	Background

The tax gap is an estimate of the difference between the taxes—including  individual income, corporate income, employment, estate, and excise  taxes—that should have been paid voluntarily and on time and what was  actually paid for a specific year. 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. Considering the costs and burdens. Optimizing resource allocation. For example, if the estimated 83.7 percent voluntary  compliance rate that produced a gross tax gap of $345 billion in tax year  2001 had been 85 percent, this tax gap would have been about $28 billion  less; if it had been 90 percent, the gap would have been about $133 billion  less. 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. 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. Any tax system could be subject to noncompliance, and its design  and operation, including the types of tools made available to tax  administrators, will affect the size of any corresponding 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. 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. We  found that requiring brokers to report basis information for securities  sales could improve taxpayers’ compliance in reporting their securities  gains and losses and help IRS identify noncompliant taxpayers. Withholding and information reporting lead to high levels of compliance. The administration’s proposed budget for fiscal year 2008 has 16 legislative  proposals on tax gap reduction of which 7 relate to expanded information  reporting. 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. The revenues expected from these initiatives are small compared to the  estimated $290 billion net tax gap for tax year 2001.
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, various approaches to reduce it, and what the proposed budget for fiscal year 2008 says about 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. Moreover, providing quality services to taxpayers is a necessary foundation for voluntary compliance. Such steps as periodically measuring noncompliance and its causes, setting tax gap reduction goals, 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 considering such factors as how well IRS uses its resources and the proper balance between taxpayer service and enforcement activities. If Congress provides IRS more enforcement resources, the amount of tax gap reduction would depend on factors such as the size of budget increases and the indirect increase in taxpayers' voluntary compliance resulting from expanded enforcement. The recent budget request for fiscal year 2008 proposes legislation and new initiatives to reduce the tax gap but expected dollar gains are modest. Further reductions likely would require many more such changes.