Measurement of corporate tax gap.

On July 6, 1992, Tax Executives Institute submitted the following comments to the Subcommittee on Commerce, Consumer, and Monetary Affairs of the House Committee on Government Operations on the measurement of the "corporate tax gap." The comments, which take the form of a letter from TEI President Reginald W. Kowalchuk to Subcommittee Chairman Doug Barnard, respond to a question posed to the Institute during a June 3 hearing on the Internal Revenue Service's Compliance 2000 initiatives. (The Institute's testimony at the hearing is reprinted elsewhere in this issue.) TEI's comments on the so-called tax gap were prepared under the aegis of its IRS Administrative Affairs Committee, whose chair is Linda B. Burke of the Aluminum Company of America.

During the Subcommittee's June 3, 1992, hearing on the Internal Revenue Service's Compliance 2000 initiatives, you asked that Tax Executives Institute explain its concerns about the measurement of the so-called corporate tax gap. (TEI was represented at the hearing by its Executive Director, Michael J. Murphy.) This letter, which we ask be associated with Mr. Murphy's testimony, responds to that request.

Defining the Problem

In announcing the Subcommittee's June 3 hearing, you properly emphasized Congress's concern with the level of voluntary compliance. Among other things, you cited figures on the size of the annual tax gap. TEI shares the Subcommittee's concern with the seriousness of the tax pp, and with its potential effect on our self-assessment system. We agree with your assessment that, unless the level of voluntary compliance is significantly increased, the result could be a further erosion of taxpayer confidence in the system.

As we testified on June 3, however, the Institute is concerned about the flaws in and the potential misuse of statistics relating to the tax pp. More to the point, we believe the first task must be to accurately define the noncompliance challenge that confronts the tax system. Not only must the horse be placed before the cart, but more fundamentally, the size of the cart must be established prior to determining the number of horses required to pull it. Hence, before the IRS can effectively focus its limited resources on increasing voluntary compliance, the level of noncompliance must be quantified and properly stratified, and its causes must be understood. In other words, before Congress and the IRS "shoot," they must know what their targets are. "Ready -- fire -- arm" is not the pathway to effective or efficient results.

Regrettably, much of the analysis and most of the figures behind the IRS's tax gap analysis is misleading -- they are the product not of solid information but of statistical sleight-of-hand. This is unfortunate, for properly defining the problem is critically important because one invariably finds what one looks for: solutions are developed to address one's "targets," even if they are more imagined than real. Thus, TEI is concerned that the large corporate community has been labeled a "target" on the basis of highly suspect information and that, as a consequence, Congress and the IRS run the risk of misallocating the government's scarce resources.

Stated differently, we believe the current approach toward measuring noncompliance creates a negative -- and untrue -- impression that most if not all noncompliance is intentional. Indeed, the very term "tax gap" is pejorative and carries with it a negative inference that every underpayment of tax is a volitional act of wrongdoing. As the IRS has itself recognized in developing its Compliance 2000 initiatives, however, that is simply not the case. The magnitude, complexity, and rapidity of tax law changes in recent years -- including the absence of meaningful administrative guidance -- have contributed to the number of tax controversies (i.e., legitimate differences of opinion between taxpayers and the IRS). The answer is for Congress to simplify the tax law and for the IRS to make the regulations more administrable and to issue them on a more timely and prospective basis, not to look for scapegoats.

Skewing of Tax Gap Figures

Because TEI is an organization of tax professionals who are responsible for the tax affairs of the largest companies in the United States and Canada, we are primarily concerned with issues affecting corporations -- either as taxpayers themselves or, indirectly, as agents for the government in respect of information reporting, withholding, and the like. Thus, the Institute is especially troubled about shortcomings in the IRS's and General Accounting Office's analyses that overstate the level of tax noncompliance by the large corporate sector (and, perhaps by extension, the extent of the midsize corporate "shortfall" as well). Specifically, we seriously question the validity of the $125 billion "tax gap" figure that has been bandied about -- $15.8 billion of which is deemed to be attributable to "large corporations."(1) As explained below, much of this problem can be traced to a lack of data.

1. The Need to Stratify Corporate Tax Gap Figures.

One concern is that there has been an inadequate stratification of the results relating to so-called large corporations. The General Accounting Office defines "large corporations" as those with $10 million or more of assets and the IRS uses the same definition. Based on the variances in the type of business transactions conducted by companies of varying sizes and, especially, the level of audit coverage, we suggest that lumping all corporations with assets of $10 million or more into a single category is improper.

As you know, corporations with assets of more than $250 million are generally part of the IRS's Coordinated Examination Program and, as such, are subjected to continual examination by the IRS.(2) Nevertheless, for tax gap analysis purposes, their experience is combined with that of corporations with assets of more than $10 million. Thus, the tax pp figures combine the results relating to CEP taxpayers -- the audit rate in respect of which greatly exceeds that for all other taxpayer groups(3) -- with the results relating to substantially smaller corporations. Since the overall audit rate of corporations is currently 25 percent, it is not difficult to see that collapsing all corporations with assets of more than $10 million into a single category skews the analysis.

To remedy this situation, TEI recommends that the GAO and IRS break down their figures into at least four categories: corporations with assets of $10 million or less, corporations with assets of more than $10 million but less than $100 million; corporations with assets of $100 million but less than $250 million; and corporations with assets of more than $250 million.

2. Improper Definition of the Tax Gap.

a. Gross Tax Gap. Even more fundamental than the lack of stratified data, however, are the faulty assumptions that underlie the IRS's and GAO's conclusions. Thus, although it is generally agreed that the "gross tax gap" is "[tlhe amount of tax that is due but not voluntarily paid," the conclusions set forth in various IRS and GAO research reports do not comport with that definition. This is because the IRS and GAO proceed on the assumption that "the amount of tax due" is the amount of adjustments proposed by IRS examining agents -- even if those adjustments are voluntarily made by the taxpayer (for example, through the filing of an amended return), conceded by the IRS itself, or reversed by the courts.(4)

Example. Corporation A files

a tax return on which it deducts

a $100 item as an ordinary

and necessary business

expense. On examination, an

IRS agent concludes that the

item is capital in nature and

proposes a $100 adjustment.

Upon protesting the proposed

adjustment to the IRS Appeals

Division, the taxpayer prevails;

the $100 adjustment is reversed.

Under the IRS's definition,

the $100 proposed adjustment

is included in the gross

tax gap, even though the taxpayer

is found not to owe any

additional tax! (A similar result

would occur if the taxpayer

prevailed not in the Appeals

Division but in a court.)

Because CEP taxpayers are under continual audit, their examinations usually commence with their volunteering certain adjustments -- some in the government's favor, some in the taxpayer's -- to correct inadvertent errors that were made in the return as filed, to reflect adjustments for "roll-over" items from previous examinations, or to take into account changes brought about by judicial decisions, IRS rulings, or Treasury Regulations issued since the original return was filed. TEI submits that it is more than inappropriate to include such volunteered items, or any additional tax paid with any amended return, in the gross tax pp estimates: It is not only wrong; it is highly misleading.(5)

The IRS itself has acknowledged the flaws in its large corporation tax gap figures. Hence, in an April 1990 report, the IRS concluded that "the uncertainty concerning true tax liabilities is particularly unsatisfactory with respect to the estimates for large corporations. "(6) Indeed, in testimony before the Permanent Subcommittee on Investigations of the Senate Committee on Government Affairs on April 17, 1991, then-Commissioner Goldberg urged Congress to "be as circumspect as possible about the data on the tax gap." See "Tax Compliance: GAO Says Corporate Tax Gap Growing: Goldberg Sees No Dramatic Increase," BNA Daily Tax Report, DTR No. 75, at G-10 (April 18, 1991).

b. Net Tax Gap. Although the IRS has attempted to refine the tax gap estimates -- by developing "net tax gap" estimates --the results remain suspect. This is because the "net" figures continue to include amounts attributable to proposed adjustments that are subsequently reversed. Thus, the IRS definition of "net tax gap" is counterintuitive to the extent it includes the amounts conceded by the IRS or lost in litigation. In fact, such reversed adjustments make up the bulk of the net tax gap estimates. Specifically, the IRS defines the "net tax gap" as "the part of the gross tax gap that is not collected through IRS enforcement activities." Thus, in the above example, because the $100 proposed adjustment was conceded, the net tax gap would be the same as the gross tax gap, or $100 -- that is to say, the amount was not collected through the IRS enforcement activities. This is exacerbated in situations where both the taxpayer and the IRS concede issues during the course of the examination.

Example. Corporation B files

a tax return on which it deducts

a $100 item and a $150 item as

ordinary and necessary business

expenses. On examination,

an IRS agent asserts

that both items are capital in

nature and proposes a total

of $250 in adjustments. Upon

protesting the proposed adjustment

to the IRS Appeals

Division, the taxpayer prevails

with respect to the $100

item but concedes the $150

item; the taxpayer ultimately

pays the tax (plus interest) with

respect to the $150 item. Under

the IRS's definition, the

gross tax gap is $250 and the

net tax gap is $100 (i.e., the

item "won" by the taxpayer). If

the IRS decides to litigate the

$100 item and loses in court,

the net tax gap remains $100.

Such a conclusion defies logic.

Taxpayers' objection to the IRS's definition of the tax gap is not only crystal clear but, we submit, unassailable: the estimates are based on the examining agent's proposals even where those proposals are ultimately reversed. Thus, the estimates are substantially overstated. This is especially the case with respect to corporations that are part of the CEP program: according to a recent GAO report, CEP taxpayers protest 90 percent of all recommended adjustments and Appeals Officers reverse a majority of those protested items; indeed, the GAO concluded that the IRS will assess only 25 percent of recommended adjustments. April 1992 GAO Report at 23.(7) In other words, if the IRS and GAO excluded items that the IRS does not prevail on, the so-called gap would be reduced by 75 percent!

The IRS has argued that "it is not obvious that the entire amount conceded or lost should be removed from the estimates of the gross tax gap." April 1990 IRS Study at 14. The IRS's rationalization is, as follows:

There are various reasons for

concessions. For example, appeals

officers sometimes simply

make mistakes in conceding

examination recommendations.

In this case, the 'true' liability

is the original recommendation -- supporting

the higher estimates

of the tax gap. Examiners

also make mistakes sometimes -- proposing

too much

additional tax -- but there are

several categories of reasons for

concessions in the appeals/litigation

process which fall between

these clear polar extremes,

making it difficult to

estimate where the "true" tax

liability lies. In addition to

uncertainty concerning what

portion of unassessed recommendations

represent "true"

tax deficiencies, it is possible

that even the higher estimates

[i.e., estimates based on proposed

adjustments] may understate 

the tax gap for large corporations.

Since the examinations

of large corporations are

not necessarily thorough in

pursuing all potential issues on

these complex returns, substantial

amounts of tax deficiency

may not be recommended

by the examiners and, hence,

may never be included in either

the higher or lower estimates.

Id. (footnote omitted).(8)

Similarly, the GAO's April 1992 report attempts to perpetuate the myth that the CEP tax gap is understated by asserting that the IRS "will undoubtedly miss some noncompliance." Indeed, it intimates that this possibility -- which is impossible to combat because it would involve proving a negative -- justifies its use of proposed assessments as a basis for its tax gap estimates. April 1992 GAO Report at 3.

These statements are both incredible and self-serving. To defending the bloating of the IRS's tax gap figures by including amounts that the IRS itself concedes are wrong -- or that a court so adjudicates -- on the grounds that IRS agents could have made more adjustments is casuistry. It is akin to saying that a person's ironclad alibi to one crime should be disregarded because the person may be guilty of something else. Similarly, anecdotal claims that Appeals Officers routinely make mistakes or that examiners "miss" issues should not drive policy decisions.(9) Indeed, TEI believes that basing tax gap estimates on supposition is dangerous precisely because the flawed estimates may lead to legislative and administrative compliance initiatives that misallocate government resources.(10)

A Proposed Approach

As stated at the outset, TEI believes that much of the problem with the IRS's (and GAO's) analysis in respect of large corporations lies with the lack of data. (The IRS itself recognizes this -- hence, then-commissioner Goldberg's call for circumspection.) To rectify this problem, TEI recommends that the IRS conduct a survey of CEP taxpayers to determine the true extent of the tax pp attributable to large corporations. Specifically, a test sample of, say, 50 or 100 corporations with assets of more than $250 million could be selected and the actual results of their audits evaluated. (The sample should be such that all major industries are represented.) TEI believes that to accurately assess whether and where there are problems, a system could be developed that tracks issues from the filing of the return to the final determination (by the IRS or a court). In implementing this proposal, a key resource will be the IRS case manager (who supervises the examinations of the selected large corporations). We believe that the case managers should be requested to prepare an analysis of (i) the return as originally filed, (ii) any amended returns filed, and (iii) the audit settlement (as set forth in the Revenue Agent's Report), including amounts "agreed" and "unagreed" at the close of the examination and amounts volunteered' by the taxpayer at the outset of the examination. The analysis should then continue with the appeals disposition of the case: amounts settled in the taxpayer's favor, amounts settled in the government's favor, and amounts left unsettled. Finally, the focus should shift to whether the case is litigated, with the analysis addressing amounts resolved in the taxpayer's favor and those resolved in the government's favor."

TEI believes that, by analyzing the actual results of the examination, appeals, and judicial processes, the IRS can accurately identify those areas where special attention needs to be devoted. We would be pleased to work with the IRS, GAO, and the Subcommittee in refining our proposal.

Conclusion

Mr. Chairman, TEI shares the Subcommittee's concerns about the level of taxpayer noncompliance. Before the Internal Revenue Service's limited resources can be effectively deployed, Congress and the IRS must do a better job of identifying specific areas of need. Thus, TEI submits that Congress and the IRS cannot prudently proceed on the basis of purely anecdotal evidence and visceral reactions unsupported by empirical evidence and, further, Congress and the IRS cannot proceed on the basis of faulty or imprecise methodology. We believe that the recommendations set forth in these comments will assist Congress and the IRS in identifying the deserving 'targets' of enhanced compliance efforts. Consequently, TEI is pleased that the report of the House Appropriations Committee on the IRS's fiscal year 1993 funding -- which was approved on June 25 -- instructs the IRS to submit with its 1994 budget request a breakdown of the sources and corresponding amounts of the tax pp. We are confident that such a breakdown will confirm that prior years' estimates of the tax pp attributable to the large corporate sector have been exaggerated.

Tax Executives Institute appreciates this opportunity to provide the Subcommittee with its views on this important subject. If you should have any questions about our comments, or if you wish for us to elaborate on our views, please do not hesitate to call either Michael J. Murphy, TEI's Executive Director, or Timothy J. McCormally, our General Counsel and Director of Tax Affairs, at [phone]. (1) See U.S. General Accounting Office, Tax Administration: IRS' Efforts to Improve Corporate Compliance 3 (April 1992) (GAO/ GGD-92-81BR) (hereinafter cited as "April 1992 GAO Report"). (2) TEI is a strong supporter of the IRS's Coordinated Examination Program. We have worked extensively with the IRS to develop proposals to improve the CEP program's operation and effectiveness. (3) According to a recent GAO report, the audit rate among CEP taxpayers was 77 percent in 1991. See April 1992 GAO Report 3. Even this impressive figure, however, understates the scrutiny to which large corporate taxpayers are subjected, for the returns of unaudited CEP taxpayers are "carefully reviewed ... for revenue potential before [the IRS decides] to exclude it from audit." Id. at 2. In other words, the returns of all CEP taxpayers are inspected every year. (4) The IRS has now developed "higher" ("primary") and lower' 'alternate*) estimates of the gross tax gap. The higher figures are based on proposed audit adjustments, whereas the lower figures exclude issues that are conceded by the Appeals Division or lost in litigation. The statement in the text is premised on the "higher"/"primary" estimates of the gross tax pp, which are invariably cited when tax gap estimates are given. (5) We also note that, for large corporations, many adjustments are of a timing nature -- i.e., a deduction that is taken on one year's return is found on examination to belong on an earlier or later year's return. Although timing adjustments many increase the 'tax gap" in a given year, it will inevitably produce an offsetting adjustment (plus interest) in an earlier or later year. There is no evidence that the IRS adjusts its tax pp estimates to take into account the correlative effects produced by timing adjustments. (6) Internal Revenue Service, Income Tax Compliance Research: Net Tax Gap and Remittance Gap Estimates (Supplement to Publication 7285), Publication 1415 (4-90), at iv (April 1990) (hereinafter cited as "April 1990 IRS Study"). (7) TEI agrees that the low sustention rate is a matter of concern. We suggest, however, that the proper focus is not on the corporate taxpayers that are forced to contest unfounded adjustments but rather on the Examination Division of the IRS which proposes such adjustments in the first place. One reason for the low sustention rate may relate to the issues selected for appeal by the taxpayer; CEP taxpayers do not normally appeal issues that they do not expect to win. (8) Although propounding the unprovable assertion that "[ilt is probable that significant additional amounts of tax deficiency could be identified cost-effectively by examining the complex returns in greater depth . . .," the April 1990 IRS Study ultimately disclaims responsibility for any inference created by noting "since we lack a reasonable way to estimate bow much more tax deficiency could be found among large corporations, our larger corporation gross tax pp estimates only include the amount detected in our operational programs." April 1990 IRS Study at 6 & n.10. (9) TEI acknowledges that there may be several reasons for the Appeals Division to concede an issue. We suggest, however, that taxpayers too can be motivated by varying factors. Thus, a taxpayer may decline to appeal an issue (or may concede the issue in appeals) not because its merits are weak but because its magnitude is minor compared with the cost of pursuing vindication. In other words, the compromises that are made as part of the audit, appeals, and litigating process are not always to the taxpayer's benefit. More important, both the IRS and taxpayers make concessions at Appeals based on each party's estimate of the hazard of litigation. From a practical standpoint, that process is the administrative equivalent of a judicial determination. (10) We acknowledge that the GAO concludes that "[iln the final analysis, the large corporation tax pp is an estimate, not a precise measure." April 1992 GAO Report at 3-4. We suggest, however, that the invocation of the $15.8 billion tax gap figure after conceding that the IRS's Appeals Division concedes 75 percent of that amount represents the height of disingenuousness. (11) the extent either the government or the taxpayer appeals a trial court determination, the analysis would have to be extended through the appellate process.

Comments on Size of the Corporate Tax Gap

May 1, 1992

On May 1, 1992, Tax Executives Institute submitted the following comments to the Internal Revenue Service concerning certain comments on the size of the so-called tax gap that were made during a meeting of the Commissioner s Advisory Group. The comments, which took the form of a letter from Timothy J. McCormally, the Institute's Tax Counsel, to Ellen Murphy, Assistant to the Commissioner Public Affairs), were prepared under the aegis of the IRS Administrative Affairs Committee, whose chair is Linda B. Burke of the Aluminum Company of America. A more comprehensive submission on the measurement of the corporate tax gap is reprinted elsewhere in this issue.

I have to admit that I was more than a little taken aback by your statement at last week's Commissioner's Advisory Group meeting (as quoted in the Daily Tax Report) concerning the size of the so-called tax gap. BNA quoted you as saying the tax pp was between $90 billion and $120 billion -- an estimate that I believe is highly suspect and, indeed, misleading especially as to large corporate taxpayers).

As you know, the tax pp has been defined as the difference between the tax reported on the taxpayer's original return and the "amount of tax due." As computed by the Internal Revenue Service and the General Accounting Office, the "amount of tax due," however, clearly encompasses items that do not result from noncompliance, including (1) adjustments voluntarily made by taxpayers on qualified amended returns (i.e., on an actual amended return or at the commencement of an audit); (2) proposed IRS adjustments that are resolved in the taxpayer's favor during administrative proceedings; and (3) proposed adjustments that are reversed by the courts. Concededly, the IRS is making strides in improving its sustention rate, but my understanding remains that far more than 50 percent of all proposed adjustments "wash out." To include those adjustments in the corporate "tax gap" is just plain wrong. Although I have less familiarity with the components of the overall tax gap figures (which I know are based on TCMP audits of individuals and smaller companies as well as on somewhat speculative estimates of the tax owing on illegal income), I suspect they are considerably bloated.

What surprised me about your statement at the CAG meeting is that it seems at odds with the IRS's own congressional testimony. The Oversight Subcommittee frequently proclaim that "thar's gold in them there hills!" I thought, however, that the IRS had itself acknowledged the potentially counterproductive nature of the tax pp figures. Hence, it has been only a little more than a year since then-Commissioner Goldberg testified before a Senate Governmental Affairs Subcommittee about the significant limitations of IRS's (and GAO's) tax gap figures. BNA quoted the Commissioner as urging Congress to "be as circumspect as possible about the data on the tax gap."