IRS has concerns with the certainty of the tax gap estimate for tax year  2001 in part because some areas of the estimate rely on old data, IRS has  no estimates for other areas of the tax gap, and it is inherently difficult to  measure some types of noncompliance. IRS’s overall approach to reducing the tax gap consists of improving  service to taxpayers and enhancing enforcement of the tax laws. Multiple Approaches Are Needed to Reduce the Tax Gap

No single approach is likely to fully and cost-effectively address  noncompliance and therefore multiple approaches are likely to be needed. Simplifying or reforming the tax code, providing IRS more enforcement  tools, and devoting additional resources to enforcement are three major  tax gap reduction approaches discussed in more detail below, but  providing quality services to taxpayers plays an important role in  improving compliance and reducing the tax gap. Evaluating the results. Optimizing resource allocation. Leveraging technology. Reducing the Tax Gap through Tax Simplification or Tax System Reform Depends on Their Design and May Have Effects Beyond Tax Compliance

Tax law simplification and reform both have the potential to reduce the  tax gap by billions of dollars. For example, IRS’s recent tax gap  estimate includes a $32 billion loss in individual income taxes for tax year  2001 because of noncompliance with these provisions. Despite the potential benefits that simplification may yield, these credits  and deductions serve purposes that Congress has judged to be important  to advance federal goals. Fundamental tax  reform would most likely result in a smaller tax gap if the new system has  few tax preferences or complex tax code provisions and if taxable  transactions are transparent. However, these characteristics are difficult  to achieve in any system and experience suggests that simply adopting a  fundamentally different tax system may not by itself eliminate any tax  gap. Providing IRS with Additional Enforcement Tools Potentially Could Improve Compliance Significantly, but Identifying and Designing Such Tools Can Be Challenging

Changing the tax laws to provide IRS with additional enforcement tools,  such as expanded tax withholding and information reporting, could also  reduce the tax gap by many billions of dollars, particularly with regard to  underreporting—the largest segment of the tax gap. Also, withholding and  information reporting help IRS to better identify noncompliant taxpayers  and prioritize contacting them, which enables IRS to better allocate its  resources. However, designing new withholding or information reporting  requirements to address underreporting can be challenging given that  many types of income are already subject to at least some form of  withholding or information reporting, underreporting exists in varied  forms, and the requirements could impose costs and burdens on third  parties. Devoting Additional Resources to Enforcement Likely Could Reduce the Tax Gap, but to What Extent Is Difficult to Predict

Devoting more resources to enforcement has the potential to help reduce  the tax gap by billions of dollars, as IRS would be able to expand its  enforcement efforts to reach a greater number of potentially noncompliant  taxpayers. However, determining the appropriate level of enforcement  resources to provide IRS requires taking into account many factors, such  as how effectively and efficiently IRS is currently using its resources, how  to strike the proper balance between IRS’s taxpayer service and  enforcement activities, and competing federal funding priorities. If  Congress were to provide IRS more enforcement resources, the amount of  the tax gap that could be reduced depends in part on the size of any  increase in IRS’s budget, how IRS would manage any additional resources,  and the indirect increase in taxpayers’ voluntary compliance that would  likely result from expanded IRS enforcement. For example, IRS  estimated that it contacted about 3 million of the over 13 million taxpayers  it identified as potentially noncompliant through its matching of tax  returns to information returns. Although additional enforcement funding has the potential to reduce the  tax gap, the extent to which it would help depends on several factors. Generally, larger budget  increases should result in larger reductions in the tax gap.
Why GAO Did This Study

The tax gap--the difference between the tax amounts taxpayers pay voluntarily and on time and what they should pay under the law--has been a long-standing problem in spite of many efforts to reduce it. Most recently, the Internal Revenue Service (IRS) estimated a gross tax gap for tax year 2001 of $345 billion and estimated it would recover $55 billion of this gap, resulting in a net tax gap of $290 billion. When some taxpayers fail to comply, the burden of funding the nation's commitments falls more heavily on compliant taxpayers. Reducing the tax gap would help improve the nation's fiscal stability. For example, each 1 percent reduction in the net tax gap would likely yield $3 billion annually. GAO was asked to discuss the tax gap and various approaches to reduce it. This testimony discusses the need for taking multiple approaches and to what extent the tax gap could be reduced through three overall approaches--simplifying or reforming the tax system, providing IRS with additional enforcement tools, and devoting additional resources to enforcement. This statement is based on prior GAO work.

What GAO Found

Multiple approaches are needed to reduce the tax gap. No single approach is likely to fully and cost-effectively address noncompliance since, for example, it has multiple causes and spans different types of taxes and taxpayers. Simplifying or reforming the tax code, providing IRS more enforcement tools, and devoting additional resources to enforcement are three major approaches, but providing quality services to taxpayers also is a necessary foundation for voluntary compliance. Such steps as periodically measuring noncompliance and its causes, setting tax gap reduction goals, evaluating the results of any initiatives to reduce the tax gap, optimizing the allocation of IRS's resources, and leveraging technology to enhance IRS's efficiency would also contribute to tax gap reduction. Simplifying the tax code or fundamental tax reform has the potential to reduce the tax gap by billions of dollars. IRS has estimated that errors in claiming tax credits and deductions for tax year 2001 contributed $32 billion to the tax gap. Thus, considerable potential exists. However, these provisions serve purposes Congress has judged to be important and eliminating or consolidating them could be complicated. Fundamental tax reform would most likely result in a smaller tax gap if the new system has few, if any, exceptions (e.g., few tax preferences) and taxable transactions are transparent to tax administrators. These characteristics are difficult to achieve, and any tax system could be subject to noncompliance. Withholding and information reporting are particularly powerful tools to reduce the tax gap. They could help reduce the tax gap by billions of dollars, especially if they make underreported income transparent to IRS. These tools have led to high, sustained levels of taxpayer compliance and improved IRS resource allocation by helping IRS identify and prioritize its contacts with noncompliant taxpayers. As GAO previously suggested, reporting the cost, or basis, of securities sales is one option to improve taxpayers' compliance. However, designing additional withholding and information reporting requirements may be challenging given that many types of income are already subject to reporting, underreporting exists in many forms, and withholding and reporting requirements impose costs on third parties. Devoting additional resources to enforcement has the potential to help reduce the tax gap by billions of dollars. However, determining the appropriate level of IRS enforcement resources requires taking into account such factors as how well IRS uses its resources, the proper balance between taxpayer service and enforcement activities, and competing federal funding priorities. If Congress provides IRS more enforcement resources, the amount of tax gap reduction would depend on factors such as the size of budget increases, how IRS manages any additional resources, and the indirect increase in taxpayers' voluntary compliance resulting from expanded enforcement. Increasing IRS's funding would enable it to contact millions of potentially noncompliant taxpayers it identifies but does not contact.