Taxpayer Compliance: Analyzing the Nature of the Income Tax Gap

Published by the Government Accountability Office on 1997-01-09.

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

                  United States General Accounting Office

GAO               Testimony
                  Before the National Commission on Restructuring the
                  Internal Revenue Service

For Release
on Delivery
Expected at
                  TAXPAYER COMPLIANCE
11:00 a.m. EST
January 9, 1997
                  Analyzing the Nature of the
                  Income Tax Gap
                  Statement of Lynda D. Willis, Director, Tax Policy and
                  Administration Issues, General Government Division


Taxpayer Compliance: Analyzing the Nature
of the Income Tax Gap

                 Messrs. Chairmen and Members of the Commission:

                 We are pleased to be invited by you to discuss the income tax gap—the
                 difference between income taxes owed and those voluntarily paid. The
                 Internal Revenue Service (IRS) has estimated that taxpayers do not
                 voluntarily pay more than $100 billion annually of taxes due on income
                 from legal sources.1 While such “tax gap” estimate is necessarily
                 imprecise, it indicates significant noncompliance and the challenge that IRS
                 faces in finding ways to reduce the tax gap.

                 When some taxpayers do not pay all the taxes they owe, that part of the
                 burden of funding approved government programs shifts to taxpayers who
                 fully comply. Thus, maintaining high levels of compliance and reducing the
                 tax gap are important for equity reasons. However, it would be unrealistic
                 to assume that our tax system, or any tax system, can achieve 100-percent
                 compliance and thus eliminate the tax gap.

                 My statement covers four points which are based on our previous reports
                 and ongoing work. These points are:

             •   First, IRS’ data suggest that U.S. taxpayers voluntarily pay about 83 percent
                 of the income taxes they owe and ultimately pay about 87 percent after IRS
                 enforcement programs. This compliance level, in combination with
                 economic growth, translates into billions of “tax gap” dollars.
             •   Second, IRS’ estimates show that voluntary compliance in reporting income
                 varies across groups of individuals. Among those filing income tax returns,
                 wage earners report 99 percent of their wages; self-employed individuals
                 who operate formally report 68 percent of their business income; and
                 “informal suppliers,” self-employed individuals who operate informally on
                 a cash basis, report just 19 percent of such income on their tax returns.
             •   Third, 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. 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 can lead to more
             •   Fourth, IRS faces many challenges in reducing the income tax gap. For
                 example, some of the “tax gap” may not be collectible at an acceptable
                 cost. Such collection might require either more intrusive record keeping or

                  Income tax gap estimates released in 1988 and 1996 have excluded unpaid income taxes owed from
                 illegal activities such as drug dealing and prostitution. IRS’ tax gap estimates in 1979 and 1983 included
                 such an estimate. Since then, IRS researchers have decided that the data and methodology for reliably
                 making this estimate are lacking.

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                    Taxpayer Compliance: Analyzing the Nature
                    of the Income Tax Gap

                    reporting than the public is willing to accept or more resources than IRS
                    can commit. Thus, it is important that IRS know as much as possible about
                    current compliance with the tax laws and use that knowledge to focus its
                    resources in a cost-effective way.

                    Successfully reducing the tax gap may depend on several systematic
                    factors in addition to overcoming the challenges faced by tax
                    administrators. Before discussing these points, I would like to discuss the
                    “tax gap” estimates and how they are derived.

                    Tax gap estimates, for the most part, have traditionally begun with IRS’
Tax Gap Estimates   Taxpayer Compliance Measurement Program (TCMP). Under this program,
                    IRS auditors did line-by-line audits of randomly selected tax returns to
                    identify under- and overreporting for a line item. IRS used these results to
                    estimate compliance for the taxpayers included in the TCMP. TCMP has been
                    used since 1963 to measure compliance on income tax returns filed by
                    individuals about every third tax year. The last TCMP for such individual
                    filers covered tax year 1988. IRS also has done a few TCMPs for individual
                    nonfilers and for small corporations (those reporting less than $10 million
                    in assets). Other data from IRS enforcement programs and special studies
                    have been used to supplement TCMP results or to estimate the tax gap for
                    large corporations and informal suppliers.

                    IRS’most recent estimate (1996) projects tax gap numbers for individuals
                    in tax years 1985, 1988, and 1992. Previous IRS estimates provided
                    projections for other tax years as well as for corporations.2 IRS estimated
                    that the income tax gap for individuals reached as high as $95 billion for
                    tax year 1992. IRS data show the tax gap has grown over time even though
                    the compliance rate has remained roughly the same because the economy
                    has grown and changes in the tax laws have had the unintended effect of
                    increasing opportunities for noncompliance. After making adjustments for
                    tax law changes and shifts in types of income, IRS estimated that overall
                    individuals have been paying about 83 percent of the total income taxes

                     IRS last updated in 1990 an estimate of the corporate income tax gap. That tax gap estimate was
                    $33 billion for tax year 1992. It did not include the most recent TCMP for small corporations, which
                    showed that their income tax compliance, dropped from 81 percent in 1980 to 61 percent in 1987. IRS
                    Research Division did not know when it would have the time and resources to finish updating the
                    corporate tax gap estimates.

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                        Taxpayer Compliance: Analyzing the Nature
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                        IRS  has been able to recover a portion of the tax gap through its
                        enforcement programs, such as audits and document matching.3 IRS
                        estimates that its enforcement programs have, on average, recovered
                        about 4 percent of all individual and corporate income taxes due in any
                        particular tax year. 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 I.1, IRS’ estimate attributes about three-fourths of the
Components of the       gross income tax gap to individuals and one-fourth to corporations. For
Tax Gap                 tax year 1992, the individual tax gap primarily arose from individuals not
                        fully reporting their income on filed tax returns ($59 billion of the
                        $95 billion estimate). The most recent estimate of the corporate tax gap
                        projected it to be $33 billion for tax year 1992. Noncompliance in reporting
                        income, deductions, and other offsets to income or tax comprised most of
                        the total—$24 billion by large corporations and $7 billion by small

                        Within these overall tax gap estimates, compliance varied by type of
                        individual taxpayers filing the tax returns (see table I.2), as follows:

                    •   Wage earners whose wages are subject to tax withholding (the most
                        systematic method for making income visible to IRS) are estimated to
                        report 99 percent of their wages.
                    •   Individuals are estimated to 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 self-employed individuals who formally
                        operate businesses other than farms report about 68 percent of their
                        business income, which is neither subject to withholding nor necessarily
                        covered by information reporting.
                    •   Finally, self-employed 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.

                        The tax gap for individual taxpayers who did not file tax returns for tax
                        year 1992 was almost $14 billion. Other components of the individual tax

                         IRS’ 1996 estimate for individuals noted that IRS enforcement programs recovered about $15 billion of
                        the $95 billion income tax gap for 1992, leaving a net gap of $80 billion.

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                     Taxpayer Compliance: Analyzing the Nature
                     of the Income Tax Gap

                     gap included overreported deductions, credits and other offsets to income
                     ($14 billion), and taxes not remitted along with the filed return ($8 billion).

                     Similarly, variations in compliance exist in the corporate sector. Small
                     corporations tend to mirror the compliance patterns of self-employed
                     individuals. Unreported business income is the biggest compliance
                     problem, and sufficient documentation of income is often lacking. In large
                     corporations, by contrast, the tax gap typically arises from different
                     interpretations of an ambiguous and complex tax code. Upon audit, IRS
                     auditors may interpret the tax provisions differently and, as a result,
                     recommend adjustments to the corporation’s tax liability.4

                     Tax administrators around the globe have worked to promote compliance
Systematic Factors   with whatever tax system is in place. On the basis of our previous work5,
That Influence Tax   we have identified some common principles that have influenced their
Compliance           success.

                     First: The simpler the rules, the better. This reflects the basic
                     principle that the simpler the tax code, the more certain the results in
                     applying it and the fewer the opportunities for disagreements over the
                     “fine points” of tax law. However, we have reported that the existing U.S.
                     system is neither simple nor certain. For example, some paragraphs in the
                     Internal Revenue Code have generated as many as 250 pages of
                     implementing regulations.

                     Second: Collecting from fewer sources is easier. Tax withholding
                     allows the tax collector to focus on the relatively small number of
                     employers rather than on all employees. For example, Congress followed
                     this reasoning in changing the collection point for diesel fuel taxes to the
                     smaller number of businesses earlier in the production chain. Subsequent
                     to this and other changes in the taxation scheme for diesel fuel, collections
                     have risen significantly.

                     Third: More visible tax information promotes higher compliance.
                     Tax withholding and information reporting are two means of making
                     income and some deductions visible to both the taxpayer and the tax
                     administrator; this visibility leads to significantly higher compliance rates.

                      IRS’ primary basis for estimates of the large corporation tax gap arise from these recommended audit
                     adjustments. When any taxpayer appeals the recommendation, the appeal process may result in the
                     recommended tax liability being reduced in whole or in part.
                      Reducing the Tax Gap: Results of a GAO-Sponsored Symposium (GAO/GGD-95-157, Jun. 2, 1995).

                     Page 4                                                                           GAO/T-GGD-97-35
                        Taxpayer Compliance: Analyzing the Nature
                        of the Income Tax Gap

                        Good records and other types of paper trails also lead to better results
                        when the tax administrator audits a return or takes some other
                        enforcement action.

                        Fourth: Good information is critical to identifying compliance
                        problems. This principle recognizes the importance of systematically
                        estimating the extent of noncompliance and variations in taxpayer
                        behavior. In this way, the tax administrator can identify areas warranting
                        attention, tax returns to audit, and the results of any efforts to improve

                        Fifth: Focus compliance efforts where they will do the most good.
                        Having information on the most significant compliance problems helps the
                        tax administrator to tailor its enforcement efforts accordingly. At present,
                        the largest component of the U.S. income tax gap arises from individuals
                        not fully reporting their income, particularly income that is not subject to
                        tax withholding. This knowledge has helped IRS to train its auditors to
                        better detect unreported income.

                        Sixth: Deal with compliance problems quickly. IRS has found that the
                        longer it takes to reach a taxpayer, whether through enforcement or
                        assistance, the less success in correcting the compliance problem.

                        IRS’goal has been to improve the compliance level from 87 percent to
The Challenge for IRS   90 percent by 2001. The tax gap estimates have provided ways for
                        determining whether compliance is improving. At the broadest level, the
                        estimates provide an indicator of the seriousness of the compliance
                        problems and any related inequities. To the extent that sufficient details
                        are known, the estimates also provide insights on the types of tax issues or
                        taxpayers associated with low and high compliance.

                        One method by which IRS hopes to improve compliance is by increasing its
                        compliance presence. Over the last 30 years, the rates at which IRS has
                        audited income tax returns have declined over 75 percent. While
                        alternative mechanisms such as document matching reach many types of
                        income that may not be reported, IRS has no substitute for auditing in the
                        case of more complex tax issues. Another method of improving
                        compliance is to educate the taxpayer about confusing or commonly
                        misunderstood tax requirements. IRS has initiated efforts to develop better
                        information that should help IRS to improve its compliance presence as

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Taxpayer Compliance: Analyzing the Nature
of the Income Tax Gap

well as to secure more opportunities for outreach and education with
taxpayer groups.

To support such efforts, IRS has been reorganizing its compliance research
function to push more research into field offices. IRS hopes that systematic
research, combined with detailed knowledge about tax and enforcement
issues, can provide a road map to large-scale compliance gains. With this
end in mind, IRS has been scheduling various research projects and
attempting to build new databases to allow its researchers access to
current data related to the compliance of various taxpayer groups. Finally,
IRS is considering different ways to measure how well our voluntary tax
system is working.

The importance of these steps has increased with the demise of TCMP. In
October 1995, concerns about costs and burdens on taxpayers prompted
IRS to cancel a planned tax year 1994 TCMP for individuals, small
corporations, and other types of small businesses.6 IRS has not yet
developed an alternative to the comprehensive, statistically valid estimates
on tax compliance that TCMP provided. Lacking such a replacement to date,
IRS hopes that its enhanced research activities will provide a partial

It is not yet clear whether IRS will be able, absent TCMP data, to continue to
provide a comprehensive tax gap estimate with any statistical precision at
the national level. Without such an estimate, IRS and Congress will not
know how well our voluntary tax system works overall and the extent that
all types of taxpayers are paying their fair share of taxes. Nor will IRS and
Congress have a broad context by which to judge the seriousness of the
compliance problems uncovered in field research of selected tax issues
and taxpayer groups.

One factor IRS must balance against its desire to increase voluntary
compliance is the additional costs and burdens that are incurred by both
IRS and the taxpayer. Depending on the actions taken, improving the
compliance rate could dramatically increase the costs to IRS and the
burdens on taxpayers. Reaching for a near-perfect compliance rate very

 While TCMP audits would actually reduce the overall long-term burden on taxpayers to the extent
that fewer compliant taxpayers would be selected for IRS audits in the future, the time and
documentation requirements for taxpayers selected for a TCMP audit can be burdensome. For a
discussion of the difficulties of measuring tax system burden, see our prior testimony entitled Tax
System Burden: Tax Compliance Burden Faced by Business Taxpayers (GAO/T-GGD-95-42, Dec. 9,

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Taxpayer Compliance: Analyzing the Nature
of the Income Tax Gap

likely would mean imposing burdens and costs that our society may not

IRSis hoping that its enhanced research efforts will allow it to target
noncompliance in a systematic way and thus guide enforcement and
educational activities while minimizing costs and burdens. We have
reported7 that IRS’ approach of supplementing its enforcement efforts with
research into the causes of noncompliance strikes us as being intuitively
logical. However, we found mixed support among IRS officials for this
approach causing tensions that could have an adverse impact on its
success. Further, IRS had not completed the infrastructure for planning and
managing the research, although progress has been made. If the research
efforts fall short of expectations, IRS may have to rely on other means,
some possibly more intrusive or more burdensome, to select taxpayers for
enforcement activities such as audits.

In summary, I would like to reiterate how important it is for IRS (or any
other tax administrator) to invest resources in measuring compliance. It is
also important for IRS to use the results to balance efforts among its
competing goals of (1) maximizing collection of taxes owed, (2) promoting
uniform compliance, and (3) minimizing taxpayer burden. I would
welcome any questions.

 Tax Research: IRS Has Made Progress but Major Challenges Remain (GAO/GGD-96-109, Jun. 5, 1996).

Page 7                                                                       GAO/T-GGD-97-35
Appendix I

Selected Tax Gap Statistics

Table I.1: Gross Tax Gap Estimates for
Tax Year 1992 (Dollars in Billions)                                                                                                   Tax gap
                                                                                                                  Tax gap         distribution
                                         Source of tax gap                                                        amount             (percent)
                                         Individual tax gap                                                          $95.3                 74.3%
                                              Unreported income on filed returns                                      58.6                 45.6
                                                 Sole proprietors                                                     29.2                 22.7
                                                 All other income                                                     29.4                 22.9
                                              Overstated deductionsa                                                  14.4                 11.2
                                              Nonfiler                                                                13.8                 10.7
                                              Individual remittance gap                                                 8.4                 6.5
                                              Math errors                                                               0.1                 0.1
                                         Corporate tax gap                                                            33.1                 25.8
                                              Small corporations                                                        7.0                 5.5
                                              Large corporations                                                      23.7                 18.5
                                              Otherb                                                                    0.4                 0.3
                                              Corporate remittance gap                                                  2.0                 1.6
                                         Total tax gap                                                             $128.4                  100.0%
                                             Includes subtractions for erroneous deductions, exemptions, credits, and other adjustments.
                                          Includes unreported income and overstated deductions for exempt organizations’ unrelated
                                         business income and for fiduciaries.
                                             Totals may not add due to rounding.

                                         Source: Income Tax Compliance Research, IRS Publication 1415 (7-88); Income Tax Compliance
                                         Research, IRS Publication 1415 (4-90); and Federal Tax Compliance Research, IRS Publication
                                         1415 (4-96).

                                         Page 8                                                                               GAO/T-GGD-97-35
                                      Appendix I
                                      Selected Tax Gap Statistics

Table I.2:
1992 Underreporting—Individual Tax                                                                     1992 tax
Gap by Source (Dollars in Billions)                                                                        gap           Net reporting
                                      Description                                                       amount            percentage
                                      Underreported income
                                            Wages and salaries                                                 $3.2              99.1%
                                            Interest                                                            0.9              97.7
                                            Dividends                                                           1.3              92.2
                                            State tax refund                                                                     99.2
                                            Alimony                                                             0.1              86.7
                                            Capital gains                                                       2.5              92.8
                                            IRS Form 4797                                                       0.7              72.0
                                            Pensions and annuities                                              1.8              96.0
                                            Taxable unemployment                                                0.3              93.1
                                            Farm income                                                         3.4              67.8
                                            Partnership and small business corporation income                   3.6              92.5
                                            Rents and royalties                                                 3.7              82.8
                                            Informal suppliers                                                 12.3              18.6
                                            Other sole proprietors                                             16.9              67.7
                                            Other income                                                        7.6              75.1
                                            Taxable Social Security                                             0.2              95.8
                                      Overstated offsets
                                            Adjustments to income                                               0.2              98.0
                                            Deductions                                                          5.1              95.6
                                            Exemptions                                                          2.9              95.5
                                            Credits                                                             6.2              59.8
                                      Total underreporting tax gapb                                           $73.1
                                          Less than $0.1 billion dollars.
                                          Totals may not add due to rounding.

                                      Source: Federal Tax Compliance Research, IRS Publication 1415 (4-96).

                                      Page 9                                                                          GAO/T-GGD-97-35
                                      Appendix I
                                      Selected Tax Gap Statistics

Table I.3: Gross Income Tax Gap for
Selected Tax Years 1985, 1988, and                                                               Gross income tax gap
1992 (Dollars in Billions)                                                                               Individual          Corporate
                                      Tax year                                             Total        income tax         income taxa
                                      1985                                                 $85.9              $70.4               $15.5
                                      1988                                                 105.2                80.9               24.3
                                      1992                                                 128.4                95.3               33.1
                                       Amount may be understated since the corporate income tax nonfiler number is not available for
                                      inclusion in the total.

                                      Source: Income Tax Compliance Research, IRS Publication 7285 (3-88); Income Tax Compliance
                                      Research, IRS Publication 1415 (4-90); Federal Tax Compliance Research, IRS Publication 1415
                                      (4-96); and Information from IRS’ Research Division.

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