	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. 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. The extent to which the tax gap would be  reduced depends on which parts of the tax system would be simplified and  in what manner as well as how any reform of the tax system is designed  and implemented. 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. However, 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. 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, there are varied forms of  underreporting, and the requirements could impose costs and burdens on  third parties. Taxpayers tend to report income subject to tax withholding or information  reporting with high levels of compliance, as shown in figure 1, because the  income is transparent to the taxpayers as well as to IRS. In addition to improving taxpayer compliance, information reporting can  help IRS to better allocate its resources to the extent that it helps IRS  better identify noncompliant taxpayers and the potential for additional  revenue that could be obtained by contacting these taxpayers. 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 in that 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. Generally, larger budget  increases should result in larger reductions in the tax gap. Each of the three  approaches I have discussed could make a contribution to reducing the  tax gap, although using multiple approaches may be the most effective  strategy since no one approach is likely to address noncompliance fully  and cost effectively. Leveraging technology. Optimizing resource allocation. As previously discussed, developing  reliable measures of the return on investment for strategies to reduce the  tax gap would help inform IRS resource allocation decisions. Evaluating the results.
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 to what extent the tax gap could be reduced through three approaches--simplifying or reforming the tax system, providing IRS with additional enforcement tools, and devoting additional resources to enforcement--as well as various factors that could guide decision-making when devising a strategy to reduce the tax gap. This statement is based on prior GAO work.

What GAO Found

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 be most likely to 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 can make currently underreported income transparent to IRS. These tools have been shown to lead to high, sustained levels of taxpayer compliance. Using these tools can also help IRS better allocate its resources to the extent they help 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, there are many forms of underreporting, 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 enforcement resources for IRS requires taking into account many factors such as how well 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 decides to provide IRS more enforcement resources, the amount the tax gap could be reduced 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 have resources to contact. Finally, using multiple approaches may be the most effective strategy to reduce the tax gap, as no one approach is likely to fully and cost effectively address noncompliance. Key factors to consider in devising a tax gap reduction strategy include periodically measuring noncompliance and its causes, setting reduction goals, leveraging technology, optimizing IRS's allocation of resources, and evaluating the results of any initiatives.