HEARING BEFORE THE
COMMITTEE ON HOMELAND SECURITY AND
GOVERNMENTAL AFFAIRS
SUBCOMMITTEE ON FEDERAL
FINANCIAL MANAGEMENT, GOVERNMENT INFORMATION AND INTERNATIONAL SECURITY
“Deconstructing the Tax Code: Uncollected Taxes and Issues of Transparency”
The Honorable J. Russell George
Treasury Inspector General
for Tax Administration
September 26, 2006
Washington, DC
STATEMENT OF
THE HONORABLE J. RUSSELL
GEORGE
TREASURY INSPECTOR GENERAL
FOR TAX ADMINISTRATION
before the
SUBCOMMITTEE ON FEDERAL FINANCIAL MANAGEMENT, GOVERNMENT INFORMATION AND
INTERNATIONAL SECURITY
“Deconstructing the Tax
Code: Uncollected Taxes and
Issues of Transparency”
September 26, 2006
Introduction
Chairman Coburn, Ranking Member Carper,
and Members of the Subcommittee, I appreciate the opportunity to appear before
you today to discuss the tax gap and Internal Revenue Service (IRS) efforts to
close it. My statement today is drawn from previous Treasury Inspector
General for Tax Administration (TIGTA) reports and testimonies covering the tax
gap and IRS compliance efforts, which were done in accordance with government
auditing standards, as well as reviews of relevant studies and literature.
The objective
of our tax system is to fund the cost of government operations. The IRS attempts to meet this objective by
implementing a tax system that provides adequate funding for the Federal
Government and is fairly applied 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, it would
offset the projected fiscal year (FY) 2006 budget deficit of $260 billion and
give us a surplus of approximately $95 billion.
Because the tax gap poses a significant threat to the integrity of our
voluntary tax system, one of my top priorities for TIGTA is to identify
opportunities for improvements to the IRS’ tax compliance initiatives.
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 increasing voluntary compliance and reducing the tax gap. When I testified on
the tax gap in July 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. To an extent, a portion of the tax gap can be
closed through more effective enforcement and a commitment of additional
enforcement resources. A significant
portion of the gap, however, may not be amenable to traditional examinations
and audits. Other means might better
address that portion, such as tax law simplification and increased third-party
reporting. Some of TIGTA’s more
significant findings and recommendations to improve tax administration and help
the IRS reduce the tax gap are presented later in my testimony.
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.[2] Within the underreported income component,
the IRS has further delineated specific categories of taxes, such as
individual, corporate, employment, estate, and excise taxes.[3]
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. [4] Data from the NRP were used to update the
2001 tax gap figures. The IRS developed
a chart called the tax gap map to graphically depict the gross tax gap for TY
2001, its components, and their relative sizes.
The map
attributes various certainties to the tax gap estimates, representing the IRS’
confidence in the figures based on the quality and age of the estimates. Figure 1 shows the most recent version of the
tax gap map.
Figure 1:
IRS Tax Gap Map
Source: IRS
As shown in the
preceding tax gap map, the IRS’ TY 2001 gross tax gap estimate for individual,
employment, corporate, and other taxes is $345 billion with a voluntary
compliance rate (VCR) of 83.7 percent based on the NRP data.
A logical
starting point for any discussion about whether a specific VCR goal can be met
is an assessment of the reliability of the measurement data. In April 2004, Senator Baucus called for a 90
percent VCR by the end of the decade.
Based upon the best information the IRS had available as of February
2006, the gross tax gap for TY 2001 was approximately $345 billion and the VCR
was approximately 83.7 percent. Assuming
the current IRS tax gap and VCR were complete and accurate, the 90 percent
compliance target would present major challenges to tax administration. For example, assuming that in TY 2010 the
total tax liability is the same as it was in TY 2001, to reach a level of 90
percent voluntary compliance, noncompliant taxpayers would have to timely and
voluntarily pay an additional $134 billion.[5] The IRS has proposed a less aggressive VCR
goal of 85 percent by 2009.
Regardless of the
VCR goal, TIGTA has concerns in all three compliance areas across the major tax
gap segments about whether the tax gap projections are complete and accurate.[6] TIGTA’s primary concerns involve the areas of
nonfiling, underreporting, and estimated payments that result in the difference
between the gross and net tax gaps.[7]
Prior to the NRP,
the IRS estimated the nonfiling gap to be $30.1 billion, which was composed of
$28.1 billion in individual income taxes and $2 billion in estate taxes. In February 2006, the IRS updated this
estimate to $25 billion in individual income taxes. The individual estimate was based on data
provided by the U.S. Census Bureau.
However, there are supplemental data that suggest substantial amounts
are not included in the tax gap estimates.
For example, the IRS tax gap map describe the nonfiling estimate as
reasonable despite the missing segments of corporate income, employment, and
excise taxes. The IRS does not have definite
plans to update the estate tax segment[8] or
to estimate the corporate, employment, and excise tax nonfiler segments,
suggesting that the nonfiler estimate is incomplete and likely inaccurate.
In July 2004,
researchers in the Small Business/Self-Employed (SB/SE) Division issued a
report on business nonfilers recommending implementation of an enhanced system
for creating and selecting inventory.
Subsequently, the SB/SE Division research office developed a prototype
that matched $4.6 trillion in transactions to over one-half of the business
nonfilers for TY 2002, detecting approximately $1 trillion of apparent taxable
income. That fact alone brings the $27
billion individual and estate nonfiling estimate into question and demonstrates
the need for more research to better estimate nonfiling for all tax segments.
The tax gap
attributed to underreporting is by far the largest identified portion of the
tax gap at an estimated $285 billion.
Yet, TIGTA concluded that this estimate may not be complete since there
are at least four areas that suggest substantial amounts are not included in
the tax gap map projections.
·
First, the business income portion of
the individual underreporting tax gap estimate is incomplete because it lacks information
from another NRP study that the IRS is undertaking on flowthrough returns[9]
of Subchapter S corporations.[10] The study, which began in October 2005, will
take two to three years to complete.
Thus, the information from these audits was not available for the
February 2006 updated TY 2001 tax gap estimates. Over 2.9 million Subchapter S Corporation
returns were filed in TY 2001 with more than 5.3 million shareholders reporting
$187.7 billion in net income.
·
Second, the tax gap map lists the underreporting gap at $5 billion
for small corporations and $25 billion for large corporations. These amounts are essentially carryovers from
the previous estimate and are of weaker certainty since no new information was
developed. For small corporations, the
estimate is based on the 1980 Taxpayer Compliance Measurement Program (TCMP)
survey. For large corporate
underreporting, the previous estimates were not based on random TCMP audits but
on operational audit coverage from the mid-1980s. These projections assume constant VCRs, yet
current experience suggests compliance may not be constant. For example, in 2003, an IRS contractor
estimated that the yearly tax gap arising from abusive corporate tax shelters
alone was between $11.6 billion and $15.1 billion.[11]
·
Third, the map similarly categorizes as reasonable a $4 billion
figure for estate taxes and provides no estimate for excise taxes, yet the
estate tax estimate was not updated during the current NRP. In addition, there are no firm plans for
further studies or updates of these components.
·
Fourth, for the employment tax component, the
combined $15 billion Federal Insurance Contributions Act and unemployment tax
gap figure was also carried over and will not be further studied. Most of the employment tax component consists
of self-employment tax. Yet, similar to the
business income portion of the individual income tax gap, this, too, is incomplete without the flowthrough data.
The IRS’ tax gap maps, both before and after the NRP, list $55 billion
as recoveries or enforced collections and other late payments.[12] This figure does not represent an actual
amount but is an estimate projected from historical information and formulas
based on what is known about the amount of collections on accounts over
time. However, TIGTA found the actual
basis of these formulas to be very limited, as well as dated. IRS officials acknowledge that these formulas
were developed “quite some time ago.”
Thus, these formulas most likely do not take into account changes in the
IRS’ ability to collect revenue.
To determine the validity of the potential $55 billion in collections, TIGTA
requested data from the IRS on actual collections for TY 2001 by year of
collection. These collections have two
basic components: voluntary payments
received by the IRS after the due date and payments received by the IRS as a
result of some type of IRS intervention.
The IRS, however, does not currently correlate either type of payment to
the applicable tax year. Consequently,
the IRS has no means of determining whether the $55 billion is ever
collected. While the IRS is currently
developing a way to associate collections resulting from enforcement actions to
the related tax years, no similar data are being developed for voluntary late
payments. Unless the latter data are similarly
correlated, the IRS will be unable to determine actual collections or an
accurate net tax gap.
In summary, much
of the information remains dated, the new information is incomplete in several
respects, and methodology differences create challenges. Considering this, a somewhat different
picture of the tax gap map emerges. TIGTA
has concluded that despite the significant efforts undertaken in conducting the
individual taxpayer NRP, 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 a considerable improvement over the much older
information based on the last TCMP survey in TY 1988, some important individual
compliance information remains unknown.
Additionally, although individuals comprise the largest segment of taxpayers
and were justifiably studied first, no new information is available 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, both the
underreporting tax gap and the nonfiling gap will indefinitely leave an
unfinished picture of the overall tax gap and compliance.
Achieving Targeted Voluntary Compliance Goals
While TIGTA has concerns about the overall
reliability of the tax gap projections, the annual amounts collected that
reduce the net tax gap, and the VCR, TIGTA determined that it was instructive
to analyze what additional amounts the IRS would have had to collect to reach
90 percent voluntary compliance at different estimated intervals for TY
2001. Figure 3 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,[13] 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 2: Additional Voluntary and Timely Payments
Required to Reach Specified VCR Levels[14]
Source: Treasury Inspector General for Tax
Administration
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 (the Department) for
FY 2007 requests funding to support ongoing NRP reporting compliance
studies. The IRS Oversight Board
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.
In June 1993,
IRS executives met with the Department and Office of Management and Budget (OMB)
officials to discuss key issues for the FY 1995 budget. The issues facing the Federal Government at
that time were similar to the current issues:
severe fiscal constraints and the desire for good tax
administration. Consequently, both the
Department and OMB agreed to work with the IRS on a comprehensive plan to
reduce the tax gap.[15] The IRS formed a task group that performed an
extensive review of the tax gap.[16] The resulting task force report addressed the
major areas of the tax gap and provided recommendations. The report concluded that:
·
Enforcement
is the most costly option and delivers only limited revenue;
·
Methods
to increase voluntary compliance are less costly but more burdensome to
taxpayers;
·
Legislative
changes are needed as the primary means to increase compliance levels;
·
The
TCMP surveys can be used to identify the types of noncompliance but not the
causes;
·
The
IRS needs to reevaluate its media and taxpayer education efforts;
·
The
tax gap needs to be treated as a multibillion dollar market, and efforts need
to be made to capture as much of that market as possible;
·
The
IRS needs to consider making a high-level official responsible for overseeing
efforts to close all components of the tax gap; and
·
The
IRS Strategic Plan needs to be modified to more closely align with the tax gap
components.
Opportunities for
Closing the Tax Gap
Although better
data will help the IRS identify noncompliant segments of the population,
broader strategies and better research are also needed to determine what
actions are most effective in addressing noncompliance. The IRS must continue to seek accurate
measures of the various components of the tax gap and the effectiveness of
actions taken to reduce it. This
information is critical to the IRS for strategic direction, budgeting and staff
allocation. The Department also needs
these measures for tax policy purposes. Additionally, Congress needs this
information to develop legislation that improves the effectiveness of the tax
system.
Recommendations
on how to close the tax gap have been circulating for many years. Some of those recommendations, made over 15
years ago, are still relevant today. I
would like to focus on the following opportunities that TIGTA, other oversight
groups, and interested stakeholders have identified to address the tax gap:
·
Reduce
the Complexity of the Tax Code;
·
Gather
Better Compliance Data;
·
Refine
Compliance Strategies;
o High-Income Taxpayers;
o Abusive Tax Shelters;
o Information Reporting on Sales of
Investments;
o Withholding on Non-employee Compensation;
o Document Matching;
o Late Filed Returns;
o Coordinated National Nonfiler Strategy;
o Tip Agreements;
o Fraud Prevention and Detection; and
·
Increase
Resources in the IRS Enforcement Functions.
Reduce the Complexity of
the Tax Code
The topic of tax
law complexity generally evokes calls for tax law simplification. Government, academic and technical studies
suggest a strong correlation between tax law complexity and tax law
compliance. The greatest case for the
correlation is that complexity allows legal tax avoidance, which at times can
evolve into illegal tax evasion. The
argument continues that because of tax law complexity, it is often difficult to
ascertain whether a taxpayer has intentionally evaded taxes, or whether there
was an honest misunderstanding.
Therefore, the IRS use of punitive penalties must be tempered to ensure
taxpayers are not penalized for honest misunderstandings.
The President’s
Advisory Panel on Federal Tax Reform cited tax code complexity as a significant
problem.[17] Among others, sources of complexity include
duplicative and overlapping provisions, phase-outs, and expiring
provisions. In addition, the panel cited
the instability of the tax code. Since
1986, there have been more than 14,400 changes to the code. This complexity is
costing the
One of the major
effects attributed to tax law complexity is that it causes lower voluntary
compliance. According to the American Institute
of Certified Public Accountants, tax law complexity:
·
Increases
perceptions that the tax system is unfair;
·
Increases
costs for tax administration and tax compliance;
·
Decreases
the quality of tax administration and tax assistance; and
·
Increases
the number of inefficient economic decisions.[18]
Although it is believed that tax law
simplification would increase voluntary compliance, there are significant
factors that suggest simplification would be difficult to achieve throughout
the Internal Revenue Code. The Joint Committee on Taxation identified various sources of complexity,
with no single source as being primarily responsible. The sources identified were:
·
A lack of clarity and readability of the law;
·
The use of the Federal tax system to advance social
and economic policies;
·
Increased complexity in the economy; and
·
The interaction of Federal tax laws with State
laws, other Federal laws and standards (such as Federal securities laws,
Federal labor laws and generally accepted accounting principles), the laws of
foreign countries, and tax treaties. [19]
The lack of
clarity and readability of the law results from:
·
Statutory language that is, in some cases, overly
technical and, in other cases, overly vague;
·
Too much or too little guidance with respect to
certain issues;
·
The use of temporary provisions;
·
Frequent changes in the law;
·
Broad grants of regulatory authority;
·
Judicial interpretation of statutory and regulatory
language; and
·
The effects of the congressional budget process.
Experts in tax policy maintain that any
tax system will have complexity.
Therefore, even though many people believe that tax simplification could
provide the impetus for increasing voluntary compliance, a simple tax system
could be a very difficult goal to achieve, given the complexities of our
society and multiple uses of the Internal Revenue Code. Thus, closing the tax gap through tax
simplification and eliminating tax expenditures could prove to be
challenging. But, to the extent that the
tax law can be simplified, most experts believe that voluntary compliance would
improve.
Another effective method to increase
voluntary compliance might be through greater visibility of transactions. A study by senior IRS researcher Kim M.
Bloomquist suggests that beyond the tax law complexity/tax law compliance
correlation there may be “trends in the environment that account for the rising
tax noncompliance.”[20] According to the study, the presumed rise in
tax noncompliance “may be due, at least in part, to a shift in taxpayer income
away from more visible to less visible sources.” The study found that income that is not
subject to third-party reporting is highest among taxpayers with the highest
incomes.[21] For the top 5 percent of taxpayers,
unmatchable income as a percentage of Adjusted Gross Income increased by over
98 percent between 1980 and 2000.
The IRS has
shown that there is a high correlation between tax compliance and third-party
information reporting. The difference in
compliance rates between individual wage-earning taxpayers and those operating
businesses is striking. The IRS has
estimated that individuals whose wages are subject to withholding report 99
percent of their wages for tax purposes.[22] In contrast, self-employed individuals who
formally operate non-farm businesses[23]
are estimated to report only about 68 percent of their income for tax
purposes. Even more alarming,
self-employed individuals operating businesses on a cash basis[24]
report just 19 percent of their income to the IRS.
TIGTA believes that a combination of
efforts will be required to increase voluntary compliance and reduce the tax
gap. Tax simplification and increased
transparency through third-party reporting are significant contributing factors
toward achieving these goals.
Gather Better Compliance Data
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 next phase of the NRP, which has begun, focuses on
Subchapter S corporations (Forms 1120S).
TIGTA is currently conducting a review of this phase.
These
initiatives will 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.[25] 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. 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.
Refine
Existing and Develop New Compliance Strategies
The IRS conducts
various compliance activities in an effort to reduce the tax gap. However, the IRS needs to develop a
comprehensive strategy to reduce the tax gap.
Nearly 27 years ago, the GAO testified that “…it is clear that the
Service [IRS] needs a comprehensive compliance strategy. To develop this, the IRS needs to determine
the extent to which it is presently detecting unreported income from the
various pockets of noncompliance. It then
needs to consider reallocating its resources based on that determination and
assess the need for additional resources to close the tax gap for each source
of unreported income.”[26]
High-Income Taxpayers
Since FY 2000, the IRS’ Small Business/Self-Employed (SB/SE) Division has
increased examinations of potentially noncompliant high-income taxpayers. In FY 2005, examinations of high-income
taxpayers were at their highest level since FY 1996. As previously noted, the IRS considers
high-income taxpayers to be those who file a U.S. Individual Income Tax Return
(Form 1040) with Total Positive Income (TPI)[27]
of $100,000 or more and those business taxpayers who file a Form 1040 with
Total Gross Receipts of $100,000 or more on a Profit or Loss From Business (Schedule
C) or on an attached Profit or Loss From Farming (Schedule F).
TIGTA recently
reported the results of its review of the IRS’ increased examination coverage
rate[28]
of high-income taxpayers.[29] The increased coverage has been due largely
to an increase in correspondence examinations,[30]
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, as stated earlier, 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 FY 2002 through FY 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,[31] TIGTA
estimates that approximately $1.2 billion[32]
(86 percent) of the $1.4 billion has been either abated[33]
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.