Narrowing the Tax Gap

1. Narrowing the Tax Gap James B. Mackie III Director, Revenue Estimating Division Office of Tax Analysis U.S. Treasury

2. Disclaimer • Any views or opinions are my own and do not necessarily reflect the official views of the U.S. Treasury.

3. Bottom Line • The tax gap is a serious multi-dimensional problem. • The tax gap can be reduced but not eliminated. • The Administration is committed to working with Congress to reduce the tax gap without unduly burdening compliant taxpayers. • The Treasury has proposed a multi-pronged approach to reducing the tax gap and has made specific Budget proposals consistent with this strategy. • Some budget proposals have been enacted.

4. Tax Gap Background

5. What is the Tax Gap? • Gross tax gap. The difference between the amount of tax that taxpayers should pay under the tax law and the amount they actually pay on time. • Estimate of $345 billion in tax year 2001, 83.7% voluntary compliance rate. • Net tax gap. Gross tax gap less taxes that were paid voluntarily but late and recoveries from IRS enforcement activities. • Estimate of $290 billion in tax year 2001, 86.3% net compliance rate

6. Sources of the Tax Gap • Caused by many kinds of errors and omissions. • Intentional evasion and unintentional errors both contribute to the tax gap. • Tax complexity leads to unintentional errors and creates opportunities for intentional evasion. • Better taxpayer service can reduce unintentional errors. • Can’t tell how much of the gap is from unintentional errors. • Over 80% of the gross tax gap is from underreporting of income. • Over 40% is underreporting of net business income (individual income tax and self-employment tax). • About 10% of the gross tax gap is from underpayment of tax and about 10% from nonfiling.

7. Information Reporting and Withholding • Noncompliance is highest among taxpayers whose income is not subject to third party information reporting or withholding. • Withholding. Wages are underreported by 1%. • Information reporting. Interest income, dividends, social security benefits, pensions, and unemployment insurance are underreported by 4.5%. • No information reporting. Net income from proprietorships, rents, and royalties is underreported by 54%.

8. Information on the Tax Gap is Dated and Incomplete • Identifying the sources and levels of noncompliance is critical to designing and implementing effective remediation. • The main source of information is the National Research Program (NRP), which has compliance data from 2001. • NRP looked only at individual income and self-employment taxes. • Estimates of compliance for other taxes (e.g., corporate income tax) are based on information that is much older – studies are 20+ years old. • Study of S corporation compliance is in final stages. • Excise tax compliance has never been studied.

9. Reducing the Tax Gap vs. Raising Revenue • Reducing the tax gap is not the same thing as raising revenue. • Some tax changes are clearly targeted towards noncompliant taxpayers and the tax gap, e.g., increased information reporting, penalties, closing specific illegal tax shelters. • Some tax changes raise revenue from compliant taxpayers and also reduce the tax gap, e.g., eliminating the home office deduction or the charitable deduction. • Some tax changes simply raise revenue without affecting the tax gap (compliance).

10. Can the Tax Gap Be Closed? • The tax gap can be narrowed, and it is important to do so. • All Americans should pay their fair share of taxes. • Expectations have to be realistic. • The tax gap is a longstanding, persistent problem. • Compliance rates are about the same as 20 years ago despite large changes in tax law and in tax enforcement. • “There is no low-hanging fruit in this area.” former IRS Commissioner Lawrence Gibbs. • IRS already gets the easy enforcement dollars.

11. Can the Tax Gap Be Closed? (cont.) • Closing the tax gap completely seems infeasible if not impossible. It would require draconian and costly measures. • Universal audits. • Very severe penalties. • High burden on compliant taxpayers. • Increase tensions between taxpayers and the government. • Large reductions in the tax gap would be VERY difficult to make and might not be worth the cost imposed on the IRS and on taxpayers. • Same problems as completely closing the tax gap. • $290 billion per year is a large overstatement of the achievable reduction in the tax gap. • Improvement in the government’s net fiscal position would be smaller because of the cost of collection.

12. Treasury’s Tax Gap Strategy:Four Principles • A Comprehensive Strategy for Reducing the Tax Gap, OTP, September, 2006. • (1) Address unintentional taxpayer errors and intentional taxpayer evasion. • (2) Target specific sources of noncompliance. • (3) Combine enforcement with taxpayer service. • (4) Respect taxpayer rights and balance enforcement against taxpayer burdens.

13. Seven Specific Strategic Components • (1) Reduce evasion through legislation and regulation. • (2) Commit to multi-year compliance research. • (3) Improve information technology. • (4) Improve IRS compliance activities. • (5) Enhance taxpayer service. • (6) Simplify the tax law. • (7) Coordinate with partners and stakeholders.

14. Implementing the Treasury Strategies • Made some progress on all fronts.

15. Budget Proposals: Legislation to Reduce Evasion • 16 specific proposals in the FY 2008 Budget. • Expand information reporting (7). • Three proposals account for most of the revenue. • Business payments to corporations: File an information return for payments summing to $600 or more to a corporation. • Basis on security sales: Brokerage houses, mutual funds, asset managers, and fiduciaries would be required to report adjusted basis on sales of publicly traded securities. • Merchant payment card reimbursements: Card processors must report to the IRS gross reimbursement payments made to merchants.

16. Budget Proposals: Legislation to Reduce Evasion (cont.) • Improve compliance by business (3). • These include a proposal to amend the collection due process rules for employment taxes that has been enacted in modified form by HR 2206. • Strengthen tax administration (3). • Make willful failure to file a return a felony. • Strengthen penalties (3). • Two have been enacted in modified form by HR 2206. • Increase and extend to other types of returns penalties on tax preparers for filing erroneous returns. (Issues: MLTN standard, no transition relief.) • Create an erroneous refund penalty. • HR 2206 also increased the penalty for writing bad checks to pay taxes (not a Budget proposal).

17. Budget Proposals: Legislation to Reduce Evasion (cont.) • Modest revenue pick-up ($29 billion over ten years). • Most revenue from information reporting. • Proposals focus on noncompliance, not raising revenue by changing the baseline against which compliance is measured. • Respectful of taxpayer rights and burdens. • “No low-hanging fruit.”

18. Sidebar: Treasury Revenue Estimating for Enforcement Initiatives • Two types of revenue effects. • Direct: revenue immediately related to specific enforcement programs, e.g., penalties collected and revenues from audits. (These are counted as revenue from IRS enforcement.) • Indirect: revenue from changes in voluntary compliance caused by the enforcement initiative.

19. Sidebar: Treasury Revenue Estimating for Enforcement Initiatives (cont.) • Three types of enforcement initiatives. • Legislative initiatives. • Statutory changes to administrative provisions of the IRC. • Score direct and indirect revenue effects (although the effects can be small). • Management initiatives. • Redeploy existing enforcement resources to increase efficiency. • Do not score. • Historical productivity increases already in baseline tax receipts. • Management decisions are made too frequently to track and evaluate.

20. Sidebar: Treasury Revenue Estimating for Enforcement Initiatives (cont.) • Resource initiatives. • Net additions to current service levels of resources applied to IRS enforcement programs. • Occasionally (rarely) have scored direct effects. • Little information on which to base indirect effects. • Generally only large changes would be expected to yield measurable revenue. • “Descore” IRS funding reductions – controversial. • Interaction of resources and legislative initiatives.

21. Budget Proposals: Legislation to Reduce Evasion (cont.) • Rejected proposals (too draconian) • Require individuals to file 1099s for transactions with doctors, auto mechanics, dry cleaners and other service providers. • Require cash transactions to be done with a payment card or check and require issuer/bank reporting to IRS. • Substantially increase the number of IRS agents and audits.

22. Budget Proposals: Legislation to Increase Simplicity • Simplify the tax treatment of families and savings incentives. • LSA, RSA, ERSA. • Clarify definition of child, simplify EITC eligibility, reduce complexity of refundable child tax credit. • These help to reduce the complexity that causes unintentional noncompliance.

23. Other Budget Proposals • $410 million in new IRS funding aimed at the tax gap. • Additional compliance research. • Investment in information technology. • Enhancement of enforcement activity. • Improvements in taxpayer service.

24. Other Budget Proposals: Additional Compliance Research • New studies for the corporate tax, employment tax, partnerships, and excise taxes. • Update the 2001 National Research Program (NRP) study. • IRS just announced that will begin these studies in the fall. • Multi-year rolling methodology will provide regular updates of the data. • New studies of the effect of IRS taxpayer service on compliance.

25. Other Budget Proposals: Information Technology • Upgrade infrastructure. • Enhance IT security. • Continued work on Customer Account Data Engine, Account Management Services, Modernized e-File, and Common Services Projects.

26. Other Budget Proposals:Enhanced Enforcement • Increase audits of high-risk small business tax returns and step up collections and prosecutions. • Expand document matching. • Increase examination for large complex business returns, foreign residents, and smaller firms with international activity. • Withhold refunds for delinquent taxpayers. • Increase oversight to help prevent third parties from using tax exempts to reduce taxes. • Increase criminal tax investigations.

27. Other Budget Proposals: Enhance Taxpayer Service • Expand voluntary income tax assistance programs directed towards low income, elderly, limited English proficiency, and disabled taxpayers. • Improve telephone and Web site services recommended by the Taxpayer Assistance Blueprint.

28. Tax Regulations: Increase Compliance • Targets specific areas of noncompliance. • Clarifies tax law and increases voluntary compliance. • Recently published guidance will improve compliance. • Transfer pricing: cross border services. • Foreign tax credit: separation of credit from income. • Reportable transactions rules (tax shelters): create “transactions of interest” category.

29. Partners and Stakeholders • Public roundtable in March • Hosted by Assistant Sec. Solomon and Commissioner Everson. • Insights. • Identify specific causes of tax gap and target them for reform • Remedies should not impose unreasonable burdens on compliant taxpayers • Simplify the tax code • Manage expectations – no solution is perfect • Work with Congressional staff. • Discuss and refine legislative proposals. • Increased information sharing with foreign countries: continually updating and expanding tax exchange information agreements (Brazil, 3/2007) and renegotiating tax treaties.

30. Current Work • Tax gap project is ongoing. • Treasury is working actively to determine the next steps consistent with the principles and strategies outlined last September.

31. Bottom Line(again) • The tax gap is a serious, multi-dimensional problem. • Tax gap can be reduced but not eliminated. • The Administration is committed to working with Congress to reduce the tax gap without unduly burdening compliant taxpayers. • The Treasury has proposed a multi-pronged attack on the tax gap and has made specific Budget proposals consistent with this strategy. • Some have been enacted.