A lack of enforcement resources, misplaced priorities, and inefficient policies at the Internal Revenue Service (IRS) are among the factors perpetuating the federal tax gap, according to a new OMB Watch report released Jan. 15. The report, Bridging the Tax Gap: The Case for Increasing the IRS Budget, illustrates why the IRS has had such a difficult time recovering the more than $300 billion in federal taxes that go unpaid every year and offers some practical solutions to the problem.

The most recent data on the gross tax gap comes from the IRS National Research Project, which evaluated tax returns from FY 2000. It put the gross tax gap at between $312 billion and $353 billion annually, or about 16 percent of all taxes owed.

The OMB Watch report argues Congress has given considerable lip service to doing something about the tax gap for years but has done little to actually give the IRS the tools to make significant progress in closing it. According to the report, in FY 1995, IRS had $4.43 billion in its budget for enforcement activities. By FY 2006, this budget had only risen to $4.65 billion — less than a five percent increase. During the same period:

• Inflation had eroded the value of this funding by 36 percent;
• The size of the economy grew 42 percent;
• The number of tax returns the IRS processed increased 11 percent, from 205 million to 228 million; and
• Hundreds of changes to the IRS's authority and tax laws gave the agency more work.

The funding shortage has also impacted the number of staff the IRS can hire. Over the last ten years, the workforce has shrunk 18 percent, according to IRS statistics. The number of revenue agents and officers — IRS employees who perform audits — has decreased even faster, by 40 and 30 percent, respectively.

Despite these facts, Congress has demanded the IRS close the tax gap without making more resources available for the agency to do so. Thus, the IRS has been forced to make difficult choices as to how to use the limited resources it has been allocated, choices that often end up hurting tax collection and taxpayer rights.

OMB Watch focuses on three areas of policy at the IRS in need of immediate improvement: audits, particularly at the upper end of the income spectrum; tax collections; and tax preparation services for low-income taxpayers eligible for the Earned Income Tax Credit (EITC).

One of the most disturbing trends in enforcement policy over the last ten years has been a sharp decline in audits, which are an essential tool in the fight against unpaid taxes. In the last decade, there has been a general decline in most types of audits. In FY 1996, the audit rate for all individual income tax returns was 1.67 percent. In FY 2006, the rate had dropped to 1.0 percent of all individuals, after reaching a low of 0.5 percent in 2000. Audits of corporations of all sizes have also dropped significantly, and more recent data cited in the report shows the audits that are being done are poorly targeted and inefficient.

For both individuals and corporations, the IRS is increasingly relying on correspondence audits rather than more intensive face-to-face audits. This trend is problematic because correspondence audits are less effective than face-to-face ones, partly because the IRS can only spot problems that are evident from information submitted by the taxpayer during correspondence audits.

Another area in need of improvement and additional funding at the IRS is tax collection. The report cites former IRS Commissioner Charles Rossotti, who in 2002 reported an annual investment of under $400 million in IRS collections could generate over $11 billion each year. Instead of providing these additional resources, Congress has authorized the IRS to outsource the responsibility of collecting small tax debts to private collection agencies (PCAs). This program has so far shown itself to be wasteful and a danger to sensitive taxpayer information. According to the report, initial data on the program for the first year of operation shows PCAs averaged a 4.5:1 return on investment (ROI), collecting $29 million, from which they were paid $6.34 million. These data are far below both the IRS' ROI levels and initial revenue projections for the program.

In addition, numerous experts continue to worry PCAs might violate taxpayer rights. Indeed, anecdotal evidence of this was heard during congressional oversight hearings on the program in 2007, and despite recommendations otherwise, there remain few safeguards in place to prevent these abuses.

Finally, the IRS has taken an approach to enforcing the EITC that relies far too much on audits and not enough on services. Mostly by congressional mandate, the IRS has taken a punitive approach to EITC error reduction, including disproportionally high audit rates and unique certification requirements. The examination rate for EITC recipients was 2.25 percent, compared to 1.0 percent for all individual income tax returns, and 1.3 percent of all individuals making over $100,000. Yet EITC audits yield only a fraction of the total revenues recovered by IRS examinations. EITC audits identified nearly $1.5 billion in excess payments, resulting in a yield of only $2,895 per audit — the lowest rate of return for any type of audit performed by the IRS.

The report concludes this is the wrong approach to fixing the problems with the EITC. As much as 50 percent of all tax returns with errors are thought to be unintentional and have been linked to the complexity of EITC eligibility requirements. There is also good evidence showing that providing services and assistance to low-income tax filers who claim the EITC sharply reduces error rates.

Unfortunately, the IRS is moving in the opposite direction, deciding to reduce the quantity and quality of services available to low-income filers through cuts to their network of Taxpayer Assistance Centers (TACs). Already understaffed, the IRS further attempted to close almost 20 percent of the TACs in 2005 before Congress intervened.

The tax gap is an eminently solvable problem. The report posits that if Congress were to prioritize funding for IRS examination, collection, and tax preparation services, it would drastically reduce the tax gap. So long as the IRS is underfunded, it will be forced to enforce the tax code unfairly and punitively. However, if the IRS is properly funded and administered correctly, the federal government will have the opportunity to make substantial progress in reducing the tax gap and to ensure the tax system is as progressive in practice as it is in law.