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

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, 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:

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

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

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

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

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

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

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

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)

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

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

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

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

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

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