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This paper describes the development of the Federal Highway Administration (FHWA) fuel tax compliance program and presents estimates of additional motor fuel tax revenues generated by enforcement programs.
Substantial revenue losses caused by motor fuel tax evasion schemes were discovered in the mid-1980s. In 1994, the FHWA estimated that the combined Federal and State fuel tax evasion losses approached $3 billion annually.
Since 1986, the Internal Revenue Service (IRS) and FHWA have worked cooperatively to reduce fuel tax evasion by supporting changes in tax collection procedures and additional enforcement resources. Since FY 1990, FHWA has provided funding to supplement State and IRS fuel tax enforcement resources under the auspices of the Joint Federal/State Motor Fuel Tax Compliance Project, or Joint Project for short. The Intermodal Surface Transportation Efficiency Act of 1991 provided $5 million annually through 1997 for the Joint Project. Funds are available to the States and the IRS to supplement fuel tax enforcement efforts and for participation in regional motor fuel tax enforcement task forces.
Enforcement activities directly contribute hundreds of millions of dollars to the Highway Trust Fund (HTF) and State transportation funds, a yield estimated at $10 to $18 per dollar spent on these programs. Furthermore, the Omnibus Budget Reconciliation Act of 1993 moved the incidence of the Federal excise tax on diesel fuel to the point of removal from bulk storage at the terminal and required all tax exempt diesel fuel to be dyed. The HTF revenue from the diesel fuel tax has increased over $1 billion in the year since these changes went into effect on January 1, 1994, net of the tax rate increases also enacted in 1993. Some $600-700 million of this increase has been estimated to be the result of improved compliance.
INTRODUCTION
The Joint Federal/State Motor Fuel Tax Compliance Project, or Joint Project for short, has been a catalyst for monumental changes in the collection of Federal and State motor fuel taxes. Since it began in 1990, the Joint Project has expanded from a modest pilot program of 12 States to a nationwide effort encompassing every region of the country. The changes in motor fuel tax collection procedures stimulated by the Joint Project have touched every aspect of motor fuel taxation--changes in law, regulation, emphasis, enforcement resources, and by far the most critical to the widespread success of the project, changes in the cooperative spirit among the public agencies and private industries that have a mutual stake in assuring that all motor fuel taxes are collected and remitted to the taxing authority. The Joint Project has been instrumental in forging an alliance among State revenue agencies, between State and Federal taxing authorities, among Federal regulatory and enforcement agencies, among State regulatory agencies, and between private industry and government. Data collected from participating agencies and motor fuel tax revenue trends attest to the remarkable success of the program. Motor fuel tax compliance efforts contribute hundreds of millions of dollars annually in additional revenue to State and Federal transportation trust funds.
HISTORY OF THE JOINT PROJECT
Substantial revenue losses caused by motor fuel tax evasion schemes were discovered in the New York metropolitan area in the mid-1980s. Although estimates of revenue losses from motor fuel tax evasion vary widely, by the early 1990s evidence suggested a substantial problem with potential losses of as much as $3 billion annually in Federal and State revenue from gasoline and diesel fuel excise taxes. The loss of this revenue, most of which is destined for Federal and State transportation trust funds, meant that the traveling public was being cheated out of resources needed to build and maintain the nation's transportation system. Since 1986, the Internal Revenue Service (IRS) and Federal Highway Administration (FHWA) have worked together to reduce fuel tax evasion by supporting changes in tax collection procedures and additional resources for fuel tax enforcement. Participants in these efforts include the Department of Justice, the Federation of Tax Administrators, the U.S. Department of Transportation (DOT) Office of the Inspector General, petroleum industry organizations, and States.
Congress approved initial funding for this program in fiscal years (FY) 1990 and 1991 by authorizing the use of Highway Trust Fund (HTF) resources administered by FHWA to support motor fuel tax enforcement activities of the IRS and the States (Table 1). The initial funds were used to organize task forces in three pilot regions to encourage cooperation in motor fuel tax enforcement efforts and the exchange of information among enforcement agencies. The Intermodal Surface Transportation Efficiency Act (ISTEA) of 1991 (Pub.L. 102-240) authorized $5 million per year through FY 1997 for highway use tax evasion projects, and beginning in FY 1992 funds were offered to every State and the District of Columbia.
The Joint Project Steering Committee was formed at the outset of the program in July 1990, and subsequently expanded as additional regional task forces were organized throughout the country in 1992. The Steering Committee is co-chaired by FHWA and IRS and is composed of representatives from the revenue agencies of nine lead States. Representatives from the DOT Office of Inspector General, the Department of Justice, Defense Criminal Investigative Service, Federation of Tax Administrators, American Association of State Highway and Transportation Officials, and several petroleum industry organizations also participate in an advisory capacity.
By FY 1995, 49 States and the District of Columbia had joined one or more of the nine regional motor fuel tax enforcement task forces and all but one of these had entered a funding agreement with the FHWA to receive tax compliance project funds. Table 2 is a list of typical activities undertaken by the task forces to improve motor fuel tax compliance. The expansion in participation has been accompanied by a corresponding increase in resources devoted to motor fuel tax enforcement, of which the $5 million in FHWA funds is but a small part. Aside from the FHWA funding, IRS examination, criminal investigation, and dyed diesel enforcement staffing has increased substantially in recent years, as discussed later.
The development and implementation of the Joint Project is described in detail in a series of four reports to Congress prepared by the FHWA (1-4).
DIESEL FUEL DYEING
The magnitude of tax evasion losses for diesel fuel taxes, estimated by the FHWA to be between 15 and 25 percent of the taxable gallons, prompted growing interest in diesel fuel dyeing to differentiate taxed from untaxed diesel fuel. At the direction of Congress, funds authorized for the Joint Project were used for a study of the feasibility and desirability of using motor fuel dyes and markers for reducing consumer fraud and tax evasion. The study was completed in August 1993, after a fuel coloring requirement for diesel fuel had already been enacted by Congress in the Omnibus Budget Reconciliation Act of 1993 (Pub.L. 103-66). The final report from the study (5) documented the widespread use of motor fuel dyes for tax enforcement purposes throughout the world, and identified the enforcement strategies that would be needed to accompany implementation of a Federal diesel fuel dyeing program.
Diesel fuel dyeing as an enforcement tool actually began in the United States in 1993 under Environmental Protection Agency (EPA) regulations and was expanded for tax enforcement purposes, beginning January 1, 1994. The fuel dyeing programs were implemented for two distinct purposes: to identify diesel fuel that does not meet the sulfur content and cetane specifications of the EPA for use in highway vehicles, and to identify fuel sold tax-exempt from the Federal excise tax on diesel fuel and available only for non-taxable uses specified in the tax code.
The EPA fuel dyeing program, effective on October 1, 1993, required fuel that did not meet the EPA sulfur content and cetane index specifications to be visibly marked with a blue dye. In accordance with Section 211(g) of the Clean Air Act, such fuel is not be used in motor vehicles designed for highway use. Anyone who knowingly introduces such fuel into a motor vehicle designed for highway use is liable for a penalty of up to $25,000 per day per violation.
The motor fuel dyeing and marking program for tax enforcement purposes was enacted in the Omnibus Budget Reconciliation Act of 1993 (Pub.L. 103-66). Section 13242 of the act moved the point of taxation for diesel fuel up the distribution chain to the point of removal from bulk storage at the terminal rack, effective January 1, 1994, and required that only dyed fuel may be removed from bulk storage after that date without payment of the Federal diesel fuel excise tax. The terminal rack is the facility where fuel from bulk storage tanks is loaded into tanker trucks for delivery to retail stations or to bulk users. In addition to the dye, a non-visible chemical marker may also be specified. Section 13242 prescribes a penalty of $1,000 or $10 for every gallon of fuel involved, whichever is greater, for using dyed or marked fuel for a taxable use. The penalty increases with subsequent violations by multiplying the penalty by the number of previous violations. Although there are differences between the allowed uses of dyed and undyed fuels under the two programs, ultimately a single color (red) was adopted by IRS and EPA regulations to satisfy the dye requirements of both programs.
While the EPA dyeing regulations had been adopted 2 years prior to the effective date, the IRS had only a few months from enactment until the legislated effective date. The IRS was forced to move quickly to implement the dyeing program, and interim regulations were published in the Federal Register on November 30, 1993. The IRS enforcement effort included visits to all bulk storage terminals to explain the new requirements, recruitment and training of 150 dyed diesel compliance officers, and funding of more than $6 million for agreements with the States to conduct roadside sampling of diesel fuel used in highway vehicles.
State enforcement programs also benefit from the Federal dyeing requirements, since generally the same undyed highway use fuel is taxed to support State transportation programs. By the end of 1995, nearly two dozen States had adopted statutory provisions, similar to the Federal changes, on point of taxation or penalty provisions for improper use of dyed fuel in highway vehicles (Table 3).
These changes in diesel fuel taxation have contributed to the substantial increase in tax revenues discussed later. The combined magnitude of Federal and State fuel taxes continues to make them an attractive target for evasion. The types of evasion schemes undoubtedly will change as a result of the diesel fuel dyeing program. Types of schemes expected to be more prevalent since the dyed fuel program and imposition of tax at the terminal took effect are listed in Table 4. Most of these were problems before dyeing but are likely to grow in significance as other schemes, such as daisy chains (the multiple transfers of fuel among fictitious companies to conceal the party liable for remitting the tax), and diversion of tax-free fuel to highway use, become more difficult. Many of these schemes, such as illegal blending of untaxed products, bootlegging across State or international boundaries, and efforts to circumvent the terminal rack, will continue to require traditional criminal investigation methods and cooperative effort among enforcement agencies.
REVENUE ENHANCEMENT FROM COMPLIANCE EFFORTS
From the outset of the Joint Project, the Steering Committee has supported compilation of results to evaluate the impact of enforcement activities on motor fuel tax revenues. Since the FHWA funds devoted to the fuel tax compliance program represent a small part of the overall effort funded by the States and the IRS, the compilation of results was not limited to just activities funded by FHWA but included, to the extent possible, data on all State and IRS enforcement efforts. Some measures of effectiveness can be easily quantified, such as the actual assessments of taxes from audits and examinations of taxpayer returns and the estimated losses from completed criminal investigations. Actual revenue collections resulting from audit assessments and from criminal prosecutions cannot always be determined, since some assessments cannot be collected and criminal fines often are not credited to offset unpaid tax liabilities. Generally, audit assessments are expected to have a high collection rate, 90 percent or better, since they are imposed on active businesses that intend to continue in business. Criminal cases are generally expected to have a much lower collection rate, 50 percent or less of the lost revenue, since the perpetrators are jailed or otherwise no longer in business. Criminal cases do have ancillary revenue benefits related to deterrence of other criminal activity and diversion of market share back to legitimate taxpaying businesses. The benefits of other strategies, such as legislative changes, strengthened registration procedures, and training, cannot be directly quantified, but revenue trends can be useful indicators of compliance results even though the impacts of specific measures cannot be readily isolated from other factors influencing revenue collections. Direct and indirect measures suggest that compliance efforts are very cost-effective and contribute hundreds of millions of dollars annually to State and Federal transportation funds.
The IRS began tabulating results of examinations of fuel tax returns conducted under the Joint Project in FY 1991 for the first five participating IRS district offices in the lead States of Indiana, New Jersey, and Texas (Table 5). Even though few examinations were completed, or closed, the first year, the results were favorable, with assessed tax of $12.70 per dollar spent conducting the examinations. Many more cases were closed the second year, with even more impressive results of nearly $39.00 assessed tax per dollar spent. The FY 1993 and 1994 results covering an additional 11 district offices in the six new lead States showed $14.00 taxed assessed per dollar spent. These results are directly attributable to the FHWA funding provided for the tax compliance program since they represent the assessments from additional examination staff positions, funded in part by FHWA, that would not otherwise have been dedicated to motor fuel tax activities. The total of nearly $70 million in motor fuel tax assessments is by itself a cost-effective return for the nearly $8 million provided to IRS from FY 1990 through 1994, but it is only the beginning of the revenue enhancement picture.
The data reported by IRS under the Joint Project covers only examination activities undertaken by the supplemental staff assigned to the project in the IRS district offices in lead States. This represents only a fraction of the total IRS examination effort in motor fuel tax enforcement. Each of the IRS district offices has motor fuel tax examination activity under the excise tax administration function. An estimate of the overall IRS effort was reported at a congressional subcommittee hearing in August 1994 (Table 6). Since FY 1989, the examination staff effort in motor fuel has increased substantially. Diesel tax examination effort in particular had more than doubled by FY 1991. The total gasoline and diesel fuel tax assessments from these activities exceeded $100 million nationwide in FY 1993.
With respect to IRS criminal investigations, since FY 1992 some of the largest motor fuel tax evasion schemes have been indicted and prosecuted. The cases indicted and prosecuted are the culmination of months or even years of investigation work. Most of the investigations leading to prosecutions since FY 1992 were supported in part by the FHWA funds provided to IRS. The increased attention generated by the Joint Project, widespread news coverage of criminal cases, congressional subcommittee hearings, and industry support have sparked a steady increase in the IRS criminal investigation effort (Table 7). Over 100 investigations were initiated by the IRS during each of FYs 1992 and 1993, with fewer initiated in FY 1994 attributable, in part, to the changes in Federal diesel fuel tax procedures effective January 1, 1994. The estimated tax losses from criminal evasion schemes is difficult to assess because of the fraudulent or incomplete paperwork involved in concealing the fraud, but since FY 1993 estimated fuel tax losses for Federal fuel tax fraud indictments averaged more than $120 million per year (Table 8). Most of these indictments are the result of cooperative investigations by Federal and State agencies and include losses of both Federal and State motor fuel taxes. The lost revenue can rarely be recovered, although fines, seizures, and bond forfeitures can result in partial recovery. A far greater revenue impact, although difficult to quantify, is the increased compliance fostered by publicity on prosecuted cases and jail sentences for the perpetrators, and the additional revenue recovered in future years when market share reverts to tax-paying businesses as the fraudulent operations are shut down.
Results of motor fuel tax enforcement activities of the States are equally impressive. The first 12 States funded under the pilot program began reporting fuel tax enforcement information on a quarterly basis in FY 1991. Under the expanded program of nine regional task forces, States report twice a year. The reports include a 2-part data summary, expenditures table, and narrative highlights. The data summaries are limited to those activities that can be quantified, are reasonably uniform among the States, and have associated tax assessment or loss estimates. These include four categories of enforcement activities: office reconciliation, office audit, field audit, and criminal investigation, as defined in Table 9. The State reports include the total effort, not just the effort funded by the FHWA tax compliance project, and the resulting tax assessments or estimated tax loss for each function. It is important to note that for many other enforcement activities listed in Table 2 the results are not as readily quantified. All of these are important elements of the overall enforcement program and many States have included information about these initiatives in the narrative portion of their reports which are summarized in the reports to Congress, in particular the 1994 report (4).
From the very first data reports submitted in FY 1991, the positive revenue-generating benefits of motor fuel tax audit and reconciliation activities have been clearly demonstrated (Table 10). The initial reports from 12 States estimated nearly $21.00 in fuel tax assessed per dollar spent on audits and reconciliations. For the first full year covered by the reports in FY 1992, the tax assessment to cost ratio was nearly $14.00 per dollar spent, and $18.10 per dollar spent if penalties and interest are included. In FY 1993 through 1995, with up to 48 States included in the data tabulations, the results range from around $10.00 to $13.00 tax assessed per dollar cost. On a State-by-State basis, all States showed a positive assessment to cost ratio of about $2.00 per dollar spent or greater, with a few States reporting assessments of more than $100 per dollar spent. The results fluctuate considerably over time within a State, and from State to State. The level of assessment per dollar spent can be used to estimate the revenue gains of providing additional resources, or conversely revenue losses associated with budget cuts, for motor fuel tax enforcement. The average assessment per dollar spent is showing a gradual decline over time. The declining assessment to cost ratio may actually be indicative of increasing compliance, since it has been theorized that overall compliance levels improve with increasing frequency, visibility, and publicity of the enforcement effort. Consequently, the assessments relative to cost are expected to decline, as taxpayers are less likely to risk the consequences of under-reporting tax liability when the likelihood of getting caught appears more certain. In budgeting enforcement resources, it is important to look not just at the assessment to cost ratio, but also at the overall compliance level associated with an aggressive enforcement effort.
The motor fuel tax revenue generated by the State reconciliation and audit activity is between $60 and $75 million for a 6-month reporting period, or around $140 million annually. Interest and penalties add another $40 or so million annually to State revenues. The split between assessed tax and interest and penalty is not exact since some States are not able to report the tax separately from the total assessment. Note also that the data reported are assessments, not actual collections. Unlike the situation for criminal cases, most of the assessments from audits and reconciliations are recovered.
Reports of criminal investigations by the States show a substantial number of cases active, but with a much lower tax loss per case than for Federal cases. In fact, some of the estimated losses from Federal cases in Table 8 include lost State revenue, as well as Federal tax losses. Estimated fuel tax losses from State-indicted criminal cases average about $25 million for a 6-month reporting period with an average of 12 convictions for fuel tax fraud (Table 11).
Even though much of the lost revenue cannot be recovered, criminal prosecutions and jail sentences can be particularly effective in deterring tax fraud and improving overall compliance, since these cases generally receive widespread publicity. "Fuel Tax Evasion Highlights", published by FHWA three to five times a year, summarize press coverage on fuel tax evasion cases. Although the compliance benefits are difficult to gauge, a few States, notably Pennsylvania, have attributed substantial revenue gains since 1993 to the criminal prosecution of widespread diesel fuel tax fraud at truck stops. After 2 years of declining diesel fuel tax revenues, Federal and State agencies in Pennsylvania launched a series of raids that resulted in many indictments and convictions for fuel tax fraud. Beginning in November 1992, as the establishments where untaxed fuel had been sold were shut down, the taxable gallons increased dramatically, by 4.2 percent, 8.4 percent, and 7.1 percent in 3 consecutive years. The enforcement actions coupled with the implementation of the Federal dyeing program and taxation at the rack are largely credited with achieving this turnaround. Several States have used the FHWA grant funds for staffing new or expanded criminal investigation efforts. The summary of State convictions is not indicative of the States' total criminal investigation efforts, since several States have participated with Federal agents in investigations but defer to Federal prosecution because it may result in stiffer penalties, and because Federal prosecutors (with the assistance and support of the Tax Division of the Justice Department) are more experienced in the prosecution of these difficult cases. In fact, State investigators, as well as other Federal investigators from the DOT Office of Inspector General, Federal Bureau of Investigation, and/or Defense Criminal Investigative Service, participated in virtually all of the Federal criminal motor fuel indictments since FY 1992. State information on motor fuel receipts and disbursements, routinely reported with State motor fuel tax returns, often provide essential information to prove tax fraud. Another area of concern in State fuel tax fraud cases is the difficulty in getting prosecutors to take fuel tax fraud cases. The State of Texas, which has an aggressive motor fuel tax fraud effort, created and staffed a special prosecution unit in Travis County, where the majority of cases are adjudicated.
As mentioned above, the data reports summarized here cover only the easily quantified activities of reconciliations, audits, and criminal investigations. Changes in point of taxation, taxpayer registration procedures, improved uniformity in State reporting requirements, more stingent criminal penalties, and other compliance initiatives have associated benefits that are much more difficult to quantify. One remarkable success story, where the revenue gains have been undeniable, has been the enactment and implementation of the Federal diesel fuel tax changes in the Omnibus Budget Reconciliation Act of 1993 (Pub.L. 103-66). Isolating the magnitude of the compliance benefit, however, is still complicated by rate increases effective late in 1993, substantial changes in refund procedures, and one-time revenue gains from accelerated tax collection. At a hearing of the Senate Finance Committee on July 18, 1995, Ms. Cynthia Beerbower, Deputy Assistant Secretary for Tax Policy of the Department of the Treasury, testified in her written statement: "After trying other procedures, the United States has learned that taxing fuels at the terminal rack and dyeing nontaxable diesel fuel are the best methods for preventing fraud, assuring that honest retailers and wholesalers do not have to compete with those supplied with untaxed fuel, and securing adequate revenue to support the nation's transportation infrastructure and for deficit reduction." On the revenue impact the testimony states: "Complete data for 1994 have now been reviewed. The total amount of 1994 receipts available for the trust funds increased by $1.23 billion over the prior year, again adjusting for the rate increase. Taking into account increased refunds and credits, and attributing some of the increase to economic growth, the Treasury Department estimates that diesel fuel tax receipts, net of refunds, were $600-$700 million higher in 1994 than in 1993 due to improved compliance alone." Based on the revenue experience in 1994, the Treasury Department has revised the projections of diesel fuel tax deposits to the HTF. For the 5-year forecast period, 1994-1998, the diesel fuel tax revenue projection is up by $5 billion (Table 12), a 22.4 percent increase from the projections prior to adoption of the 1993 diesel tax law changes. Both projections are based on the same tax rate per gallon deposited in the HTF. Some of the increase reflects revised economic growth estimates, but most is attributed to improved compliance as a result of the diesel dyeing program and taxation at the terminal rack.
FHWA's estimate of diesel fuel tax evasion in the 1992 report to Congress (2), ranged from $623 million to $1,038 million annually. Since enactment of the dyed fuel program, at least 60 percent of the estimated evasion losses are now being recovered, an extremely favorable result considering that the FHWA fuel dye and marking report to Congress (5) concluded that recovering 50 percent of the estimated losses would be optimistic. And yet, even if motor fuel tax evasion has been reduced from a range of 15 to 25 percent of the taxable product to a range of 3 to 7 percent, that still represents several hundred million dollars of revenue yet to be recovered. And with a comparable range for gasoline, where evasion may actually be increasing again because of the greater difficulty of evading diesel fuel taxes, the total Federal evasion losses may still amount to nearly $1 billion, which leaves a substantial potential revenue target for future compliance efforts, although the relative cost and effort to recover it would likely increase.
State diesel fuel tax revenue, since the Federal diesel changes, have likewise increased beyond the expected normal growth, although not as much as at the Federal level (Table 13). The 1994 State reports of taxable diesel fuel use, from the FHWA Highway Statistics 1994 (6), showed diesel fuel use increased 6.9 percent in 1994 compared to 1993, nearly twice the expected growth in fuel use. Assuming half the increase was additional compliance resulting from the dyed diesel program, State transportation programs received a revenue bonus of over $150 million. Several States have seen double digit percentage increases in diesel fuel tax revenue over the past 2 years, attributed in part to changes in tax law or increased enforcement efforts.
CONCLUSIONS
Since 1990, FHWA has committed $22 million to the fuel tax compliance efforts of the Joint Project. To put that into perspective, the annual FHWA contribution to fuel tax compliance programs, represents about 1 to 2 days revenue losses from evasion of Federal motor fuel taxes, as estimated in 1994. In return, the Joint Project has accumulated information documenting hundreds of millions dollars of revenue enhancements from compliance initiatives. Overall, these data summaries present a very impressive picture of the cost-effectiveness of enforcement efforts. By every measure, the progress is positive--substantial tax assessments resulting from audit and examination activities totaling some $240 million annually of Federal and State taxes, increasing numbers of indictments and convictions for criminal fraud alleging fuel tax losses as great as $170 million annually, growing resources and staffing dedicated to the effort, better trained and equipped personnel, more and more States and enforcement agencies participating, and compliance revenue benefits of some $800 million annually in State and Federal diesel fuel tax revenue as a result of the Federal tax law changes including fuel dyeing.
The FHWA fuel tax compliance funds have been money well spent, but it must be emphasized that the FHWA funds represent only a small fraction of the resource commitments that were necessary to achieve these impressive results. Additional tens of millions of dollars in State and Federal resources, and industry expenditures to implement diesel fuel dyeing, were committed to the effort. The single most important contribution of the Joint Project and the FHWA funds was to bring all the parties to the table to work cooperatively on solutions. Information sharing and cooperation costs little but pays huge dividends.
It would have been hard to imagine 5 years ago at the first Steering Committee meeting how much motor fuel tax administration and enforcement would have changed in this short period of time. We fully expect that the partnership forged by the Joint Project will continue to provide a forum to promote cooperation and support for motor fuel tax compliance efforts, and will serve as a model for cooperative efforts to enhance the collection of other highway user taxes and fees.
