Tax Year 2006 Individual Income Tax

Underreporting GapDrew Johns – IRS Office of Research

New Research on Tax Administration: An IRS-TPC Conference

June 21, 2012

The content of this presentation and views expressed here ultimately reflect the opinions of the presenter and do not necessarily represent the position of the Internal Revenue Service.

RAS:R – June 21, 20123

Tax Gap Map for TY 2006 ($B)

Nonfiling$28

IndividualIncome Tax

$25CorporationIncome Tax

#Employment

Tax#

ExciseTax#

EstateTax

$3

Tax Paid Voluntarily & Timely: $2,210Total Tax

Liability

$2,660Enforced & Other

Late Payments of Tax

$65

Net Tax Gap: $385(Tax Never Collected)

(Net Compliance Rate = 85.5%)

Gross Tax Gap: $450

(Voluntary Compliance Rate = 83.1%)

Actual Amounts

Updated Estimates

No Estimates Available

Categories of Estimates

#

Underpayment$46

IndividualIncome Tax

$36CorporationIncome Tax

$4

EmploymentTax$4

EstateTax$2

ExciseTax$0.1

FICATax on Wages

$14

UnemploymentTax$1

IndividualIncome Tax

$235

Non-BusinessIncome$30.6

BusinessIncome$65.3

CorporationIncome Tax

$67

EstateTax$2

ExciseTax#

BusinessIncome

$122

Large Corporations

(assets > $10m)$48

Self-EmploymentTax$57

Non-BusinessIncome

$68

Small Corporations

(assets < $10m)$19

Credits

$28

Adjustments,Deductions,Exemptions

$17

Underreporting$376

EmploymentTax$72

Source: http://www.irs.gov/pub/irs-soi/06rastg12map.pdf

RAS:R – June 21, 20124

Key Estimation Issues

Ideal audit sample has two qualities: Representative of the entire population Comprehensive- detects all misreporting

National Research Program (NRP) audits Randomly selected, therefore representative Not comprehensive in detecting all income

1976 TCMP: for every $1.00 of IRP income detected without use of IRP documents, $2.28 went undetected

Supplemented w/estimates of undetected income

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NRP Form 1040 Studies

TY01: Random sample ~45,000 returns TY06: Random sample ~13,000 returns

First of smaller, more timely annual studies Independent samples that can be combined

Classification: Type of exam

No contact: accepted as filed or w/ minor adjustment Correspondence exam (a few simple issues) Face-to-face exam: RA or TCO (about 90% of returns)

Issues/Line Items

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Accounting for Undetected Income Detection Controlled Estimation (DCE)

Original methodology by Jonathan Feinstein (1990, 1991)

Extended by Brian Erard & Feinstein (2005, 2006, 2007 & forthcoming)

DCE Rationale Examiners have detection strengths and weaknesses Statistical procedure controls for who conducted the

exam Scales up observed audit result as if line item was

examined by the “best” examiner

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Basic DCE Methodology

Audit Adjustment (actually observed)

N: True Noncompliance equation D: Detection equation

Observed audit adjustment depends on both true noncompliance and examiner detection capability

DNA *

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Estimated at the Line Item Level Routinely classified line items

Items not typically covered by IRP documents Schedules C, D, E, and F, Form 4797 income, Form 1040

“other income” line Non-routinely classified line items

Items typically covered by IRP documents Wages & salaries, interest, dividends, state and local tax

refunds, pensions and IRA’s, gross Social Security income, and unemployment income

Misreporting of adjustments, exemptions, deductions, and credits assumed fully detected

RAS:R – June 21, 20129

DCE as Estimated

Estimated only for face-to-face audits Need sufficient number (~15) of returns on which a

given examiner audited a given line item Joint estimation with common detection equation

Routinely classified items (except C/F) estimated jointly Non-routinely classified items estimated jointly

Return level estimates: The probability of undetected income for a given line item The amount of undetected income conditional on the

presence of undetected income

RAS:R – June 21, 201210

Imputing DCE to TY06 NRP

TY06 sample too small to estimate DCE Not a sufficient number of returns audited by the

same examiner Solution:

Estimate using larger TY01 NRP sample Impute undetected income to the TY06 NRP data

Stage 1: TY01 DCE simulations Stage 2: TY06 DCE imputations

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Stage 1: TY01 DCE Simulations Allocate undetected income to reflect a

realistic distribution across returns Want to allocate undetected income to a small

number of returns using the estimated probability Instead of allocating small amount to many returns

For each income item and each return Draw a random number between 0 and 1 If random number < estimated probability then allocate

undetected income

Repeat 10 times (10 simulations)

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Stage 2: Deciles For each income item, calculate reported

income deciles for TY01 & TY06 If income item reported, calculate income item

deciles Else, calculate reported AGI deciles

For each TY01 simulation, calculate by decile: Mean undetected income of returns with

undetected income Mean probability of the presence of undetected

income

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Stage 2: Imputations

For each line item on face-to-face audits Draw a random number between 0 and 1 If random number < estimated probability for the

decile then allocate the mean undetected income Adjust the mean undetected income by the ratio of

the TY06 to TY01 mean detected incomes Repeat for each of the 10 TY01 simulations to

create 10 TY06 data sets with imputed income

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Supplemental Information Tip Income

Very hard to detect Excluded from DCE estimation

S corporation and Partnership Income Underreporting by both shareholder and entity Examiners rarely audit the entity Undetected income further adjusted based on the

results of the TY2003/2004 NRP S corporation reporting compliance study

RAS:R – June 21, 201215

Tax Calculator

Income and deductions: Step 1: Add unreported income (detected + undetected) for

first line item (wages and salaries) Step 2: Calculate tentative tax and subtract reported

tentative tax to estimate line item tax gap Step 4: Drop unreported income Repeat Steps 1 to 4 for remaining line items

Credits: Step 1: Add all unreported income and deductions Step 2: Calculate credits and subtract reported credits

Repeat for all 10 simulations and average

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Income “Visibility” Chart

Source: http://www.irs.gov/pub/irs-soi/06rastg12overvw.pdf

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Summary

Methodological improvements Return level estimates of undetected income Line-item level DCE estimation Tax calculator replaced average marginal tax

curves TY06 NRP data used for the first time

Future research DCE estimation using multiple years of the new

annual NRP samples