TaxProf Blog

Editor: Paul L. Caron, Dean
Pepperdine University School of Law

Monday, September 16, 2013

TIGTA: IRS Must Improve Comprehensiveness, Accuracy, Reliability & Timeliness of Tax Gap Estimate

TIGTA The Treasury Inspector General for Tax Administration today released The Internal Revenue Service Needs to Improve the Comprehensiveness, Accuracy, Reliability, and Timeliness of the Tax Gap Estimate (2013-IE-R008):

The Tax Gap is defined as the difference between the true tax liability in any year and the amount of tax that is paid voluntarily and on time. The IRS's most recent Tax Gap estimate was $450 billion for Tax Year 2006. The Tax Gap estimate is a widely used measure in tax policy and administration. Some officials state that the absolute number is unimportant since the estimate is a significant amount. However, an important consideration for concern about accuracy is the relationship between the different forms of noncompliance and the types of tax. Furthermore, as Congress considers tax reform, it is important that the Tax Gap estimate reflects as accurately as possible the many forms and areas of noncompliance so that tax policy options can be considered.

Several issues affect the comprehensiveness, accuracy, reliability, and timeliness of the Tax Gap estimate.

First, the voluntary compliance rate computation derived from the Tax Gap estimate is now used by the IRS and the Department of the Treasury as the measure for achieving the Agency Priority Goal of increasing voluntary compliance. This may require more frequent or interim updates to the estimates. Furthermore, in order to have a credible goal, the data should be verifiable and valid. However, the IRS develops the Tax Gap estimates in accordance with its own policies and procedures. While Federal agencies are generally required to follow Office of Management and Budget Standards and Guidelines for Statistical Surveys, the IRS stated that these standards are not technically applicable to the conduct of the National Research Program. The IRS does adhere to several aspects of the OMB standards through its own policies and procedures, including elements in the planning and design phases, but does not adhere completely to other aspects associated with developing cost estimates, the production of estimates and projections, and conducting a formal peer review process.

Second, the individual income tax underreporting gap estimate could be more comprehensive if it included estimates for the informal economy and offshore tax evasion. While the estimation method does include a process to impute undetected income, separate quantified estimates would provide better information on the size of these compliance issues. These areas present significant challenges to tax administration, and the absence of a related estimate could hinder or delay possible solutions.

Third, the current method to estimate the corporate Tax Gap needs to be improved. There are two concerns about the accuracy and reliability of the Tax Year 2006 corporate income tax underreporting gap estimate. Both concerns relate to using recommended tax from operational examinations as the basis for projecting the Tax Gap.

  • The difficulty in deriving the actual tax liability of large corporations. Unlike recommended tax assessments for individual and small corporate taxes, large corporations often contest recommended taxes. The result is often an assessed amount that is substantially less than the recommended tax. Therefore, using recommended tax as a basis for projections of noncompliance may not provide reliable information.
  • A significant portion of small corporations are substantially no more than incorporated sole proprietorships. In fact, in Tax Year 2003, there were about 758,000 corporations with gross receipts of less than $100,000 reported. Consequently, it is extremely likely that a large portion of small corporations exhibit the same pathologies as those found in sole proprietorships. That is, a small percentage of these returns also account for a significant portion of the underreporting.

We recommended that the Director, Office of Research, Analysis, and Statistics, take the following actions: (1) conduct a study to determine the feasibility of providing interim updates of the Tax Gap estimate; (2) develop a process and procedures to ensure compliance with the applicable OMB standards; (3) issue a published report to explain the methods, assumptions, and premises used to develop the estimates; (4) develop the capability to estimate the Tax Gap for the informal economy; (5) perform a study to determine the feasibility of creating an estimate of the Tax Gap due to offshore tax evasion; (6) consider modifying the estimation model for large corporations from using recommended tax from operational examinations to tax assessments from operational examinations; and (7) consider conducting a National Research Program review on small corporations filing Form 1120, U.S. Corporate Income Tax Return, with total assets of less than $10 million.

The IRS agreed with our first three recommendations. The IRS substantially agreed with recommendation four by agreeing to perform a feasibility study to estimate the Tax Gap for the informal economy. The IRS agreed with recommendation five and substantially agreed to recommendation six by studying the merits of alternative approaches to estimating noncompliance by large corporations. Finally, the IRS is conducting a National Research Program review of small corporations with less than $250,000 in assets; however, it is a very small sample and therefore the IRS will consider the feasibility of conducting more studies of small corporations.

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