James R. White
April 3, 2007

The Honorable Jim Ramstad
Ranking Minority Member
Subcommittee on Oversight
Committee on Ways and Means
House of Representatives

Dear Mr. Ramstad:

Effective tax administration requires a balance of taxpayer service and tax law enforcement. To provide enforcement and taxpayer service in fiscal year (FY) 2008, the Internal Revenue Service (IRS) has requested an $11.6 billion_[1] operating level budget with about 63 percent going for enforcement activities and 31 percent for taxpayer service (including operational support). The remaining request includes funding to develop and implement modernized information systems.

IRS provides much of its services to taxpayers during the annual tax return filing season, making filing season performance a key indicator of how well IRS is serving taxpayers. In past reports and testimonies, we said that IRS has made significant progress improving taxpayer service since passage of the IRS Restructuring and Reform Act of 1998 (RRA 98)._[2] Improvements include increased electronic filing, better access to IRS’s telephone assistors, and more accurate answers to taxpayers’ questions. However, we have also described taxpayer service challenges such as the quality of assistance at walk-in and volunteer sites where taxpayers get face-to-face assistance. Moreover, the Commissioner of Internal Revenue stated that this year’s filing season is high risk for several reasons, including challenges in implementing the new telephone excise tax refund (TETR), split refund option (refunds can now be directly deposited to up to three separate accounts), and several tax law extensions that passed late in 2006.

Although IRS has increased revenue collected through its enforcement programs in recent years, enforcement continues to be included on our list of high-risk federal programs._[3] This is due, in part, to the persistence of a large tax gap._[4] IRS estimated the gross tax gap to be $345 billion for tax year 2001. After late payments by taxpayers and revenue brought in by IRS’s enforcement efforts, the resulting net tax gap is estimated to be $290 billion.

Another high-risk challenge is IRS’s ongoing Business Systems Modernization (BSM) program, a multibillion-dollar, highly complex effort that involves the development and delivery of a number of modernized information systems that are intended to replace the agency’s aging business and tax processing systems. The program is critical to supporting IRS’s taxpayer service and enforcement goals and reducing the tax gap. We recently reported that despite progress made in implementing BSM projects and improving modernization management controls and capabilities, significant challenges and serious risks remain, and further program improvements are needed, which IRS is working to address._[5]

In light of the challenges IRS faces, you asked us to assess IRS’s 2007 tax filing season performance, FY 2008 budget request, and the status of the BSM program. Our objectives were to (1) describe IRS’s 2007 tax filing season performance for returns processing and taxpayer assistance including the impact of tax system changes, such as the TETR, split refund option, and several tax law extensions that passed late in 2006, (2) assess IRS’s proposed FY 2008 budget and compare it with prior years’ spending and staffing and determine what information it provides on the impact of  proposals on the tax gap, how new spending initiatives are justified, and whether there are opportunities to reduce or reallocate resources, and (3) evaluate the status of IRS’s efforts to develop and implement BSM.

On March 15, 2007, we briefed your staff and staff of the Subcommittee Chair on the preliminary observations of our review. This report transmits the updated materials we used at the briefing, which are reprinted as appendix I in the complete version of this report.

In summary, we made the following major points:

• Despite initial concerns and IRS’s characterization of this year’s filing season as high risk, early data show that tax systems changes have not had a significant effect on filing season operations or performance. In particular, TETR-related requests and telephone calls have been far less than IRS planned. As of March 16, 2007, IRS has processed 63.5 million individual income tax returns, with 69 percent including TETR requests. The number of returns filed electronically is 5 percent greater than this time last year. Also, IRS is achieving its goals for telephone service. However, there are areas of concern. In early March, the latest release of the Customer Account Data Engine (CADE), one of IRS’s key tax return processing systems, became operational—2 months behind schedule. As a result of the delay, IRS has had slower processing times and delayed refunds for up to several days for millions of taxpayers. This delay may have a more serious impact on IRS’s ability to deliver future releases of CADE, because it caused contention for key resources, but it is too early to know. Taxpayers’ use of the Free File program (an alliance of companies that offer free return preparation and electronic filing on their Web sites to eligible taxpayers) is 5.5 percent below last year at this time.
• IRS’s 2008 budget request would increase spending, particularly for enforcement. The $11.6 billion requested total operating budget is an increase of $608.8 million (5.6 percent) over the FY 2007 continuing resolution level. IRS proposes spending $7.2 billion for enforcement (including operational support), an increase of 6.5 percent, continuing a trend since 2004 of shifting a greater proportion of overall spending toward enforcement as compared to taxpayer service. IRS’s budget request includes initiatives and legislative proposals to address the tax gap. There is limited data in IRS’s request on the expected impact of the proposals on the gap. The expected direct enforcement revenue to be gained is small compared to the size of the tax gap. For example, IRS expects to yield about $699 million in FY 2010, or about ¼ of 1 percent of the tax year 2001 net tax gap from additional enforcement staffing. However, the indirect effect on voluntary compliance is unknown. Several research studies by economists, while subject to data limitations, suggest that indirect revenue might exceed direct revenues gained. We asked for supplementary documents on six initiatives to better understand their expected benefits and costs. The documented justifications for those initiatives varied in the depth of useful information they provided. We continue to assess the justifications for the initiatives and whether IRS could cost effectively provide additional information that could be useful for the Congress and others as they assess IRS’s budget request. IRS identified savings in the 2008 budget request, but other savings opportunities may exist. For example, IRS may be able to change the mix of services provided—such as giving taxpayers more options for help by e-mail or its Web site in place of more costly telephone or walk-in operations—but its study to identify cost-effective service delivery methods is several months behind schedule.
• IRS continues to make progress in implementing BSM projects and meeting cost and schedule commitments, but two key projects—CADE (discussed above) and Modernized e-File (a new electronic filing system)—experienced significant cost overruns during 2006. Future BSM project releases face serious risks, which IRS is working to mitigate. For example, delays in deploying the latest release of CADE have resulted in contention for key resources and will likely impact the design and development of the next two important releases, which are scheduled to be deployed later this year. IRS has made significant progress in implementing our prior recommendations and improving its modernization management controls and capabilities. However, critical controls and capabilities related to requirements development and management and post implementation reviews of deployed BSM projects have not yet been fully implemented. In addition, more work remains to be done by the agency to fully develop a long-term vision and strategy for completing the BSM program, including establishing time frames for consolidating and retiring legacy systems.

Scope and Methodology

To assess IRS’s filing season performance for processing, telephones, face-to-face assistance and its Internet Web site, we obtained and analyzed IRS’s performance and production data and compared it to annual goals and prior years’ performance. Our work also included direct observations of key filing season operations, and interviews with IRS officials and other external stakeholders.

To assess IRS’s 2008 budget request, we reviewed IRS’s congressional budget justifications and supplementary documents to (1) identify trends in spending and staffing from FYs 2004 through 2008, (2) assess information on the tax gap and selected spending initiatives to assess the information provided to justify the request, and (3) identify areas of potential opportunities for savings and efficiencies. Our assessment is based on a comparative analysis funding, expenditures, and other documentation and interviews with IRS officials.

Our filing season and budget audit work was done primarily at IRS’s National Office and its operating divisions including the Large and Mid-Size Business operating division in Washington, D.C; Small Business/Self-Employed operating division in New Carrollton, Md; and Wage and Investment Division operating division headquarters and Joint Operations Center and call site in Atlanta, Ga. We also interviewed officials at the IRS Oversight Board in Washington, D.C. Additionally, we reviewed relevant external documentation and our reports and reports of the Treasury Inspector General for Tax Administration.

Our analysis of the BSM program was based primarily upon the results of our detailed review of the FY 2007 BSM expenditure plan that we issued in a recent report._[6]

In past work, we assessed IRS’s budget and filing season performance data. We considered filing season performance measures and data that cover the quality, accessibility, and timeliness of IRS’s services to be objective and reliable based on our prior work. Since the data sources and procedures for producing this year’s budget and filing season data have not significantly changed from prior years, we determined that the data were sufficiently reliable for the purposes of this report. To the extent possible, we corroborated information from interviews with documentation and data and where not possible, we report the information as attributed to IRS officials. We have determined that the estimates for cost savings and Web site performance come from competent sources and are reasonable. Data limitations are discussed where appropriate. We performed our work from December 2006 through March 2007 in accordance with generally accepted government auditing standards.

Agency Comments

In commenting on a draft of this report, IRS officials emphasized that the budget’s initiatives and legislative proposals will result in additional direct and indirect revenue and, ultimately, increase compliance. It also reported that it will soon release its strategic plan for taxpayer service delivery, which will serve as the foundation for future decisions for service improvements and efficiencies.

We are sending copies of this report to the Chairmen and Ranking Minority Members of other Senate and House committees and subcommittees that have appropriation, authorization, and oversight responsibilities for the IRS. We are also sending copies to the Commissioner of Internal Revenue, the Secretary of the Treasury, the Chairman of the IRS Oversight Board, and the Director of the Office of Management and Budget. Copies are also available at no charge on the GAO Web site at http://www.gao.gov.

If you or you staff have any questions or wish to discuss the material in this briefing further, please call me. Contact points for our offices of Congressional Relations and Public Affairs may be found on the last page of this report. GAO staff who made major contributions to this report are listed in Appendix II in the complete version of this report.

Sincerely yours,

James R. White
Director

_[1] The $11.6 billion includes $11.1 billion in new appropriated funds and $0.5 billion in other funds.

_[2] See, for example, GAO, Tax Administration: IRS Improved Some Filing Season Services, but Long-term Goals Would Help Manage Strategic Trade-offs, GAO‑06‑51 (Washington, D.C.: Nov. 14, 2005), Internal Revenue Service: Assessment of the Interim Results of the 2006 Filing Season and Fiscal Year 2007 Budget Request, GAO‑06‑615T (Washington, D.C.: Apr. 6, 2006), and Tax Administration: Most Filing Season Services Continue to Improve, but Opportunities Exist for Additional Savings, GAO‑07‑27 (Washington, D.C.: Nov. 15, 2006).

_[3] GAO, High-Risk Series: An Update, GAO‑07‑310 (Washington, D.C.: January 2007).

_[4] The tax gap is an estimate of the difference between what taxpayers pay in taxes voluntarily and on time and what they should pay under the law.

_[5]GAO, Business Systems Modernization: Internal Revenue Service’s Fiscal Year 2007 Expenditure Plan, GAO‑07‑247 (Washington, D.C.: Feb. 15, 2007).

_[6] GAO‑07‑247.