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The National Taxpayer Advocate's 2003 Annual Report to Congress estimates that, in the year 2001, the amount of tax voluntarily and timely paid by taxpayers was approximately $311 billion less than the actual tax liability of taxpayers. The Report attributes the tax gap to underreporting ($249 billion), underpayment ($32 billion) and nonfiling ($30 billion). The Report indicates that the tax gap is growing and, as a consequence, law-abiding taxpayers are being asked to pay more than their fair share of taxes to make up for the resulting revenue shortfall. In addition, the Federal budget deficit is projected to be $477 billion for fiscal year 2004.

We request that the staff of the Joint Committee on Taxation issue periodic reports to the Congress containing proposals to reduce the size of the tax gap. These reports should include proposals to curtail tax shelters, close unintended loopholes, and address other areas of noncompliance in present law. In addition, we would appreciate receiving recommendations to reform tax expenditures that the Joint Committee staff believes the Congress should review from a policy standpoint.

Please provide as much detail as possible with respect to each proposal, including, to the extent practicable, descriptions of the proposals and estimates of their revenue effects. We would like the Joint Committee staff to prepare a report at least once each Congress.

Sincerely yours,

Ваши

Max Banus Chuck Grassley

Max Baucus
Ranking Member

Charles E. Grassley
Chairman

cc: Senator Bob Graham

I. TAX PROCEDURE AND ADMINISTRATION

A. Impose Withholding on Certain Payments Made by Government Entities

Present Law

Withholding requirements

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The Internal Revenue Code of 1986 (the "Code") requires employers to withhold income tax on wages paid to employees, including wages and salaries of employees or elected officials of Federal, State, and local government units. Withholding rates vary depending on the amount of wages paid, the length of the payroll period, and the number of withholding allowances claimed by the employee.3

Certain nonwage payments also are subject to mandatory or voluntary withholding. For

example:

Employers are required to withhold FICA and Railroad Retirement taxes from wages paid to their employees. Withholding rates are generally uniform.

• Payors of pensions are required to withhold from payments made to payees, unless the payee elects no withholding. Withholding from periodic payments is at variable rates, parallel to income tax withholding from wages, whereas withholding from nonperiodic payments is at a flat 10-percent rate.

A variety of payments (such as interest and dividends) are subject to backup
withholding if the payee has not provided a valid taxpayer identification number
(TIN). Withholding is at a flat rate based on the fourth lowest rate of tax applicable
to single taxpayers. This rate is 28 percent for 2005.

Certain gambling proceeds are subject to withholding. Withholding is at a flat rate based on the third lowest rate of tax applicable to single taxpayers. This rate is 25 percent for 2005.

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• Voluntary withholding applies to certain Federal payments, such as Social Security payments. Withholding is at rates specified by Treasury regulations.

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Voluntary withholding applies to unemployment compensation benefits.
Withholding is at a flat 10-percent rate."

Foreign taxpayers are generally subject to withholding on certain U.S.-source income which is not effectively connected with the conduct of a U.S. trade or business. Withholding is at a flat 30-percent rate (14-percent for certain items of income).10

Many payments made by government entities are not subject to withholding under present law. For example, no tax is generally withheld from payments made to workers who are not classified as employees (i.e., independent contractors).

Information reporting

Present law imposes numerous information reporting requirements that enable the Internal Revenue Service ("IRS") to verify the correctness of taxpayers' returns. For example, every person engaged in a trade or business generally is required to file information returns for each calendar year for payments of $600 or more made in the course of the payor's trade or business." Special information reporting requirements exist for employers required to deduct and withhold tax from employees' income. 12 In addition, any service recipient engaged in a trade or business and paying for services is required to make a return according to regulations when the aggregate of payments is $600 or more. Government entities are specifically required to make an information return, reporting payments to corporations as well as individuals.' Moreover, the head of every Federal executive agency that enters into certain contracts must file an information return reporting the contractor's name, address, TIN, date of contract action, amount to be paid to the contractor, and any other information required by Forms 8596 (Information Return for Federal Contracts) and 8596A (Quarterly Transmittal of Information Returns for Federal Contracts)."

8 Sec. 3402(p)(1).

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Reasons for Change

The lack of a withholding mechanism on nonwage payments leads to substantial underpayments of tax each year and has long been identified as contributing to the tax gap. example, it is estimated that tax compliance for wage earners whose income is subject to withholding is approximately 99 percent, while compliance for individuals with income not subject to withholding is significantly less.17

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For

Payments made by the Federal government and State and local governments represent a significant amount of those annual payments that are not subject to withholding. Imposing withholding on nonwage payments made by the Federal government and State and local governments would improve taxpayer compliance, reduce the tax gap, and promote fairness. Requiring withholding on government payments also addresses concerns regarding the poor compliance records of Federal contractors. For example, a recent Government Accountability Office ("GAO”) study of Department of Defense and IRS records showed that over 27,000 Federal contractors owed about $3 billion in unpaid taxes as of September 30, 2002.

Description of Proposal

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The proposal requires withholding on payments for goods and services1 made by all branches of the Federal government and its agencies and all units of State and local

governments,20 including counties and parishes. Local governments with less than $100 million of annual expenditures are excluded from the withholding requirement.

The rate of withholding is three percent on all payments, regardless of whether the payments are for goods or services.

The proposal imposes information reporting requirements on payments that are subject to withholding under the proposal but are not subject to information reporting under present law.

16 The tax gap is the amount of tax that is imposed by law for a given tax year but is not paid voluntarily and timely. The estimated size of the annual net tax gap (i.e., the gross tax gap reduced by the taxes eventually collected) is about $255 billion. National Taxpayer Advocate, 2004 Annual Report to Congress, Publication 2104 (Rev. 12-2004), at 211.

17

For example, self-employed individuals whose income is subject to neither withholding nor to information reporting are estimated to report only 36 percent of their income. National Taxpayer Advocate, 2003 Annual Report to Congress, Publication 2104 (Rev. 122003), at 265.

18

U.S. General Accounting Office, Financial Management: Some DOD Contractors Abuse the Federal Tax System with Little Consequence, GAO-04-95 (February 2004).

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Thus, the proposal does not apply, for example, to welfare and other types of public assistance payments.

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Multistate agencies also would be covered by the terms of the proposal.

The proposal does not apply to payments of wages or to any other payment with respect to which mandatory (e.g., U.S.-source income of foreign taxpayers) or voluntary (e.g., unemployment benefits) withholding applies under present law.21 The proposal also does not apply to the following: payments of interest; payments for real property; payments to tax-exempt entities or foreign governments; intragovernmental payments; and payments made pursuant to a classified or confidential contract (as defined in section 6050M(e)(3)).

Effective Date

The proposal applies to payments made after the first December 31st that is at least six months after the date of enactment.

,,22

Discussion

The withholding of tax on wages has been described as "the cornerstone of our tax compliance system for employees.' Employees who are subject to withholding have little opportunity to underreport income. Withholding also provides taxpayers with a gradual and systematic method to pay their taxes. Thus, taxpayers subject to withholding are less likely to face a large liability at the end of the tax year and have less motivation for underreporting their income.

In contrast, the absence of withholding on many types of payments has been cited as contributing to the growing compliance problem.23 Studies have consistently shown that rates of noncompliance are considerably higher for taxpayers with income not subject to withholding than for those taxpayers whose income is subject to withholding.24 For example, the National Taxpayer Advocate concluded that the absence of a withholding mechanism on certain nonwage payments creates several problems, including contributing to the substantial tax gap and

21 The proposal does not exclude payments that are potentially subject to backup withholding under section 3406. If, however, payments are actually being withheld under backup withholding, withholding under the proposal does not apply. The purpose of the backup withholding system is to decrease noncompliance by ensuring taxpayers provide valid taxpayer identification numbers. Backup withholding only applies when a taxpayer has failed to furnish a taxpayer identification number and the taxpayer has either a history of underreporting or has failed to certify that backup withholding is not applicable. Thus, payments potentially subject to backup withholding, but for which amounts are not actually being withheld, are not of the type excluded from the proposal.

22 GAO Testimony before the Committee on Small Business, House of Representatives, Tax Administration, Improving Independent Contractor Compliance with Tax Laws, GAO/TGGD-94-194, August 4, 1994.

23 See GAO Report to Congressional Requesters, Tax Administration, Approaches for Improving Independent Contractor Compliance, GAO/GGD-92-108, July 1992, at 4.

24

GAO Report to the Chairman, Subcommittee on Oversight, Committee on Ways and Means, House of Representatives, Tax Administration: Tax Compliance of Nonwage Earners, GAO/GGD-96-165, August 1996, at 12.

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