Federal Taxes: Information on Payroll Taxes and Earned Income Tax Credit
Noncompliance (Testimony, 03/07/2001, GAO/GAO-01-487T).
This testimony covers two areas of taxation (1) how payroll taxes fund
Social Security and the Medicare Hospital Insurance (HI) programs and
(2) noncompliance associated with the Earned Income Tax Credit (EITC)
and efforts to deal with that noncompliance. Payroll taxes provide
funding for the Social Security Program and for the Medicare HI program.
These taxes are paid in equal portions by employees and their employers.
Employees and their families become eligible to collect these benefits
once workers have been employed for a sufficient amount of time. While
Social Security benefits are calculated using a formula that considers
lifetime earnings, HI benefits are based on the health of the covered
individual and are paid directly to the health care provider.
Demographic trends indicate that these programs will impose an
increasing burden on the federal budget and the overall economy in the
future. Regarding EITC, significant compliance problems can expose the
Internal Revenue Service (IRS) to billions of dollars in overpayments.
EITC noncompliance is identified as taxpayer errors and intent to
defraud. Several steps have been taken by IRS and Congress to reduce
noncompliance, including the passage of laws that enabled the IRS to
disallow EITC claims with invalid social security numbers and the
implementation of a 5-year EITC compliance initiative.
--------------------------- Indexing Terms -----------------------------
REPORTNUM: GAO-01-487T
TITLE: Federal Taxes: Information on Payroll Taxes and Earned
Income Tax Credit Noncompliance
DATE: 03/07/2001
SUBJECT: Noncompliance
Income taxes
Tax credit
Tax administration
Tax refunds
Tax violations
Disadvantaged persons
Social security benefits
Health insurance
Internal controls
IDENTIFIER: Social Security Program
Medicare Hospital Insurance Program
Old-Age and Survivors Insurance Program
Social Security Disability Insurance Program
Social Security Trust Fund
Medicare Trust Fund
Earned Income Tax Credit
******************************************************************
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GAO-01-487T
For Release on Delivery Expected at 10: 00 a. m. EST on Wednesday March 7,
2001
GAO- 01- 487T
FEDERAL TAXES Information on Payroll Taxes and Earned Income Tax Credit
Noncompliance
Statement of Michael Brostek Director, Tax Issues Testimony
Before the Committee on Finance United States Senate
United States General Accounting Office
GAO
Page 1 GAO- 01- 487T
Chairman Grassley, Ranking Member Baucus, and Members of the Committee:
I am pleased to join you today as you address a number of tax issues. You
asked that I cover two areas of taxation: (1) how payroll taxes fund Social
Security and the Medicare Hospital Insurance programs and (2) noncompliance
associated with the Earned Income Tax Credit (EITC) and efforts to deal with
that noncompliance. My testimony is based primarily on work we have done in
the past. I will summarize my main points and then cover the two tax issues
in greater detail.
Payroll taxes are so named because they represent taxes imposed on wages.
They provide the funding for the Social Security program- including both
Old- Age and Survivors Insurance (OASI) and Disability Insurance (DI)- and
for the Hospital Insurance (HI) portion of Medicare- referred to as part A.
These taxes are paid in equal portions by employees and their employers- and
have on occasion been called “contributions” since they are to
be used to fund these social insurance programs. Once workers have paid
taxes and worked sufficient time in covered employment, they and their
families are considered to have earned the right to future benefits. Social
Security benefit payments are calculated based on a formula that replaces a
larger portion of wages for low wage earners than for higher wage earners.
Hospital insurance benefits do not vary on the basis of individuals' wage
histories; any benefits paid depend on the health situation of covered
workers. As we have reported in the past, demographic trends indicate that
these programs will impose an increasing burden on the federal budget and
the overall economy in the future.
The EITC is a refundable tax credit established by Congress in 1975. The
EITC offsets much of the impact of Social Security taxes paid by low- income
workers and is intended to encourage low- income persons to seek work rather
than welfare. There are significant compliance problems associated with the
EITC that have led to our listing the Internal Revenue Service's (IRS)
administration of the credit among the high risk areas for the federal
government. Congress and IRS have taken various steps to reduce EITC
noncompliance, and, as a result, IRS has denied about $1.5 billion in
erroneous EITC claims over the past 2 years. However, information Statement
Federal Taxes: Information on Payroll Taxes and Earned Income Tax Credit
Noncompliance
Statement Federal Taxes: Information on Payroll Taxes and Earned Income Tax
Credit Noncompliance
Page 2 GAO- 01- 487T
is not yet available with which to determine whether those steps have been
effective in reducing the overall rate of noncompliance associated with the
credit. IRS has also not reported any data on the extent to which EITC
overclaims were due to taxpayer errors, which may flow at least in part from
the complex provisions of the credit, or from fraud.
Payroll taxes are the main source of financing for Social Security- which
includes OASI and DI- and for the HI program in Medicare- also referred to
as Medicare part A. The payroll taxes for these programs are levied on wages
and on the net self- employment income of workers under the Federal
Insurance Contributions Act (FICA) and the Self- Employment Contributions
Act (SECA). 1
Although Social Security is often discussed as a retirement program, Social
Security (OASDI) is a social insurance program that provides cash payments
to persons or families to replace income lost through retirement, death, or
disability. Workers make “contributions” in the form of payroll
taxes that are then credited by the Treasury to the Social Security trust
funds. Once individuals have worked a sufficient time to qualify, they
become eligible for benefits under the program.
Medicare HI is a nationwide health insurance program for the aged and
certain disabled persons. It covers inpatient hospital stays, skilled
nursing care, hospice, and certain home health services. Most Americans age
65 or older are entitled to Medicare on the basis of paying HI taxes on
earnings during their working careers. Medicare also has a part B-
Supplementary Medical Insurance- that covers physician and outpatient
hospital services, diagnostic tests, and certain other medical services and
supplies. Medicare part B is not funded by payroll taxes, but rather by
premiums of
1 Over 95 percent of all jobs were subject to OASDI and HI payroll taxes in
1999. Several categories of workers are not subject to these taxes. For
example, certain state and local government workers who participate in
alternative retirement systems and federal government workers hired before
1984 may not be subject to OASDI taxes. Payroll Tax Financing
of Social Security and Medicare Benefits
Statement Federal Taxes: Information on Payroll Taxes and Earned Income Tax
Credit Noncompliance
Page 3 GAO- 01- 487T
enrollees (about 25 percent of total annual funding) and appropriations of
general funds (about 75 percent of total funding).
While both the Social Security OASDI and Medicare HI are overwhelmingly
financed by payroll taxes, those trust funds receive some general revenues
in the form of income taxes paid on a portion of the Social Security
benefits of upper- income retirees. 2
Collection of the payroll taxes that fund OASDI and Medicare HI is
administered by IRS. However, because these payroll taxes are earmarked to
fund specific retirement, disability, and medical benefits for which workers
become eligible through their qualified employment, they are fundamentally
different from income taxes, which are imposed on certain segments of the
population and which are not earmarked for any specific purpose.
Under FICA, employees and their employers each pay one- half of the OASDI
and HI tax, which in aggregate represents 15.3 percent of covered wages. 3
The employer's portion of the payroll tax is a deductible expense for income
tax purposes for employers, but the employee portion is not tax deductible
by individuals. 4 The OASDI tax is imposed on workers' earnings up to a
maximum of $80,400 in 2001. This “taxable wage base” is adjusted
annually based on the growth of average wages in the economy. In 2001, the
combined OASDI tax (employer and employee, OASI and DI) is 12.4 percent-
broken down into 10.6 percent for OASI and 1.8 percent for DI. The
2 As is discussed later, the trust funds receive interest on their balances.
The Medicare HI trust fund also receives some income from other sources,
such as premiums of voluntary enrollees. 3 Most economists agree that
employees bear most, if not all, of the burden of the employer's share in
the form of lower wages or lower fringe benefits. 4 Under SECA, the same 15.
3 percent payroll tax rate is levied on self- employed persons' earnings,
with the same split between OASDI and HI as occurs under FICA. For many
years, the self- employed paid a lower rate than the combined employee and
employer rate under FICA. Since 1990, the SECA tax structure has been
designed to achieve parity between employees and the self- employed. The
base of the SECA tax is adjusted downward to reflect the fact that employees
do not pay the employer's portion of the tax. The adjusted base is
equivalent to net self- employment earnings (up to the taxable wage base)
less 7.65 percent. In addition, self- employed workers are allowed to deduct
half of their SECA tax liability for income tax purposes to reflect the fact
that employees do not pay income tax on the employer's portion of the FICA
tax. Who Pays Payroll Taxes
and How?
Statement Federal Taxes: Information on Payroll Taxes and Earned Income Tax
Credit Noncompliance
Page 4 GAO- 01- 487T
HI tax is 2.9 percent, divided evenly between the employee and the employer.
Until 1994, the wage base for HI was identical to that for OASDI. Since
1994, however, the HI tax has been imposed on all of a worker's wages and
self- employment earnings. Figure 1 illustrates the flow of payroll taxes
into the Social Security and Medicare trust funds.
Figure 1: Distribution of Payroll Tax Funding for Social Security and
Medicare
Source: GAO analysis.
Although a number of specific rules apply in determining eligibility for
OASI benefits, in general, workers who have earned a sufficient number of
credits for time worked establish eligibility for themselves, their
dependents, and their survivors. Reduced retirement benefits are available
at age 62, and full benefits have been available at age 65. However, the
full retirement benefit age will gradually move to age 67, beginning with
persons who reached age 62 in 2000. Numerous rules are based on individuals'
work histories and wages earned- but not on FICA taxes actually paid- apply
in determining the specific amount of retirement benefits that will be paid
to them or their survivors. Overall, while FICA taxes apply at a fixed rate,
up to the maximum wage level, OASI provides greater proportional benefits to
low wage earners than to higher wage earners. Table 1 illustrates that
retirement payments to low How Are Benefits
Determined?
Employee Share of Payroll Tax (7.65 percent)
Social Security 6.2 percent of annual wage base
Hospital Insurance 1.45 percent of
total wages Social Security Trust Funds Old- Age and Survivors
Insurance Disability Insurance
Employer Share of Payroll Tax (7.65 percent)
Social Security 6.2 percent of annual wage base Hospital Insurance
1.45 percent of total wages
2.9 percent 12.4 percent
General Fund Treasury
Hospital Insurance Trust Fund
Statement Federal Taxes: Information on Payroll Taxes and Earned Income Tax
Credit Noncompliance
Page 5 GAO- 01- 487T
income wage earners replace a larger portion of their earnings than do the
payments to higher wage earners.
Table 1: Social Security Replacement Rates for Entitlement Year 2000
Replacement Rates a Low earnings b Average earnings c Maximum earnings d
52.8 39.2 23.7
a Total monthly benefits payable for year of entitlement at full retirement
income (at age 65) expressed as a percentage of earnings in the year prior
to entitlement for workers with steady career incomes.
b Earnings equal to 45 percent of the Social Security average- wage index. c
Earnings equal to the Social Security average- wage index. d Earnings equal
to the maximum wage taxable for Social Security purposes.
Source: Committee on Ways and Means, U. S. House of Representatives,
“2000 Green Book: Background Material and Data on Programs within the
Jurisdiction of the Committee on Ways and Means,” Oct. 6, 2000, p. 57.
As with retirement benefits, a number of rules apply in determining who is
eligible for disability benefits. Generally, a disability is defined as the
inability to engage in “substantial gainful activity” by reason
of physical or mental impairment. Workers who have become fully qualified
for OASI benefits and who become disabled are also generally qualified for
disability benefits. Workers who become disabled before becoming fully
qualified for OASI benefits may nevertheless qualify for disability benefits
under certain circumstances. Payments to disabled individuals, like those to
retirees, take into account personal work histories and wages earned. As
with retirement benefits, lower wage earners have a larger portion of their
wages replaced than do higher wage earners.
Part A Hospital Insurance (HI) benefits are automatically available to
almost all persons age 65 or older through eligibility established by time
spent in covered employment during their working careers. Those under 65 who
are receiving Social Security disability payments also may be covered after
a 24- month waiting period. Most persons needing a kidney transplant or
renal dialysis may also be covered, regardless of age. Medicare payments go
to those providing the covered medical service rather than to the covered
Statement Federal Taxes: Information on Payroll Taxes and Earned Income Tax
Credit Noncompliance
Page 6 GAO- 01- 487T
individual. For certain types of medical services, patients may be required
to pay deductibles or additional charges.
Under current law, employers withhold OASDI and HI payroll taxes from
employees' pay along with federal and state income taxes, if any. Both the
employees' and the employers' shares of FICA taxes are deposited- along with
other federal taxes- to a designated Federal Reserve bank or other
authorized depository. All federal taxes are then deposited in the Treasury.
Treasury credits the Social Security and HI trust funds for the applicable
amounts. Neither eligibility for benefits nor the amount of benefits is
based on the amount of taxes paid by an individual, and neither IRS nor the
Social Security Administration (SSA) directly credits to the individual the
annual and cumulative FICA taxes paid by or on behalf of each individual.
Cumulatively, the OASDI and HI taxes collected represent dedicated receipts.
They are accounted for in earmarked funds: the Social Security OASI trust
fund, Social Security DI trust fund, and Medicare HI trust fund. These trust
funds hold funds in the form of special nonmarketable U. S. Treasury
securities that are backed by the full faith and credit of the U. S.
government. They are an asset to the trust fund and a legal claim on- or an
obligation of- the general fund of the Treasury. When benefits are to be
paid, securities sufficient to fund those benefits are redeemed, and
benefits are paid by the Treasury.
Virtually since their creation, Social Security and Medicare HI have been
funded on a “pay- as- you- go” basis in the sense that taxes
collected from current workers are used to pay benefits to current
beneficiaries. Because it is important that the trust funds always have
sufficient balances to cover required payments, some reserves are necessary.
These reserves- that is, the excess of current receipts over current benefit
payments- have been lent to the Treasury. The proceeds to the Treasury are
used either to meet other general government expenditures or to pay down
debt held by the public. In a time of budget deficits, borrowing from these
trust funds serves to reduce the need for the government to borrow from the
public. In a time of budget surplus, borrowing from the trust funds can
generate cash to pay down debt held by the public. The How Are Payroll Taxes
Collected, Transmitted to the Government, Accounted for, and Used?
Statement Federal Taxes: Information on Payroll Taxes and Earned Income Tax
Credit Noncompliance
Page 7 GAO- 01- 487T
trust funds earn interest on the funds lent to the Treasury. This interest
is paid in the form of additional Treasury securities. Until 1983, program
revenues and expenses were closely matched, and the reserves were modest.
After the 1983 Social Security Commission recommendations were enacted,
balances grew. As a result, interest credits have become a more important
source of revenue for the OASDI trust funds.
As we have reported, 5 both Social Security and Medicare face serious
financing challenges. Today, taxes paid into the trust funds exceed benefits
paid out. However, as more and more of the “baby
boom” generation enters retirement, this will change. The combination
of a larger elderly population, increased longevity, and rising health care
costs will drive significant increases in health and retirement spending
when the “baby boom” generation begins to retire.
Over the long term, the trust funds are not solvent. SSA projections show
that, absent a change in the structure of the program, the OASDI trust funds
will only be able to pay full benefits through 2037. 6 However, as we have
reported, 7 because a trust fund's accumulated balance does not necessarily
reflect the full future cost of existing government commitments, it is not
an adequate measure of the fund's solvency or the program's sustainability.
The cash flows for these programs will create pressure on the federal budget
long before these so- called trust fund exhaustion dates.
Beginning in 2015, OASDI funds will begin to experience a negative cash flow
that will escalate as time passes. HI cash deficits are projected to begin
in 2009. When the cash deficits begin, the funds must redeem their
securities. To obtain the cash to redeem those
5 Long- Term Budget Issues: Moving From Balancing the Budget to Balancing
Fiscal Risk (GAO- 01385T, Feb. 6, 2001). 6 OASI is solvent through 2039,
while DI is solvent only until 2023. After cash flows become insufficient to
cover expenses, incoming payroll taxes will cover a decreasing portion of
expenditures as more and more retirees enter the system.
7 Federal Trust and Other Earmarked Funds: Answers to Frequently Asked
Questions (GAO- 01- 199SP January 2001). Longer Term Outlook
Statement Federal Taxes: Information on Payroll Taxes and Earned Income Tax
Credit Noncompliance
Page 8 GAO- 01- 487T
securities and pay benefits, the government would have to raise taxes, cut
spending for other programs, increase borrowing from the public, or retire
less debt (if there is a surplus)- or some combination of these. As the
Comptroller General testified last month, our long- term simulations show
that, absent a change in the design of Social Security and Medicare,
ultimately the government would do little more than mail checks to the
elderly and their healthcare providers. 8
The EITC is a refundable tax credit established by Congress in 1975. The
credit offsets the impact of Social Security taxes paid by lowincome workers
and encourages low- income persons to seek work rather than welfare. The
EITC is available to taxpayers with and without children and depends on the
nature and amount of qualifying income and on the number of children who
meet age, relationship, and residency tests. The amount of EITC allowed to
an individual is first applied as a payment against any income tax liability
of that individual. Any remaining amount is refunded to the individual.
Workers can receive the credit as a lump sum payment after filing an income
tax return or in advance as part of their paycheck.
Table 2 shows, for the past 3 years, the number of EITC recipients, the
relatively small number of those who reported receiving an advance EITC, and
the total EITC amount.
Table 2: Number and Amount of EITC Claims
EITC Calendar year 1998 Calendar year 1999 Calendar year 2000
Total number of recipients 19.7 million 19.4 million 19.2 million Number who
reported receiving an advance EITC
216,238 185,027 169,002 EITC amount $29.7 billion $30.6 billion $31.2
billion
Source: IRS.
8 GAO- 01- 385T. The EITC and
Noncompliance
Statement Federal Taxes: Information on Payroll Taxes and Earned Income Tax
Credit Noncompliance
Page 9 GAO- 01- 487T
In December 1998, the Council of Economic Advisers concluded that “the
EITC is one of our most successful programs for fighting poverty and
encouraging work.” 9 Among other things, the report said that the EITC
had lifted 4.3 million Americans out of poverty in 1997, had reduced the
number of children living in poverty that year by 2.2 million, and had
increased the labor force participation of single mothers.
For many EITC recipients, the credit is more than enough to fully offset
Social Security taxes. Most EITC recipients earn credits that exceed their
income tax liabilities. The Joint Committee on Taxation has estimated that
87 percent of the credit earned in 2000 will be refunded as direct payments
to taxpayers. For many of the recipients these refunds will be more than
enough to offset their payroll tax burdens. For example, a head- of-
household filer who has two children and earns $15,000 in wages would have
earned an EITC of $3,396 in 2000. This amount would have exceeded her
precredit income tax liability of $24 plus her $1,148 portion of payroll tax
liability. It would also have been more than enough to offset her employer's
$1,148 share of the payroll tax, which most economists believe to be borne
by the employee. However, many low- income individuals and couples,
especially those without children, do not earn the EITC. Looking at all low-
income taxpayers together, the Congressional Budget Office estimated that in
1999 households with cash incomes between zero and $10,000, on average,
received EITC refunds equal to 4.1 percent of their incomes. This average
refunded credit was enough to offset the average payroll tax liability of
these households, but it would not have completely offset the burden of the
employer's portion of the payroll tax. The average refunded credit for
households with cash incomes between $10,000 and $20,000 typically would not
have been sufficient to offset any of the employer's share of the payroll
tax and only a portion of the employee's share for those households.
9 Good News for Low Income Families: Expansions in the Earned Income Tax
Credit and the Minimum Wage, The Council of Economic Advisers, December
1998.
Statement Federal Taxes: Information on Payroll Taxes and Earned Income Tax
Credit Noncompliance
Page 10 GAO- 01- 487T
Since 1995, we have identified EITC noncompliance as one of the high- risk
areas within IRS because such noncompliance exposes the federal government
to billions of dollars of risk through overpayments of the EITC. 10 Although
IRS has estimated that billions of dollars have been overpaid to EITC
recipients, it has not reported on the portions of noncompliance that may be
due to unintentional errors, perhaps attributable at least in part to the
complexity of the EITC, or to fraudulent efforts to obtain the credit.
In April 1997 and September 2000, respectively, IRS reported on the results
of two EITC compliance studies- the first involving tax year 1994 EITC
claims accepted by IRS between January 15 and April 21, 1995, 11 and the
second involving tax year 1997 claims processed by IRS between January 20
and May 29, 1998. 12 Although changes in IRS' study methodology as well as
legislative changes between 1994 and 1997 made the results of the two
studies noncomparable, both studies documented a significant amount of EITC
noncompliance. 13
Of $17.2 billion in EITC claimed during the first study period, IRS
estimated that $4.4 billion (about 26 percent) was overclaimed.
Of $30.3 billion in EITC claimed during the second study period, IRS
estimated that $9.3 billion (about 31 percent) was overclaimed. 14
10 We had identified IRS tax filing fraud as the high risk area until this
year, when we renamed the highrisk area “noncompliance with the
EITC” to better reflect the focus of our current concern- billions of
dollars for EITC claims that IRS paid but should not have.
11 Study of EITC Filers for Tax Year 1994, IRS, April 1997. 12 Compliance
Estimates for Earned Income Tax Credit Claimed on 1997 Returns, IRS,
September 2000. 13 Both studies were designed to estimate the amount of EITC
claimed erroneously. Neither study was designed to detect or quantify EITC
claims that taxpayers could have made but did not. 14 In both studies, IRS
also estimated the amount of overclaims that it would have caught through
its enforcement programs. After netting out those estimates, the overclaim
rates for 1995 and 1998 were reduced to about 24 percent and 26 percent,
respectively. EITC Noncompliance
Statement Federal Taxes: Information on Payroll Taxes and Earned Income Tax
Credit Noncompliance
Page 11 GAO- 01- 487T
The largest source of taxpayer error identified by IRS in both studies
related to EITC requirements that are difficult for IRS to verify-
principally those related to eligibility of qualifying children. Currently,
to be a qualifying child, a child must (1) be the taxpayer's son, daughter,
adopted child, grandchild, stepchild, or eligible foster child (i. e., meet
a relationship test); (2) be under age 19, under age 24 and a full- time
student, or any age and permanently and totally disabled (i. e., meet an age
test); and (3) have lived with the taxpayer in the United States for more
than half the year or for the entire year if an eligible foster child (i.
e., meet a residency test). Failure to meet the residency test was the most
common qualifying child error identified in both studies. 15
IRS' studies identified the following as other sources of EITC errors.
Complicated living arrangements-- when a child meets the rules to be a
qualifying child of more than one person, the person with the higher
modified adjusted gross income (AGI) is the only one who can claim the EITC
using that child. 16 The person with the lower modified AGI cannot use that
child to claim the EITC even if the other person does not claim the EITC.
This rule does not apply if the other person is the taxpayer's spouse and
they file a joint return.
Misreporting of filing status- these errors involved married taxpayers
filing as single or head of household when they should have filed as married
filing separately. Persons who file as married filing separately are not
eligible to claim the EITC.
Income misreporting- these errors included misreporting of earned income and
underreporting of investment income.
15 We reported on the advance payment option in 1992; Earned Income Tax
Credit: Advance Payment Option Is Not Widely Known or Understood by the
Public (GAO/ GGD- 92- 26, Feb. 19, 1992). Although information in that
report is dated, it did indicate that there were potential compliance
problems associated with the advance payment option. Many individuals who
received the advance payment did not report that receipt on their tax
return, thus setting up the possibility that they could receive the credit
again as a lump sum payment.
16 To compute their modified AGI, taxpayers have to add certain amounts,
such as tax exempt interest and some other gains and losses, to their AGI.
According to IRS, for most people the modified AGI is the same as the AGI.
Statement Federal Taxes: Information on Payroll Taxes and Earned Income Tax
Credit Noncompliance
Page 12 GAO- 01- 487T
EITC “noncompliance” as identified in IRS' studies and as
referred to in this testimony includes errors caused by mistakes- possibly
due to the complexity of the EITC- or an intent to defraud. Both of these
potential sources of error have been of concern to IRS and others. Some
analysts consider the EITC to be a complex tax provision that challenges
those applying for it to properly understand and follow the qualifying
rules. On the other hand, the credit's possible susceptibility to fraud has
also been a concern to Congress and IRS for many years. Although being able
to differentiate between these different causes may be important in
identifying appropriate corrective measures, IRS' primary goal in conducting
its compliance studies was to identify the level of overall EITC
noncompliance. Determining the causes of overpayments is more challenging
and costly, especially determining whether an EITC claim is fraudulent,
which requires knowing the difficult- toprove intent behind the taxpayer's
actions.
IRS' reports on its two compliance studies did not discuss the extent to
which EITC overclaims were due to mistakes versus fraud. However, as we
discussed in a July 1998 report on IRS' first study, IRS examiners and case
reviewers did make a determination of intent for almost every case involving
an overclaim. 17 Based on those determinations, about one- half of the
returns with an EITC overclaim and two- thirds of the total amount
overclaimed were considered to be the result of intentional errors. Because
these assessments were judgmental and made without any specific criteria,
they were considered too imprecise to be included in IRS' report. However,
as we said in 1998, the results did indicate that IRS' compliance efforts
should include activities aimed at taxpayers who intentionally misclaim the
EITC.
17 Earned Income Credit: IRS' Tax Year 1994 Compliance Study and Recent
Efforts to Reduce Noncompliance (GAO/ GGD- 98- 150, July 28, 1998).
Statement Federal Taxes: Information on Payroll Taxes and Earned Income Tax
Credit Noncompliance
Page 13 GAO- 01- 487T
Concerned about the level of EITC noncompliance, Congress and IRS have taken
various steps to reduce it. After the 1994 compliance study, Congress took
the following steps:
According to law, an EITC is not to be allowed unless the tax return
contains the EITC- qualifying- child's Social Security number (SSN) as well
as the SSNs of the taxpayer and the taxpayer's spouse, if any. Before 1997,
if IRS identified a return with an invalid SSN, it had to resolve that issue
through its normal audit procedures. 18 Because those procedures are
resource intensive, IRS was not able to follow up on most of the invalid
SSNs identified. In 1995, for example, IRS stopped the refunds on about 3
million returns with invalid SSNs. 19 However, IRS was only able to follow
up with taxpayers on about 700,000 of those returns. For the other 2.3
million returns, IRS released the refunds without any follow- up. In 1996,
Congress authorized IRS to treat invalid SSNs as “math errors,”
similar to the way that IRS had historically handled computational mistakes.
With that authority, IRS has been able to (1) automatically disallow any
EITC claim associated with an invalid SSN and (2) make appropriate
adjustments to any refund that the taxpayer might be claiming.
Congress passed the Taxpayer Relief Act of 1997, which, among other things,
(1) required paid tax return preparers to fulfill certain due diligence
requirements when preparing EITC claims for taxpayers; 20 (2) provided that
taxpayers who were denied the EITC as the result of an IRS audit are
ineligible to receive the EITC in subsequent years unless they provide
evidence of their eligibility through a recertification process; (3) gave
IRS access to the Department of Health and Human Services' (HHS) Federal
Case Registry of Child Support Orders, a federal database containing state
information on child support payments that could help IRS identify erroneous
EITC claims by noncustodial parents; and (4) required SSA to
18 IRS considers an SSN invalid if it is missing from the return or if the
SSN and associated name on the return do not match data in SSA's records. 19
These invalid SSNs were for EITC- qualifying children and dependents. How
many involved the EITC is unknown. 20 To demonstrate due diligence,
preparers, among other things, must complete an EITC worksheet or the
equivalent and must have no knowledge that any of the information used to
determine the taxpayer's eligibility for, or the amount of, the EITC is
incorrect. The 1997 Act provides for a penalty of $100 for each failure to
comply. Efforts to Reduce EITC
Noncompliance
Statement Federal Taxes: Information on Payroll Taxes and Earned Income Tax
Credit Noncompliance
Page 14 GAO- 01- 487T
collect SSNs of birth parents and provide IRS with information linking the
parents' and child's SSNs.
Congress began providing IRS with appropriated funds (about $143 million a
year) for a 5- year EITC compliance initiative beginning in fiscal year
1998.
As part of the 5- year compliance initiative and using the tools provided by
Congress, IRS implemented a plan that calls for reducing EITC noncompliance
through expanded customer service and public outreach, strengthened
enforcement, and enhanced research. In implementing its plan, IRS has taken
several actions, with some significant results. For example:
In 1999 and 2000, IRS identified a total of about 3.4 million “math
errors” related to the EITC, about 24 percent of which involved
invalid SSNs. 21 According to IRS, it denied about $675 million in erroneous
EITC claims during fiscal years 1999 and 2000 because of EITC- related
“math errors.”
Other types of EITC noncompliance are not as easy to identify as invalid
SSNs. These types of noncompliance can be detected only through an indepth
review. For the past few years, IRS has targeted for in- depth review
certain types of EITC claims, such as those involving the use of a child's
SSN on multiple returns for the same year, that IRS had identified as
important sources of noncompliance. Returns identified by IRS were to be
audited to determine if the EITC claims were valid. During fiscal years 1999
and 2000, according to IRS, it completed more than 500,000 of these audits
and identified about $800 million in overclaims.
In the fall of 1999, IRS began an integrated EITC education and compliance
effort directed at tax return preparers. IRS designed this effort because
data indicated that 62 percent of returns with EITC claims were prepared by
paid preparers. IRS divided preparers into five groups based on a preparer's
filing history, with each group getting a different type of visit. Last
year, for example, IRS visited about 1,000 preparers for the purpose of
determining if they complied with the due diligence requirements. According
to IRS, its examiners proposed penalties totaling
21 Other EITC math errors include such things as errors in computing earned
income and in figuring the EITC.
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about $435, 000 for 143 of those preparers. We do not know how, if at all,
IRS' visits resulted in improved due diligence by preparers. That question
may be addressed in IRS' report on the results of its visits, which,
according to IRS, will be issued about May 1.
IRS implemented a program to enforce the recertification requirements of the
Taxpayer Relief Act of 1997. According to IRS data, (1) about 312,000
taxpayers were required to recertify after being denied the EITC for tax
year 1997 and (2) about 193,000 of those taxpayer did not claim the EITC on
their tax year 1998 returns. IRS sees these results as an indication that
recertification has reduced the number of improper claims. 22
IRS expanded its EITC outreach and educational efforts. For example, it
developed partnerships with groups that are advocates for low- income
taxpayers and with businesses and large employers who include EITC
information in monthly billings or employees' pay statements. IRS also
refocused its media campaign and publications toward educating the public
about EITC eligibility requirements.
IRS developed a database that can be used to help verify the accuracy of
taxpayers' claimed dependents and EIC- qualifying children. It incorporates
data from an assortment of sources including the HHS and SSA information
provided for in the 1997 Act. According to IRS, the database is used to
screen returns during processing for potential compliance issues and to
select for pre- refund audits those with the highest potential. Also,
according to IRS, the returns being selected are primarily ones filed by
EITC claimants.
Despite these initiatives, it remains to be seen how, if at all, Congress'
and IRS' efforts have succeeded in reducing the 31- percent EITC overclaim
rate identified by IRS' tax year 1997 EITC compliance study. IRS is doing a
study of tax year 1999 returns and plans to study tax year 2001 returns. The
results of those studies, when compared to the results of the tax year 1997
study, should provide a basis for assessing the impact on overall EITC
noncompliance.
22 It is also possible that some taxpayers did not reapply because they were
confused about the recertification requirements. We are reviewing IRS'
implementation of that program at the request of the Oversight Subcommittee
of the House Committee on Ways and Means.
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Although well- designed and effectively- implemented processes should help
reduce EITC noncompliance, certain features of the EITC represent a trade-
off between compliance and other desired goals. Unlike income transfer
programs, such as Temporary Assistance for Needy Families and Food Stamps,
the EITC was designed to be administered through the tax system.
Accordingly, while other income transfer programs have staff who review
documents and other evidence before judging applicants to be qualified to
receive assistance, the EITC relies more directly on the self- reported
qualifications of individuals. This approach generally should result in
lower administrative costs and possibly higher participation rates for the
EITC than the other assistance programs. However, EITC noncompliance may
also be higher. This is especially true when eligibility depends on
information that cannot be readily and rapidly verified by IRS as it
processes tax returns. EITC eligibility, particularly related to qualifying
children, is difficult for IRS to verify through its traditional enforcement
procedures, such as matching return data to third- party information
reports. Correctly applying the residency test, for example, often involves
understanding complex living arrangements and child custody issues.
Thoroughly verifying qualifying child eligibility basically requires IRS to
audit individual tax returns, as was done in the tax year 1994 compliance
study- a costly, time- consuming, and intrusive proposition.
- - - - I appreciate this opportunity to appear today to provide a basic
description of the payroll taxes funding Social Security and Medicare
hospital insurance and to discuss what is known about EITC noncompliance.
Mr. Chairman, that concludes my prepared statement. I would be happy to
answer any questions you or other Members of the Committee might have.
Contact and Acknowledgements
For further information regarding this testimony, please contact Michael
Brostek at (202) 512- 9110. Individuals making key
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contributions to this testimony included David Attianese, Kenneth Bombara,
Christine Bonham, Barbara Bovbjerg, Carol Henn, Susan Irving, Deborah Junod,
and John Lesser.
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Long- Term Budget Issues: Moving From Balancing the Budget to Balancing
Fiscal Risk (GAO- 01- 385T, Feb. 6, 2001). Federal Trust and Other Earmarked
Funds: Answers to Frequently Asked Questions (GAO- 01- 199SP, January 2001).
Medicare Reform: Issues Associated With General Revenue Financing (GAO/ T-
AIMD- 00- 126, Mar. 27, 2000).
Medicare Reform: Leading Proposals Lay Groundwork, While Design Decisions
Lie Ahead (GAO/ T- HEHS/ AIMD- 00- 103, Feb. 24, 2000).
Social Security: Evaluating Reform Proposals (GAO/ AIMD/ HEHS00- 29, Nov. 4,
1999).
Social Security Reform: Implementation Issues for Individual Accounts (GAO/
HEHS- 99- 122, June 18, 1999).
Social Security: Different Approaches for Addressing Program Solvency (GAO/
HEHS- 98- 33, July 22, 1998).
Earned Income Tax Credit Tax Administration: Assessment of IRS' 2000 Tax
Filing Season (GAO- 01- 158, Dec. 22, 2000). Earned Income Credit: IRS' Tax
Year 1994 Compliance Study and Recent Efforts to Reduce Noncompliance (GAO/
GGD- 98- 150, July 28, 1998).
Tax Administration: Earned Income Credit Noncompliance (GAO/ TGGD- 97- 105,
May 8, 1997). Related GAO
Products
Statement Federal Taxes: Information on Payroll Taxes and Earned Income Tax
Credit Noncompliance
Page 19 GAO- 01- 487T
Earned Income Credit: IRS' 1995 Controls Stopped Some Noncompliance, But Not
Without Problems (GAO/ GGD- 96- 172, Sept. 18, 1996). Earned Income Tax
Credit: Advance Payment Option Is Not Widely Known or Understood by the
Public (GAO/ GGD- 92- 26, Feb. 19, 1992).
(440029)
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