Senate Finance Taxation & IRS Oversight Tax Gap Hearing

Senate Finance Subcommittee on Taxation & IRS Oversight

Closing the Tax Gap: Lost Revenue from Noncompliance and the Role of Offshore Tax Evasion

Tuesday, May 11, 2021

Witnesses

Barry Johnson, Acting Chief, Research & Analytics Officer, Internal Revenue Service

Doug O’Donnell, Deputy Commissioner, Services & Enforcement, Internal Revenue Service

The Honorable J. Russell George, Treasury Inspector General For Tax Administration, U.S. Department of the Treasury

Nina E. Olson, Executive Director, Center for Taxpayer Rights

Charles O. Rossotti, Former Commissioner (1997-2002), Internal Revenue Service

Opening Statements
Chairman Sheldon Whitehouse (D-R.I.)
In his opening statement, Whitehouse emphasized that in terms of tax policy, there is widespread agreement that taxpayers should pay what they owe. He said tracking offshore money is difficult, but research shows that the U.S. loses billions through offshore tax evasion. He specifically outlined one study estimating that the highest earning one percent of taxpayers hide 20 percent of their income and account for 36 percent of unpaid taxes. Whitehouse said the U.S. has unfortunately reached this point as a result of successive cuts to the Internal Revenue Service (IRS) budget over the past decade. He continued by quoting former IRS Commissioner John Koskinen, “cutting the IRS budget gives a tax cut to tax cheats.” Whitehouse outlined three policy prescriptions he supports: 1) ensure the IRS has resources to collect what taxpayers owe and explore mandatory funding for the IRS for sustained and predictable support; 2) require more reporting of the type of income the “super-rich” tend to hide; and 3) implement a technological reboot at the IRS as the agency still relies on outdated systems. Finally, Whitehouse mentioned his No Tax Breaks for Outsourcing Act as a solution for ending the incentives for multinational corporations to shift profits offshore.

Ranking Member John Thune (R-S.D.)
In his opening statement, Thune said he is optimistic that Congress can work to find common ground and solutions that address the tax gap. He added that there is bipartisan agreement in needing to close the gap as the difference between what is owed and what was paid has been a persistent issue for many years. Thune said the estimated net tax gap is $381 billion but noted IRS Commissioner Charles Rettig has previously stated that it could exceed $1 trillion per year. Thune said some believe increased IRS funding will solve the problem, but argued that President Biden’s proposed $80 billion allocation over the next decade is too much. Thune said he agrees with the Congressional Budget Office’s suggested $40 billion in funding and asserted that such a level would facilitate a better return on investment. Thune outlined his hope that any policy changes will promote smarter and more effective audits as well as increased accountability and transparency. He said President Biden has proposed requiring banks to give the IRS new documentation on income from businesses such as partnerships, sole proprietorships, and individuals with business income. He pushed back on this proposal stating that Americans will be concerned with the prospect of government overreach and that local banks will turn into extensions of tax enforcement on behalf of the IRS. Thune emphasized enforcement is just one tool in reducing the gap and believes the solution requires a comprehensive strategy from the IRS with appropriate safeguards for taxpayers.

Testimony
Barry Johnson, Acting Chief, Research & Analytics Officer, Internal Revenue Service
In his testimony, Johnson said the tax gap can be divided into three components: non-filing, or not filing required returns on time; underreporting, or not reporting one’s full tax liability when the return is filed on time; and underpayment, or not paying by the due date the full amount of tax reported on a timely filed return. Johnson said the last official tax gap totals $441 billion, with a non-filing gross tax gap of $39 billion, an underreporting gap of $352 billion, and an underpayment gap of $50 billion. Johnson said the underpayment gap is the easiest component to measure because it is calculated directly from IRS administrative records, but the other two components – non-filing and underreporting – present greater estimation challenges because they measure activity that is not revealed to the IRS at all. Johnson said while the IRS’s tax gap estimation methodology has been a “gold standard” grounded in classical statistical methods, there is a lot of room for improvement and modernization. He concluded that new proposed methodologies to fully leverage IRS audit data and the application of cutting edge analytic methods will improve both the timeliness and coverage of the tax gap estimates and help shape IRS service and enforcement strategies. Johnson said their analysis so far shows this approach can help them better detect and measure both emerging issues as well as problems that are concentrated in small segments of the population.

Doug O’Donnell, Deputy Commissioner, Services & Enforcement, Internal Revenue Service
In his testimony, O’Donnell said he plans to use this hearing to discuss how the IRS is working to address the tax gap and ensure the integrity of the tax system. O’Donnell discussed the challenges facing the IRS, noting that the IRS has struggled to keep up with the complexity of the tax law and the technological and staffing challenges as a result of diminishing funding. He said improved systems and data analytics capabilities, as well as more data scientists, analysts and enforcement personnel would improve the IRS’s ability to better assist both U.S. taxpayers and Foreign Financial Institutions (FFIs) who want to comply and improve fairness by taking appropriate enforcement actions on noncompliant taxpayers. O’Donnell said closing the tax gap requires policy and legislative changes to increase IRS authority, funding, and reporting. He emphasized that the proposed funding from the Biden Administration will provide the IRS necessary resources, staff, and technology to better address sophisticated tax evasion.

J. Russell George, Treasury Inspector General For Tax Administration, Department of the Treasury
In his testimony, George said finding effective solutions that address the tax gap problem can yield substantial tax revenue. He noted that the current IRS computer systems are outdated, and that the tax gap is likely much higher than most estimates. George continued that funding the IRS is crucial, as audits have the largest impact on tax compliance and as a result of budget cuts, the IRS has lost many enforcement employees. He said the number of examinations declined even though the number of returns filed increased. George added that the share of corporate income tax returns however has fallen by nearly a third. He then mentioned the use of online platform companies as a source of continued problems as the IRS lacks a strategy to address challenges in that area. He also said the increased use of cryptocurrency is a concern as it is very difficult for the IRS to identify taxpayers with virtual currency transactions because of the lack of third-party information reporting. Lastly, he said improving international tax compliance remains a challenge for the IRS because they have not developed a reliable estimate of the international tax gap and previous non-IRS estimates range from $40 billion to $123 billion annually. George said the passage of the Foreign Account Tax Compliance Act gave the IRS the tools needed to act, but the IRS has not taken the compliance actions needed to meaningfully enforce it.

Nina E. Olson, Executive Director, Center for Taxpayer Rights
In her testimony, Olson said she will discuss problems created by the current state of IRS resources, technology, and skillset. She said addressing the tax gap requires a change in the context of minimizing undue taxpayer burden and protecting taxpayer rights. Olson said this process will also require significant investment in new technology, leadership, employees, training, procurement skills, and funding. She acknowledged that this would be a “massive redesign of IRS systems” and that it will not happen overnight. Olson continued that without these changes, we will not address the tax gap but rather risk increasing it by failing to meet the needs of taxpayers who are compliant. She said the drive to enforce tax laws cannot come at the expense of taxpayers. She also emphasized the tax gap does not equal tax evasion and that framing noncompliance as tax evasion undermines compliance efforts and creates an environment in which tax agency personnel can feel justified in undermining taxpayer rights and protections. Olson said proposals to expand information reporting are promising but should be accompanied by additional taxpayer protections. One recommendation she offered was for Congress to extend IRC 6201(d) to apply to IRS examination and matching activities and ensure proper use of reporting to avoid unnecessary litigation.

Charles Rossotti, Former Commissioner (1997-2002), Internal Revenue Service
In his testimony, Rossotti noted that where income is reported and checked through W-2s and 1099s, compliance is 95 to 99 percent, and where income is not reported, compliance is as low as 50 percent. He then discussed his multi-faceted proposal to 1) move more income from low visibility to higher visibility by filling the gaps regarding information that is not reported by third parties to the IRS; 2) upgrade IRS technology to increase efficiency; and 3) rebuild the IRS’s skilled workforce. He said it is essential to make compliance as easy as possible and reduce the number of unnecessary audits. He urged the committee to follow the bipartisan practice of establishing pertinent taxpayer rights when it considers legislating authority for the IRS and noted that his plan proposes several new taxpayer rights. Rossotti concluded in saying fundamental fairness alone should be a compelling enough reason to address this problem, particularly when Congress is contemplating raising taxes on people who already pay what they owe.

Question & Answer

Tax Gap
Whitehouse mentioned that tax gap estimates range from $441 billion to $1 trillion and asked how the international tax gap fits into that discrepancy. Johnson said the current tax gap estimates include some international activity but not all. He said the international activity is measured by domestic tax return filers and that the IRS does not include activities from taxpayers with assets abroad and foreign businesses. Johnson said they hope to address this in the future with new methodology. He added it is likely that the tax gap attributable to international activity is quite large, but that they do not have a separate stand-alone estimate of the international tax gap because it is difficult to calculate.

Sen. Debbie Stabenow (D-Mich.) asked Johnson to explain why the top one percent of Americans account for a disproportionate share of the tax gap and are more likely not to pay their taxes compared to the bottom 40 percent of Americans. Johnson said when there is both information reporting and withholding, the reporting of that income is 99 percent accurate, but when an individual’s income is not subjected to reporting and withholding, the accuracy rate drops to 45 percent and there is a higher level of nonreporting.

Sen. Steve Daines (R-Mont.) pushed back on the claim that low- to moderate-income (LMI) individuals are audited at higher rates than higher income individuals and asked what the specific audit rates are. Johnson said the audit rate for a low-income taxpayer is lower than the audit rate for high income taxpayers. Daines said according to the IRS, high income taxpayers are audited at eight percent, and earned income recipients are audited at 1.2 percent.

Tax Havens & Evasion
Whitehouse said outside research has suggested that U.S. citizens hold as much as $1 trillion in offshore tax havens and asked if that number is accurate. Johnson said based on 2017 Foreign Account Tax Compliance Act (FATCA) reporting, that number is about $2 trillion. Whitehouse also discussed the FATCA and implementation progress. George noted that the IRS is lacking very basic tools, thereby diminishing their ability to actually enforce the provisions of the act. Specifically, he noted that the IRS does not have the ability to require the taxpayers and associated overseas entities to provide taxpayer identification numbers for the IRS to then match the relevant information.

Thune asked Olson about the “tax gap not equaling tax evasion” and how conflating the two phrases could have negative impacts. Olson said there are many causes for the tax gap which can range from tax law complexity to procedural complexity. She said it can also be pure evasion or even be a protest in how money is being used. She warned that the consequences of this conflation run the risk of converting compliant taxpayers into noncompliant taxpayers.

Stabenow asked why the IRS is not able to target tax evading individuals when it is known that tax evasion and offshore techniques occur mostly amongst the wealthiest. George said many factors come into play, but it is mainly due to a lack of resources. He said it also depends on where the tax examiners are located and who can do more complex returns, as you need someone to physically look at information as it relates to such complex returns, compared to a very simple taxpayer return which could be audited with a simple correspondence. George said the number of IRS examiners are located mostly in areas near LMI taxpayers.

IRS Enforcement, Reporting Requirements & Funding
Sen. Sherrod Brown (D-Ohio) asked what will help the IRS move to more effectively target businesses that, in his view, largely drive the tax gap. Rossotti responded that one observation that underlies his proposal is that over the last 40 years, the fraction of business income earned in pass-throughs has become a large sector and IRS compliance programs have not kept up. Rossotti outlined his proposed additional 1099 report which would provide information on money in and money out of certain financial accounts and would be limited to upper income taxpayers. Rossotti added that the IRS simply needs the technology to make use of information that they already have, citing the example that the IRS has no ability to check K-1s.

Sen. Tom Carper (D-Del.) asked Rossotti to fully outline what policies would be most effective in addressing current IRS deficiencies. Rossotti again outlined the need for a multipronged approach, specifically, additional information reporting requirements as well as long term and stable funding for technology and workforce development. He estimated that a six percent per year increase over a 10-year period would cover such needs.

Daines emphasized that both Republicans and Democrats oppose tax evasion and want to close the tax gap. That said, he also noted his concerns regarding estimates put forth by the Biden Administration of the revenue that can be raised from their proposed $80 billion investment. Olson echoed these concerns, outlining her doubts that the IRS would be able to “ramp up” that quickly and agreeing that Rossotti’s proposal for level increases over a sustained period of time makes more sense.

Sen. Chuck Grassley (R-Iowa) Grassley also discussed the importance of a robust whistleblower program, highlighting the demonstrated cost effectiveness as well as the fact that it targets resources at bad actors. Olson agreed with this sentiment, noting that it is especially useful when looking at offshore accounts.

Sen. Rob Portman (R-Ohio) echoed his colleagues in that there is bipartisan support for increased enforcement. He also noted the disparity in revenue estimates as a result of increased IRS funding and highlighted that there is a point of diminishing returns that must be considered. Johnson agreed that as the IRS is able to audit a larger percentage of cases, there will of course be a lower return over time. He continued that his office is working to produce increasingly accurate and useful revenue estimates that they hope will assist Congress in allocating the correct amount of funding.

Portman asked Rossotti to further outline his reporting proposal but added the caveat that there are also limits to reporting. He emphasized that reporting changes must be justified by a measurable increase in enforcement without excessive burden while also protecting taxpayer privacy. Rossotti responded that the combination of new technology using the information that the IRS already has, supplemented by increased audits and new information reporting, would make the most measurable impact in addressing the tax gap.

Private Debt Collection
Grassley outlined his support for the IRS private debt collection program and noted the role it can play in closing the tax gap. He highlighted one issue that hinders efficacy in this area is the old age of accounts assigned to the program. Grassley stated that the Taxpayer First Act shortened this timeline and asked if the IRS has implemented this updated timeframe in terms of assigning accounts to the program. George said that the IRS is taking steps but will need to report back at a later date on the extent to which it has been completed.

Grassley also expressed concern about a finding in a recent report that the IRS failed to assign high income taxpayer accounts to private debt collection despite meeting the requirements. He argued the IRS is not making full use of the private debt collection program and asked how to improve the process. George said the IRS receives very dated accounts, and the longer you wait to supply delinquent accounts to private debt collectors, the less likely there will be a return. He also noted that private debt collectors are still collecting more money than the cost to the government. George concluded that facilitating more expedient transfer of these accounts to private debt collectors would help address this problem.

Investment Tax Credit (ITC)
Brown asked if the ITC comprises a significant part of the tax gap. Olson said it is about 3.9 percent of the tax gap if using the $441 billion estimate, and about 1.7 percent if using the $1 trillion estimate.

Brown asked if there would be fewer improper payments in ITC returns if the IRS had the authority to establish minimum competency standards for paid tax preparers. Olson said it is a significant provision that would reduce noncompliance in that area as so much of the returns are prepared by paid preparers or even ghost preparers, an area where the highest error rates occur.

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