Tax Gap: IRS Needs Specific Goals and Strategies for Improving Compliance

The tax gap—the difference between tax amounts that taxpayers should have paid and what they actually paid—has been a persistent problem for decades. The tax gap estimate is an aggregate estimate of the five types of taxes that IRS administers—individual income, corporation income, employment, estate, and excise taxes. For each tax type, IRS attempts to estimate the tax gap based on three types of noncompliance: (1) underreporting of tax liabilities on timely filed tax returns; (2) underpayment of taxes due from timely filed returns; and (3) nonfiling, when a taxpayer fails to file a required tax return altogether or on time.

GAO was asked to review IRS's tax gap estimate for tax years 2008 to 2010. This report provides information on (1) the main drivers of the tax gap; (2) IRS's confidence in the tax gap estimates; (3) IRS's goals, if any, for reducing the tax gap; and (4) the extent to which IRS uses tax gap estimates and underlying data to develop strategies to reduce the tax gap. GAO reviewed IRS tax gap data and reports and interviewed IRS officials.

The Internal Revenue Service's (IRS) latest tax gap estimate found that taxpayers voluntarily and timely paid about 81.7 percent of the taxes they should have paid for tax years 2008-2010.

As with past estimates, underreporting of individual income taxes accounted for the largest portion of the 2008-2010 tax gap. IRS believes the tax gap estimates are sufficiently reliable to provide a snapshot of tax compliance as a whole because much of the estimates are based on the most current data available, such as from IRS's National Research Program (NRP).

IRS previously set or acknowledged goals to improve voluntary compliance. However, IRS has since moved away from that approach. IRS officials now believe there are limited benefits to establishing goals because IRS cannot control all aspects of compliance and updated methodologies may cause fluctuations in the estimates. IRS does, however, have an impact on taxpayers' compliance through its service and enforcement programs. Without long-term, quantitative goals for improving voluntary compliance, it will be difficult for IRS to determine the success of its compliance efforts and adjust its approaches.

The Internal Revenue Manual states IRS needs to measure taxpayer compliance and other factors so compliance information and tools can be improved. IRS uses tax gap data to study compliance behaviors and update computer formulas designed to identify tax returns with a high likelihood of noncompliance. Yet IRS has not documented a comprehensive strategy that shows how it intends to use NRP data to update compliance strategies. Officials said the uses of NRP are widely known from general documentation about NRP. Without developing and documenting a strategy for using the NRP data to update compliance strategies, IRS may not fully leverage the compliance data or allocate enforcement resources in the most cost-effective manner, and it may be difficult for Congress and others to understand the merits of what they are being asked to fund.

GAO recommends that IRS re-establish goals for improving voluntary compliance and develop and document a strategy that outlines how it will use its data to update compliance strategies to address the tax gap. IRS disagreed with GAO's recommendation on establishing goals and agreed with the recommendation on compliance strategies. GAO continues to believe that goals are essential for results-oriented management.

Every year, taxpayers fail to pay hundreds of billions of dollars in taxes.  This tax gap—the difference between tax amounts that taxpayers should  pay and what they actually pay voluntarily and on time—has been a  persistent problem for decades. In 2016, the Internal Revenue Service  (IRS) estimated that taxpayers voluntarily and timely paid about 81.7  percent of the taxes they should have for tax years 2008 to 2010. The  average annual gross tax gap was $458 billion for those years. IRS  estimated that through late payments and enforcement actions it will  collect an additional $52 billion annually for tax years 2008 to 2010. The  average net tax gap of $406 billion for those years results in 83.7 percent  of taxes that should have been paid ultimately being paid.

You asked us to review IRS’s latest tax gap estimate for tax years 2008 to  2010. This report provides information on (1) the main drivers of the tax  gap; (2) IRS’s confidence in the tax gap estimates; (3) IRS’s goals for  reducing the tax gap; and (4) the extent to which IRS uses tax gap  estimates and underlying data to develop strategies and actions to reduce  the tax gap.

To address these objectives, we reviewed IRS’s tax gap estimates; IRS  documents on estimating compliance, estimating the tax gap, and  ensuring taxpayer compliance; and past GAO and Treasury Inspector  General for Tax Administration reports on the 2001 and 2006 tax gap  estimates. We also interviewed IRS officials responsible for estimating the  tax gap and those responsible for establishing goals and developing  strategies for improving voluntary compliance. We also examined data  from IRS’s National Research Program (NRP) study of individual tax  returns from 2008 to 2010, which IRS based part of its individual  underreporting tax gap estimates, to show additional detail on aspects of  compliance.

We determined that IRS’s tax gap and associated compliance rate  estimates were sufficiently reliable for the purposes of our reporting  objectives based on reliability tests we conducted. See appendix I for  more information on scope and methodology.

We conducted this performance audit from July 2016 through October  2017 in accordance with generally accepted government auditing  standards. Those standards require that we plan and perform the audit to  obtain sufficient, appropriate evidence to provide a reasonable basis for  our findings and conclusions based on our audit objectives. We believe  that the evidence obtained provides a reasonable basis for our findings  and conclusions based on our audit objectives.

We have consistently stressed the importance of IRS conducting tax  compliance research. Likewise, analyzing compliance data can help IRS  identify ways to enhance taxpayer compliance. Without such data, it is  more difficult for IRS to decide whether its efforts to address specific  areas of noncompliance should focus on non-enforcement activities, such  as improved forms or publications, or enforcement activities. Analyzing  the data can also help identify changes that could be made to tax laws  and regulations that may improve compliance.

In April 2016, IRS released its most recent tax gap estimate. IRS  estimated that taxpayers should have paid an average of about $2.5  trillion dollars per year in federal taxes for tax years 2008 to 2010. IRS  also estimated that taxpayers paid approximately $2.04 trillion voluntarily  and on time for those years, on average, leaving $458 billion in unpaid  taxes per year. However, IRS estimates that through late payments and  enforcement actions it eventually will collect an additional $52 billion on  average for those years, leaving the average net tax gap at $406 billion  for 2008 to 2010, as shown in figure 1.

The tax gap estimate is an aggregate estimate of the five types of taxes  that IRS administers—individual income, corporation income,  employment, estate, and excise taxes. For each tax type, IRS attempts  to estimate the tax gap based on three types of noncompliance: (1)  underreporting of tax liabilities on timely filed tax returns; (2)  underpayment of taxes due from timely filed returns; and (3) nonfiling,  when a taxpayer fails to file a required tax return altogether or on time.

IRS has not developed specific estimates for the tax gap related to  income earned from illegal activities (e.g., prostitution) or certain forms of  fraud. However, if IRS discovers these types of income over the course of  an audit, it could be included in the tax gap estimates. In general, refund  fraud related to identity theft would not be included in the tax gap estimate  because it does not involve evading a tax liability. The tax gap includes  unintentional errors as well as intentional evasion, such as intentionally  underreporting income, intentionally overreporting expenses, and  engaging in abusive tax shelters or frivolous tax schemes.

There is no single approach to estimating all of the components of the tax  gap. IRS uses NRP examinations of a stratified, random sample of tax  returns along with statistical modeling to produce estimates of  noncompliance for the population of individual income tax return filers.  Other areas of the tax gap are estimated using payment data or other  statistical models. Each approach IRS uses is subject to non-sampling  error and the areas of the estimate that are samples are subject to  additional sampling errors. The uncertainty of the estimates is not readily  captured by standard errors that typically accompany estimates based on  sample data. For that reason, IRS does not report standard errors,  confidence intervals, and statistical comparisons across years.

Prior to the 2008–2010 estimate, IRS had released two other tax gap  estimates that used data from NRP examinations: (1) a tax year 2001 tax  gap estimate that was released in February 2007 and (2) a tax year 2006  tax gap estimate that was released in December 2011. As shown in  figure 2, the gross tax gap estimate has increased, in nominal terms, from  $345 billion for 2001 to $458 billion, on average, for 2008–2010, an  increase of $113 billion or about 33 percent. However, when we adjusted  for inflation (using fiscal year 2016 dollars), the gross tax gap estimates  amount to $460 billion in 2001, $530 billion in 2006, and $509 billion in  2008–2010. The inflation-adjusted gross tax gap increased by about 11  percent from 2001 to 2008–2010; however, the 2008–2010 estimate is  slightly lower, by about 4 percent, than the 2006 estimate.

Over the three estimates, the voluntary compliance rate (VCR)—the  percentage of owed tax for a given year that is paid voluntarily and  timely—has decreased slightly from 83.1 percent for 2006 to 81.7, on  average, for 2008–2010. IRS also estimated the VCR and distribution of  tax liability for each component of the tax gap. Generally, employment  taxes have the highest estimated compliance rates while individual  income and estate taxes have the lowest estimated compliance rates.  There was a decrease in the VCR for individual income tax from 79  percent for tax year 2001 to 74 percent in the recent 2008–2010 estimate.  According to IRS, this decline, along with the individual income tax’s  increase in the share of liability, contributes to the slight decline in the  overall VCR.

The amount of the tax gap that IRS estimated it would collect through  enforcement efforts and late payments varied across the three estimates.  In 2001, IRS estimated it would collect $55 billion and that figure would  increase by $10 billion, to $65 billion in 2006. However, for the 2008– 2010 tax gap estimate, the enforced collections or late payments  decreased by $13 billion per year, on average, from the 2006 estimate, to  $52 billion. According to IRS, the methodology used to calculate prior  estimates may have been too optimistic, resulting in an overstatement of  as much as 25 percent. Additionally, IRS stated that the economic  downturn in 2008 reduced the total tax liability from which IRS could  collect revenue over this period.

However, differences in the tax gap estimates across years may not all be  attributed to changes in taxpayer behavior (voluntary compliance) or IRS  enforcement activities. According to IRS, the tax gap estimates have  increased in part because IRS included some new tax gap components  and updated some methods, which it believes increased the  comprehensiveness and accuracy of the estimates. IRS reported that  changes in economic activity and changes in tax law and administration  also contribute to differences in tax gap estimates over time.

Enforcement of Tax Laws and GAO’s High-Risk List

In our 2017 High-Risk Report we continued to include Enforcement of Tax  Laws as a high-risk area. Key components of this high-risk area include  both addressing the tax gap and improving tax compliance. IRS  enforcement of the tax laws helps fund the U.S. government by collecting  revenue from noncompliant taxpayers and, perhaps more importantly,  promoting voluntary compliance by giving taxpayers confidence that  others are paying their fair share. However, IRS still faces challenges to  its capacity for implementing new initiatives and carrying out ongoing  enforcement and taxpayer service programs under an uncertain  budgetary environment.

Given the estimated size of the tax gap, even modest reductions would  yield significant financial benefits for the country. We have made  numerous recommendations over time to help IRS, the Department of the  Treasury (Treasury), and Congress address tax noncompliance.  Nonetheless, as we have reported in the past, closing the entire gap is  not feasible since it could entail more burdensome record keeping or  reporting than the public is willing to accept or more resources than IRS is  able to commit. For example, third-party information reporting has  shown to improve accuracy of income reporting by individual taxpayers;  however, it requires increased record keeping and reporting by the third  party and requires IRS resources to properly match the third-party  information to individual tax returns.

Underreporting by Individual Taxpayers Accounts for the Largest Portion of the Tax Gap

Underreporting of tax liabilities accounted for most of the tax gap estimate  for tax years 2008–2010, making up 84 percent of the entire estimated  gross tax gap, as shown in figure 3. Individual income taxes made up the  largest portion of underreporting, followed by employment taxes and  corporation income taxes.

Underreporting of business income accounted for nearly half of the  individual income tax underreporting gap. This includes income from sole  proprietors, which accounted for the largest share of individual income  tax underreporting, as shown in table 1. Most business related income tax  return items also had high net misreporting percentages, which is the sum  of the net misreported amount divided by the sum of the absolute values of the amounts that should have been reported, as a percentage. To  show additional detail on aspects of the tax gap, we conducted some  additional analysis on selected line items of the individual NRP data,  which is presented in appendix II.

As we have previously reported, the extent to which individual income tax  taxpayers accurately report their income is closely aligned to the amount  of income that is reported to them and to IRS by third parties. For  example, according to 2008–2010 IRS data, taxpayers misreported over  half of the types of income for which there is little or no third-party  information reporting, such as business income. In contrast, when  employers withhold taxes and report the wages and salaries to  employees and IRS through Form W-2, Wage and Tax Statement (W-2),  there is better compliance. As shown in figure 4, 1 percent of these types  of income were misreported while nearly 99 percent were accurately  reported on individual income tax returns. Similarly, taxpayers  misreported less than 10 percent of income for which banks and other  financial institutions provided information returns (Forms 1099) to account  holders and IRS that show taxpayers’ annual income from some types of  investments.

Generally, new requirements on third parties to submit information returns  would require statutory changes. We have previously identified additional  information reporting opportunities as well as improvements that IRS  could make on its own to existing forms and how it uses them. For  example, we suggested in August 2008 that Congress may wish to make  all taxpayers with rental real estate activity subject to the same  information reporting requirements as other taxpayers operating a trade  or business; however, no legislative action has been taken on this  suggestion. We recommended in August 2010 that IRS require  mortgage-secured property addresses to be reported on other forms  (Forms 982 and 1099-C) to help IRS detect taxpayers who fail to pay  taxes on certain forgiven mortgage debts. Legislative and executive  actions have been taken consistent with our recommendation. However,  IRS has not revised two forms to collect specific information from  taxpayers and lenders concerning the amount of forgiven debt attributable  to a principle residence and the locations of a taxpayer’s principle  residence.

For items subject to substantial third-party information reporting, IRS is  able to use automated processes to address noncompliance. The  automated underreporter program, through which IRS matches amounts  reported on returns with amounts reported on information returns  submitted by third parties, is one such process. This computer matching  program allows IRS to identify discrepancies between tax returns and  information returns and propose automatic changes to taxpayers.

For items with little to no third-party information reporting, IRS has to rely  on more resource-intensive methods, such as correspondence or face-to- face examinations, to address noncompliance. While these examinations  may be started by reviewing specific line items, they may also be  expanded to cover other areas of the tax returns if there are indications of  misreporting in areas of the return not previously identified. However, it is  harder for IRS to detect noncompliance in areas with little third-party  information reporting.

The second largest part of the underreporting tax gap is made up of  employment taxes, which are comprised of three main components: self- employment tax, Federal Insurance Contribution Act (FICA) Social  Security and Medicare withholding, and Federal Unemployment Tax Act  (FUTA) taxes, as shown in table 2. The self-employment component is  estimated from IRS’s NRP individual income tax data. However, IRS  lacks NRP data for other components of employment tax. Therefore, it  estimates both FICA and FUTA by applying the estimated compliance  rates from a 1993 employment tax gap report, which used tax year 1984  employment tax return data, to the current reported taxes.

IRS recently completed an NRP study of employment tax returns that  reviewed federal income tax withholding and FICA, the first such study  IRS had conducted in over 30 years. We reported that although the  examinations for the study were completed, IRS had not developed  formal plans to analyze the results to (1) identify areas of noncompliance,  (2) address such noncompliance, or (3) update its employment tax gap  estimate. According to IRS officials, they had not developed formal  plans due to competing research priorities and limited resources and  because the NRP results had not yet been finalized. We recommended  that IRS develop plans to analyze the NRP results in 2017 to address  areas of noncompliance identified and update its employment tax gap  estimates. IRS agreed with our recommendations and stated that it will be  determining how to use the data from this new study to update the  employment tax gap estimate.

As shown in table 3, IRS developed corporation income tax  underreporting estimates for two types of corporations: small corporations  (those without a balance sheet or with assets less than $10 million) and  large corporations (those with assets of $10 million or more). IRS  estimated the voluntary compliance rate for all corporations to be 83  percent for tax years 2008–2010. The estimates are based on adjusted  data from operational examinations, which focus on the tax returns most  likely to have substantive noncompliance rather than examinations of a  statistically representative sample of corporation tax returns. IRS does not  have a program comparable to NRP for corporation income tax because  of the difficulty of constructing a representative sample for a small group  of highly diverse large corporations, among other reasons.

The limited scope and selection criteria for non-NRP examinations  introduce statistical bias, meaning that the examination issues and results  from examinations of corporation tax returns are not necessarily  representative of the overall corporation population. However, IRS has  developed some methods to project the results of the examinations to the  larger population of corporations, and, despite these limitations, IRS  considers the corporation estimates to provide a rough gauge of  corporation income tax noncompliance.

IRS’s divisions responsible for large and small corporation examinations  each have management systems in place to track issues identified from  corporation examinations. While this information is not derived from the  tax gap estimates, IRS has identified several common examination issues  for both large and small corporations, as shown in table 4.

For the 2008–2010 tax gap estimate, IRS for the first time estimated the  net tax gap by each type of tax, as shown in table 5. Unlike most of the  tax gap, IRS can tabulate late payments. Since enforcement and other  late payments often happen many years after a given tax year has ended,  IRS must project into the future to estimate how much tax it will eventually  collect for that tax year. IRS expects to recoup the smallest percentage of  taxes from the gross individual income tax estimate.

IRS Has Confidence in Most Aspects of the Tax Gap Estimate and Is Taking Steps to Improve It

IRS officials stated IRS believes the tax gap estimates are sufficiently  reliable for the intended purpose of providing a snapshot of tax  compliance as a whole. The tax gap estimate is actually many estimates  used together to develop one overall picture of tax compliance. IRS has  more certainty in some areas of the estimate than others. Generally, IRS  officials consider those components of the tax gap estimate that are  based on the most current data (2008–2010 data) to be more robust.  However, as shown in table 6, IRS recognizes that some component  estimates of the tax gap estimate are more uncertain than others, in part  because some component estimates rely on older data and it is inherently  difficult to estimate some types of noncompliance. IRS has no estimates  for some areas of the tax gap.

According to IRS officials, IRS has higher amounts of confidence in all of the underpayment components, because they are based on data  from systems that can distinguish enforcement and late payments  from other payments (IRS has the most confidence in these  components);  the individual income nonfiling component, because it is based on a  new methodology combining two methods that incorporate  improvements to the methods used in prior estimates;  the individual income underreporting component, because it is  primarily based on adjusted NPR examination data, which is a  statistically representative sample of individual tax returns; and  the corporation underreporting component, because it is based on  operational examination data, adjusted for selection bias.

IRS has a lesser amount of confidence in  the estate nonfiling and underreporting data, because they are  forecasts updating estimates based on assumptions made in studies  completed in 2000; and  the withholding taxes (FICA and FUCA) part of the employment  underreporting data, because the data are partially a forecast based  on data from an older compliance study.

The methodologies used to develop the component estimates differ by  component, resulting in a mix of statistical sample and operational-based  data being used, as well as forecasts from earlier estimates. IRS is  therefore unable to calculate confidence intervals for any of the tax gap  estimates. IRS officials stated that that they continue to try to identify a  value for those components without estimates, such as corporation  income, excise tax nonfiling, and excise tax underreporting, but have not  yet found a sufficiently reliable data source nor method upon which to  base estimates.

To increase its confidence in the estimates of underreported individual  income, IRS uses an econometric technique called detection controlled  estimation (DCE). This regression-based model controls for variables that  could affect the amount of underreporting IRS examiners detected. IRS  uses this adjustment because it knows its examiners do not detect all  underreported income during examinations, and therefore it adjusts the  NRP data to account for such undetected income when estimating the tax  gap. The statistical technique estimates the noncompliance detected by a  hypothetical “best practices” examiner—an ideal that is unattainable—and  then statistically estimates the noncompliance detected by the  hypothetical examiner to adjust upward the findings from research  examinations conducted by actual examiners.

The DCE adjustment accounts for more than half (about $150 billion) of  the total individual income tax underreporting estimate. IRS also used the  DCE adjustment for the self-employment tax estimates used in the  employment tax underreporting estimate. Appendix III provides more  information on the extent to which DCE adjustments contributed to the  2008–2010 tax gap estimate.

IRS has taken steps to improve the tax gap estimate. For example, IRS  used an updated methodology to calculate the estimated nonfiling amount  for the 2008–2010 estimate that combined two prior methodologies.  Specifically, IRS expanded how it matches information between the U.S.  Census Bureau’s annual Current Population Survey and IRS data to  estimate the amount of taxes that were not filed. IRS believes this  updated methodology allows it to create a better matched dataset and  identify nonfilers more accurately. See appendix IV for details on changes  to IRS’s tax gap methodology.

IRS plans to release its next tax gap estimate in 2019 to cover tax years  2011 to 2013. IRS is also undertaking several additional studies that may  offer data IRS can use to improve the tax gap estimate, including these  examples:

Taxpayers’ tipping behavior: IRS is surveying taxpayers to help  estimate total tip income and tipping rates by industry/occupation and  by major method of payment (e.g., credit card, debit card, and cash).

Limited studies on C corporations and other midsize  corporations: IRS studied compliance of C corporations with assets  less than $250,000 and with a balance sheet, and corporations with  assets of $10 to $50 million for tax year 2010. These studies plan to  identify potential areas of noncompliance.

Partnership misreporting pilot: In 2016, IRS initiated this study to  measure reporting compliance for certain partnerships, as well as to  estimate tax misreported at the taxable partner level as a result of  partnership misreporting. This study was initiated in response to a  recommendation from a prior report.

NRP employment tax estimates: As previously mentioned, IRS is  determining how it will use the NRP employment tax study it  concluded in 2017 to improve the tax gap estimates.

IRS Has Broad Compliance Goals but Lacks Specific Quantitative Goals for Increasing Voluntary Compliance

IRS’s current strategic plan (2014–2017) discusses general approaches  to make voluntary compliance easier for taxpayers and to ensure taxes  owed are paid. However, in some areas, the plan does not include  specific tactics for improving compliance strategies. Rather, it addresses  the elements of voluntary compliance and enforcement actions through  two of its goals:

Delivering high-quality and timely service to reduce taxpayer burden  and encourage voluntary compliance.

Effectively enforcing the law to ensure compliance with tax  responsibilities and combat fraud.

IRS officials stated the strategic plan goals are a component of IRS’s  Future State—which is a vision for agency-wide operations that aims to  improve services across different taxpayer interactions such as individual  account assistance, exams, and collections—and are directly reflected in  three of its six themes:  facilitate voluntary compliance by empowering taxpayers with secure  innovative services, tools, and support; understand noncompliant taxpayer behavior, and develop approaches  to deter and change it; and  select highest value work using data analytics and a robust feedback  loop.

According to IRS officials, the remaining themes support these goals  indirectly by seeking to improve IRS’s effectiveness. IRS officials noted  the IRS Future State vision has outlined two measures that will support  the overall goal of increased compliance. The first will be the percentage  of compliance issues resolved within 1 year of filing. The second is the  percentage of taxpayers with recurring compliance issues. However, IRS  has not yet determined the target levels for these goals. According to  officials, the levels for these goals will be published with the next IRS  strategic plan (2018–2022), which IRS is scheduled to release in mid- 2018.

IRS Lacks Specific Quantitative Goals to Improve Voluntary Compliance

IRS previously set or acknowledged quantitative goals to improve  voluntary compliance. However, IRS has since moved away from that  approach. In 2005, we recommended that IRS establish a long-term  quantitative voluntary compliance goal for individual income tax  underreporting and for tax underpayment, as well as for other areas of  noncompliance. IRS agreed with the concept of our recommendation  and, in response, established a voluntary compliance rate goal of 85  percent by 2009, which was published in IRS’s fiscal year 2007 budget  request.

In 2006, Treasury issued its Comprehensive Strategy for Reducing the  Tax Gap, with a seven-component strategy for reducing the tax gap: (1)  reduce opportunities for evasion, (2) make a multiyear commitment to  research, (3) continue improvements in information technology, (4)  improve compliance activities, (5) enhance taxpayer service, (6) reform  and simplify the tax law, and (7) coordinate with partners and  stakeholders. In 2007, IRS developed a more detailed report that  emphasized the same seven components outlined in the Treasury report  and also outlined projects, initiatives, legislative proposals, and other  actions designed to combat the sources of noncompliance.

In the 2007 report, IRS acknowledged the goal set by the then Chairman  of the Senate Finance Committee for IRS to meet a 90 percent voluntary  compliance rate by tax year 2017 and the goal set by the IRS Oversight  Board of 86 percent by tax year 2009. In 2009, IRS published another  report that followed up on the efforts discussed in the 2006 and 2007  Treasury and IRS reports. However, IRS has not published any reports  since that time that focus on goals for reducing the tax gap.

In 2012, Treasury, along with IRS, set an agency priority goal to increase  voluntary tax compliance from 83.1 to 86 percent by September 30,  2013. However, Treasury and IRS decided not to renew the agency  priority goal because they said the measure did not satisfy the criteria of  having indicators and quarterly milestones against which to track process  or being able to determine whether the goal has been achieved by the  end of a 2-year period, as established by the Office of Management and  Budget. Since the tax gap estimates are only updated every few years,  Treasury and IRS officials said there was no way for Treasury or IRS to  show improvements or declines in meeting the goal on a quarterly basis  or over the 2-year goal term. More recently, IRS officials told us that  while they want to achieve a high level of voluntary compliance, neither  IRS nor Treasury has set a recent high level department- or agency-wide  quantitative goal aimed at reducing the tax gap or increasing voluntary  compliance.

Establishing clear compliance goals and measuring progress toward them  benefit both IRS and external stakeholders and are consistent with the  results-oriented performance management principles set forth in the  Government Performance and Results Act of 1993 and the GPRA  Modernization Act of 2010. As we have previously reported, setting  long-term strategic goals is essential for results-oriented management,  because such goals explain in greater specificity the results an agency is intending to achieve. The goals form a basis for an organization to  identify potential strategies for fulfilling its mission and for improving its  operations to support achievement of that mission. Directly aligning  strategic goals and strategies for achieving those goals is important for  assessing an agency’s ability to achieve those goals. Further, when  program results could be influenced by external factors, agencies can use  intermediate goals and measure to identify the program’s discrete  contribution to a specific result.

IRS has moved away from specific numeric goals to improve compliance  because it now believes there are limited benefits to them. According to  IRS officials, IRS actions alone do not determine the level of taxpayer  compliance and there are also several challenges associated with  establishing meaningful and useful compliance goals. IRS officials  reported that many of these challenges are due to the tax gap only being  estimated every few years. As a result, fluctuations in the estimate over  time may not be generally attributed to changes in compliance behavior  but the fluctuations might instead result from the imprecision of the  estimates or updated methodologies.

According to IRS, changes in the economy may also have an effect on  tax compliance rates. For example, a downturn in the economy would  likely result in less tax needing to be paid, but it might also cause some  taxpayers to comply less than they otherwise would. Further, separating  those two effects would be difficult, particularly given the unobserved  nature of most noncompliance. Finally, IRS officials stated other factors,  such as IRS services, enforcement efforts, evolving social norms, or  changes in legislation, may affect the overall compliance rate.

Although IRS may not have full control over all of the factors that affect  voluntary compliance, it does have an impact on taxpayer’s compliance  through its service and enforcement programs. Furthermore, IRS is not  alone in not having full control over the results it seeks to achieve. A  number of methods can be used to map or model the causal relationships  among the inputs, processes, and outputs produced by various strategies  and the forces that influence achievement of outcomes, such as results  mapping and logic modeling. Recognizing that outside influences may  present risks or challenges to achieving outcomes, OMB Circular Number  A-11 states that while agencies cannot mitigate all risks related to  achieving strategic objectives and performance goals, they should  identify, measure, and assess challenges related to mission delivery, to  the extent possible.

We have previously reported that setting long-term quantitative goals for  IRS offers several benefits. First, compliance goals coupled with  periodic measurements of compliance levels would provide IRS with a  better basis for determining to what extent its various service and  enforcement efforts contribute to compliance. Second, long-term,  quantitative goals would help IRS consider new strategies to improve  compliance, especially since these strategies could take several years to  implement. Third, focusing on intended results can promote strategic and  disciplined management decisions that are more likely to be effective  because managers who use fact-based performance analysis are better  able to target areas most in need of improvement and to select  appropriate interventions. Fourth, agency accountability can be enhanced  when both agency management and external stakeholders—such as  Congress—can assess an agency’s progress toward meeting its goals.

Likewise, a survey of the Organization for Economic Cooperation and  Development countries and other advanced economies found that some  governments are paying increased attention to estimating tax gaps for  their major types of taxes. Several countries shared their quantitative  goals for reducing the tax gap or increasing their tax revenue with the  survey. For example, Denmark set a target to ensure that the tax gap  does not exceed 2 percent of estimated total tax liability.

Without long-term, quantitative voluntary compliance goals and related  performance measures, it will be more difficult for IRS to determine the  success of its strategies, adjust its approach when necessary, and remain  focused on results, especially since factors that affect compliance change  over time. Having compliance goals as IRS has had in the past, coupled  with data, would provide a solid base upon which IRS could develop a  more strategic, results-oriented approach to improving compliance.

IRS Uses National Research Program Data to Guide Compliance Efforts but Has Not Documented a Long- Term Strategy

IRS officials told us tax gap data are used as a high-level overview of tax  compliance. IRS officials also stated they use the underlying tax gap data  (i.e., NRP data and other data) in several ways to update compliance  efforts. However, IRS has not documented a comprehensive strategy that  shows, for example, how it intends to analyze and use the tax gap data,  particularly from the NRP, to develop or improve compliance programs.

IRS officials told us they use the NRP data to study specific compliance  behaviors. For example, IRS has studied taxpayer behavior in claiming  the Earned Income Tax Credit (EITC), the child tax credit, and the  additional child tax credit. Sometimes these studies are used to develop  legislative proposals that are included as part of the annual budget  process and outlined in Treasury’s annual revenue proposals. Officials  stated the legislative proposals are based on the knowledge of  compliance derived from analysis of NRP data and they are organized  into themes, such as reducing the tax gap, improving voluntary  compliance, or improving tax administration. However, these revenue  proposals are requests for changes to the tax laws and, ultimately, it is at  Congress’s discretion whether to enact them. IRS officials reported that  other times NRP data are used to compute the annual improper payment  rate for the EITC. According to officials, IRS also uses these data to  annually categorize the root causes of EITC noncompliance.

IRS uses the NRP data to update compliance plans by updating the  Discriminate Function (DIF) formulas. DIF formulas are designed to score  returns for the likelihood that the tax reported on the return is significantly  underreported. DIF scores help IRS ensure that noncompliant taxpayers  are more likely to be selected for examination and compliant taxpayers  are less likely to be unnecessarily examined. IRS determines DIF scores  for individual income, small corporation income, partnership, and S  corporation returns.

IRS officials described high-level concepts of how the various NRP and  other studies contribute to compliance and enforcement strategies.

Officials from IRS’s Office of Research, Applied Analytics, and Statistics  (RAAS) said they think the various uses of the NRP are widely known  from general documentation about the NRP and its study design. RAAS  officials also noted the fiscal year 2009 budget justification that led to  special funding for the NRP still reflects IRS’s current strategy for  undertaking various NRP studies. Further, IRS officials pointed us to  documentation from the 2000s that discussed a need for a multiyear  research commitment and IRS’s goal to move NRP studies beyond the  individual income tax to include other taxes. We previously recognized  IRS’s commitment to multiyear research and have noted the gains it has  made in regularly estimating compliance. Our analysis of the decade-old  documents found evidence of a commitment to research that generally  seemed sufficient for that period.

However, IRS officials did not provide us more recent documents that  describe its current efforts to study compliance or show how it plans to  use NRP data to update compliance strategies. IRS officials also provided  us with business plans for some of their other business units and  divisions. The plans we reviewed noted, at a high level, that data and  analysis will be used to improve workload selection but did not discuss  how specific research efforts or the results of those efforts would be  integrated into the missions.

The Internal Revenue Manual section on the NRP states that IRS needs  to measure taxpayer compliance with federal income tax laws along with  contributing factors so that customer-focused programs and services can  be enhanced or developed and so that compliance information and tools  can be improved. A 2001 NRP prospectus states the NRP will help to  increase public confidence in the fairness of our tax system by helping  IRS identify where compliance problems occur and focus its resources  accordingly. Further, it states that for strategic planning and budget  purposes, IRS requires regular estimates of compliance. The NRP  research efforts support this critical need. According to IRS, the NRP will  also improve IRS’s ability to detect noncompliance; reduce the burden of  unnecessary IRS contacts on compliant taxpayers; and support the  strategic goals, program development, and resource allocation of IRS  operating divisions.

Using quality information, such as NRP data, to achieve the agency’s  objectives is one of the 17 principles for internal controls. Further, the  standards for internal controls also recognize documentation is a  necessary part of an effective system, but the level and nature of  documentation vary based on the size of an entity and the complexity of  the operational process. Documentation is required to demonstrate the  design, implementation, and operating effectiveness of a system.  Considering the size and relative importance of the tax gap, documenting  a strategy for how IRS plans to use NRP data to reduce the tax gap  would be consistent with internal controls. However, without a strategy  that provides an overall picture of how NRP data are used, it may be  difficult for Congress and other decision makers to understand the merits  of what they are being asked to fund. Further, without developing and  documenting a strategy for incorporating the results of NRP data, IRS  risks not fully leveraging the compliance data it collects or not allocating  enforcement resources in the most cost-effective manner.

We have a long-standing history of reporting on the need for IRS to  develop a comprehensive compliance strategy:  In 1994, we concluded that until IRS produces a comprehensive  compliance strategy, existing data could be used as part of an interim  compliance strategy that directs resources at the most noncompliant  taxpayers. We found that using such a starting point, IRS could  focus more of its efforts on highly noncompliant areas, such as small  corporation income and sole proprietorship income that made up  almost a third of the tax gap.

In 2005, we concluded that reducing the tax gap will be a challenging  task given persistent levels of noncompliance and will not likely be  achieved through a single solution. Rather, the tax gap must be  attacked on multiple fronts and with multiple strategies over a  sustained period, thus building a foundation to help taxpayers  voluntarily comply.

Between 2005 and 2007, we testified six times on the need for IRS to  develop a strategy to attack the tax gap on multiple fronts with  multiple approaches.

In 2007, we reported on the need for IRS to develop a strategy to  address noncompliant sole proprietor income, which accounts for a  significant share of the tax gap.

Further, documenting a strategy for using NRP data to guide compliance  efforts would be consistent with two key criteria for removal from the  High-Risk List:

Action plan: A corrective action plan exists that defines the root  cause and solutions and that provides for substantially completing  corrective measures, including steps necessary to implement  solutions we recommended.

Demonstrated progress: Ability to demonstrate progress in  implementing corrective measures and resolving the high-risk area.

The nation’s long-term fiscal projections show that the federal  government is on an unsustainable fiscal path. One way to help improve  the nation’s fiscal position would be to reduce the tax gap. Reducing the  tax gap will be a challenging task given persistent levels of taxpayer  noncompliance. However, even modest reductions would yield significant  financial benefits and help improve the government’s fiscal position.

IRS has shown a continued commitment to study sources of  noncompliance and has made strides in improving NRP and other tax gap  data. However, additional efforts could further assist IRS in addressing  the tax gap. A long-term, quantitative goal for improving voluntary  compliance may provide IRS with a concrete target the agency can use in  fulfilling its mission. Without a quantitative goal, it will be more difficult for  IRS to determine the success of its strategies, adjust its approach when  necessary, and remain focused on results, especially since factors that  affect compliance change over time. Likewise, a strategy that outlines  how IRS plans to use NRP data to update compliance strategies would  help IRS determine resource tradeoffs and more fully leverage the  investment it makes in compliance research, while providing Congress  with a better understanding of the merits of the research it is being asked  to fund.

We are making the following two recommendations to IRS:  The Commissioner of Internal Revenue should re-establish long-term,  quantitative goals for improving voluntary compliance. (Recommendation  1)

The Commissioner of Internal Revenue should instruct the appropriate  officials to develop and document a strategy that outlines how IRS will  use National Research Program data to update compliance strategies  that could help address the tax gap. (Recommendation 2)

We provided a draft of this report to the Commissioner of Internal  Revenue. IRS provided written comments, which are summarized below  and reprinted in appendix V. IRS also provided technical comments,  which we incorporated where appropriate.

IRS disagreed with our recommendation that it re-establish long-term,  quantitative goals for improving voluntary compliance. In its letter, IRS  stated that the voluntary compliance rate is ill-suited as a strategic or  performance metric for IRS for various reasons. For example, IRS stated  that improving voluntary compliance, determining the success of its  strategies, and adjusting its approach could be accomplished in the  absence of a quantitative goal. However, as we note in the report, setting  long-term strategic goals is essential for results-oriented management,  because such goals explain in greater specificity the results an agency is  intending to achieve. Further, focusing on intended results can promote  strategic and disciplined management decisions that are more likely to be  effective because managers who use fact-based performance analysis  are better able to target areas most in need of improvement and to select  appropriate interventions.

IRS also stated that its actions alone do not determine the level of  voluntary compliance, which is determined by the interaction of many  factors, such as taxpayer behavior, tax law complexity, and IRS  resources. We agree that IRS may not control all factors that affect  voluntary compliance. However, IRS does influence taxpayer compliance  through its service and enforcement programs. Furthermore, as we point  out in the report, while agencies cannot mitigate all outside influences that  may present risks or challenges to achieving outcomes, they should  identify, measure, and assess such challenges to the extent possible.  Given the benefits of setting long-term quantitative goals—as discussed  in this report—we continue to believe it is prudent for IRS to establish  such goals.

IRS agreed with our recommendation that it develop and document a  strategy that outlines how IRS will use National Research Program data  to update compliance strategies that could help address the tax gap.

As agreed with your office, unless you publicly announce the contents of  this report earlier, we plan no further distribution until 30 days from the  report date. At that time, we will send copies to the Chairmen and  Ranking Members of other Senate and House committees and  subcommittees that have appropriation, authorization, and oversight  responsibilities for IRS. We will also send copies of the report to the  Commissioner of Internal Revenue and other interested parties. In  addition, this report will be available at no charge on the GAO website at  http://www.gao.gov.

If you or your staff has any questions about this report, please contact me  at (202) 512-9110 or mctiguej@gao.gov. Contact points for our offices of  Congressional Relations and Public Affairs are on the last page of this  report. GAO staff members who made major contributions to this report  are listed in appendix VI.

Appendix I: Objectives, Scope, and Methodology

Our objectives were to determine (1) the main drivers of the tax gap; (2)  the Internal Revenue Service’s (IRS) confidence in the tax gap estimates;  (3) IRS goals, if any, for reducing the tax gap; and (4) the extent to which  IRS uses tax gap estimates and underlying data to develop strategies and  actions to reduce the tax gap.

To determine the main drivers of the tax gap and IRS’s confidence in the  estimates, we reviewed IRS’s tax gap estimates and underlying data; IRS  technical papers and reports; third-party reviews of the data; and past  GAO and Treasury Inspector General for Tax Administration reports on  the 2001, 2006, and 2008–2010 tax gap estimates. We also interviewed  officials from IRS’s Office of Research, Applied Analytics, and Statistics  (RAAS) who are responsible for estimating the tax gap. We determined  that IRS’s tax gap and compliance estimates were sufficiently reliable for  the purposes of this report, particularly since IRS already has publicly  released its tax gap estimates and disclosed their limitations. These  purposes include discussing the major tax gap components, the orders of  magnitude for various components, and IRS’s opinions about the  certainty of its estimates.

To determine IRS’s goals for increasing voluntary compliance, we  reviewed IRS’s and the Department of the Treasury’s (Treasury) strategic  plans and Treasury’s General Explanations of the Administrations Fiscal  Year Revenue Proposals (commonly referred to as the Green Book) from  2011 to 2017. We also reviewed other IRS and Treasury documentation,  such as the strategies for improving voluntary compliance that were  developed in the mid-2000s. Additionally, we reviewed Treasury’s agency  priority goals, including the goal it set in 2012 to increase voluntary  compliance. We also reviewed the statutory requirements for agency  performance goals under GPRAMA. We interviewed Treasury officials in  the Office of Tax Analysis and the Office of Strategic Planning and  Performance Improvement about prior goals that were set and the goal- setting process. We interviewed IRS officials responsible for developing  strategies and establishing goals to reduce the tax gap, specifically  officials in the Deputy Commissioner’s Office for Service and  Enforcement and the Small Business/Self-Employed, Large Business and  International, and Wage and Investment divisions.

To determine the extent to which IRS uses the tax gap and other  underlying data to update compliance efforts, we requested  documentation on any plans or strategies that show how the various tax  gap and other compliance studies work together toward a larger  compliance strategy. We found that the agency had not developed these  documents. We interviewed staff from the Deputy Commissioner’s Office  for Service and Enforcement and RAAS about the agency’s plans to use  tax gap data and other compliance studies when developing compliance  strategies.

To show additional detail on aspects of compliance using the same data  upon which the individual income tax underreporting tax gap estimates  are based, we examined IRS’s tax gap estimates for tax years 2008– 2010 and the underlying data from its National Research Program (NRP)  study of individual income tax returns. This information is presented in  appendix II. Unlike other IRS examinations, NRP examinations can be  used to estimate taxpayer reporting compliance because they are drawn  from a stratified, statistically representative sample of the population of  individual income tax returns. We interviewed IRS officials from RAAS  about their research and analysis of the NRP data, and we gathered  related documentation where available. IRS officials described the quality  review and data reliability processes they used to collect data from the  NRP examinations.

Because the NRP sample was based on random selections, the sample  was only one of a large number of samples that IRS could have drawn.  Since each sample could have provided different estimates, we express  our confidence in the precision of our estimates based on the sample as a  95 percent confidence interval plus or minus a margin of error. This is the  interval that would contain the actual population value for 95 percent of  the samples that could have been drawn. The estimates presented in  appendix II have margins of error of less than 10 percent or 10  percentage points. In analyzing the NRP data, we conducted several  reliability tests to ensure the data we used were sufficiently complete. For  example, we electronically tested the data for obvious errors. We  concluded that the data were sufficiently reliable for the purposes of this  report based on these steps and on our previous reviews of tax gap  estimates and NRP data.

We conducted this performance audit from July 2016 to October 2017 in  accordance with generally accepted government auditing standards.  Those standards require that we plan and perform the audit to obtain  sufficient, appropriate evidence to provide a reasonable basis for our  findings and conclusions based on our audit objectives. We believe that  the evidence obtained provides a reasonable basis for our findings and  conclusions based on our audit objectives.

Appendix II: Additional Analyses of National Research Program Individual Data

We analyzed the raw National Research Program (NRP) data for  individual income tax returns, including itemized deductions, for tax years  2008–2010. These data do not account for the undetected income that  the Internal Revenue Service (IRS) adjusts for when developing tax gap  estimates. Therefore these data are not comparable to the tax gap data  presented elsewhere in this report, but they allow additional analysis of  areas of misreporting.

Table 7 provides greater details on certain line items from the individual  income tax return that align with various third-party information reporting  levels determined by IRS. Line items with substantial or some information  reporting tended to have lower overall misreporting percentages. Line  items that had the largest percentage of taxpayers with misreported  income were those for sole proprietor and farming income, both of which  are subject to little to no information reporting.

Based on the analysis of these data, we also estimate that  line items with the largest mean amounts of underreporting are  business sale and supplemental income or loss;  the business sale line item also has the largest mean amount of  overreporting, averaging $21,000 per return; and  sole proprietor income and farm income have very similar  misreporting data; over 75 percent of the income is misreported and,  of that, over 80 percent is under reported while under 20 percent is  overreported.

We also analyzed selected credits and deductions to determine the  average noncompliance rates of these line items, as shown in table 8.  Because credits and deductions offset taxpayers’ income or tax owed,  taxpayers who underreported a credit or deduction overreport their tax  liability or tax owed; taxpayers who overreport a credit or deduction  underreport their tax liability or tax owed. However, we did not determine  the extent to which misreporting was because of issues specific to how  taxpayers claimed the credits and deductions or because taxpayers  misreported their income, which could affect eligibility for certain credits  and deductions. For example, the 2016 income limit to claim the Earned  Income Tax Credit (EITC) is $39,296 for single, surviving spouse, or head  of household taxpayers with one qualifying child. If IRS determined that  such taxpayers who claimed the EITC and reported less than $39,296 in  income on their tax returns had underreported their income in order to  stay under the threshold, those taxpayers would no longer be eligible for  the credit and would have overreported the credit.

Based on the analysis of these data, we estimate that of the selected credits, EITC is the most claimed credit and about half  of the time it is misreported;  thirty-five percent of the time the child tax credit was misreported with  about two- thirds of that being underreported, which is inconsistent  with filing patterns for most of the other credits and deductions; of the selected deductions, the deduction for real estate taxes is most  often claimed and about a quarter of the time it is misreported;  the medical expenses line item has the highest percentage of  misreporting; 80 percent of the time the deduction is overreported;  and  the mortgage interest deduction has the highest average overreported  amount, over $4,000 per return.

Appendix III: Detection Correction Factor’s Effect on Tax Gap Estimation

In estimating the individual income tax gap, the Internal Revenue Service  (IRS) applies an econometric technique called detection controlled  estimation (DCE), which is a regression-based model that controls for  variables that could affect the amount of underreporting detected. The  statistical technique first produces a hypothetical ‘‘best practices’’  examiner—an ideal which is unattainable—based on who conducted the  examinations and the observed examination results. It then statistically  estimates the noncompliance detected by the hypothetical examiner to  adjust upward the findings from research examinations conducted by  actual examiners. The technique estimates total undetected  underreporting by imputing the average underreporting undetected by  IRS’s National Research Program (NRP) examination to the detected  underreporting, controlling for certain return line item characteristics.  According to IRS officials, this approach is reasonable and the best  currently available to attempt to estimate the full amount of underreported  individual income. As shown in table 9, more than half of the  underreporting component of the tax gap consists of income that IRS did  not detect during examinations. DCE is not applicable to the  underpayment and nonfiling components of the tax gap.

Appendix IV: Additional Information on IRS’s Tax Gap Methodology Changes

In efforts to improve the tax gap estimates, the Internal Revenue Service  (IRS) updated two areas of the 2008–2010 tax gap estimate by  developing updated methodologies.

Nonfiling individual income tax: IRS summed together the total of  taxpayers who do not file tax returns and those who filed late. The  2008–2010 estimate of taxpayers not filing a return was made by  combining the two methods used to estimate the 2006 and 2001 tax  gap estimates. In 2006, IRS used a sample of individuals not  appearing on filed tax returns. In 2001, IRS conducted an “exact  match” between the Census Bureau’s annual Current Population  Survey and IRS data. The 2008–2010 estimate of late filers was  based on the total balance due from late filed tax returns, adjusted for  income reported to IRS on information returns. IRS believes its  current methodology is an improvement over the 2006 estimate as it  uses the population data rather than a sample, avoiding  disadvantages resulting from sampling. IRS reported improvements in  the Census and IRS information associated with nonfilers allowed  them to create a better matched dataset and identify nonfilers more  accurately.

Nonfiling self-employment data: The methodology IRS used to  calculate self-employment tax nonfiling is the same that it used for  individual income tax. However, for the 2008–2010 estimate, IRS  changed where it reports self-employment tax nonfiling within the tax  gap estimate. For the 2008–2010 estimate, this tax is now reported in  the employment tax category, whereas for the 2001 and 2006  estimates it was reported in the individual income tax category. IRS  officials stated that for the 2006-2010 estimate IRS decided to break  self-employment out separately and report it with the employment tax  because they believe it allows a more comprehensive view of  employment taxes.

IRS also updated how the underlying data supporting the tax gap are  organized in two ways:

Changes in net tax gap estimates: As previously mentioned, IRS  published net tax gap estimates by each tax type (individual income,  corporation income, employment, and estate tax) for the first time in  the 2008–2010 estimate. IRS officials stated that they made progress  by providing this data. However, IRS is unable to break out the net tax  gap further by tax component because during examinations,  adjustments are not categorized by component (i.e., underreporting,  underpayment, and nonfiling).

Changes in individual income underreporting: Starting in 2008– 2010, IRS modified the categories it uses to break down the individual  income underreporting component. These changes affect how IRS  calculates the net misreporting percentage (NMP) for individual  income tax, but not how it calculates the tax gap. IRS uses the NMP  to show the relationship between third-party information reporting and  individual income tax reporting compliance. IRS reported the changes  reflect an improvement in methodology. IRS cautions that any  comparison of the 2008–2010 NMP to the 2006 NMP estimates  should consider those improvements. The prior calculation method  involved adding offsets to income, such as deductions, exemptions,  and adjustments, which distorted the comparison across categories.  IRS determined a better approach was to combine income items into  categories and to report offsets to income as a separate category.  (See figure 5.)

Appendix VI: GAO Contact and Staff Acknowledgments

In addition to the contact named above, Jeff Arkin (Assistant Director),  James Ashley, Jehan Chase, Charles Fox, John Hussey, Donna Miller,  John Mingus, Edward Nannenhorn, Cynthia Saunders, Robyn Trotter,  and Elwood White made significant contributions to this report.

According to IRS estimates, taxpayers collectively pay a bit more than 80% of the taxes they owe. This difference between the taxes people and businesses owe and what they pay on time is known as the tax gap, which IRS estimated to be $458 billion, on average, for 2008-2010.

IRS used to set specific, numeric goals for improving taxpayer compliance, but has moved away from that approach. Officials told us that there are too many factors outside of IRS's control for such goals to be useful.

We recommended that the IRS re-establish quantitative goals for improving voluntary compliance and develop a strategy for using data to close the tax gap.