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Before the Committee on Budget, U.S. Senate: 

United States Government Accountability Office: 


For Release on Delivery Expected at 10:00 a.m. EST: 

Wednesday, February 15, 2006: 

Tax Gap: 

Making Significant Progress in Improving Tax Compliance Rests on 
Enhancing Current IRS Techniques and Adopting New Legislative Actions: 

Statement of David M. Walker: Comptroller General of the United States: 


GAO Highlights: 

Highlights of GAO-06-453T, a testimony before the Committee on the 
Budget, U.S. Senate: 

Why GAO Did This Study: 

The Internal Revenue Serviceís (IRS) most recent estimate of the 
difference between what taxpayers timely and accurately paid in taxes 
and what they owed was $345 billion. IRS estimates it will eventually 
recover some of this tax gap, resulting in an estimated net tax gap of 
$290 billion. The tax gap arises when taxpayers fail to comply with the 
tax laws by underreporting tax liabilities on tax returns; underpaying 
taxes due from filed returns; or nonfiling, which refers to the failure 
to file a required tax return altogether or in a timely manner. 

The Chairman and Ranking Minority Member of the Senate Committee on the 
Budget asked GAO to present information on the causes of and possible 
solutions to the tax gap. This testimony addresses the nature and 
extent of the tax gap and the significance of reducing the tax gap, 
including some steps that may assist with this challenging task. For 
context, this testimony also addressed GAOís most recent simulations of 
the long-term fiscal outlook and the need for a fundamental 
reexamination of major spending and tax policies and priorities. 

What GAO Found: 

Our nationís fiscal policy is on an imprudent and unsustainable course. 
As long-term budget simulations by GAO show, over the long term we face 
a large and growing structural deficit due primarily to known 
demographic trends, rising health care costs, and lower federal 
revenues as a percentage of the economy. GAOís simulations indicate 
that the long-term fiscal challenge is too big to be solved by economic 
growth alone or by making modest changes to existing spending and tax 
policies. Rather, a fundamental reexamination of major policies and 
priorities will be important to recapture our future fiscal 

Underreporting of income by businesses and individuals accounted for 
most of the estimated $345 billion tax gap for 2001, with individual 
income tax underreporting alone accounting for $197 billion, or over 
half of the total gap. Corporate income tax and employment tax 
underreporting accounted for an additional $84 billion of the gap. 

Reducing the tax gap would help improve fiscal sustainability. Given 
the tax gapís persistence and size, it will require considering not 
only options that have been previously proposed but also new 
administrative and legislative actions. Even modest progress would 
yield significant revenue; each 1 percent reduction would likely yield 
nearly $3 billion annually. Reducing the tax gap will be a challenging 
long-term task, and progress will require attacking the gap with 
multiple strategies over a sustained period. These strategies could 
include efforts to regularly obtain data on the extent of, and reasons 
for, noncompliance; simplify the tax code; provide quality service to 
taxpayers; enhance enforcement of tax laws by utilizing enforcement 
tools such as tax withholding, information reporting, and penalties; 
leverage technology; and optimize resource allocation. 

IRSís Tax Year 2001 Gross Tax Gap Estimates by Type of Noncompliance 
and Type of Tax:  

[See Table 1] 

What GAO Recommends: 

GAO is not making any new recommendations but discusses some past 
recommendations and highlights some new areas for possible attention. 

To view the full product, including the scope and methodology, click on 
the link above. For more information, contact Michael Brostek at (202) 
512-9110 or 

[End of section] 

Chairman Gregg, Senator Conrad, and Members of the Committee: 

I appreciate this opportunity to discuss the annual tax gap--the 
difference between what taxpayers timely and accurately pay in taxes 
and what they should pay under the law--and how reducing that gap can 
help the nation cope with its large and growing long-term fiscal 
challenges. The Internal Revenue Service (IRS) most recently estimated 
a gross tax gap that reached $345 billion for tax year 2001. IRS 
estimated that it would recover around $55 billion through late 
payments and IRS enforcement actions, resulting in a net tax gap of 
around $290 billion.[Footnote 1] The tax gap arises when taxpayers 
intentionally or unintentionally fail to comply with the tax laws. 
Their failure to pay taxes increases the burden of funding the nation's 
commitments for those taxpayers who voluntarily pay their taxes. 

For context in considering the tax gap, I will first provide the 
committee with an overview of the federal government's fiscal condition 
and the challenges we will face in funding our nation's commitments. 
Next, I will discuss the size and components of the tax gap. Finally, I 
will discuss the significance of reducing the tax gap and various means 
to achieve that goal, including measuring the extent of, and reasons 
for, noncompliance; simplifying the tax code; improving taxpayer 
service; enhancing IRS enforcement through the use of tools such as 
withholding, information reporting, and penalties; leveraging 
technology; and optimizing resource allocation. 

My remarks are based on our previous work on a variety of issues, in 
particular, recent testimonies and a report on reducing the tax 
gap.[Footnote 2] These efforts were conducted in accordance with 
generally accepted government auditing standards. 

Let me begin by highlighting three major points: 

* GAO's long-term budget simulations show that over the long term we 
face large and growing structural deficits due primarily to known 
demographic trends, rising health care costs, and lower federal 
revenues as a percentage of the economy. Continuing on this 
unsustainable fiscal path will gradually erode, if not suddenly damage, 
our economy, our standard of living, and ultimately our national 
security. Our current path also will increasingly constrain our ability 
to address emerging and unexpected budgetary needs and increase the 
burdens that will be faced by our children, grandchildren, and future 
generations. Reducing the current tax gap would contribute to our 
fiscal sustainability while simultaneously improving fairness for those 
citizens who fully and timely meet their tax obligations. 

* Underreporting of income by businesses and individuals accounted for 
most of the estimated $345 billion tax gap for 2001, with individual 
income tax underreporting alone accounting for $197 billion, or over 
half of the total gap. Corporate income tax and employment tax 
underreporting accounted for an additional $84 billion. 

* Given the persistence and size of the tax gap, we need not only to 
consider options that have been previously proposed but also explore 
new administrative and legislative approaches to reducing the tax gap. 
Even modest progress would yield significant revenue; each 1 percent 
reduction would likely yield nearly $3 billion annually. Reducing the 
tax gap will be a challenging, long-term task and progress will require 
attacking the gap on multiple fronts and with multiple strategies over 
a sustained period. These strategies could include efforts to regularly 
obtain data on the extent of, and reasons for, noncompliance; simplify 
the tax code; provide quality services to taxpayers; enhance 
enforcement of the tax laws by utilizing enforcement tools such as tax 
withholding, information reporting, and penalties; leverage technology; 
and maximize resource allocation. 

Long-term Fiscal Challenge Provides Impetus to Reexamine Tax Policies 
and Compliance: 

The federal government's financial condition and long-term fiscal 
outlook present enormous challenges to the nation's ability to respond 
to emerging forces reshaping American society, the United States' place 
in the world, and the future role of the federal government. Over the 
next few decades as the baby boom generation retires and health care 
costs continue to rise, federal spending on retirement and health 
programs--Social Security, Medicare, Medicaid, and other federal 
pension, health, and disability programs--will grow dramatically. 
Absent policy changes on the spending and/or revenue sides of the 
budget, a growing imbalance between expected federal spending and tax 
revenues will mean escalating and eventually unsustainable federal 
deficits and debt that will threaten our future economy, standard of 
living, and, ultimately, our national security. Ultimately, the nation 
will have to decide what level of federal benefits and spending it 
wants and how it will pay for these benefits. 

GAO's long-term simulations illustrate the magnitude of the fiscal 
challenges associated with an aging society and the significance of the 
related challenges the government will be called upon to address. 
Indeed, the nation's long-term fiscal outlook is daunting under many 
different policy scenarios and assumptions. For instance, under a 
fiscally restrained scenario, if discretionary spending grew only with 
inflation over the next 10 years and all existing tax cuts expire when 
scheduled under current law, spending for Social Security and health 
care programs would grow to consume over 80 percent of federal revenue 
by 2040. (See fig. 1.) On the other hand, if discretionary spending 
grew at the same rate as the economy in the near term and if all tax 
cuts were extended, by 2040 federal revenues may just be adequate to 
pay only some Social Security benefits and interest on the growing 
federal debt. (See fig. 2.) 

Figure 1: Composition of Spending as a Share of GDP Under Baseline 

[See PDF for image] 

Note: In addition to the expiration of tax cuts, revenue as a share of 
GDP increases through 2016 due to (1) real bracket creep, (2) more 
taxpayers becoming subject to the AMT, and (3) increased revenue from 
tax-deferred retirement accounts. After 2016, revenue as a share of GDP 
is held constant. 

[End of figure] 

Figure 2: Composition of Spending as a Share of GDP Assuming 
Discretionary Spending Grows with GDP After 2006 and All Expiring Tax 
Provisions are Extended: 

[See PDF for image] 

Note: This includes certain tax provisions that expired at the end of 
2005, such as the increased AMT exemption amount. 

[End of figure] 

Addressing the projected fiscal gaps shown here will require 
policymakers to examine the advisability, affordability, and 
sustainability of existing programs, policies, functions, and 
activities throughout the entire federal budget--spanning discretionary 
spending, mandatory spending, including entitlements, and tax policies 
and programs. Neither slowing the growth of discretionary spending nor 
allowing tax cuts to expire--nor both options combined--would by 
themselves eliminate our long-term fiscal imbalance. Additional 
economic growth is critical and will help to ease the burden, but the 
projected fiscal gap is so great that it is wholly unrealistic to 
expect that we will grow our way out of the problem. The President's 
2007 budget released last week included some proposals to reduce the 
growth in Medicare spending. Whether or not these proposals are 
adopted, they should serve to raise public awareness of the importance 
of health care costs to both today's budget and tomorrow's. This could 
also serve to jump start discussion about appropriate ways to control a 
major driver of our long-term fiscal outlook--health care spending. 
Clearly, tough choices will be required. Changes in existing budget 
processes and financial, fiscal, and performance metrics will be 
necessary to facilitate these choices. 

Early action to change existing programs and policies would yield the 
highest fiscal dividends and provide a longer period for prospective 
beneficiaries to make adjustments in their own planning. The longer we 
wait, the more painful and difficult the choices will become and the 
less transition time we will have. By waiting, an important window is 
lost during which today's relatively large workforce can increase 
saving and begin preparing for the necessary changes in fiscal policy, 
Social Security, and health care as well as other reforms that may be 
necessary parts of the solution to this coming fiscal crunch. However, 
the long-term challenge is fast becoming a short-term one as the 
retirement of the baby boomers' generation will begin as early as 2008 
and since overall workforce growth has already begun to slow. While our 
long-term fiscal imbalance cannot be eliminated with a single strategy, 
reducing the tax gap is one approach that could help address the 
looming fiscal challenges facing the nation. 

Underreporting Accounted for Most of the Tax Gap Estimate: 

The tax gap is an estimate of the difference between the taxes-- 
including individual income, corporate income, employment, estate, and 
excise taxes--that should have been timely and accurately paid and what 
was actually paid for a specific year. The estimate is an aggregate of 
estimates for the three primary types of noncompliance: (1) 
underreporting of tax liabilities on tax returns; (2) underpayment of 
taxes due from filed returns; and (3) nonfiling, which refers to the 
failure to file a required tax return altogether or timely.[Footnote 3] 
Estimates for each type of noncompliance include estimates for some or 
all of the five types of taxes that IRS administers. 

IRS develops its tax gap estimates by measuring the rate of taxpayer 
compliance--the degree to which taxpayers fully and timely complied 
with their tax obligations. That rate is then used, along with other 
data and assumptions, to estimate the dollar amount of taxes not timely 
and accurately paid. For instance, IRS most recently estimated that for 
tax year 2001, 83.7 percent of owed taxes were paid voluntarily and 
timely, which translated into an estimated gross tax gap of $345 
billion. IRS developed these estimates using compliance data collected 
through the National Research Program (NRP).[Footnote 4] 

Using its recently collected compliance data, IRS has estimated that 
underreporting of income represented over 80 percent of the tax gap for 
2001 (an estimated $285 billion out of a gross tax gap estimate of $345 
billion), as indicated in table 1. 

Table 1: IRS's Tax Year 2001 Gross Tax Gap Estimates by Type of 
Noncompliance and Type of Tax: 

Dollars in billions. 

Type of noncompliance: Underreporting; 
Type of tax: Individual income tax: $197; 
Type of tax: Corporate income tax: $30; 
Type of tax: Employment tax: $54; 
Type of tax: Estate tax: $4; 
Type of tax: Excise tax: No estimate; 
Type of tax: Total: $285. 

Type of noncompliance: Underpayment; 
Type of tax: Individual income tax: $23; 
Type of tax: Corporate income tax: $2; 
Type of tax: Employment tax: $5; 
Type of tax: Estate tax: $2; 
Type of tax: Excise tax: $1; 
Type of tax: Total: $34. 

Type of noncompliance: Nonfiling; 
Type of tax: Individual income tax: $25; 
Type of tax: Corporate income tax: No estimate; 
Type of tax: Employment tax: No estimate; 
Type of tax: Estate tax: $2; 
Type of tax: Excise tax: No estimate; 
Type of tax: Total: $27. 

Type of noncompliance: Total; 
Type of tax: Individual income tax: $244; 
Type of tax: Corporate income tax: $32; 
Type of tax: Employment tax: $59; 
Type of tax: Estate tax: $8; 
Type of tax: Excise tax: $1; 
Type of tax: Total: $345. 

Source: IRS. 

Note: Figures may not sum to totals due to rounding. 

[End of table] 

Within the underreporting estimate, IRS attributed about $197 billion, 
or about 57 percent of the total tax gap, to individual income tax 
underreporting, including underreporting of business income, such as 
sole proprietor,[Footnote 5] informal supplier,[Footnote 6] and farm 
income (about $109 billion); nonbusiness income, such as wages, 
interest, and capital gains (about $56 billion); overstated credits 
(about $17 billion); and overstated income adjustments, deductions, and 
exemptions (about $15 billion). Underreporting of corporate income tax 
contributed an estimated $30 billion, or about 10 percent, to the 2001 
tax gap, which included both small corporations (those reporting assets 
of $10 million or less) and large corporations (those reporting assets 
of over $10 million). 

Employment tax underreporting accounted for an estimated $54 billion, 
or about 16 percent, of the 2001 tax gap and included several taxes 
that must be paid by self-employed individuals and employers. Self- 
employed individuals are generally required to calculate and remit 
Social Security and Medicare taxes to the U.S. Treasury each quarter. 
Employers are required to withhold these taxes from their employees' 
wages, match these amounts, and remit withholdings to Treasury at least 
quarterly. Underreported self-employment[Footnote 7] and employer- 
withheld employment taxes, respectively, contributed an estimated $39 
billion and $14 billion to IRS's tax gap estimate. The employment tax 
underreporting estimate also includes underreporting of federal 
unemployment taxes (about $1 billion). 

Taxpayers who do not file their tax returns on time or at all and 
otherwise do not pay their tax liabilities accounted for the remainder 
of the 2001 tax gap--around $61 billion. For example, nonfiling and 
underpayment noncompliance by individual taxpayers alone contributed an 
estimated $48 billion to this portion of the tax gap. 

IRS has concerns with the certainty of the overall tax gap estimate in 
part because some areas of the estimate rely on old data and IRS has no 
estimates for other areas of the tax gap. For example, IRS used data 
from the 1970s and 1980s to estimate underreporting of corporate income 
taxes and employer-withheld employment taxes. For large corporate 
income tax underreporting, IRS based its estimate on the amount of tax 
recommended from operational examinations rather than the tax 
ultimately assessed as part of the total tax liability.[Footnote 8] 
According to IRS officials, IRS relies on the amount of tax recommended 
because it is difficult to determine the true tax liability of large 
corporations due to complex and ambiguous tax laws that create 
opportunities for differing interpretations and that complicate the 
determination. These officials further stated that because these 
examinations are not randomly selected and are not focused on 
identifying all tax noncompliance, the estimate produced from the 
examination data is not representative of the tax gap for all large 
corporations. They also explained that due to these complexities and 
the costs and burdens of collecting complete and accurate data, IRS has 
not systematically measured large corporation tax compliance through 
statistically valid studies, even though the officials acknowledged 
that such studies would be useful in estimating the related tax 
gap.[Footnote 9] 

IRS has no estimates for corporate income, employment, and excise tax 
nonfiling or for excise tax underreporting. For these types of 
noncompliance, IRS maintains that the data are either difficult to 
collect, imprecise, or unavailable. In addition, it is inherently 
difficult for IRS to observe and measure some types of underreporting 
or nonfiling, such as tracking cash payments that businesses make to 
their employees, as businesses and employees may not report these 
payments to IRS in order to avoid paying employment and income taxes, 
respectively.[Footnote 10] 

IRS's overall approach to reducing the tax gap consists of improving 
service to taxpayers and enhancing enforcement of the tax laws. 
Recently, IRS has taken a number of steps that may improve its ability 
to reduce the tax gap. Favorable trends in staffing of IRS enforcement 
personnel; examinations performed through correspondence, as opposed to 
more complex face-to-face examinations; and the use of some enforcement 
sanctions such as liens and levies are encouraging. Also, IRS has made 
progress with respect to abusive tax shelters through a number of 
initiatives and recent settlement offers that have resulted in billions 
of dollars in collected taxes, interest, and penalties. In addition, 
IRS has successfully prosecuted a number of taxpayers who have 
committed criminal violations of the tax laws. 

Reducing the Tax Gap Will Require Expanding Existing Approaches and 
Considering New Legislative Actions: 

Given its persistence and size, we need not only to consider expanding 
current approaches but also explore new legislation to help IRS in 
reducing the tax gap.[Footnote 11] Although IRS has made a number of 
changes in its methodologies for measuring the tax gap over the past 
three decades, which makes comparisons difficult, regardless of 
methodology the voluntary compliance rate that underpins the gap has 
tended to range from around 81 percent to around 84 percent. Thus, 
although the dollar amounts of the tax gap have changed, IRS has 
consistently reported a persistent, relatively stable portion of the 
taxes that should have been timely and accurately paid were not paid. 

As we have reported in the past,[Footnote 12] closing the entire tax 
gap may not be feasible nor desirable, as it could entail more 
intrusive recordkeeping or reporting than the public is willing to 
accept or more resources than IRS is able to commit. However, given its 
size, even small or moderate reductions in the net tax gap could yield 
substantial returns, which could improve the government's fiscal 
position. For example, based on IRS's most recent estimate, each 1 
percent reduction in the net tax gap would likely yield nearly $3 
billion annually. Thus, a 10 percent to 20 percent reduction of the net 
tax gap would translate into from roughly $30 billion to $60 billion in 
additional revenue annually.[Footnote 13] 

However, reducing the tax gap will be challenging[Footnote 14] and it 
must be attacked on multiple fronts and with multiple strategies, some 
of which follow. 

Regularly Measure Compliance and Set Compliance Goals: 

A critical step toward reducing the tax gap is to understand the 
sources and nature of taxpayer noncompliance. Regularly measuring 
compliance, including the reasons why taxpayers are not compliant, can 
offer many benefits, including helping IRS identify new or growing 
types of noncompliance, identify changes in tax laws and regulations 
that may improve compliance, understand the effectiveness of its 
programs to promote and enforce compliance, more effectively target 
examinations of tax returns, and determine its resource needs and 
allocations. Likewise, regularly measuring compliance can provide IRS 
with information against which to set goals for improving compliance 
and measure progress in achieving such goals. 

In our July 2005 report on reducing the tax gap, we made 
recommendations to IRS to develop plans to periodically measure tax 
compliance; take steps to improve its data on the reasons why taxpayers 
do not comply; and establish long-term, quantitative goals for 
voluntary compliance levels with an initial focus on individual income 
tax underreporting and total tax underpayment. Taken together, these 
steps can help IRS build a foundation to understand how its taxpayer 
service and enforcement efforts affect compliance and make progress on 
reducing the tax gap. The Commissioner of Internal Revenue agreed with 
our recommendations, highlighted challenges associated with them, and 
commented on various steps IRS would take to implement each 
recommendation. We are encouraged that according to IRS's Fiscal Year 
2007 Congressional Budget Justification, IRS has recently established a 
voluntary compliance goal, with a target of 85 percent voluntary 
compliance by 2009, and plans to periodically measure progress against 
this goal. 

Simplify the Tax Code: 

Efforts to simplify the tax code and otherwise alter current tax 
policies may help reduce the tax gap by making it easier for 
individuals and businesses to understand and voluntarily comply with 
their tax obligations. Among the many causes of tax code complexity is 
the growing number of preferential provisions in the tax code, such as 
exemptions and exclusions from taxation, deductions, credits, deferral 
of tax liability, and preferential tax rates.[Footnote 15] Tax 
expenditures--as they are known by statute[Footnote 16]--can be a tool 
to further some federal goals and objectives, such as financing higher 
education or funding research and development. However, their aggregate 
number contributes to the complexity that taxpayers face in doing their 
taxes and planning their financial decisions. As figure 3 shows, the 
number of tax expenditures reported by the Department of the Treasury 
has more than doubled since 1974. Figure 4 shows the Revenue Loss 
Estimates for the Five Largest Tax Expenditures Reported for Fiscal 
Year 2005. 

Figure 3: Number of Tax Expenditures Reported by Treasury, 1974-2005: 

[See PDF for image] 

Note: The number of tax expenditures reflects all provisions reported 
by Treasury, including those enacted but effective for future fiscal 
years. For example, Treasury's last list included tax expenditures 
enacted in 2005 that will be effective in fiscal years 2006 and later. 
The trend also reflects changes in Treasury's income tax baseline that 
defines a tax expenditure. 

[End of figure] 

Figure 4: Revenue Loss Estimates for the Five Largest Tax Expenditures 
Reported for Fiscal Year 2005: 

[See PDF for image] 

Note: "Tax expenditures" refers to the special tax provisions that are 
contained in the federal income taxes on individuals and corporations. 
OMB does not include forgone revenue from other federal taxes such as 
Social Security and Medicare payroll taxes. 

[A] If the payroll tax exclusion were also counted here, the total tax 
expenditure for employer contributions for health insurance premiums 
would be about 50 percent higher or $177.6 billion. 

[B] This is the revenue loss and does not include associated outlays of 
$14.6 billion. 

[End of figure] 

The multiple tax preferences for education assistance illustrate the 
consequences of the proliferation of tax expenditures. In our July 2005 
report[Footnote 17] on postsecondary tax preferences, we found that 
hundreds of thousands of taxpayers do not appear to make optimal 
decisions when selecting education-related tax preferences. One 
explanation of these taxpayers' choices may be the complexity of 
postsecondary tax preferences, which experts have commonly identified 
as difficult for tax filers to use. Also, many argue that complexity 
creates opportunities for tax evasion, through vehicles such as tax 
shelters. Simplification may reduce opportunities for taxpayers to 
avoid taxes through the creation of complex and abusive tax shelters. 

Another area of the tax system that may deserve additional exploration, 
although not directly related to the tax gap, is whether the federal 
income-based tax system is sustainable and administrable in a global 
economy and how we should tax the income of U.S. multinational 
corporations that is earned outside of the United States.[Footnote 18] 
Every year, U.S.-based multinational corporations transfer hundreds of 
billions of dollars of goods and services between their affiliates in 
the United States and their foreign subsidiaries.[Footnote 19] Such 
transactions may be a part of normal business operations for 
corporations with foreign subsidiaries. However, it is generally 
recognized that given the variation in corporate tax rates across 
countries, an incentive exists for corporations with foreign 
subsidiaries to reduce their overall tax burden by maximizing the 
income they report in countries with low income tax rates, and 
minimizing the income they report in or repatriate to countries with 
high income tax rates. Various studies have suggested that U.S.-based 
multinational corporations appear to engage in transactions such as 
these that shift income from their affiliates in high-tax countries to 
subsidiaries in low-tax countries to take advantage of the differences 
in tax rates in foreign countries.[Footnote 20] 

The growth in multinational corporate transactions and structures has 
also introduced increasing complexity in administering the tax code. 
The loss of highly skilled technical employees at IRS who can examine 
compliance issues arising from globalization, such as transfer pricing, 
underscores the challenge that IRS faces in ensuring it has sufficient 
staff with adequate skills to address these complex issues. 

Enhance Services to Taxpayers: 

Providing quality services to taxpayers is an important part of any 
overall strategy to improve compliance and thereby reduce the tax gap. 
One method of improving compliance through service is to educate 
taxpayers about confusing or commonly misunderstood tax 
requirements.[Footnote 21] For example, if the forms and instructions 
taxpayers use to prepare their taxes are not clear, taxpayers may be 
confused and make unintentional errors. One method to ensure that forms 
and instructions are sufficiently clear is to test them before use. 
However, we reported in 2003 that IRS had tested revisions to only five 
individual forms and instructions from July 1997 through June 2002, 
although hundreds of forms and instructions had been revised in 2001 
alone.[Footnote 22] 

Enhance Enforcement Tools Available to IRS: 

In terms of enforcement, IRS will need to use multiple strategies and 
techniques to identify and deter noncompliance. As figure 5 shows, one 
pair of tools have been shown to lower levels of noncompliance-- 
withholding tax from payments to taxpayers and having third parties 
report information to IRS and the taxpayers on income paid to 
taxpayers. For example, banks and other financial institutions provide 
information returns (Forms 1099) to account holders and IRS showing the 
taxpayers' annual income from some types of investments. Similarly, 
most wages, salaries, and tip compensation are reported by employers to 
employees and IRS through Form W-2. Findings from NRP indicate that 
around 98.8 percent of these types of income are accurately reported on 
individual returns. 

Figure 5: Individual Income Tax Underreporting Categorized by Amount 
Subject to Withholding and Information Reporting, 2001: 

[See PDF for image] 

[End of figure] 

In the past, we have identified a few specific areas where additional 
withholding or information reporting requirements could serve to 
improve compliance:[Footnote 23] 

* Requiring tax withholding and more or better information return 
reporting on payments made to independent contractors. Past IRS data 
have shown that independent contractors report 97 percent of the income 
that appears on information returns, while contractors that do not 
receive these returns report only 83 percent of income. We have also 
identified other options for improving information reporting for 
independent contractors, including increasing penalties for failing to 
file required information returns, lowering the $600 threshold for 
requiring such returns, and requiring businesses to separately report 
on their tax returns the total amount of payments to independent 
contractors.[Footnote 24] IRS's Taxpayer Advocate Service recently 
recommended allowing independent contractors to enter into voluntary 
withholding agreements.[Footnote 25] 

* Requiring information return reporting on payments made to 
corporations. Unlike payments made to sole proprietors, payments made 
to corporations for services are generally not required to be reported 
on information returns. IRS and GAO have contended that the lack of 
such a requirement leads to lower levels of compliance for small 
corporations. Although Congress has required federal agencies to 
provide information returns on payments made to contractors since 
1997,[Footnote 26] payments made by others to corporations are 
generally not covered by information returns. The Taxpayer Advocate 
Service has recommended requiring information reporting on payments 
made to corporations,[Footnote 27] and the Administration, in its 
fiscal year 2007 budget, has proposed requiring additional information 
reporting on certain goods and service payments by federal, state, and 
local governments.[Footnote 28] 

* Requiring more data on information returns dealing with capital gain 
income. Past IRS studies have indicated that much of the noncompliance 
associated with capital gains is a result of taxpayers overstating an 
asset's "basis," the amount of money originally paid for the asset. 
Currently, financial institutions are required to report the sales 
prices, but not the purchase prices, of stocks and bonds on information 
returns. Without information on purchase prices, IRS cannot use 
efficient and effective computer-matching programs to check for 
compliance and must use much more costly means to examine taxpayer 
returns in order to verify capital gain income. The Taxpayer Advocate 
Service has recommended requiring financial institutions to track cost 
basis information and report it to IRS and taxpayers.[Footnote 29] 

Although withholding and information reporting are highly effective in 
encouraging compliance, such additional requirements generally impose 
costs and burdens on the businesses that must implement them. However, 
continued reexamination of opportunities to expand information 
reporting and tax withholding could increase the transparency of the 
tax system. Opportunities to expand information reporting and tax 
withholding could be especially relevant toward improving compliance in 
areas that are particularly complex or challenging to administer, such 
as with net income and losses passed through from "flow-through" 
entities such as S corporations and partnerships to their shareholders 
and partners.[Footnote 30] 

Another enforcement tool that can potentially deter noncompliance is 
the use of penalties for filing inaccurate or late tax and information 
returns. Congress has placed a number of civil penalty provisions in 
the tax code. However, as with civil penalties related to other federal 
agencies, inflation may have weakened the deterrent effect of IRS 
penalties. For example, the Treasury Inspector General for Tax 
Administration has noted that the $50 per partner per month penalty for 
a late-filed partnership tax return, established by Congress in 1978, 
would equate to $17.22 in 2004 dollars. In its fiscal year 2007 budget, 
the administration has proposed expanding penalty provisions applicable 
to paid tax return preparers to include non-income tax returns and 
related documents. In addition, Congress recently increased certain 
penalties related to tax shelters and other tax evasion 
techniques.[Footnote 31] Given Congress's recent judgment that some tax 
penalties were too low and concerns that inflation may have weakened 
the effectiveness of the civil penalty provisions in the tax code, 
additional increases may need to be considered to ensure that all 
penalties are of sufficient magnitude to deter tax noncompliance. 

Leverage Technology: 

Leveraging technology to improve IRS's capacity to receive, process, 
and utilize taxpayer returns could help IRS better determine how to 
allocate its resources to reduce the tax gap and would seem to be a 
prudent investment. IRS has invested heavily in modernizing its 
technology and those investments have paid off. Telephone service has 
improved and taxpayers are much more likely to get through to IRS and 
obtain assistance from IRS than before IRS upgraded its technology. 
Further, electronic filing has grown substantially. Tax information 
submitted to IRS electronically enables faster, more accurate 
processing and quicker interactions between IRS and taxpayers. 
Electronically filed returns are processed as they are received, 
therefore giving IRS access to more timely and accurate tax 
information, which can be used for better data analysis capability and 
quicker focus on issues that need resolution. IRS estimates it saves 
$2.15 on every individual tax return that is processed electronically. 
According to IRS data, electronic filing has allowed IRS to use more 
than a 1,000 fewer staff years to process paper returns, resources that 
can then be dedicated to other service or enforcement work.[Footnote 

However, IRS's Business Systems Modernization project, through which 
the agency is modernizing its outdated technology, is far from 
complete. IRS needs to continue to strengthen management of this effort 
and make prudent technology investments to maximize the efficiencies 
that can be gained in IRS operations and services to taxpayers. 

Optimize Resource Allocation: 

Sound resource allocation is another tool for addressing the tax gap. 
The more effectively IRS can allocate its resources, the more progress 
should result. The new NRP data, for example, are to be used to better 
identify which tax returns to examine so that fewer compliant taxpayers 
are burdened by unnecessary audits and IRS can increase the amount of 
noncompliance that is addressed through its enforcement activities. As 
part of its attempt to make the best use of its enforcement resources, 
given budget constraints, IRS has developed rough measures of return on 
investment in terms of tax revenue that is directly assessed from 
uncovering noncompliance. Developing such measures is difficult because 
of incomplete information on all the costs and all the tax revenue 
ultimately collected from specific enforcement efforts, as well as on 
the indirect tax revenues generated when current enforcement actions 
prompt voluntary compliance improvements in the future. Continuing to 
develop the return on investment measures could help officials make 
more informed decisions about allocating resources, particularly during 
periods of budget constraints. Even with better data, however, 
officials will need to make judgments that take into account 
intangibles, such as how to achieve an equitable enforcement presence 
across the various taxpayer groups. 

Concluding Observations: 

Our nation's fiscal imbalance and challenges have created an imprudent 
and unsustainable path that needs to be addressed. While our long-term 
fiscal imbalance is too large to be corrected by one strategy, reducing 
the tax gap can help address the looming fiscal challenges. Collecting 
the billions of dollars that already should be paid, for example, would 
help ease the many difficult decisions that need to be made about our 
spending programs as well as the rest of the tax system. However, the 
tax gap itself has been large and pervasive over the years and 
therefore, reducing the gap will not only require expansions of current 
efforts, but also new and innovative solutions. While IRS takes the 
lead in continuing to find ways to significantly reduce the tax gap, 
support from Congress will be essential since legislation will likely 
be needed to implement many of the tax gap reduction ideas offered 
today. We look forward to continuing to work with Congress and IRS on 
these issues. 

Chairman Gregg, Senator Conrad and members of the committee, this 
concludes my testimony. I would be happy to answer any questions you 
may have at this time. 

Contact and Acknowledgments: 

Contact points for our Offices of Congressional Relations and Public 
Affairs may be found on the last page of this testimony. For further 
information on this testimony, please contact Michael Brostek on (202) 
512-9110 or Individuals making key contributions to 
this testimony include Tom Short, Assistant Director; Jeff Arkin; 
Elizabeth Fan; and Cheryl Peterson. 


[1] Throughout this statement, references to the tax gap refer to the 
gross tax gap unless otherwise noted. 

[2] GAO, Tax Compliance: Reducing the Tax Gap Can Contribute to Fiscal 
Sustainability but Will Require a Variety of Strategies, GAO-05-527T 
(Washington, D.C.: Apr. 14, 2005); Tax Gap: Multiple Strategies, Better 
Compliance Data, and Long-Term Goals Are Needed to Improve Taxpayer 
Compliance, GAO-06-208T (Washington, D.C.: Oct. 26, 2005); and Tax 
Compliance: Better Compliance Data and Long-term Goals Would Support a 
More Strategic IRS Approach to Reducing the Tax Gap, GAO-05-753 
(Washington, D.C.: July 18, 2005). 

[3] Taxpayers who receive filing extensions, pay their full tax 
liability by payment due dates, and file returns prior to extension 
deadlines are considered to have filed timely. 

[4] NRP replaced the Taxpayer Compliance Measurement Program, which 
last measured compliance for individuals for 1988 but then was canceled 
because of concerns about costs and burdens on taxpayers. GAO, Tax 
Administration: New Compliance Research Effort Is on Track, but 
Important Work Remains, GAO-02-769 (Washington, D.C.: June 27, 2002); 
and GAO, Tax Administration: Status of IRS' Efforts to Develop Measures 
of Voluntary Compliance, GAO-01-535 (Washington, D.C.: June 18, 2001) 
discuss the development of the NRP study. 

[5] Sole proprietors are self-employed individuals who should file a 
Schedule C with their individual tax return to report profits and 
losses from their business. Sole proprietors include those who provide 
services, such as doctors or accountants; produce goods, such as 
manufacturers; and sell goods at fixed locations, such as car dealers 
and grocers. 

[6] Informal suppliers are sole proprietors who work alone or with few 
workers and, by definition, operate in an "informal" manner. Informal 
suppliers include those who make home repairs, provide child care, or 
sell goods at roadside stands. These taxpayers should report business 
profits or losses on a Schedule C. 

[7] As employment taxes and income taxes for self-employed taxpayers 
are largely assessed on the same income, self-employed individuals who 
underreport their income consequently underreport the employment tax 
due on that income. 

[8] IRS continually examines tax returns from about 1,100 of the 
nation's largest corporations, all of which have assets of more than 
$250 million. For fiscal year 2002, IRS examined around 7 percent of 
all large corporations. 

[9] GAO, Tax Administration: Compliance Measures and Audits of Large 
Corporations Need Improvement, GAO/GGD-94-70 (Washington, D.C.: Sept. 
1, 1994); Tax Administration: Factors Affecting Results from Audits of 
Large Corporations, GAO/GGD-97-62 (Washington, D.C.: Apr. 17, 1997); 
and Tax Administration: IRS Measures Could Provide a More Balanced 
Picture of Audit Results and Costs, GAO/GGD-98-128 (Washington, D.C.: 
June 23, 1998). 

[10] For a more detailed discussion about data sources and 
methodologies used in estimating the tax gap, see GAO-05-753. 

[11] We have suggested similar steps for the entire tax system as well 
as all major spending programs in order to confront the nation's fiscal 
challenge through a fundamental review, reexamination, and 
reprioritization of government's capacity to align itself with the 
needs and demands of the 21st century. See GAO, 21st Century 
Challenges: Reexamining the Base of the Federal Government, GAO-05-
325SP (Washington, D.C.: February 2005). 

[12] GAO, Taxpayer Compliance: Analyzing the Nature of the Income Tax 
Gap, GAO/T-GGD-97-35 (Washington, D.C.: Jan. 9, 1997). 

[13] Any significant reduction of the tax gap would likely depend on an 
improvement in the level of taxpayer compliance. In some instances, the 
amount of the tax gap can change without a corresponding change in the 
level of compliance. For example, a reduction in marginal tax rates 
could result in a smaller tax gap simply because the amount of tax that 
should be paid has been reduced, even if the level of compliance 
remains unchanged. 

[14] Recognizing these challenges, we have long been concerned about 
tax noncompliance and IRS's efforts to address it. Since 1990, we have 
had various aspects of tax noncompliance on our high-risk list, and 
last year we have affirmed our broad concern by consolidating two prior 
high-risk areas into one--Enforcement of Tax Laws. See GAO, High-Risk 
Series: An Update, GAO-05-207 (Washington, D.C.: January 2005). 

[15] GAO, Government Performance and Accountability: Tax Expenditures 
Represent a Substantial Federal Commitment and Need to be Reexamined, 
GAO-05-690 (Washington, D.C.: Sept. 23, 2005). 

[16] The Congressional Budget and Impoundment Control Act of 1974, Pub. 
L. No. 93-344, Sec. 3, 88 Stat. 299 (July 12, 1974) (codified at 2 
U.S.C. sec. 622(3)). 

[17] GAO, Student Aid and Postsecondary Tax Preferences: Limited 
Research Exists on the Effectiveness of Tools to Assist Students and 
Families through Title IV Student Aid and Tax Preferences, GAO-05-684 
(Washington, D.C.: July 29, 2005). 

[18] Although not necessarily a solution to the tax gap, given the 
challenges facing our income-based tax system, some have suggested 
moving more towards a consumption-based tax system. Our recent report 
on understanding the tax reform debate discusses a number of topics 
that tax experts have identified as those that should be considered 
when evaluating tax policy. See GAO, Understanding the Tax Reform 
Debate: Background, Criteria, & Questions, GAO-05-1009SP (Washington, 
D.C.: September 2005). 

[19] GAO, International Taxation: Information on Federal Contractors 
with Foreign Subsidiaries, GAO-04-293 (Washington, D.C.: Feb. 2, 2004). 

[20] A survey of studies that examine income shifting by multinational 
corporations appears in Department of the Treasury, Office of Tax 
Policy, The Deferral of Income Earned Through U.S. Controlled Foreign 
Corporations (Washington, D.C.: December 2000), 197-213. 

[21] GAO/T-GGD-97-35. 

[22] GAO, Tax Administration: IRS Should Reassess the Level of 
Resources for Testing Forms and Instructions, GAO-03-486 (Washington, 
D.C.: Apr. 11, 2003). 

[23] GAO, Tax Gap: Many Actions Taken, but a Cohesive Compliance 
Strategy Needed, GAO/GGD-94-123 (Washington, D.C.: May 11, 1994). 

[24] GAO, Tax Administration: Approaches for Improving Independent 
Contractor Compliance, GAO/GGD-92-108 (Washington, D.C.: July 23, 

[25] Internal Revenue Service, Taxpayer Advocate Service, National 
Taxpayer Advocate 2005 Annual Report to Congress (Washington, D.C. Dec. 
31, 2005). 

[26] Taxpayer Relief Act of 1997, Pub. L. No. 105-34 (1997). 

[27] National Taxpayer Advocate 2005 Annual Report to Congress. 

[28] Executive Office of the President, Office of Management and 
Budget, Budget of the United States Government, Fiscal Year 2007. 

[29] National Taxpayer Advocate 2005 Annual Report to Congress. 

[30] Partnerships and S corporations are businesses commonly referred 
to as flow-through entities, as they do not generally pay taxes on 
income. Instead, they distribute net income and losses to partners, 
shareholders, and beneficiaries, who are subsequently required to 
report net income or losses on their individual tax returns and pay any 
applicable taxes. 

[31] American Jobs Creation Act of 2004, Pub. L. No. 108-357 (2004). 

[32] Some state and federal tax experts have recognized that mandatory 
electronic filing for certain categories of tax practitioners is one 
remaining option with the potential to significantly increase 
electronic filing. However, mandatory electronic filing would likely 
impose some costs and burdens on tax practitioners.