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Tax Year 2006 Individual Income Tax Underreporting Gap

Tax Year 2006 Individual Income Tax Underreporting Gap. Drew Johns – IRS Office of Research New Research on Tax Administration: An IRS-TPC Conference June 21, 2012.

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Tax Year 2006 Individual Income Tax Underreporting Gap

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  1. Tax Year 2006 Individual Income Tax Underreporting Gap Drew Johns – IRS Office of Research New Research on Tax Administration: An IRS-TPC Conference June 21, 2012

  2. The content of this presentation and views expressed here ultimately reflect the opinions of the presenter and do not necessarily represent the position of the Internal Revenue Service.

  3. RAS:R – June 21, 2012 Tax Gap Map for TY 2006 ($B) Enforced & Other Late Payments of Tax $65 Net Tax Gap: $385 (Tax Never Collected) (Net Compliance Rate = 85.5%) Underreporting $376 Nonfiling $28 Underpayment $46 Corporation Income Tax $67 Employment Tax $72 Estate Tax $2 Excise Tax # Individual Income Tax $235 Individual Income Tax $25 Individual Income Tax $36 Corporation Income Tax # Corporation Income Tax $4 Non-Business Income $30.6 Non-Business Income $68 Small Corporations (assets < $10m) $19 FICA Tax on Wages $14 Categories of Estimates Employment Tax $4 Employment Tax # Business Income $122 Business Income $65.3 Self-Employment Tax $57 Large Corporations (assets > $10m) $48 Actual Amounts Updated Estimates No Estimates Available Estate Tax $2 Estate Tax $3 # Adjustments, Deductions, Exemptions $17 Unemployment Tax $1 Excise Tax $0.1 Excise Tax # Credits $28 Tax Paid Voluntarily & Timely: $2,210 Total Tax Liability $2,660 Gross Tax Gap: $450 (Voluntary Compliance Rate = 83.1%) Source: http://www.irs.gov/pub/irs-soi/06rastg12map.pdf

  4. RAS:R – June 21, 2012 Key Estimation Issues Ideal audit sample has two qualities: Representative of the entire population Comprehensive- detects all misreporting National Research Program (NRP) audits Randomly selected, therefore representative Not comprehensive in detecting all income 1976 TCMP: for every $1.00 of IRP income detected without use of IRP documents, $2.28 went undetected Supplemented w/estimates of undetected income

  5. RAS:R – June 21, 2012 NRP Form 1040 Studies TY01: Random sample ~45,000 returns TY06: Random sample ~13,000 returns First of smaller, more timely annual studies Independent samples that can be combined Classification: Type of exam No contact: accepted as filed or w/ minor adjustment Correspondence exam (a few simple issues) Face-to-face exam: RA or TCO (about 90% of returns) Issues/Line Items

  6. RAS:R – June 21, 2012 Accounting for Undetected Income Detection Controlled Estimation (DCE) Original methodology by Jonathan Feinstein (1990, 1991) Extended by Brian Erard & Feinstein (2005, 2006, 2007 & forthcoming) DCE Rationale Examiners have detection strengths and weaknesses Statistical procedure controls for who conducted the exam Scales up observed audit result as if line item was examined by the “best” examiner

  7. RAS:R – June 21, 2012 Basic DCE Methodology Audit Adjustment (actually observed) N: True Noncompliance equation D: Detection equation Observed audit adjustment depends on both true noncompliance and examiner detection capability

  8. RAS:R – June 21, 2012 Estimated at the Line Item Level Routinely classified line items Items not typically covered by IRP documents Schedules C, D, E, and F, Form 4797 income, Form 1040 “other income” line Non-routinely classified line items Items typically covered by IRP documents Wages & salaries, interest, dividends, state and local tax refunds, pensions and IRA’s, gross Social Security income, and unemployment income Misreporting of adjustments, exemptions, deductions, and credits assumed fully detected

  9. RAS:R – June 21, 2012 DCE as Estimated Estimated only for face-to-face audits Need sufficient number (~15) of returns on which a given examiner audited a given line item Joint estimation with common detection equation Routinely classified items (except C/F) estimated jointly Non-routinely classified items estimated jointly Return level estimates: The probability of undetected income for a given line item The amount of undetected income conditional on the presence of undetected income

  10. RAS:R – June 21, 2012 Imputing DCE to TY06 NRP TY06 sample too small to estimate DCE Not a sufficient number of returns audited by the same examiner Solution: Estimate using larger TY01 NRP sample Impute undetected income to the TY06 NRP data Stage 1: TY01 DCE simulations Stage 2: TY06 DCE imputations

  11. RAS:R – June 21, 2012 Stage 1: TY01 DCE Simulations Allocate undetected income to reflect a realistic distribution across returns Want to allocate undetected income to a small number of returns using the estimated probability Instead of allocating small amount to many returns For each income item and each return Draw a random number between 0 and 1 If random number < estimated probability then allocate undetected income Repeat 10 times (10 simulations)

  12. RAS:R – June 21, 2012 Stage 2: Deciles For each income item, calculate reported income deciles for TY01 & TY06 If income item reported, calculate income item deciles Else, calculate reported AGI deciles For each TY01 simulation, calculate by decile: Mean undetected income of returns with undetected income Mean probability of the presence of undetected income

  13. RAS:R – June 21, 2012 Stage 2: Imputations For each line item on face-to-face audits Draw a random number between 0 and 1 If random number < estimated probability for the decile then allocate the mean undetected income Adjust the mean undetected income by the ratio of the TY06 to TY01 mean detected incomes Repeat for each of the 10 TY01 simulations to create 10 TY06 data sets with imputed income

  14. RAS:R – June 21, 2012 Supplemental Information Tip Income Very hard to detect Excluded from DCE estimation S corporation and Partnership Income Underreporting by both shareholder and entity Examiners rarely audit the entity Undetected income further adjusted based on the results of the TY2003/2004 NRP S corporation reporting compliance study

  15. RAS:R – June 21, 2012 Tax Calculator Income and deductions: Step 1: Add unreported income (detected + undetected) for first line item (wages and salaries) Step 2: Calculate tentative tax and subtract reported tentative tax to estimate line item tax gap Step 4: Drop unreported income Repeat Steps 1 to 4 for remaining line items Credits: Step 1: Add all unreported income and deductions Step 2: Calculate credits and subtract reported credits Repeat for all 10 simulations and average

  16. RAS:R – June 21, 2012 Income “Visibility” Chart Source: http://www.irs.gov/pub/irs-soi/06rastg12overvw.pdf

  17. RAS:R – June 21, 2012 Summary Methodological improvements Return level estimates of undetected income Line-item level DCE estimation Tax calculator replaced average marginal tax curves TY06 NRP dataused for the first time Future research DCE estimation using multiple years of the new annual NRP samples

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