oversight

IRS Can Use Tax Gap Data to Improve Its Programs for Reducing Noncompliance

Published by the Government Accountability Office on 1990-04-19.

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

                    United States General Accounting OfPice
                    Testimony



                                                                                                    -
For Release           IRS    Can Use Tax     Gap Data        to     Improve      Its
on Delivery           Programs    for   Reducing       Noncompliance
Expected    at
9:30 a.m. EDT
Thursday
April    19, 1990




                      Statement  of
                      Paul L. Posner,        Associate            Director
                      Tax Policy   and      Administration              Issues

                      Before    the
                      Subcommittee     on Oversight
                      Committee     on Ways and Means
                      House of Representatives




                            a-m3c*      Y     l+ii>~
 GAO/T-GGD-90-32
                                                                                   GAO   Form160(X2/87)
                 IRS CAN USE TAX GAP DATA TO IMPROVE ITS-
                   PROGRAMS FOR REDUCING NONCOMPLIANCE
                      SUMMARY OF STATEMENT BY
                          PAUL L. POSNER
     ASSOCIATE DIRECTOR, TAX POLICY AND ADMINISTRATION                    ISSUES
                    GENERAL GOVERNMENTDIVISION
                  U.S. GENERAL ACCOUNTING OFFICE
The Internal      Revenue Service's     (IRS) most recent    estimate    of the
gross tax gap-- the difference        between the amount of income tax
that taxpayers      owe and the amount they voluntarily          pay for a
year--depicts      the tax gap as large and growing.        IRS estimated     the
gross tax gap to be $84.9 billion           for 1987 and projected      that it
will   reach $113.7 billion       by 1992.     Reducing this gap is
important     given its potential     impacts on public     confidence     in the
voluntary     tax system and on the budget deficit,         but the questions
are how and with what resources.
Knowing more about the specific              nature of noncompliance         and the
impact of current       IRS programs in resolving           noncompliance      could
help IRS better      target    its   resources     to close    the gap.
Accordingly,     the Subcommittee        asked us to analyze         four major
components of the tax gap: (1) sole proprietors                   or self-
employed individuals;         (2) informal       suppliers,    such as street
vendors,     who operate    on a cash basis;         (3) small    corporations     with
assets under $10 million;           and (4) large corporations           with assets
of $10 million      or more.       These components comprised           over half of
the $84.9 billion       tax gap in 1987.
Our study suggests     that IRS could do more to evaluate              and target
its programs to these major         areas     of noncompliance.       Current
programs have limitations         in addressing      the tax gap, including        a
declining  rate of audit       coverage     and the exclusion       of payments
made to corporations      in the Information        Returns     Program.
Although  improvements      in IRS' programs are important,            a cost
effective  strategy    to reduce the tax gap must go beyond IRS'
resources  by more fully       engaging     the resources    of third     parties,
such as employers,     tax practitioners         and state governments,         to
help taxpayers    achieve     a higher    level   of compliance.
IRS needs to better        track   the effectiveness      of its programs       in
reducing    the tax gap in order to develop            a comprehensive
strategy.      Although    IRS is undertaking        some new evaluation
initiatives      to assess compliance       problems    and revenues generated
by its enforcement       programs,    IRS does not have sufficient           data
to either     identify   the issues most responsible           for the most
troublesome      pockets   of the tax gap or to track how well its
programs reduce the tax gap.           Linking     the results      of these
programs with trends         in major components of the tax gap would
give the agency a new scorecard           to evaluate      its   success   and
decide on the need for new initiatives               and resources.
Mr.    Chairman            and Members of                           the     Subcommittee:

We are      pleased              to testify                  on our           work            for      you on the                 tax        gap.
As you know,               IRS defines                      the      gross          tax        gap as the                   difference
between       the      amount            of        income            tax      that            taxpayers               owe and the
amount       they      voluntarily                     pay for               a calendar                  year.              In    1988,         IRS
estimated           the     gross             tax      gap          to     be $84.9                 billion           for        1987        and
projected           that         it     would          reach              $113.7          billion              by 1992.                 In     this
testimony,           I will             discuss              more          specifically                       the     tax        gap's         size,
our     analysis           of         IRS'     data          on the           tax         gap,         and IRS programs                         for
reducing         the       tax         gap,         along           with      ideas             for      improving                them.


Reducing         the       tax         gap is          an important                       challenge,                  given           its
potential           negative                 effects              on public               confidence                  in the            voluntary
tax     system       and on the                     budget           deficit.                   In     its          1988 tax            gap
report,       IRS noted                 that          its         enforcement                   programs              annually               bring      in
about       $20 billion,                     which          includes               tax        liabilities                   from        past
years.        Clearly,                 more could                   be done              to reduce                  the     tax       gap;      but,
the     questions               are     how and with                       what          resources.


Knowing        the        specific              nature              and causes                  of     noncompliance                        could
help      IRS to better                      target           its         enforcement                   resources                to     reduce         the

gap.        However,             the         tax      gap estimate                       is     aggregated                  by broad
categories           of         taxpayers              and does               not         provide              sufficiently
detailed         information                    on who and what                           caused              the     noncompliance.
As a result,               IRS cannot                  evaluate                how well                 its         enforcement
programs         are       reducing                 specific               parts          of        the gap.
To gain          insight         into           its       nature          and causes,                 you asked              US      to
analyze          major         components                of     IRS'          gross         tax    gap estimate                     for
1987.    1       Our work             illustrates                that          IRS could              further           analyze                the
tax     gap data             to gain           valuable               insights              on the         types        of
noncompliant                 taxpayers                and issues               of     noncompliance.                        Such
insights             could      help           IRS evaluate                   its     ability             to reduce            pockets
of     the      tax     gap and identify                        other          promising              ways        to use            its

enforcement               resources.



THE TAX GAP IS LARGE AND GROWING


IRS'         estimate          depicts            the         gross       tax        gap as large                 and growing,                        In
1988,         IRS reported                that           the    tax       gap        was $84.9              billion           for         1987

and projected                  that       it      will         grow       to        $113.7        billion             by 1992.


Individual               and business                    taxpayers              who do not                voluntarily                 report
taxes         owed contribute                     to      the      tax        gap.           In   1987,          according                to     IRS,
they         reported          83 percent                 of    their           tax        liabilities.                 Because                this
rate         has been fairly                    constant              since           1973,       IRS largely                 attributed
the     tax       gap's        growth           to       inflation              and economic                 expansion,                   both        of
which         raise        income.              IRS explained                       that      higher          income          usually

means more taxes                      owed,           which        means more unpaid                          taxes          and a larger
gross          tax      gap,    even assuming                      a constant                 level         of    compliance.


 lTax Administration:                         Profiles                   of     Major         Components               of     the         Tax Gap
 (GAO/GGD-90-53BR,                      Apr.4,     1990).

2
Since       1979,        IRS has estimated                      the        gross      tax     gap three            times.            For

the     most     part,          IRS has based                  the     estimates             on the      additional                tax
assessments              that      examiners             recommended                 from     their      review        of       tax
returns.            The recommended                    assessments                 largely        came from          detailed
examinations              that         IRS annually                  completes         on some large
corporations              and that              IRS periodically                     does on individuals                       and
businesses             under       its        Taxpayer          Compliance             Measurement             Program
(TCMP).          TCMP measures                   compliance                across      random         samples        of
various         tax      returns,             such     as those             for      individuals             and small
corporations.                   IRS views             the      amount        of      additional          recommended                   tax
as a measure              of      noncompliance                 when compared                 to the         tax    that        was
voluntarily              paid.2


ANALYSIS OF THE TAX GAP'S MAJOR COMPONENTS
YIELDS INSIGHTS ON THE NATURE OF NONCOMPLIANCE


In    its      gross       tax     gap estimate,                     IRS aggregated               the    amount        of
noncompliance               for        over      20 types             of    components.               At your         request,
we analyzed              four      major         components:                 (1)     sole     proprietors,                or    self-
employed         workers           who report               business               income     and deductions                   on a
Schedule         C of          their      tax        return;          (2)     informal          suppliers,            or       self-
employed         workers--             such as street                  vendors          or    "moonlighters"--who
operate         on a cash              basis:         (3)      small        corporations,               or    those         with

21RS is now questioning whether                                       recommended assessments  that are
lost through appeals and other                                       ways should continue  to be part of
the gross tax gap.
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assets         under         $10         million:             and         (4)     large         corporations,                     or    those
with     assets             of        $10 million              or more.                 These          components                    accounted
for     over         half         of     the      $84.9        billion              tax       gap in             1987.


For each             component,                 we sought                detailed              information                    on the      types
of     taxpayers              and noncompliance                            that        caused          the         tax        gap,     IRS
programs             to pursue                 this        noncompliance,                      and ways IRS could                         better
pursue         it.          Because             IRS'         tax     gap report                 did         not     contain            this

information,                     we used a wide                     variety            of       IRS sources                   to get      the
best     and most                 recent          data        on noncompliance                         and enforcement.                          The
accuracy             of     the         data      depends            on IRS'              underlying                examinations,
analyses,              and research,                       which          we did          not        attempt             to    evaluate.
Our analysis                     of     these         data         led     to     the        following              ins ights            on the
four      components.


--     Sole      proprietors                    accounted                 for     $16.6          billion,                or about          20
       percent,             of         the     1987 gross                 tax     gap.              IRS'     examinations                 showed
       that      they            underpaid             23 percent                 of        their          tax     liabilities,
       reflecting                 both         unreported                 income          and overstated                       deductions.
       Of the             eight         types         of     sole         proprietors,                     those         who underpaid
       the     most          taxes           were service                  providers,                 producers                of goods,           and
       sellers             of goods              at    fixed             locations.3




31RS listed                  over 50 types of service      providers     (e.g.,    lawyers,
accountants,                  doctors);    almost 40 types of producers         (e.g.,
construction,                  manufacturing,     mining):   and almost 50 types of
fixed-location                   sellers   (e.g.,  car dealers,    grocers,     jewelers).
4
--       Informal          suppliers             who did            not          report         income           accounted               for
         $7.7     billion,             or about          9 percent,                     of     the      tax      gap.            Because
         they     operate           in cash,         their            ihcome              is often              neither
         documented             nor      subjected             to     third-party                     controls.                  Of 16
         types      of     informal          suppliers,                   those           who accounted                    for     the          most
         noncompliance,                  according             to     a study                 done      for      IRS,        were        those
         who made home repairs,                          provided                 child         care,           or    sold        food          at
         roadside          stands.


--       Small      corporations                 accounted                 for         $5.2     billion,              or about              6
         percent,          of     the     tax     gap.          Their             noncompliance                      was about
         equally          divided         between         unreported                         income       and overstated
         deductions,              such as for             depreciation                         and repairs.                      Compliance
         ranged          from     50 percent             for         those             with      $50,000             or    less        in
         assets          to 90 percent             for         those             with         $5-10       million.                Of nine
         types      of     small         corporations,                     those             in services              and retail
         sales      had the             lowest     compliance                      rates.


 --      Large      corporations                 accounted                 for         $15.8         billion,             or about              19
         percent,          of     the     tax     gap.              IRS attributed                      their         noncompliance
         largely          to     improper         accounting                     for         reported           income           and
         deductions.                  For example,                  they         misallocated                   income           among
         foreign          and domestic             subsidiaries                         and misstated                     periods           for
         depreciating                 or expensing                  assets.                  Of 27 types              of     industries,
         those      with         the     most noncompliance                             were         concentrated                 in
         petroleum              or banking,          based            on IRS'                 1988 examination                      results.

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Research           by IRS and others                        offers          some reasons                     for     noncompliance
in    the     four         components.               First,               noncompliance                    often        occurs          due to
uncertainty                about     tax        laws        and a desire                    to     increase             profits.            For
example,           noncompliance                 by sole             proprietors                   and small              corporations
often        resulted            from      confusion             over            their         tax        liabilities              or    from
efforts           to      increase         their        profits             by reducing                    tax      liabilities.
For       large        corporations,                complex               tax      laws        contributed                to
noncompliance,                   such as determining                             what       expenses               can be deducted
under        the       research          credit.             Second,               studies            show that
noncompliance                   is more prevalent                         and difficult                     to pursue           when
taxes        are not            withheld           and information                        returns            are not           submitted.
IRS'        studies         show that              taxpayers               report           almost           all        wages and
salaries,              which       are withheld,                  and           interest             and dividends,                 which
are       subject          to    information                reporting.                     But,       they         report       only      13
percent           of      informal         supplier            income,                which          is     unlikely           to be
withheld            or subject             to      information                   reporting.


ENHANCING IRS'                   APPROACH TO REDUCING THE TAX GAP


IRS generally                   does not           design           its         major       enforcement                  programs         to
specifically                pursue         components                of         the      tax      gap.         With         some limited
exceptions,                these        programs            address              noncompliance                     in a general             way
by focusing                on the        types         of     tax         returns           rather            than       the    type      of
noncompliance.                     As a result,                 these            programs             cannot            be easily
aligned            with      the     tax     gap components.                             Although             IRS generally

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believes        its         programs              are         effective,             the      programs             have
limitations                in reducing                 the       tax     gap.


For    example,             due to various                       reasons,            IRS'      rate     for         examining
returns       has steadily                       dropped           to      about       1 percent             for      individuals
and under           2 percent               for         all      corporations.                     However,           because           IRS
has recently                focused              its      examinations                 on cases         with          higher
potential           for       generating                  tax      revenue,            IRS reports                 that     its
revenue       yield           has increased.                           For     those        returns          that         are
examined,           IRS officials                       have       expressed               concerns          about         whether
examiners           identify               all         noncompliance                 and recommend assessments
that      can withstand                    appeal.               In     1989,        IRS'      Research             Division
estimated           that           individuals                  appeal         about        63 percent              of     the        amount
of     recommended                 assessments                  while        large         corporations               appeal           about
81 percent.                  It     also         estimated              that       IRS loses           about          70 percent               of
the     amount         of         recommended                 assessments              that        individuals                  and
corporations                 appeal.               Further,             IRS estimates                 that         income         tax
examinations                only       uncover                about        one-third           of     the     unreported
income        due to inadequate                           documentation                    on what       taxpayers                earned.


IRS'      document-matching                            program          helps        to disclose              unreported
income;        it      generated                 over         $1.8      billion            in recommended                  taxes         and
penalties           in       1988.           However,                 IRS cannot            match      all         information
returns        to tax              returns             when information                     returns          have erroneous
 information                about      who received                     the       income.           Nor does IRS have                       the
resources             to     investigate                  all         indications             of    unreported                  income

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that      emerge         from      the matching.                      Further,             IRS has not               expanded            the
program       to        include        payments            to     all       types         of        businesses,              such      as
corporations.


IRS     recognizes             these       limits          and has            some         initiatives                to     improve
enforcement.                  For example,                IRS has           a special                examination              program
to probe          for     unreported                  income      by sole               proprietors.                  IRS also           has
created       a    cross-index                 file       to     enable            it    to match             information
returns       that        had inadequate                    information                  on the         identity             of     a sole
proprietor.


The limitations                   in    IRS'          current         approach             and the            size     of      the      tax
gap have prompted                      outside           observers            as well               as IRS officials                    to
offer      ideas         to     improve          IRS'       enforcement.                       In     1989,     for         example,
we recommended                  using      information                   returns           to       identify          employers
who misclassify                   employees              as independent                    contractors.
Misclassification                      lowers          federal           revenues              because         taxes         are      not
withheld           and independent                     contractors                 usually           are      less         compliant.4
We also       recommended                 that         IRS develop                 a business              document            matching
program       to,        among other                  things,           identify           corporations                which          have
not     reported           income         or     filed          tax      returns.5                  IRS is studying
the     feasibility               of    implementing                  both         recommendations.                         To capture
taxes      owed by informal                      suppliers,                an IRS Assistant                      Commissioner

4Tax Administration:      Information                                      Returns Can Be Used to                                 Identify
Employers Who Misclassify       Workers                                    (GAO/GGD-89-107, Sept.                                 1989).
SThe Merits of Establishing     a Business  Information                                                          Returns
Program (GAO/T-GGD-87-4,    Mar. 17, 1987).
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suqgested          that     state       and local             authorities                    verify          that     vendors
and others          seeking         business           licenses              filed           their         federal          tax
returns.


While      we have not           evaluated             all         of     the      IRS initiatives                    and the
proposals          made, we believe                   that         they      warrant            consideration                     and
demonstrate           the     value         of     looking              beyond         IRS for         both         ideas         and
resources.            However,          given         a limited                 budget,         IRS needs             to decide
which      ones would          most         cost-effectively                       reduce            the     tax     gap.
Further,        we know from                our     past      work          that        simply         increasing
enforcement           resources             will      not     lower             the     tax     gap very             quickly.
In    1988,     we reported             that        an attempt                  to hire         more         examiners             did
not     produce       revenues          within         the         timeframes                that      Congress
envisioned.               IRS could           not     quickly             hire         the     allotted             number         of
examiners          and then          easily         train          and      absorb            them to do
examinations              without       lowering             the         productivity                 of     experienced
revenue        agents.6             In essence,              our         work         showed that             not     only         does
IRS need better               information              on resources                     and examination                     results,
but     that    increasing             IRS resources                     cannot         be the         sole         response             to
quickly        reverse        a growing             tax      gap.


Instead,        we believe             a multi-faceted                      approach            is     needed          to    attack
the     many dimensions                of        noncompliance.                       Through         this         approach,             IRS
would      build      on its         partnership              with          third        parties             to enhance             its


6Tax Administration:                    Difficulties                     in Accurately                 Estimating                 Tax
Examination    Yield,                 GAO/GGD-88-119,                      August 1988.
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overall       enforcement                effort.               Employers           can help              by withholding
income       taxes      and depositing                    the      taxes          in a timely                  manner.           They
also       can help         by properly              classifying                  workers          as employees
instead       of     as independent                  contractors.                    Business              and government
entities         can help           by submitting                  information                 returns            to report
required         payments,           which          enables            IRS to match                them with               tax
returns       to     identify            unreported               income.            Correctly                 reporting          such
payments         reduces           the     cost      of        these        matches.             Representatives                    of
taxpayers           and tax         practitioners                  can help            by encouraging                     and
assisting           taxpayers             to comply             when they             file       their           tax     returns.


Even with           such help,             we believe              that          IRS cannot              solely          rely     on
enforcement            to capture             all        noncompliance.                       Taxpayer            assistance
and education               play         important             roles        in     encouraging                 compliance.
IRS must           continue,         with          the     help        of    third           parties,            to assist
taxpayers.             IRS has been offering                            more workshops                     for     small
businesses           and testing               innovative               ways         to help            small      businesses
to     comply.         IRS also            must      continue               to     educate         taxpayers--
including           compliant             ones-- about             their           compliance              responsibilities
and enlist            their        support          in     improving               compliance.


The success            of     any changes                 in    IRS'        enforcement                 will      rest         on the
 support      of      taxpayers            and third              parties.              We recognize                    that
 changes      may generate                 concerns.               A program's                  start-up               costs     may
 exceed      benefits           in the         short-term.                   New administrative                          or
paperwork           burdens         may be opposed                     by        IRS and others.                       Taxpayers'

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support         may diminish              when better               enforcement,                      such as expanded
information              reporting,             increases           paperwork                  burdens        along      with        the
prices         of goods          and services              from          businesses                  and informal
suppliers.               Even so,         we believe               that          the        concerns         can be
addressed             to minimize              any burdens               and that              a lower        tax      gap is
worth      some additional                     costs     and risks.


IRS CAN ANALYZE ITS TAX GAP DATA TO
BETTER TARGET ENFORCEMENTRESOURCES


The study             we did      for     you suggests                   that           IRS could           further       analyze
its      tax     gap data         to more specifically                             pinpoint            the     types     of
taxpayers             and noncompliance                  giving            rise          to the        tax    gap.        Knowing
more about              noncompliance              could          allow          IRS to target                enforcement
resources             on troublesome               pockets           of         the      tax     gap that           can be cost-
effectively              pursued.


We believe              that     such knowledge                   also          could        provide         IRS with          a
better          basis      to evaluate             the     effectiveness                        of    its    enforcement
programs,              as well      as proposals                  that          offer        promise         for      reducing
the      tax     gap.          Although          IRS estimates                   the        total      revenues         produced
by its           enforcement             programs,           it      does          not       have sufficient                 data     to
track          the     issues     most responsible                        for         the      tax    gap and whether
these          programs         reduce         noncompliance                    among taxpayers.                      As a
result,              IRS cannot         link      the    enforcement                     programs'           results          to    the
 tax     gap components                 for     any specific                    tax      year.

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For    example,               with      the        exception               of      TCMP, IRS does not                             track          the
issues       of         noncompliance                     raised          through             its     examinations.
Without        such tracking,                        it      is     difficult                 for     IRS to evaluate
whether           its     examinations                     successfully                   deal        with         the major              issues

causing        the        tax        gap for              such      components                  as large            corporations                    or
sole       proprietorships.                          The lack              of      a system             to track              issues,              as
well       as the         recommended                     assessments,                   from       examinations                    through
appeals        and ultimately                        to      collection                  also       has complicated                         IRS'
efforts           to better             understand                  problems              with        its         current           programs,
such       as why it             loses             an estimated                  70 percent                 of     appealed
assessments.


IRS recognizes                   that         it     needs          to     know more about                         noncompliance                       and
its      enforcement                 results.                For      example,                to detect              noncompliance
early,        IRS now has teams of                                 employees              who are reviewing                          random
samples           of     tax      returns            at      all      service             centers.                 IRS'       goal          is     to
identify            trends           in noncompliance                           as returns              are        filed           rather          than
wait       3 years            or more for                  the      results              of     examinations                  or special
studies.                IRS believes                 that          this         effort          eventually                 will
highlight               issues        that          need          immediate              attention.


Regardinq               the      need for            more          information                  about            enforcement
results,               IRS published                 a report              in       1989        on its            study       of various
problems               and ongoing                 improvements                   in     estimating                enforcement
revenue.                For example,                  IRS is             using         more         recent         data           and is

 12
revising            assumptions               on how much recommended                                      tax     gets       assessed
and collected.                    The report                 also          outlined              future            improvements                   such
as (1)       compiling                actual         revenue               by type            of      tax        and year           of         the
tax     liability              and (2)          developing                   a system               to capture               the         flow         of
enforcement               revenue         across             functions,                   such as the                Examination                      and
Collection             Div is ions.


Further,            IRS is        studying             cases              that        are     appealed              and litigated                      to
learn      more about                 noncompliance                      and enforcement                         results.
According            to    IRS,        this      study             will          identify             why it         loses
recommended               assessments,                 such          as the              types        of     noncompliance                      that
cause       the most problems,                         and provide                       information                on enforcement
results        by computing                    the     amount              of      taxes           lost.           In turn,              this
information               could        enhance              IRS'          evaluations                 of     its     programs                  and
allocations               of    its      resources                 in      deciding                how to reduce                   the         gap.




In    conclusion,               we believe                  that          IRS'        estimate              of     the      gross         tax         gap
can be a good starting                           point             for          better        tailoring              enforcement
programs            to reduce            the         gap.          The tax               gap's        size         and growth
suggest         that       IRS needs                 to do more                  to      evaluate            and target                  its
programs            based       on the major                   areas             of      noncompliance.                      More in-
depth       analyses            of     noncompliance                       by tax            gap component                   could             create
a more systematic                       basis         for      targeting                    enforcement               resources.
Regularly            evaluating                enforcement                      programs'             success            in reducing

 13
the     tax    gap could         show whether                IRS should            redirect        resources      to
other       programs      or initiatives.


Overall,        we support          IRS'      efforts              to    improve      its     enforcement
programs        and its         information            on noncompliance.                      We believe       these
initiatives         have been needed                   for         a long     time,         and we encourage
IRS to        complete     them.           Striv-ing          for        improvement          is   crucial     given
a growing        tax     gap,     a voluntary                tax        system,     and a serious            budget
deficit.


That       ends my prepared           statement.                    I would        be happy        to answer      any
questions.




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