April 18, 2007
HP-360

Testimony of Treasury Assistant Secretary For Tax Policy
Eric Solomon
Before the Senate Finance Committee on
Ways to Reduce the Tax Gap

Mr. Chairman, Ranking Member Grassley, and distinguished Members of the Committee, thank you for the opportunity to discuss our strategy to reduce the tax gap, including the legislative proposals included in the President's Fiscal Year (FY) 2008 Budget request to Congress.

The vast majority of Americans pay their taxes voluntarily and on time. The voluntary compliance rate is approximately 85 percent. Nonetheless, there remains a substantial difference between what taxpayers should pay and what they actually pay. The IRS estimates that the tax gap was $290 billion in 2001, after accounting for late payments and enforcement activities. Each year, compliant taxpayers are required to make up for this shortfall.

The Administration is committed to reducing the tax gap without unduly burdening honest taxpayers who currently meet their tax obligations. In September 2006, the Office of Tax Policy released a comprehensive strategy (the Treasury Strategy) to reduce the tax gap. This strategy forms the basis for our legislative and IRS appropriation proposals in the FY 2008 Budget, while also emphasizing that any strategy must take into account additional components such as a commitment to research, improvements to information technology, and strengthening taxpayer service.

In recent months, there has been a significant level of discussion about the tax gap. Much of this discussion has focused on the IRS's release last February of estimates of the tax gap in 2001. These estimates included the results from the 2001 National Research Program (NRP), which examined compliance with the individual income and self-employment (SECA) taxes. The estimates of compliance with other types of taxes were projections derived from older studies.

Before focusing on our proposals, it is important to differentiate between the gross tax gap and the net tax gap. The "gross tax gap" is the difference between the amount of tax that taxpayers should pay under the tax law and the amount they actually pay on time. The IRS estimates that the gross tax gap was $345 billion in tax year 2001, resulting in a voluntary compliance rate of 83.7 percent. This estimate, however, does not take into account taxes that were paid voluntarily but late, or recoveries from IRS enforcement activities. Taking these factors into account, the "net tax gap" was an estimated $290 billion in tax year 2001, which represents a net compliance rate of 86.3 percent. Thus, $55 billion of the gross tax gap for 2001 is in the government coffers.

These compliance rates are consistent with historical patterns. IRS estimates of voluntary compliance rates have ranged between 80 and 85 percent for over two decades, although research limitations generally prevent us from measuring fluctuations during this time period. The tax gap is not a new problem, and it will not be eliminated overnight.

The tax gap results from a variety of errors, including non-filing, underreporting of taxes, or underpayment of taxes. It is estimated that over 80 percent of the gross tax gap is attributable to underreporting of tax (including underreported income or overstated deductions and credits). Over 40 percent of the gross tax gap is attributable to underreporting of net business income by individuals (affecting both individual income and self-employment taxes).

Noncompliance is highest among taxpayers whose income is not subject to third-party information reporting or withholding requirements. For 2001, it was estimated that 54 percent of net income from proprietors (including businesses, farms, and ranches), rents and royalties was misreported. In contrast, only one percent of tax due on wage income, which is reported by employers and subject to withholding, was not reported to the IRS by return filers in 2001.

IRS data do not reveal the extent to which the tax gap results from intentional evasion rather than unintentional errors by well-meaning taxpayers who are confused by the increasing complexity of the tax law. Determining taxpayer intent during a regular examination is very difficult. For obvious reasons, taxpayers do not concede that their erroneous reporting is intentional, and any analysis of the nature of the error by IRS examiners is inherently subjective. Moreover, complexity provides those taxpayers who are predisposed to taking aggressive positions the opportunity to argue that their errors were unintentional.

It is safe to assume that both intentional and unintentional errors contribute to the tax gap and that any strategy to reduce the gap must address both intentional evasion as well as taxpayer confusion due to the complexity of the tax code.

These findings suggest the need for a targeted response designed to address the most significant sources of noncompliance. Four key principles have guided the development of our tax gap strategy:

• Unintentional taxpayer errors and intentional taxpayer evasion should both be addressed.
• Sources of noncompliance should be targeted with specificity.
• Enforcement should be combined with a commitment to taxpayer service
• Tax policy and compliance proposals should be sensitive to taxpayer rights and maintain an appropriate balance between enforcement activity and imposition of taxpayer burden.

These principles point to the need for a comprehensive, integrated, multi-year strategy to improve tax compliance. Components of this strategy must include: (1) legislative proposals to reduce opportunities for evasion; (2) a multi-year commitment to compliance research; (3) continued improvements in information technology; (4) improvements in IRS compliance activities; (5) enhancements of taxpayer service; (6) simplification of the tax law; and (7) coordination between the government and its partners and stakeholders.

Since release of the Treasury Strategy last September, the Administration has taken a number of steps to implement each of its seven components. The FY 2008 Budget requests $409.5 million in new funding for initiatives aimed at reducing the tax gap. These initiatives include additional compliance research, investments in information technology, enhancements of front-line enforcement activities, and improvements in taxpayer service aimed at increasing voluntary compliance. The Budget also includes 16 legislative proposals designed to reduce opportunities for evasion. In addition, the FY 2008 Budget contains legislative proposals to simplify the tax treatment of families and savings incentives which, if enacted, would help to eliminate some of the complexity that gives rise to unintentional noncompliance.

We have also been working with our partners and stakeholders to develop and refine our tax gap strategy. Commissioner Everson and I held a public roundtable at the IRS last month to discuss ways to address the tax gap. Panelists at the roundtable included a former IRS Commissioner and a former Assistant Secretary for Tax Policy, researchers, and members of organizations representing businesses and preparers. In addition, we have been meeting regularly with Finance Committee staff to discuss and refine our legislative proposals to reduce the tax gap.

As outlined above, development of legislative proposals to reduce opportunities for evasion is one element of our broader strategy to increase taxpayer compliance, improve tax collection, and reduce the tax gap. As presented in the FY 2008 Budget, our compliance legislative proposals fall into four categories: (1) expand information reporting; (2) improve compliance by businesses; (3) strengthen tax administration; and (4) expand penalties. On the front end, the legislative proposals would help to apprise the IRS of the payment of income through third-party information reporting, one of the most effective tools in improving compliance. On the back end, the legislative proposals would increase incentives to comply with existing law through strengthened penalties. The package of legislative proposals includes targeted provisions that, if enacted, would assist the IRS in enforcing the tax law more efficiently and effectively in targeted areas that present risks of noncompliance.

The legislative proposals are designed to reduce the tax gap, not to raise revenue through a change in the baseline against which compliance is measured. In addition, the legislative proposals attempt to reduce the tax gap by making compliance more efficient while balancing the burden placed on compliant taxpayers. If, on the other hand, draconian measures were to be enacted, they could become so burdensome as to detract from voluntary compliance, compounding rather than reducing the tax gap.

Although the legislative proposals set forth an approach toward improved tax compliance, we recognize that they do not come close to eliminating the tax gap. Making collection of the entire tax gap a reality, however, would require universal audits followed by draconian collection practices, imposing prohibitive costs and burdens on taxpayers as well as the IRS, and fundamentally changing the relationship between taxpayers and the government. Through the multi-pronged approach set forth in the Treasury Strategy, however, we can make significant progress in improving compliance.

In addition to the sixteen legislative proposals, the FY 2008 Budget indicates that the Treasury is continuing to develop proposals to improve compliance and reduce the tax gap. In particular, the Budget mentioned that IRS coordination with State governments could be improved. Under current law, State tax agencies may adjust taxpayer returns in response to an IRS audit. A proposal under development would permit reciprocal adjustments by the IRS in response to a State audit determination. This proposal raises technical issues relating to the assessment limitations period that we are currently working to resolve. Another aspect of Federal-State tax coordination could involve expanded information sharing. In particular, State governments maintain databases in connection with numerous licenses issued pursuant to State law, such as driver's and professional licenses. In some cases, States may suspend certain licensing privileges in connection with State tax noncompliance. Access to such State data could assist the IRS in improving Federal tax compliance. The Treasury Department continues to consider the advantages and disadvantages of these additional proposals to improve tax compliance.

The President's FY 2008 Budget recommends sixteen changes to the tax code that, if enacted, would improve compliance and reduce the tax gap. Since the Budget was released in early February, members of my staff and I have been meeting regularly with Finance Committee staff to discuss and refine the Administration's proposals and to address a number of technical issues that they present. Those discussions have been useful both in improving the proposals and in helping to highlight the challenges that we face in reducing the tax gap through targeted changes to the tax law. A brief description of some of the technical issues arising under several of the legislative proposals will help to frame the issue and illustrate the limitations of legislative solutions to this problem.

Basis Reporting. One of the Budget proposals would require that brokerage firms report to their customers basis information in connection with the sale of certain publicly traded securities. This proposal builds on section 6045 of the Code, which requires reporting of gross sale proceeds, which must be combined with basis information to determine the tax treatment of the sale. The proposal also builds on a growing trend in the securities industry to provide basis information voluntarily to customers.

The basis-reporting proposal raises a number of technical issues that are derived from the complex treatment of securities sales under our tax laws. Those issues include, for example: (1) defining the universe of "securities" subject to basis reporting; (2) putting mechanisms in place to ensure that brokers subject to the proposal have relevant basis information from both their customers and from issuers of securities; (3) determining basis for so-called "transferred-in" securities that were not purchased through the broker, including securities purchased separately and transferred into a brokerage account, gifts and inheritances; (4) addressing the interaction of the proposal with taxpayer-specific basis adjustment provisions that operate independently of the broker, such as the wash-sale rules in section 1091, the straddle rules in section 1092, and rules requiring capitalization of certain interest and carrying costs under section 263(g); and (5) determining an appropriate effective date to ensures a smooth transition to the new basis reporting regime.

Payment Card Reporting. Technical issues presented by the Budget proposal regarding information reporting on merchant payment card reimbursements also highlight the challenges of our work in this area. Proprietors, merchants, and other business taxpayers frequently receive income through their customers' use of credit or debit cards. While the use of such payment cards creates a paper trail, that trail does not lead to the IRS, unless a revenue agent were to seek it on a case-by-case basis. At the same time, that existing paper trail would make it relatively easy to generate information reports to the IRS, systematically addressing the possibility of unreported income. Because the existing payment-card system routinely delivers exact dollar and cents amounts to the correct payees, often at the speed of electronic dispatch, it is certain that the information that the IRS needs is accessible. Information reports regarding payment-card reimbursements would result in better compliance by merchants who accept these cards.

Nevertheless, there are numerous technical issues to be addressed. The payment-card system is complex, involving payment-card organizations, merchant acquiring banks, various service providers, and other entities. In the case of a payment card branded with the name of a particular retail chain, the bank may reimburse the retail chain, which in turn may reimburse a franchise proprietor. In this situation, who should obtain the merchant's Taxpayer Identification Number and generate an information report? We have met with representatives of the payment card industry to understand their concerns with the proposal. Many in this industry are concerned with the incremental burden of reporting, including potential duplication of reporting responsibilities, and have requested greater clarity regarding the party responsible for the reporting when there are other agents involved as intermediaries between the banks and the merchants. Others are concerned about how the IRS will use the data. We recognize these concerns and, while the gross reimbursements reported would not be an equivalent to gross income, the proposed information reporting would assist the IRS by providing the merchant's overall volume of payment card sales in relation to expenses claimed and cash transactions reported. The reporting would also assist the IRS in analyzing the accuracy of reporting for payment card sales.

There are also other technical issues presented by the proposal, such as treatment of "charge backs," in which a merchant is debited for the amount that a credit-card company refunded to a consumer attributable to a defective item, as well as payment-card transactions in which a merchant may sell some goods but also provide "cash back" to consumers. The Budget proposal would grant explicit authority to promulgate administrative rules that address such technical complications, by eliminating duplication of reporting requirements and creating exceptions to reporting of amounts that are not useful for compliance purposes.

Erroneous Refund Penalty. Another legislative proposal raising some technical questions is the erroneous refund penalty. Under current law, the accuracy-related penalty that a taxpayer might pay generally would depend on the amount of underpayment of tax. If a taxpayer wrongfully claims a refund, however, there may be no penalty as long as no additional tax liability is attributable to the wrongful claim, as often happens when there has been overwithholding. Consequently, the IRS has observed aggressive behavior that is undeterred by the tax code's current accuracy-related penalty framework, which is geared toward deterrence of reported tax deficiencies. As a practical matter, some taxpayers and their advisors may be taking advantage of the existing penalty structure by aggressively claiming credits that generate refunds, in an effectively risk-free gamble. To address this problem, our proposal would impose a penalty on an unreasonable claim for refund or credit.

The proposal seeks to create a parallel system of deterrence applicable even if the taxpayer is in a refund, rather than a deficiency, procedural posture, thus stemming the tide of aggressive claims that are made without reasonable basis or reasonable cause, regardless of the procedural context. There remain open questions about the scope of this proposal. In addition to refunds, should the proposal cover erroneous claims that purport to reduce tax liability? Should there be a threshold amount below which the proposed penalty would not apply? If a taxpayer were subject to penalties in addition to the proposed penalty, in which stacking order should the multiple penalties apply? Should the proposed penalty apply to excise or other types of taxes in addition to income taxes? The goal of the Treasury proposal would be to assert the highest applicable penalty, without duplication of penalties. In this regard, the Treasury proposal's creation of the new penalty would carve out Earned Income Tax Credit (EITC) refund claims from the scope of the penalty because these claims are already governed by their own compliance regime.

Prison Scam Disclosure Authorization. The Treasury Department's proposal for disclosure of certain tax violations by Federal and State prisoners would allow the IRS to disclose limited information about such violations so that prison officials could deter such conduct through administrative sanctions. Under existing law, when the IRS discovers that prison inmates are making fraudulent refund claims, taxpayer privacy laws do not permit the IRS to share this information with prison officials, who may be most proximately positioned to address this misconduct. While cooperation among law enforcement officials would appear to be reasonable, numerous technical questions have arisen. What information should be disclosed? When would be the proper time for disclosure, during or after an investigation? To whom should a disclosure be made, Federal officials, State employees, or local wardens? What limitations should be imposed on further use of the IRS information? Does the proposal properly preserve prisoner rights?

Collection Due Process. Similar questions may arise regarding the Treasury Department's proposal to amend the Collection Due Process (CDP) procedures as they apply to employment taxes. Employment taxes include employer and employee shares of Federal Insurance Contribution Act (FICA) tax as well as Federal Unemployment Tax Act amounts and income tax withheld from employee wages. Employee FICA shares and withheld income tax constitute the largest portion of employment taxes. These taxes are often referred to as "trust fund" taxes, because employers are supposed to hold them in trust for the government after they are withheld from employee wages. These amounts include Social Security Trust Fund taxes credited to employees, whether or not actually paid to the Treasury.

Unpaid employment tax liabilities are some of the most difficult taxes for the IRS to collect. In some cases, an employer may be able to retain employees and stay in business by paying only net wages, even if he or she cannot pay employment tax. Employment taxes are due quarterly and, when there are successive failures to pay quarterly employment tax installments, they continue to accrual over successive periods resulting in a "pyramid" of liability. In a case like this, employment taxes often pile up while the IRS attempts to collect, ultimately by imposing a levy. Under the CDP provisions in the Code, the IRS generally must provide the taxpayer with notice and an opportunity for an administrative hearing, with judicial review, before levy. In the employment tax context, an opportunity for a CDP hearing must be provided for every quarter that there are unpaid taxes the IRS seeks to collect. By the time this CDP procedure is completed, the employment taxes may have become uncollectible, even if determined to be due by the end of the review.

The Treasury Department's proposal would add employment taxes to the exception that allows a CDP hearing to be held within a reasonable time after, rather than before levy. While collection of employment taxes would be in the best interest of employees and the Federal Trust Fund, there nevertheless may be concerns that amendment to the CDP provision might abridge taxpayer rights. On the other hand, the opportunities available to the taxpayer who in good faith seeks to address an unpaid employment tax balance prior to levy and the urgency of the pyramiding problem are factors that support the adoption of the proposal. To be clear, under the proposal, employment tax returns showing a balance due would not be subject to levy until after the IRS has made several attempts to correspond with the taxpayer regarding the balance due a process whereby taxpayers have several opportunities to contact the IRS and enter into a voluntary payment arrangement prior to enforced collection. Those taxpayers who fail to address payment would be subject to a levy, and would have the opportunity for a post-levy CDP hearing.

We are pleased that a number of the Budget proposals have been introduced and considered in different legislative vehicles this year. We look forward to working with the Committee to address the technical issues so these proposals can achieve their intended purposes.

The Treasury Strategy identified our published guidance program as an important component of the multi-pronged strategy to improve compliance. Published guidance clarifies ambiguous areas of the law, increasing voluntary compliance. With the increasing complexity of the tax law, it is more important than ever for us to publish timely guidance to give direction to those taxpayers who make a good faith effort to comply with the law, but have difficulty doing so because of uncertainty in its application. Published guidance is also an important tool to target specific areas of noncompliance and prevent abusive behavior.

Each year, the Treasury Department and the IRS publish a Priority Guidance Plan. The 2006-2007 plan includes 264 guidance projects scheduled for completion between July 2006 and June 2007. Numerous projects are added during the year as new tax laws are enacted or new compliance issues are identified.

Recent published guidance projects that will improve compliance and that target potential areas of abuse include:

Transfer Pricing: We have produced, and continue to produce, significant guidance in the area of transfer pricing. In an increasingly globalized economy, cross-border transactions between controlled entities present significant compliance challenges, making guidance in the transfer pricing area an important part of our administrative efforts to address the tax gap. In August 2006, we issued temporary and final regulations addressing the treatment of cross-border services, and followed them up with additional guidance in December 2006. We issued proposed transfer pricing regulations addressing cost-sharing in August 2005. We intend to finalize both sets of regulations, with appropriate modifications.

Foreign Tax Credit: We have taken strong steps to halt misuse of the foreign tax credit. Last month we issued proposed regulations that would disallow foreign tax credits tied to participation in certain artificially engineered, highly structured transactions. In August 2006, we issued proposed regulations that would address the inappropriate separation of creditable foreign taxes from foreign source income. We intend to make appropriate modifications and finalize both sets of regulations as soon as possible.

Information Sharing: We continue to update and expand our network of tax treaties and tax information exchange agreements ("TIEAs"). We are also renegotiating tax treaties that do not have sufficient limitation on benefits or exchange of information provisions. We are entering into new TIEAs, such as the one signed with Brazil in March 2007, and bringing signed TIEAs into force, with jurisdictions such as the Netherlands Antilles, the British Virgin Islands, and the Cayman Islands. These information-sharing agreements are critical tools for the IRS to combat cross-boarder aspects of compliance.

Private Annuities: In October 2006, we published proposed regulations regarding the Federal tax treatment of private annuity contracts. Recent Congressional hearings have highlighted how taxpayers were applying prior law treatment of these contracts to facilitate abusive private annuity arrangements, often involving off shore issuers. The proposed regulations, when adopted as final, will shut down those arrangements.

Trust Information Reporting: In 2006, we published a series of regulations that provide a comprehensive set of information reporting rules for grantor trusts where ownership interests in those trusts are held indirectly. Historically, taxpayers who held such interests were often unable to comply fully with their tax obligations because they lacked necessary information about the activities of the trust. This project highlights work that can be done administratively to ensure that taxpayers who make every effort to meet their obligations have the information they need to determine and report their liability accurately.

Reportable Transaction Rules: In the American Jobs Creation Act, Congress enacted a number of changes to the statutory rules requiring disclosure to the IRS of potentially abusive transactions, strengthening the IRS' hand in this area. In October 2006, we published proposed regulations that follow prior interim guidance and, when adopted as final, will build on the expanded statutory provisions to ensure that the IRS knows about and is able to react quickly to, emerging problematic transactions.

An effective approach to dealing with the tax gap requires multiple, interrelated strategies. I have discussed the work that the Treasury Department is doing with regard to the legislative and regulatory components of the Treasury Strategy. Each of the multiple components of the strategy is necessary, but none is sufficient in isolation. We look forward to continuing our work with this Committee and others in Congress to implement our strategy and looking for new ways to reduce the tax gap.

Thank you again, Mr. Chairman, Ranking Member Grassley, and other Members of the Committee for the opportunity to appear before you today. I would be pleased to answer any questions you may have.