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.
Tax Gap Map for TY 2006 ($B)
Total
Tax
Liability
$2,660
Tax Paid Voluntarily & Timely: $2,210
Gross Tax Gap: $450
Enforced & Other
Late Payments of Tax
(Voluntary Compliance Rate = 83.1%)
$65
$28
#
Employment
Tax
#
Estate
Tax
$3
Excise
Tax
#
(Tax Never Collected)
(Net Compliance Rate = 85.5%)
Underreporting
$376
Nonfiling
Individual
Income Tax
$25
Corporation
Income Tax
Net Tax Gap: $385
Individual
Income Tax
$235
Corporation
Income Tax
$67
Employment
Tax
$72
Non-Business
Income
Income
$30.6
$68
Small
Corporations
(assets < $10m)
$19
FICA
Tax on Wages
Business
Income
Income
$65.3
$122
Adjustments,
Deductions,
Exemptions
$17
Credits
$28
Large
Corporations
(assets > $10m)
$48
$14
Underpayment
$46
Estate
Tax
$2
#
Categories of Estimates
Self-Employment
Tax
Actual Amounts
$57
Unemployment
Tax
$1
Excise
Tax
Updated Estimates
#
No Estimates Available
Individual
Income Tax
$36
Corporation
Income Tax
$4
Employment
Tax
$4
Estate
Tax
$2
Excise
Tax
$0.1
Source: http://www.irs.gov/pub/irs-soi/06rastg12map.pdf
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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)
A  N *D
 N: True Noncompliance equation
 D: Detection equation
 Observed
audit adjustment depends on both
true noncompliance and examiner detection
capability
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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
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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
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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
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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
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