Enforcement of Tax Laws
The Internal Revenue Service (IRS) recently estimated that the gross tax gapthe difference between taxes owed and taxes paid on timewas $450 billion for tax year 2006. For a portion of the gap, IRS is able to identify the responsible taxpayers. IRS estimated that it would collect $65 billion from these taxpayers through enforcement actions and late payments, leaving a net tax gap of $385 billion. The tax gap has been a persistent problem in spite of a myriad of congressional and IRS efforts to reduce it, as the rate at which taxpayers voluntarily comply with U.S. tax laws has changed little over the past three decades. Given that the tax gap has been persistent and dispersed across different types of taxes and taxpayers, coupled with tax code complexity and a globalizing economy, reducing the tax gap will require applying multiple strategies over a sustained period of time.
IRS enforcement of the tax laws is vital for financing the U.S. government. Through enforcement, IRS collects revenue from noncompliant taxpayers and, perhaps more importantly, promotes voluntary compliance by giving taxpayers confidence that others are paying their fair share. GAO designated the enforcement of tax laws as a high-risk area in 1990.
IRS and Congress have shown a commitment to addressing the tax gap. Importantly, IRS continues to research the extent and causes of taxpayer noncompliance and is using the results to revise its examination programs. While still in the early planning stages, IRS has met with key stakeholders to develop options for expanding compliance checks before issuing refunds to taxpayers. IRS is also extending a program to encourage taxpayers to voluntarily report their previously undisclosed foreign accounts and assets, which has resulted in billions of dollars in collections. IRS, as well as Congress, has taken other innovative actions aimed at further improving tax compliance, often directly based on GAOs work, including the following:
- Since 2012, brokers have been required to report their clients basis for securities sales.
- Since 2011, banks and other third parties have been required to report businesses credit card and similar receipts.
- Starting in 2014, U.S. financial institutions and other entities are required to withhold a portion of certain payments made to foreign financial institutions that have not entered into an agreement with IRS to report details on U.S. account holders to IRS.
- Starting with tax year 2010, IRS is requiring businesses to report on their tax returns uncertain tax positionsthose for which a business reported a reserve amount in its financial statements to account for the possibility that IRS does not sustain the position upon examination or that the position may be litigated.
- IRS is continuing its multiyear effort to replace the systems it uses to process individual tax returns and receive electronically filed tax returns.
The impact of these initiatives on taxpayer compliance and the tax gap may not be known for years and will depend, in part, on how IRS implements them. Using the new information from financial institutions could require IRS to develop new business processes and uses of information technology. Implementation will also be influenced by IRSs ability to provide quality taxpayer services, such as telephone, correspondence, and online assistance. GAO found that some services have experienced performance declines in recent years and IRSs website could offer additional interactivity for taxpayers.
Another initiative IRS undertook in 2010 was to begin implementing new requirements for paid tax return preparers, such as competency testing, with the goals of leveraging relationships with paid preparers and improving the accuracy of the tax returns they prepare. Given that they prepare approximately 60 percent of all tax returns filed, paid preparers have an enormous impact on IRSs ability to administer tax laws effectively. In January 2013, the U.S. District Court for the District of Columbia enjoined IRS from enforcing the new requirements for paid preparers. IRS has filed a motion to suspend the injunction and intends to appeal the District Court's decision.
Further refining of direct revenue return-on-investment measures of its enforcement programs could improve how IRS allocates resources across its programs. Better use of such measures, subject to other considerations of tax administration, such as minimizing compliance costs and ensuring equitable treatment across different groups of taxpayers, could help maximize income tax collections. Resource allocation will become increasingly important as IRS is tasked with broader responsibilities, such as those in the Patient Protection and Affordable Care Act, in a time of tight budgets.
Additionally, targeted legislative action may be needed to address some compliance issues. IRS has statutory authoritycalled math error authorityto correct certain errors, such as calculation mistakes or omitted or inconsistent entries, during tax return processing. Expanding such math error authority could help IRS correct additional errors before interest is owed by taxpayers and avoid burdensome audits.
Additional types of information reporting could also help improve compliance. Taxpayers are much more likely to report their income accurately when the income is also reported to IRS by a third party. By matching information received from third-party payers with what payees report on their tax returns, IRS can detect income underreporting, including the failure to file a tax return. Currently, businesses must report to IRS payments for services they make to unincorporated persons or businesses, but payments to corporations generally do not have to be reported. Taxpayers who rent out real estate are required to report to IRS expense payments for certain services, such as payments for property repairs, only if their rental activity is considered a trade or business. Expanding information reporting in these areas could increase payee reporting compliance. In 2010, the Joint Committee on Taxation estimated revenue increases for a 10-year period from third-party reporting of (1) rental real estate service payments to be $2.5 billion and (2) service payments to corporations to be $3.4 billion.
A broader opportunity to address the tax gap involves simplifying the Internal Revenue Code, as complexity can cause taxpayer confusion and provide opportunities to hide willful noncompliance. Fundamental tax reform could result in a smaller tax gap if the new system has fewer tax preferences or complex tax code provisions, reducing IRSs enforcement challenges and increasing public confidence in the fairness of the tax system. Short of fundamental reform, targeted simplification opportunities exist. For example, changing tax laws to include more consistent definitions across tax provisions, such as which higher education expenses qualify for some of the savings and tax credit provisions in the tax code, could help taxpayers more easily understand and comply with their obligations.
For IRS to improve its enforcement of tax laws it must continue to
- perform compliance research on a regular basis and use the results to identify areas of noncompliance;
- seek ways to leverage paid preparers to improve tax compliance;
- implement new (1) requirements for sources of taxpayer information and (2) technologies to enhance the effectiveness and timeliness of service and enforcement corrective measures; and
- develop return on investment measures to better allocate resources and maximize income tax collection.
In that regard, IRS should implement GAOs open recommendations, such as those on developing measures of direct revenue return on investment.
To assist IRS in reducing the tax gap, Congress should consider expanding IRSs math error authority to correct taxpayer calculation mistakes or omitted or inconsistent entries during tax return processing before issuing refunds. Congress should also consider requiring payers to report service payments to corporations and making rental real estate owners subject to the same payment reporting requirements regardless of whether they engaged in a trade or business under current law. In the event that IRS cannot implement its new requirements without additional statutory authority, Congress should consider whether tax compliance could be improved by regulating paid preparers. The ongoing debate about tax reform also provides opportunities to consider the effect of tax simplification on taxpayer compliance and the tax gap.