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)

       United States
GA!0   General Accounting Office
       Washington, D.C. 20548

       General Government Division


       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.


       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.


       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
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.


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
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

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
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
    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

           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

    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

    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


    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. Orders should be sent to the
following address, accompanied by a check or money order
made out to the Superintendent of Documents, when
necessary. VISA and Mastercard credit cards are accepted, also.
Orders for 100 or more copies to be mailed to a single address
are discounted 25 percent.

Orders by mail:

U.S. General Accounting Office
P.O. Box 6015
Gaithersburg, MD 20884-6015

or visit:

Room 1100
700 4th St. NW (corner of 4th and G Sts. NW’)
U.S. General Accounting Office
Washington, DC

Orders may also be placed by calling (202) 512-6000
or by using fax number (301) 258-4066, or TDD (301) 413-0006.

Each day, GAO issues a list of newly available reports and
testimony. To receive facsimile copies of the daily list or any
list from the past 30 days, please call (202) 512-6000 using a
touchtone phone. A recorded menu will provide information on
how to obtain these lists.

For information on how to access GAO reports on the INTERNET,
send an e-mail message with ‘info” in the body to:


or visit GAO’s World Wide Web Home Page at:

United States
General Accounting    Office
Washington,   D.C. 20548-0001

Of6cial   Business
Penalty   for Private   Use $300

Address   Correction    Requested