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Tax Year 2006 Individual Income Tax Underreporting Gap Drew Johns – IRS Office of Research New Research on Tax Administration: An IRS-TPC Conference June.

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Presentation on theme: "Tax Year 2006 Individual Income Tax Underreporting Gap Drew Johns – IRS Office of Research New Research on Tax Administration: An IRS-TPC Conference June."— Presentation transcript:

1 Tax Year 2006 Individual Income Tax Underreporting Gap Drew Johns – IRS Office of Research New Research on Tax Administration: An IRS-TPC Conference June 21, 2012

2 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.

3 RAS:R – June 21, Tax Gap Map for TY 2006 ($B) Nonfiling $28 Individual Income Tax $25 Corporation Income Tax # Employment Tax # Excise Tax # Estate Tax $3 Tax Paid Voluntarily & Timely: $2,210 Total Tax Liability $2,660 Enforced & 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 Individual Income Tax $36 Corporation Income Tax $4 Employment Tax $4 Estate Tax $2 Excise Tax $0.1 FICA Tax on Wages $14 Unemployment Tax $1 Individual Income Tax $235 Non-Business Income $30.6 Business Income $65.3 Corporation Income Tax $67 Estate Tax $2 Excise Tax # Business Income $122 Large Corporations (assets > $10m) $48 Self-Employment Tax $57 Non-Business Income $68 Small Corporations (assets < $10m) $19 Credits $28 Adjustments, Deductions, Exemptions $17 Underreporting $376 Employment Tax $72 Source:

4 RAS:R – June 21, 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

5 RAS:R – June 21, 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

6 RAS:R – June 21, 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

7 RAS:R – June 21, 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

8 RAS:R – June 21, 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

9 RAS:R – June 21, 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

10 RAS:R – June 21, 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

11 RAS:R – June 21, 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)

12 RAS:R – June 21, 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

13 RAS:R – June 21, 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

14 RAS:R – June 21, 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

15 RAS:R – June 21, 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

16 RAS:R – June 21, Income “Visibility” Chart Source:

17 RAS:R – June 21, 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


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