                            were guided by the considerations we noted earlier. We estimated the
                            revenue effect of each shift by multiplying the gain or loss of resources for
                            each category by our estimated ratios of direct revenue to cost for those
                            categories. We estimated the effect on the coverage rate within each
                            category by multiplying the coverage rate prior to the reallocation by the
                            percentage change in each category’s resources caused by the
                            reallocation.




                            Page 20                                                    GAO-13-151 Tax Gap
Appendix II: Detailed Tables
                                                   Appendix II: Detailed Tables




Table 1: Costs, Direct Revenue, Exam Coverage Rates and No-Change Rates for Different Types and Groups of Exams
Opened In Fiscal Years 2007 and 2008 (Weighted Average of the 2 Years)

                                                   Correspondence exams                                           Field exams
                                                Cost      Direct                          No-            Cost      Direct                   No-    Combined
                                           per year    revenue /      Coverage         change       per year    revenue /   Coverage     change     coverage
Taxpayer group                          ($ millions)       cost            rate           rate   ($ millions)       cost         rate       rate         rate
Individual income tax returns, total          516.4            7.0           0.8%       15.5%        1,093.7          1.8       0.2%      11.5%         1.0%
Returns with total positive income
under $200,000:
     Business and nonbusiness
     returns with earned income tax
     credit by size of total gross
     receipts:
          Under $25,000                       247.5            5.5           1.8%       11.1%           22.9          1.2       0.1%      13.0%         1.9%
          $25,000 or more                      15.6            3.2           4.4%       11.1%           84.2          1.0       2.1%       8.5%         6.5%
     Nonbusiness returns without
     earned income tax credit
          Without Schedules C, E,             114.4            7.9           0.4%       21.0%           89.8          1.6       0.1%      15.5%         0.4%
          F, or Form 2106
          With Schedule E or Form              56.2            6.5           0.9%       10.5%          119.1          1.6       0.3%       7.0%         1.3%
          2106
     Business returns without
     earned income tax credit:
          Nonfarm business returns
          by size of total gross
          receipts:
                     Under $25,000             32.9            5.7           0.8%       16.0%          128.3          1.2       0.5%       7.5%         1.2%
                     $25,000 under             13.8            4.4           1.0%       13.0%           98.7          1.0       1.0%       9.5%         1.9%
                     $100,000
                     $100,000 under             8.2            5.5           2.2%        9.6%           95.6          1.2       2.8%       8.0%         5.0%
                     $200,000
                     $200,000 or                1.0            2.6           0.3%       45.1%          152.4          1.0       2.2%      15.4%         2.5%
                     more
          Farm returns                          1.0            3.5           0.2%       40.1%           17.6          2.0       0.2%      16.6%         0.5%
Returns with total positive income of
at least $200,000 and under $1
million:
     Nonbusiness returns                       14.6           25.6           1.7%       34.9%           72.3          2.9       0.6%      15.9%         2.3%
     Business returns                           8.2           13.0           1.2%       34.6%          130.9          1.7       1.6%      17.8%         2.9%
Returns with total positive income of           3.1           47.2           2.8%       52.7%           81.8          6.0       3.3%      21.3%         6.2%
$1 million or more
                                                   Source: GAO analysis of IRS data.




                                                   Page 21                                                                              GAO-13-151 Tax Gap
                                             Appendix II: Detailed Tables




                                             Note: Dollar figures have been adjusted for inflation to 2011 dollars using the GDP deflator. Direct
                                             revenue has been discounted over the gap between the year in which IRS incurred the exam costs
                                             and the year in which the revenue was collected.


Table 2: Potential Changes in Direct Revenue and Exam Coverage Rates Resulting from a Hypothetical Reallocation of Exam
Resources

                                                   Correspondence exams                                          Field exams
                                                   Change in                                                 Change in
                                      Change in         direct   Coverage                       Change in         direct    Coverage
                                      resources      revenue          rate    Coverage          resources      revenue           rate    Coverage
Taxpayer group                       ($ millions) ($ millions)     before     rate after       ($ millions) ($ millions)      before     rate after
Individual income tax returns,             50.0         874.0                                        -50.0        130.1
total (net)
Returns with total positive income
under $200,000:
    Business and nonbusiness
    returns with earned income
    tax credit by size of total
    gross receipts:
         Under $25,000                    -26.4        -145.5        1.8%          1.6%
         $25,000 or more                    -3.5        -11.3        4.4%          3.4%              -14.9         -14.1        2.1%          1.8%
    Nonbusiness returns without
    earned income tax credit:
         Without Schedules C, E,           41.5         328.4        0.4%          0.5%
         F, or Form 2106
         With Schedule E or                14.7          94.9        0.9%          1.2%
         Form 2106
    Business returns without
    earned income tax credit:
         Nonfarm business
         returns by size of total
         gross receipts:
                  Under $25,000
                  $25,000 under             -1.7         -7.4        1.0%          0.9%              -26.5         -25.4        1.0%          0.7%
                  $100,000
                  $100,000 under                                                                     -22.3         -26.8        2.8%          2.1%
                  $200,000
                  $200,000 or                                                                        -28.9         -29.4        2.2%          1.8%
                  more
         Farm returns
Returns with total positive income
of at least $200,000 and under $1
million:
    Nonbusiness returns                    14.0         356.7        1.7%          3.3%                9.1          26.5        0.6%          0.7%
    Business returns                         8.2        106.8        1.2%          2.5%




                                             Page 22                                                                        GAO-13-151 Tax Gap
                                               Appendix II: Detailed Tables




                                                     Correspondence exams                                          Field exams
                                                     Change in                                                  Change in
                                        Change in         direct       Coverage                    Change in         direct   Coverage
                                        resources      revenue              rate     Coverage      resources      revenue          rate    Coverage
Taxpayer group                         ($ millions) ($ millions)         before      rate after   ($ millions) ($ millions)     before     rate after
Returns with TPI of $1 million or              3.2          151.4            2.8%        5.7%           33.6        200.2         3.3%          4.7%
more
                                               Source: GAO analysis of IRS data.

                                               Note: Dollar figures have been adjusted for inflation to 2011 dollars using the GDP deflator. Direct
                                               revenue has been discounted over the gap between the year in which IRS incurred the exam costs
                                               and the year in which the revenue was collected.


Table 3: Ratios of Direct Revenue to Cost for Field Exams Opened in 2007 and 2008 after Accounting for Various Factors

                                                                                      Adjusted Adjusted for inflation, Adjusted for inflation,
                                                                                   for inflation    discounting and discounting, difficulty
Taxpayer group                                                                 and discounting              difficulty          and location
Individual income tax returns, total                                                        1.8                      1.8                          1.8
Returns with total positive income under $200,000:
    Business and nonbusiness returns with earned income tax
    credit by size of total gross receipts:
         Under $25,000                                                                      1.2                      1.2                          1.2
         $25,000 or more                                                                    1.0                      1.0                          1.0
    Nonbusiness returns without earned income tax credit:
         Without Schedules C, E, F, or Form 2106                                            1.6                      1.7                          1.7
         With Schedule E or Form 2106                                                       1.6                      1.8                          1.8
    Business returns without earned income tax credit:
         Nonfarm business returns by size of total gross
         receipts:
                  Under $25,000                                                             1.2                      1.3                          1.3
                  $25,000 under $100,000                                                    1.0                      1.0                          1.0
                  $100,000 under $200,000                                                   1.2                      1.2                          1.2
                  $200,000 or more                                                          1.0                      1.0                          1.0
         Farm returns                                                                       2.0                      1.8                          1.9
Returns with total positive income of at least $200,000 and
under $1 million:
    Nonbusiness returns                                                                     2.9                      2.7                          2.7
    Business returns                                                                        1.7                      1.6                          1.6
Returns with TPI of $1 million or more                                                      6.0                      5.1                          5.0
                                               Source: GAO analysis of IRS data.

                                               Note: Dollar figures have been adjusted for inflation to 2011 dollars using the GDP deflator. Direct
                                               revenue has been discounted over the gap between the year in which IRS incurred the exam costs
                                               and the year in which the revenue was collected.




                                               Page 23                                                                        GAO-13-151 Tax Gap
Appendix III: Economic Guidelines for
                      Appendix III: Economic Guidelines for
                      Enforcement Resource Allocation Decisions



Enforcement Resource Allocation Decisions

                      An economic cost-benefit evaluation of IRS’s overall activities would
                      involve a comparison of the social costs and social benefits associated
                      with those activities. 1 IRS’s function is to collect tax revenue that the
                      federal government transfers among citizens as cash payments or in the
                      form of goods and services. The collection process imposes costs on
                      society but produces no direct benefit itself. The government’s use of the
                      collected revenue may ultimately produce a net benefit for society if the
                      social value of that use exceeds the social cost of raising the revenue.
                      IRS has no influence over how tax revenue is used; it can only contribute
                      to increasing the net social benefit by increasing the amount of revenue
                      collected for a given amount of social cost (or decreasing the social cost
                      of raising a given amount of revenue). Specific resource allocation
                      choices can be compared on the basis of the amount of revenue they
                      produce for a given amount of total social costs.


Components of Total   The social costs of tax collection comprise the following:
Social Costs
                      •   IRS budget costs.
                      •   Tax burden. This is the actual money collected from taxpayers.
                          Amounts collected as a result of IRS enforcement activities from
                          taxpayers who, otherwise, would have been noncompliant may have a
                          zero social cost. The cost that those amounts represent can be
                          attributed to the tax law, rather than to IRS enforcement efforts. If
                          those additional amounts of taxes due are not collected, the tax
                          burdens evaded by noncompliant individuals are offset by the
                          additional taxes that compliant taxpayers must pay in order to support
                          a given government budget.
                      •   Compliance burden. IRS’s enforcement activities can affect the costs
                          that taxpayers incur when complying with the tax law by increasing
                          the time and money that they spend preparing their returns and
                          interacting with IRS.




                      1
                       Social costs are the sum of all private costs and any external costs to society
                      arising from the production of a good or service. Private costs are incurred by
                      producers of goods and services and are reflected in the prices charged to
                      consumers for those goods and services. External costs are costs arising from
                      production, such as pollution, that are borne by third parties (other than the
                      producers or consumers). Similarly, social benefits are the sum of all private
                      benefits and any external benefits arising from the production of a good or
                      service.




                      Page 24                                                         GAO-13-151 Tax Gap
                    Appendix III: Economic Guidelines for
                    Enforcement Resource Allocation Decisions




                    •   Efficiency costs. IRS’s enforcement activities can alter the tax
                        avoidance and evasion behavior of individuals, which affects the
                        efficiency of resource allocation in the economy. If an enforcement
                        activity increases the aggregate costs of tax avoidance and evasion,
                        economic efficiency and the average standard of living is reduced.
                        Conversely, if the activity reduces such aggregate costs, economic
                        efficiency would improve.
                    •   Equity costs. IRS’s resource allocation can affect how exam-related
                        compliance burdens are distributed across different groups of
                        taxpayers and also how the risk of noncompliant taxpayers getting
                        penalized for evasion varies across groups. It is difficult to know what
                        society as a whole would view as an equitable distribution of these
                        burdens and risks; therefore it is difficult to assess the equity effects of
                        any particular reallocation of resources.
                    The only component of social costs that can be reliably measured is the
                    IRS budget cost, and it is difficult to attribute even that cost to very
                    specific enforcement activities (such as specific audits). Consequently,
                    IRS planners cannot consider all types of social costs in a rigorously
                    quantitative manner when making their resource allocation decisions.


Marginal Analysis   Economists use the term “margin” when referring to the scopes of the
                    various types of decisions that individuals make. For example, if IRS
                    examination planners were deciding how to allocate the last million
                    dollars of their budget between different types of audits, the marginal
                    social cost of the choice they made would be a million dollars, plus the
                    sum of all other social costs resulting from the IRS activities supported by
                    that million dollars. The marginal revenue would be the amount of
                    additional tax collections attributable (both directly and indirectly) to those
                    activities. The most economically efficient choice would be the one that
                    produced the highest ratio of marginal revenue to marginal social cost.

                    The ratio of marginal revenue to marginal social cost provides a basis for
                    comparing the cost of collecting taxes by different approaches. Such
                    comparisons can be made across broadly defined approaches (e.g.,
                    increasing taxpayer services to promote higher voluntary compliance
                    versus increasing enforcement efforts to reduce noncompliance).
                    Alternatively, as in this study, comparisons could be made across more
                    narrowly defined alternatives (e.g., devoting more resources to audits of
                    taxpayers with incomes below a certain amount versus devoting those
                    resources to audits of taxpayers with incomes above that amount).




                    Page 25                                                      GAO-13-151 Tax Gap
Appendix IV: Comments from the Internal
              Appendix IV: Comments from the Internal
              Revenue Service



Revenue Service




              Page 26                                   GAO-13-151 Tax Gap
Appendix IV: Comments from the Internal
Revenue Service




Page 27                                   GAO-13-151 Tax Gap
Appendix V: GAO Contact and Staff
                  Appendix V: 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, James Wozny (Assistant
Staff             Director), Kevin Daly (Assistant Director), Michael Brostek, Ethan
Acknowledgments   Wozniak, Suzanne Heimbach, Sara Daleski, Lois Hanshaw, Karen
                  O’Conor, Ray Bush, Elizabeth Fan, and Robert MacKay made key
                  contributions to this report.




(450795)
                  Page 28                                                 GAO-13-151 Tax Gap
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