United States GA!0 General Accounting Office Washington, D.C. 20548 General Government Division B-277192 June 13, 1997 The Honorable Xavier Becerra House of Representatives Subject: Earned Income Credit: Noncomnliance Relative to Other Components of the Income Tax Gan Dear Mr. Becerra: This letter responds to your request that we compare noncompliance and associated Internal Revenue Service (IRS) enforcement issues for Earned Income Credit (EIC) claimants and other taxpayer groups, such as the self- employed. Your question is a follow-up to our May 1997 testimony on EIC noncompliance before the House Committee on Ways and Means.’ As you requested, the data presented are summarized from our previous work. RESULTS IN BRIEF IRS estimated that 25.8 percent of EIC, or $4.4 billion, was overclaimed in tax ye& 1994. This is a relatively high error rate, but the gross dollar amount is lower than that of some other taxpayer groups. For example, underreporting of income by self-employed individuals accounted for nearly $30 billion of the estimated $128 billion in taxes owed but not vohmtarily paid for tax year 1992. In general, the simpler the tax rules and the more visible tax information is to the IRS, the higher the compliance. Consistent with this, the overclaim rate among EIC recipients is relatively high, in large part, because taxpayers determine their own eligibility. Similarly, noncompliance among the self- employed is relatively high because their business income is neither subject to withholding nor generally covered by information reporting. EIC NONCOMPLIANCE As used in connection with the EIC, noncompliance occurs when taxpayers either claim credits to which they are not entitled or claim credits in excess of the an-~ountto which they are entitled. IRS’ study of tax year 1994 EIC filers ‘Tax Administration: Earned Income Credit Noncom&uwe (GAO/T-GGD-97-105,May 8, 1997). GAO/GGD-97-120R EIC Noncompliance and the Tax Gap B-277192 showed that; of $17.2 billion in EIC claimed, $4.4 billion (25.8 percent) was overclaimed. IRS determined that, if this noncompliance rate were adjusted to reflect new enforcement efforts and procedures implemented after tax year 1994, the overall noncompliance rate would have been about 21 percent. As we noted in our testimony, much of EIC noncompliance is rooted in taxpayers’ self-determination of eligibility combined with IRS limited ability to verify eligibility before issuing a refund. Erroneous EIC claims are frequently related to taxpayers claiming EICqualifying children who, in fact, do not qualify as such or to choosing the wrong filing status.2 In both instances, IRS cannot easily verify the information on the return without using field resources to determine taxpayer eligibility in a fashion similar to that used by organizations administering welfare programs. However, IRS has taken several steps in the past few years to combat EIC noncompliance, with some resulting success. These efforts have focused primarily on identifying missing, invalid, and duplicate Social Security numbers. NONCOMPLIANCE FROM OTHER SOURCES The income tax gap is the difference between income taxes owed and those voluntarily paid. IRS data suggest that U.S. taxpayers voluntarily pay about 83 percent of the income taxes they owe. IRS estimates that its enforcement programs, including audits and document matching have,, on average, recovered about 4 percent of all individual and corporate income taxes due, but not voluntarily paid, in any particular tax year.3 Thus, IRS estimates that overall compliance reaches about 87 percent after IRS enforcement programs. However, because of the time consumed by these programs and by any subsequent appeals and litigation, the 87 percent compliance level cannot be reached until a number of years after the taxes were due. As shown in table 1, the estimated gross income tax gap for tax year 1992 totaled $128 billion.4 IRS attributed about three-fourths of the gap to individuals and one-fourth to corporations. For tax year 1992, the gross individual income tax gap primarily consisted of individuals underreporting their income on filed tax returns ($59 billion of the $95 billion estimate). Nonfilers and taxpayers overstating offsets to tax (including 2A change in hling status, by itself, will not necessarily disqualify a taxpayer from claiming the EIC. Only taxpayers who use the married-fihng-separately status are ineligible for the credit. However, reporting an incorrect filing status has implications for correetiy reporting income. For example, taxpayers who file as a head of household when they should have filed as married may underreport income by excluding their spouse’s income, and thus overclaim the EIC in whole or in part. %3 1996 estimate for individuals noted that IRS enforcement programs recovered about $15 billion of the $95 billion gross income tax gap for 1992, leaving a net gap of $80 billion 41RSmade its most recent estimate of the individual income tax gap in 1996 for tax years 1985, 1988, and 1992. IRS last updated its corporate income tax gap estimate in 1990. It included a projection for tax year 1992 that did not reflect the most recent compliance audit data for small corporations, which showed that their income tax compliance dropped from 81 percent in 1980 to 61 percent in 1987. 2 GAO/GGD-97-120R EIC Noncompliance and the Tax Gap B-277192 tax credits,. deductions, and exemptions) each accounted for tax gap amounts in excess of $10 billion. Table 1: Gross Income Tax Gax, Estimates for Tax Year 1992 “Includes subtra&ions for erroneous deductions, exemptions, credits (including the EIC), and other adjustments. bIncludes unreported income and overstated deductions for exempt organizations’unrelated business income and for fiduciaries. cPercenta.gesdo not add to totals due to rounding. Source: Income Tax ComtAiance Research, IRS Pub. 1415 (7-88); Income Tax Comnliance Research, IRS Pub. 1415 (4-90); and Federal Tax Comnliance Research, IRS Pub. 1415 (496). Table 2 provides a more detailed breakdown of the underreporting and offset portions of the individual, gross income tax gap. Underreporting of income by the self- employed-informal suppliers and other sole proprietors-accounted for nearly $30 billion in unpaid taxes for 1992.5 Overstated credits, including the EIC, accounted for about $6 billion of the 1992 tax gap. 51nformal suppliers are self-employed individuals who operate informally, on a cash basis. 3 GAO/GGD-97-120R EIC Noncompliance and the Tax Gap B-277192 Table 2: 1992 Individual Income Tax Gan bv Source of Underreported Income and Overstated Offsets “Self-employed individuals who operate informally on a cash basis. bLessthan $0.1 billion dollars. Total does not add due to rounding. Source: Federal Tax ComDliance Research,IRS Pub. 1415 (4-96). 4 GAO/GGD-97-120R EIC Noncompliance and the Tax Gap B-277192 As with the. EIC, making tax information visible to IRS is key to improving voluntary compliance. IRS data show that compliance is highest under tax withholding, a little lower without withholding but with information reporting to IRS, and much lower when neither system is in place. For example, IRS estiates that persons whose wages are subject to tax withholding (the most systematic method for making income visible to IRS) report 99 percent of their wages, and that individuals report 98 percent of their interest income and 92 percent of their dividend income, most of which is subject to tax information reporting but not tax withholding requirements. In contrast, IRS estimates that - sole proprietors who formally operate businesses other than farms report about 68 percent of their business income, which is neither subject to withholding nor generally covered by information reporting, and informal suppliers, who are even less likely to have income reported to IRS on information returns, report an estimated 19 percent of their business income. In addition to the relative visibility of the income to tax administrators, other factors also influence the level of compliance. For example, complex tax laws lead to more noncompliance. We will send copies of this letter to the Chairman and Ranking Minority Member of the Committee on Ways and Means, the Chairman and Ranking Minority Member of the Senate Committee on Finance, the Secretary of the Treasury, and the Commissioner of Internal Revenue. We wiIl also make copies available to others on request. Deborah Parker Junod was the major contributor to this letter. If you or your staff have any questions, please contact me at (202) 512-9110. v James R. White Associate Director, Tax Policy and Administration Issues (268806) 5 GAO/GGD-97-120R EIC Noncompliance and the Tax Gap Ordering Information The first copy of each GAO report and testimony is free. Additional copies are $2 each. 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Earned Income Credit: Noncompliance Relative to Other Components of the Income Tax Gap
Published by the Government Accountability Office on 1997-06-13.
Below is a raw (and likely hideous) rendition of the original report. (PDF)