IRS Audit Strategy: Quantity vs. Quality and Its Impact on the Tax Gap

Introduction

As a former IRS Senior Tax Specialist with over a decade of experience in tax administration and policy, I've witnessed firsthand the evolving strategies employed by the Internal Revenue Service to address the persistent challenge of the tax gap. Today, I want to shed light on a critical issue that has long plagued the IRS's enforcement efforts: the misguided focus on the quantity of audits over their quality. This approach, while seemingly productive on paper, has had far-reaching implications for both the effectiveness of the IRS's enforcement strategy and the size of the tax gap itself.

Historical Context of the Tax Gap

Before delving into the specifics of audit strategy, it's crucial to understand the concept of the "tax gap" and how it has evolved over time. The tax gap refers to the difference between the total amount of taxes owed to the government and the amount actually collected. It's a key indicator of the overall health and effectiveness of a country's tax system.

The Tax Gap in 1998

In 1998, the IRS estimated the gross tax gap to be approximately $282 billion for tax year 1998. This figure was based on three main components:

Underreporting of income: $248 billion (88% of the gross tax gap)
Underpayment of reported taxes: $30 billion (11%)
Non-filing of tax returns: $4 billion (1%)
The primary contributors to this gap were individual income taxes (including self-employment taxes), which accounted for about 80% of the total.

The Tax Gap in 2024

Fast forward to 2024, and the situation has only worsened. The most recent IRS estimates place the average annual gross tax gap for tax years 2014-2016 at $496 billion. Projecting this trend forward, it's likely that the current tax gap has surpassed $600 billion annually. The components of the tax gap remain similar, with underreporting still accounting for the lion's share of the discrepancy.

Comparison of Tax Gaps: 1998 vs. 2024

The stark increase in the tax gap over the past quarter-century is alarming, to say the least. While inflation and economic growth account for some of this increase, they don't tell the whole story. A significant factor contributing to this widening gap has been the IRS's enforcement strategy, particularly its focus on quantity over quality in audits.

In 1998, the IRS conducted approximately 1.19 million individual audits, representing about 1% of all individual returns filed. By 2022, this number had dropped to just 626,204 audits, or 0.38% of individual returns. This decline in audit rates might suggest a decrease in enforcement efforts, but the reality is more complex.

The Impact of the 1998 IRS Restructuring and Reform Act

A critical turning point in IRS enforcement strategy came with the implementation of the Internal Revenue Service Restructuring and Reform Act of 1998 (RRA98). This legislation was enacted in response to perceived abuses of power by the IRS and aimed to make the agency more taxpayer-friendly. While well-intentioned, the Act inadvertently set the stage for a shift in focus that would have far-reaching consequences for tax enforcement and the tax gap.

Key provisions of RRA98 included:

1. Reorganization of the IRS along functional lines rather than geographic regions.
2. Enhanced taxpayer rights and protections.
3. Increased oversight of IRS operations.
4. Changes to performance metrics for IRS employees.

The last point is particularly significant. Prior to RRA98, the IRS primarily measured its enforcement success by the dollars assessed and collected. However, the Act prohibited the use of enforcement statistics to evaluate IRS employees or to impose production quotas or goals. This led to a fundamental shift in how the IRS approached audits and enforcement actions.

The Unintended Consequences

In the wake of RRA98, the IRS began to focus more on the number of audits conducted rather than the amount of revenue collected. This shift created what I call "the perfect storm" for complex tax evasion and avoidance schemes to flourish. Here's why:

1. Emphasis on Quantity: With the focus on the number of audits, there was an incentive to conduct simpler, quicker audits rather than complex, time-consuming investigations.
2. Reduced Scrutiny of High-Income Returns: Complex returns from high-income individuals and large corporations, which often yield the highest recoveries but take the most time to audit, became less attractive targets under the new metrics.
3. Increased Targeting of Low and Middle-Income Taxpayers: In contrast, audits of low and middle-income taxpayers, particularly those claiming the Earned Income Tax Credit (EITC), increased. These audits are typically simpler and faster to conduct, allowing the IRS to boost its audit numbers.
4. Lack of Representation: Low and middle-income taxpayers often lack professional representation during audits and may not fully understand their rights. This makes them more vulnerable to aggressive enforcement actions and less likely to challenge unfair assessments.
5. Sophisticated Schemes Go Undetected: As resources were diverted to simpler audits, complex tax avoidance strategies used by wealthy individuals and corporations received less scrutiny, allowing them to proliferate.

During my time at the IRS, I witnessed firsthand how management would discourage complex investigations and focus on the number of cases closed. Complex cases were closed with no changes and management often discouraged if not forbid the issuance of a subpoena for bank records the taxpayer refused to provide. Meanwhile, our office increased its audits of small businesses and individuals claiming the EITC, many of whom were unrepresented and struggled to navigate the complex audit process.

This change in strategy had a profound impact on the composition of the tax gap. While the overall number of audits increased in the years immediately following RRA98, the effectiveness of these audits in addressing sophisticated tax evasion declined. The result was a widening tax gap, with a disproportionate burden falling on those least equipped to defend themselves against IRS scrutiny.

Impact of Enforcement Strategy on Tax Gap

The evolution of IRS enforcement strategies from 1998 to 2024 has been marked by a shift towards automation and data analytics. While these tools have their place, they've often been used to facilitate quantity-focused approaches rather than enhancing the quality of audits.

Automated Underreporter Program: This program automatically flags discrepancies between reported income and information returns. While efficient, it often misses more sophisticated forms of tax evasion.

Correspondence Audits: These mail-based audits have increased in proportion to face-to-face audits. They're quicker but less comprehensive, potentially missing nuanced issues.

Decline in Specialist Expertise: Budget constraints have led to a reduction in specialized audit staff, limiting the IRS's ability to tackle complex cases effectively.

Research by the National Taxpayer Advocate has shown that this quantity-over-quality approach has had limited success in reducing the tax gap. In fact, it may have contributed to its growth by failing to address more significant sources of tax evasion and creating a perception that sophisticated tax avoidance strategies are likely to go undetected.

Conclusion

The widening tax gap between 1998 and 2024 is a clear indicator that the current enforcement strategy is falling short. By prioritizing the quantity of audits over their quality, the IRS has inadvertently created an environment where complex tax avoidance can flourish while resources are disproportionately allocated to simpler, less impactful cases.

To effectively address the tax gap, policymakers and IRS leadership must reconsider this approach. A shift towards more targeted, thorough audits, supported by increased funding for specialized training and advanced analytics tools, could yield significantly better results. By focusing on quality over quantity, the IRS can enhance its deterrent effect, improve recovery rates, and begin to close the ever-widening tax gap.

It's time for a paradigm shift in how we approach tax enforcement. Only by recognizing the limitations of our current strategy and embracing a more nuanced, quality-focused approach can we hope to tackle the immense challenge posed by the modern tax gap. The integrity of our tax system and the fiscal health of our nation depend on it.

References

Internal Revenue Service. (1998). "Federal Tax Compliance Research: Tax Gap Estimates for Tax Years 1998-2000."
Internal Revenue Service. (2023). "Tax Gap Estimates for Tax Years 2014-2016."
Treasury Inspector General for Tax Administration. (2022). "Trends in Compliance Activities Through Fiscal Year 2021."
National Taxpayer Advocate. (2023). "Annual Report to Congress."
Government Accountability Office. (2024). "Tax Compliance: Trends in IRS Audit Rates and Results."
Journal of Public Economics. (2022). "The Deterrence Value of Tax Audits: A Meta-analysis."
Tax Policy Center. (2023). "An Analysis of the Declining IRS Audit Rate: Implications for Tax Revenue and Equity."