HEARING BEFORE THE
COMMITTEE ON BUDGET
“IRS and the Tax Gap”
The Honorable J. Russell George
Treasury Inspector General
for Tax Administration
February 16, 2007
HEARING BEFORE THE
COMMITTEE ON BUDGET
“IRS and the Tax Gap”
The Honorable J. Russell George
Treasury Inspector General
for Tax Administration
February 16, 2007
STATEMENT OF
THE HONORABLE J. RUSSELL
GEORGE
TREASURY INSPECTOR GENERAL
FOR TAX ADMINISTRATION
before
the
COMMITTEE ON BUDGET
“IRS and the Tax Gap”
February 16, 20007
Introduction
Chairman Spratt,
Ranking Member Ryan, and Members of the Committee, I appreciate the opportunity
to appear before you today to discuss the tax gap.
The objective
of our tax system is to fund the cost of government operations. The Internal Revenue Service (IRS) attempts to
meet this objective by administering a tax system that provides adequate
funding for the Federal Government while ensuring fairness to all taxpayers. But, as we know, the system has failed to
capture a significant amount of the tax revenue that is owed, which we call the
tax gap. The IRS defines the tax gap as “the difference
between what taxpayers are supposed to pay and what is actually paid.”[1]
It
is worth noting, that if we were to capture the estimated annual tax gap of
$345 billion, it would completely offset the projected fiscal year (FY) 2007
budget deficit of $172 billion and provide a surplus of $173 billion.[2] Considering it in those terms, the tax gap
poses a significant threat to the integrity of our voluntary tax system. Therefore, one of my top priorities for TIGTA
is to identify opportunities for improvements to the IRS’ administration of our
tax system. Similar to nearly all other Federal
agencies, the IRS has limited resources to apply to the objectives it seeks to
achieve. Nevertheless, the IRS must face
the challenge of trying to increase voluntary compliance and reduce the tax
gap.
When I testified on the tax gap last year, I reported that some of the
most challenging barriers to closing the tax gap are tax law complexity, incomplete
information on the tax gap and its components, and reduced IRS enforcement
resources. These same barriers exist
today. However, while tax law
simplification may help close the tax gap, a portion of the tax gap may also be
closed through more effective tax administration and enforcement, as well as a
commitment of additional resources for those efforts.
My remarks will briefly discuss the size and source of the tax gap and
then present some of TIGTA’s significant findings and recommendations to
improve tax administration and help reduce the tax gap.
The Tax Gap: Its Size and Sources
The IRS
describes the tax gap as having three primary components — unfiled tax returns,
taxes associated with underreported income on filed returns, and underpaid
taxes on filed returns.[3] Within the underreported income component,
the IRS has further delineated specific categories of taxes, such as
individual, corporate, employment, estate, and excise taxes.[4]
In 2006, the IRS
updated its estimate of the tax gap, which had been based on data for tax year
(TY) 1988. The new estimate was based on
data obtained from the National Research Program (NRP) for TY 2001 individual
income tax returns. [5] Data from the NRP were used to update the 2001
tax gap figures. The IRS’ most recent
gross tax gap estimate is $345 billion with a corresponding voluntary
compliance rate (VCR) of 83.7 percent.
In any
discussion about whether a specific VCR goal can be met, the logical starting
point would be an assessment of the reliability of the measurement data. In April 2006, my staff reported results of a
review to determine whether the IRS’ compliance efforts and strategies will
enable it achieve a greater VCR by 2010.[6] In all three compliance areas across the
major tax gap segments---nonfiling, underreporting and non-payment---TIGTA has concerns
about whether the tax gap projections are complete and accurate.[7] While TIGTA has concerns about the overall reliability of
the tax gap projections, the review of the tax gap estimates was not meant to be
critical of the efforts the IRS took in re-establishing compliance measurement.
On the contrary, TIGTA commended the IRS
for restoring these critical measurements and for designing them to be much
less burdensome to taxpayers than previous efforts. The IRS’ updated estimate is based on the
best available information.
When considering the updated tax gap estimate, TIGTA found it instructive
to analyze what additional amounts the IRS would have had to collect to increase
voluntary compliance at different estimated intervals for TY 2001. Figure 1 shows the range for TY 2001 based
upon the total tax liability for TY 2001, as estimated in February 2006. The IRS has proposed in the FY 2007 budget
that the VCR will be raised from 83.7 percent to 85 percent by 2009. Accordingly, if the total tax liability
remained constant, the IRS would have to collect, on a voluntary and timely
basis, $28 billion more in TY 2009, thus reducing the gross tax gap to $317
billion. To reach 90 percent voluntary
compliance by TY 2010,[8] the amount voluntarily
and timely collected for TY 2010 would be an additional $134 billion, thus
reducing the gross tax gap to $211 billion if the total tax liability remained
constant.
Figure 1: Additional Voluntary and Timely Payments
Required to Reach Specified VCR Levels[9]
Source: Treasury Inspector General for Tax
Administration
In summary, TIGTA
concluded in its review of the updated tax gap estimate that the IRS still does
not have sufficient information to completely and accurately assess the overall
tax gap and the VCR. Although having new
information about TY 2001 individual taxpayers is better when compared to the
much older TY 1988 information from the last TCMP survey, some important individual
compliance information remains unknown.
Additionally, although individuals comprise the largest segment of
taxpayers and were justifiably studied first, no new information about
employment, small corporate, large corporate, and other compliance segments is
available. With no firm plans for
further studies or updates in many areas of the tax gap, the current tax gap
estimate is an unfinished picture of the overall tax gap and compliance.
The IRS Needs to Overcome Institutional Impediments to More Effectively
Address the Tax Gap
Institutional impediments in this context of tax
administration are the established policies, practices, technologies,
businesses processes or requirements that add unintended costs or are no longer
optimal given changes to strategies, goals, and technologies. The costs of these impediments include lost
opportunities and the delayed development of innovative solutions.
Impediments can also be perceived as
opportunities. The removal of an
impediment creates opportunities to achieve increased efficiency and
effectiveness in tax administration.
TIGTA’s perspective is that the current institutional impediments the
IRS faces can give way to beneficial opportunities.
Incomplete
Compliance Research
Performing a
compliance measurement program is expensive and time consuming. The estimated cost for performing the TY 2001
individual taxpayer NRP was approximately
$150 million. According to IRS
officials, resource constraints are a major factor in NRP studies and affect
how often the NRP is updated. Operational
priorities must be balanced against research needs. From FY 1995 through FY 2004, the revenue agent workforce declined
by nearly 30 percent while the number of returns filed grew by over 9
percent. This shortfall in examiner
resources makes conducting large-scale research studies problematic.
The IRS’ budget submission to the
Department of the Treasury for FY 2007 requested funding to support ongoing NRP
reporting compliance studies. The IRS
Oversight Board[10]
supports ongoing dedicated funding for compliance research. Unfortunately, funding for those resources in
previous fiscal years did not materialize.
Without a resource commitment for continual updating of the studies, the
information will continue to be stale and less useful in measuring voluntary
compliance.
The IRS’
National Research Program (NRP) is designed to measure taxpayers’ voluntary
compliance, better approximate the tax gap, and develop updated formulas to
select noncompliant returns for examination. The first phase of this program addressed
reporting compliance for individual taxpayers, and data from this phase were
used to produce the updated estimates of this portion of the tax gap. These initial findings should enable the IRS
to develop and implement strategies to address areas of noncompliance among
individual taxpayers.
The second
phase of the NRP, which has begun, focuses on Subchapter S corporations (Forms
1120S). TIGTA recently reviewed the on-going NRP
study of Subchapter S corporations and reported that the study was effectively
planned.[11] The NRP study is on target, with just over 17
percent of the examinations closed as of November 3, 2006. Revenue agents conducting the examinations
received appropriate and timely training.
A multi‑layered quality review process is in place, and feedback
is provided when appropriate to resolve any problems identified. The study should provide valuable data when
completed.
While the IRS is
actively involved in managing and monitoring the NRP study, TIGTA noted some
areas in which there can be further improvement. Some NRP study results may not be complete,
accurate, or provide information sufficient to update existing return selection
formulas.
The
three concerns TIGTA noted could reduce the reliability of the NRP study
results. However, the IRS is taking or has
planned actions that should reduce these risks.
Final decisions on how to address these concerns cannot be made until
more of the examinations are completed.
As a result, TIGTA did not recommend any additional actions the IRS
should take. However, TIGTA will monitor
the adequacy of the IRS’ decisions and actions to address the concerns in
future reviews.
The individual
and Subchapter S corporation NRP initiatives allow the IRS to update
return-selection models for more effective return selection for its compliance
efforts.
In 2005, TIGTA reported that the return-selection formulas, developed in the
1980s, only accounted for the selection of 22 percent of the corporate returns
selected for examination in FY 2004.[13] Updated selection models should contribute to
more effective use of the IRS’ compliance resources.
In April 2006, TIGTA
recommended that the IRS Commissioner
continue to conduct NRPs on a regular cycle for the major segments of the tax
gap.[14] TIGTA also recommended that the IRS augment
the direct measurement approach, and devise indirect measurement methods to
assist in quantifying the tax gap. The
IRS agreed with these recommendations, subject to available resources. In addition, TIGTA recommended that the IRS Commissioner
consider establishing a tax gap advisory panel that includes tax and economic
experts to help identify ways to better measure voluntary compliance. The IRS agreed to look into establishing such
an advisory group with the intent of using it to validate and improve
estimation methods.
Increase
the Economy, Efficiency and Effectiveness of Compliance Strategies
TIGTA has made
several recommendations to improve the efficiency and effectiveness of IRS
operations. These improvements would help
the IRS address the tax gap. Some of
TIGTA’s more significant recommendations concern:
Less Effective Examination Techniques
Used for High-Income Taxpayers
In July 2006, TIGTA
reported the results of its review of the IRS’ increased examination coverage
rate[15]
of high-income taxpayers.[16] The increased coverage has been due largely
to an increase in correspondence examinations,[17]
which limit the tax issues the IRS can address in comparison with face‑to‑face
examinations. In addition, the
compliance effect may be limited because over one-half of all high-income
taxpayer examination assessments are not collected timely.
The examination
coverage rate of high-income taxpayers increased from 0.86 percent in
FY 2002 to 1.53 percent in FY 2005.
Included in this statistic is an increase in the examination coverage
rate of high-income tax returns, Forms 1040 with a Schedule C. This examination coverage rate increased from
1.45 percent in FY 2002 to 3.52 percent in FY 2005. However, the increase in examination coverage
is due largely to an increase in correspondence, rather than face-to-face,
examinations. While face-to-face
examinations increased by 25 percent from FY 2002 through FY 2005,
correspondence examinations increased by 170 percent over the same period.
As a result, the
percentage of all high-income taxpayer examinations completed through the
Correspondence Examination Program grew from 49 percent in FY 2002 to 67 percent
in FY 2005. The increase in
correspondence examinations for high-income
taxpayers who filed a Schedule C was even larger. Examinations closed by correspondence
comprised about 30 percent of all high-income taxpayer Schedule C examinations
from FYs 2002 through 2004. In FY 2005,
approximately 54 percent of all high-income taxpayer Schedule C examinations
were conducted by correspondence.
High-income
households typically have a large percentage of their income that is not
subject to third-party information reporting and withholding. The absence of third‑party information
reporting and withholding is associated with a relatively higher rate of
underreporting of income among business taxpayers. It is
difficult to determine through correspondence examination techniques whether
these taxpayers have reported all of their income.
In FY 2004, the IRS assessed more than $2.1
billion in additional taxes on high-income taxpayers through its Examination
program. This figure includes
assessments of $1.4 billion (66 percent) on taxpayers who did not respond to
the IRS during correspondence examinations.
Based on a statistical sample of cases,[18] TIGTA
estimates that approximately $1.2 billion (86 percent) [19]
of the $1.4 billion has been either abated[20]
or not collected after an average of 608 days — nearly two years after the
assessment was made. Our conclusion is
that the Examination and Collection programs for high-income taxpayers may not
be positively affecting compliance, given the substantial assessments that have
been abated or not collected.
TIGTA recommended
that the IRS complete its plan to maximize the compliance effect of high-income
taxpayer examinations. TIGTA also
recommended that the plan should include the mixture of examination techniques,
issues examined, and collection procedures. The IRS agreed with our recommendations.
Incomplete Document Matching Programs
TIGTA has also identified improvements
that should be made to improve compliance in business tax filing. [21] The GAO has reported that more than 60
percent of U.S.-controlled corporations and more than 70 percent of
foreign-controlled corporations did not report tax liabilities from 1996
through 2000. [22] Although individual wage earners who receive
a Wage and Tax Statement (Form W-2) have their wages verified through a
matching program, a similar comprehensive matching program for business
documents received by the IRS does not exist. TIGTA has recommended that the IRS evaluate
all types of business documents it receives to determine whether this
information can be used to improve business compliance. In its response to our recommendations, the
IRS wrote that it could not implement this recommendation at that time. However, the IRS also shared its belief that
ongoing efforts would provide the results that our recommendation hoped to
achieve and asked for the opportunity to continue its efforts.
An IRS study,
based on TIGTA recommendations, found that in FY 2000, business information
documents[23]
reported $697 billion of potential taxable income.[24] Furthermore, business information documents
identified 1.2 million unresolved IRS business nonfiler tax modules. An IRS tax module contains records of tax
liability and accounting information pertaining to the tax for one tax
period. TIGTA has also reported on
issues related to the increasing global economy. Investments made abroad by U.S. residents have
grown in recent years, nearly tripling from $2.6 trillion in 1999 to $7.2
trillion in 2003. To address the tax
compliance challenges presented by foreign investments, TIGTA recommended that
the IRS make better use of the foreign-source income information documents
received from tax treaty countries.
TIGTA also recommended that, prior to issuing refunds to foreign
partners, the IRS implement an automated crosscheck of withholding claims
against available credits for partnerships with foreign partners.[25]
Implementing a
comprehensive matching program to identify noncompliance among businesses would
be difficult and could require some legislative changes, but it could identify
significant pockets of noncompliance among business taxpayers.
Regulations
for Granting Extensions of Time to File Delay the Receipt of Taxes Due
Taxpayer payment compliance means that the amounts owed are paid on
time. However, for decades, the IRS has
allowed taxpayers with extended return filing due dates to send in late
payments and pay only interest and small failure-to-pay penalties. Obtaining an extension of time to file a tax
return does not extend the due date for tax payments, and failure-to-pay
penalties are typically assessed when payments are made late, even if the
taxpayer has received an extension.
In 1993, IRS management eliminated the requirement
to pay all taxes by the payment due date in order to qualify for an extension
of time to file. Once an extension has
been granted, the taxpayer is exempt from a 5 percent per month delinquency penalty[26]
for the period of the extension. TIGTA
evaluated the impact of these rules on individual and corporate taxpayers and
found that 88 percent of untimely tax payments for returns filed after April 15
were attributable to extended-due-date taxpayers.[27] Corporations are required to pay estimates of
their unpaid taxes in order to be granted extensions. However, TIGTA found corporate estimates to
be highly flawed; in calendar year (CY) 1999 alone, approximately 168,000
corporations received an extension, yet failed to pay $1.8 billion in taxes
when they were due.
TIGTA projected that the tax gap from extension-related individual
income tax underpayments would amount to approximately $46.3 billion in CY 2008,
of which approximately $29.8 billion would not be paid until after the end of
FY 2008. Due to the more complex nature
of corporate taxes, similar figures were not available for corporations,
although TIGTA estimated that by TY 2008, approximately $768 million in
additional corporate taxes would be timely paid if TIGTA’s recommendations were
adopted. The IRS agreed to study TIGTA’s
recommendations.
Uncoordinated Nonfiler
Strategy
According
to the IRS’ February 2006 tax gap estimate, individual and estate tax non-filers
accounted for about 8 percent of the total tax gap[28] for TY 2001. Corporate income, estate and excise tax
non-filing estimates were not available.
The IRS study, together with previous IRS studies, indicates the tax gap
for individual non-filers almost tripled from $9.8 billion in TY 1985 to about $27
billion[29] in TY 2001.
In the past, the IRS has had several
strategies for reducing the tax gap attributable to individual non-filers. The most recent National Non-filer Strategy,
which was developed for FY 2001 through FY 2003, was made obsolete in July 2002
when the IRS was reorganized. Since
then, each IRS business division has been responsible for tracking and
monitoring completion of its own action items.
Consequently, there has been no formal system in place for coordinating
and tracking all actions across all IRS divisions.
In November
2005, TIGTA reported that as increasing
voluntary compliance remains an organization-wide effort, the individual
business divisions within the IRS have taken steps to improve efficiency in
working non-filer cases.
[30] The actions
taken by business divisions included:
However, these were not
coordinated activities that were planned and controlled within the framework of
a comprehensive strategy. Since FY 2001,
each business division has independently directed its own non-filer
activities. The IRS did not have a
comprehensive, national non-filer strategy or an executive charged with
overseeing each business division’s non-filer efforts. TIGTA concluded that the IRS needed better
coordination among its business divisions to ensure resources are being
effectively used to bring non-filers into the tax system and ensure future
compliance. The IRS also needed an organization-wide
tracking system to monitor the progress of each business division’s actions.
In addition to better coordination and an organization-wide tracking system, the IRS also needed measurable program goals. TIGTA suggested three measurable goals that could be established:
·
The
number of returns secured from non-filers.
·
Total
payments received.
·
The
recidivism rate.
Without such measurable program goals, the IRS is unable to determine whether efforts to improve program efficiency and effectiveness are achieving desired results. The IRS agreed with all of TIGTA’s recommendations. For FY 2006, the IRS developed its first comprehensive non-filer work plan.
Limited Tip Program
Expansion
Historically, the IRS has been concerned about
employees not reporting tips earned in industries in which tipping is
customary. An IRS study showed that the
amount of tip income reported in CY 1993 was less than one-half of the tip
income, leaving over $9 billion unreported.
To address this underreporting, the IRS developed the Tip Rate
Determination and Education Program (the Tip Program), which is a voluntary
compliance program originally designed for the food and beverage industry. It was modeled after the tip compliance
agreement used by casinos in the former IRS Nevada District. The Tip Program
offers employers multiple voluntary agreement options designed to provide
nonburdensome methods for employers and employees to comply with tip reporting
laws. The Tip Program was extended to
the cosmetology industry in 1997 and the barber industry in 2000.
Since the Tip
Program was introduced, voluntary compliance has increased significantly. In TY 1994, tip wages reported were $8.52
billion. For TY 2004, the amount exceeded
$19 billion. To date, over
16,000 employers, representing over 47,000 individual establishments, have
entered into tip agreements.
TIGTA reviewed
the Tip Program and reported that the IRS has not consistently monitored the
establishments in the food and beverage and cosmetology industries that had
entered into tip agreements since FY 2000 to determine if tip agreements
secured actually increased tip income for these establishments.[34] Additionally, due to the voluntary nature of
participation and limited IRS resources, disparity with the number of tip
agreements secured between various locations across the country is an issue.
In FY 2006, the IRS did not plan to actively solicit any new tip agreements
beyond the gaming industry. The majority
of FY 2006 Tip Program staffing was to be expended on soliciting and monitoring
tip agreements with the gaming industry and on audits of casino employees.
Recognizing
that the Tip Program has not reached some small businesses in the food and beverage
industry, the IRS developed the Attributed Tip Income Program (ATIP). The Department of the Treasury approved the
ATIP Revenue Procedure on July 11, 2006 and the ATIP Revenue Procedure was issued on
July 28, 2006. The ATIP Revenue Procedure aims at
increasing tip reporting for small businesses that report at least
20 percent of their tip income as charged tips.
It should provide benefits similar to those of previous tip reporting
agreements for employers and employees who report tips at or above a minimum
level of gross receipts.
The
IRS plans to test the ATIP with the food and beverage industry for three
years. The ATIP Revenue Procedure was
designed as a three-year pilot to provide time to assess its impact on tip
reporting compliance. It will take up to
this length of time to assess whether the ATIP Revenue Procedure has achieved
its goal and to consider whether it is appropriate to expand and modify it for other
industries.
TIGTA recommended
several improvements to the IRS’ Tip Program, including expansion to the cosmetology
and taxi/limo industries. The Tip
Program has not expanded to the taxi/limo industry. TIGTA estimated that the IRS could achieve
$342 million in additional tax assessments over five years if it resumes
soliciting new tip agreements with the cosmetology industry and expands the
agreements to the taxi/limo industry.
The
IRS agreed with TIGTA’s recommendations, including consideration of expanding
the Tip Program after evaluating the results of the ATIP with the food and beverage
industry. If the ATIP proves successful,
the IRS should develop similar procedures for specific industries, including
the cosmetology and tax/limo industries.
Unclear Offer in Compromise
Program Requirements
The IRS has the authority to settle or
compromise Federal tax liabilities by accepting less than full payment under
certain circumstances. This is
accomplished through an Offer in Compromise (OIC). An OIC is an agreement between a taxpayer and
the Federal Government that settles a tax liability for payment of less than
the full amount owed. Improving the
methods for identifying candidates for the OIC could result in substantial
benefits since taxpayers generally do remain in compliance when offers are
accepted. However, between FYs 1996 and
2005, only approximately 24 percent of the 1.1 million offers received by the
IRS were accepted. Over this same
10-year period, 50 percent either did not meet preconditions of filing an offer
or were returned to the taxpayer (e.g., for missing information) during the offer
evaluation.
Taxpayers who wish to participate in the
program initiate an offer; however, this attracts offer applications from
taxpayers who do not qualify for the program or taxpayers who do not fully
understand the depth of financial verification the IRS conducts before
accepting an offer. TIGTA analyzed offer
dispositions and reported the following:[35]
The high rates
of returned offers occurred because requirements of the OIC program were not
always clear to taxpayers. In addition,
taxpayers had little to lose; if their offers were not accepted, collection of
their taxes was, in effect, delayed. The
OIC application fee implemented by the IRS during FY 2004 was intended to
reduce the number of frivolous offers; however, this fee is not applicable to
offers that are considered to be not-processable. Also, in light of the potential benefit of a
fresh start, the fee may not be significant to some taxpayers.
The IRS effectively monitors accepted
offers to ensure compliance with the terms of the offers. TIGTA reviewed a sample of 84 taxpayers whose
offers were accepted during FY 1999. The
IRS had identified noncompliance in 33 (39 percent) instances and took
appropriate action to resolve the noncompliance. At the time of TIGTA’s review, 96 percent of the
84 taxpayers were in compliance with the OIC payment terms and the five-year
compliance requirements for filing their returns and paying the taxes due.
The IRS conducted a more comprehensive
analysis[37] of
individual taxpayer compliance with filing and paying requirements for offers
accepted during CYs 1995 through 2001.
According to that analysis, approximately 80 percent of the individual
taxpayers remained in compliance. This
includes taxpayers who received the first collection notice but did not receive
any subsequent notices.
Also, taxpayers remain in compliance
after the five-year monitoring period.
TIGTA’s review of a sample of 245 taxpayers whose offers were accepted
between October 1, 1994, and December 31, 1998, determined that 220 taxpayers
(90 percent) were compliant with filing and payment requirements on tax periods
subsequent to the five-year monitoring period.
[38]
Incomplete Payroll Tax Assessments
Social Security
and Medicare taxes are paid to the Department of the Treasury from two primary
sources (1) payroll taxes consisting of amounts withheld from employees and
matching amounts paid by employers and (2) self-employment taxes. Employers are generally required by law to
withhold from their employees’ incomes the employees’ shares of Social Security
and Medicare taxes. Included in the
employer’s calculation of these taxes are wages earned by the employees and
tips received by the employees and reported to the employer. One-half of the calculated tax amount is
withheld from the employee’s wages and the employer pays a matching
amount. Self-employed taxpayers must pay
the entire amount of Social Security and Medicare taxes themselves in the form
of self-employment taxes.
Social Security and Medicare Tax on Unreported Tip Income (Form 4137) was originally designed to calculate only the Social Security and Medicare taxes owed on tips not r