CRS Updates Report on Tax Gap and Information Reporting

The high current and forecast budget deficits as well as pay-as-you-go (PAYGO) procedures have resulted in congressional and executive branch interest in raising additional revenue through proposals for improved tax compliance. The Bush Administration's FY2009 budget includes a proposal (the proposal) to require each payment card processor to inform the IRS on the net dollar amount paid to reimburse each merchant (i.e., seller) for his payment card receipts in a calendar year. Payment cards consist of both credit cards and debit cards. The card processor is responsible for delivering the payment card transaction to the appropriate card issuer in order that the customer is billed and the merchant receives funds for the purchase. The proposal would allow the IRS to compare the aggregate net payment card amounts reported by processors with the payment card amounts reported by merchants. The proposal would be effective for payment transactions made on or after January 1, 2010. The Bush Administration maintains that this third-party reporting would significantly increase compliance.

The payment card industry has several possible configurations. A configuration may consist of four parties, three parties, or two parties. A four-party system would include a payment card association, a card issuer, a merchant acquirer, and a processor. Regardless of the number of parties in the configuration, the processing function is the point where the proposed reporting requirement would apply.

The Treasury argues that the proposal would yield substantial revenue because of third-party reporting, which has been shown to significantly increase compliance. Proponents maintain that the proposal would improve the allocation of productive resources. They also claim that private sector compliance costs would be reasonable. And, they argue that the IRS has the ability to process additional information returns.

The proposal is not without its critics. Some question the accuracy of the U.S. Treasury estimates of the revenue yield. The U.S. Treasury estimates that the proposal would yield $5.735 billion for FY2009-FY2013 and $18.730 billion for FY2009-FY2018. Opponents also are concerned about the possible reduction in privacy from the proposal. In addition, they maintain that private compliance costs would be substantial. Some argue that numerous potential administrative difficulties have not been addressed, and there would be a disproportionate burden on small businesses.

The proposal was included as a revenue offset in H.R. 6275, the Alternative Minimum Tax Relief Act of 2008, which passed the House on June 25, 2008, and was referred to the Senate Committee on Finance. The proposal was also included by the Senate as a revenue offset in H.R. 3221, the Foreclosure Prevention Act. On July 11, 2008, this bill was passed by the Senate and returned to the House.

This report will be updated as issues develop and any new legislation is introduced.

                            Contents

The payment card industry has several possible configurations. A configuration may consist of four parties, three parties, or two parties. A four-party system would include a payment card association, a card issuer, a merchant acquirer, and a processor. The primary payment card associations are Visa and MasterCard.⁸ "MasterCard and Visa provide the networks through which financial institutions interact to complete payment transactions pursuant to their respective rules and regulations."⁹ A card issuer is simply a nonfinancial or financial institution (usually a bank) that issues payment cards. A merchant acquirer is "a card association member that initiates and maintains relationships with merchants that accept payment cards."¹⁰ A processor is "an organization that is connected to a payment card association and provides authorization, clearing and settlement services on behalf of a member."¹¹ "The processor is responsible for delivering the transaction to the appropriate card issuer so that the customer is billed and the merchant receives funds for the purchase."¹²

In a three-party system, the roles of card issuer and acquirer are combined in one institution.¹³ Examples of the three-party systems are American Express and Discover Card.¹⁴ For a two-party system, "payment cards are issued by a merchant to its retail customers for use only at the issuing merchant's locations."¹⁵ An example of a two-party system is a department store that issues its own payment cards.

Regardless of the number of parties in the configuration, the processing function is the point where the proposed reporting requirement would apply. The proposal states, "Generally, the reporting institution would be the bank or central organization to which the merchant sends payment card transactions for actual payment."¹⁶ The Treasury's description of the proposal gives an example of the processor as "the merchant acquiring bank." The processor would inform the IRS of the net dollar amount paid to reimburse each merchant for their payment card receipts in a calendar year. This reported amount by the processor can be compared with the amount reported by the merchant to the IRS.

Revenue Yield Due to Third-Party Reporting

The Treasury argues that the proposal would yield substantial revenue because of third-party reporting, which has been shown to significantly increase compliance.¹⁸ The Internal Revenue Service has estimated individual income tax underreporting by "visibility" categories for 2001. For income subject to little or no information reporting, the net misreporting percentage was 53.9%.¹⁹ For income subject to some information reporting, the net misreporting percentage was 8.6%.²⁰ These data suggest that the proposal would substantially reduce noncompliance.

In addition, payment card reimbursement information for a business could be used to determine if revenue from cash payments to the business has been understated. Former IRS Commissioner Mark Everson gave the following example:

Proponents argue that the proposal would improve the allocation of productive resources. Better tax compliance due to greater enforcement causes some resources to shift to away from sectors of the economy where they were attracted by the ease of tax evasion. These resources will shift to other sectors where they will now earn a higher after-tax rate of return.

Reasonable Private Sector Compliance Costs

Proponents argue that private sector compliance costs would be reasonable as indicated by current reporting practices of payment card processors and compliance costs of existing information reporting.

Current Reporting Practices of Payment Card Processors. The payment card processors (usually banks that have issued payment cards) already report summaries of payment card transactions to both customers who have purchased goods and services and merchants who have been reimbursed for selling these goods and services.²² Thus, former IRS Commissioner Mark Everson argued that the proposal merely required that available information be sent to the IRS.²³

Compliance Costs of Existing Information Reporting. The Government Accountability Office (GAO) conducted a study concerning two information reporting proposals: merchant payment card reimbursements and payments to corporations. One of the purposes of this study was to identify the compliance costs of existing information reporting using case studies.²⁴ A finding of low existing compliance costs would suggest that compliance costs of additional reporting requirements may also be low.

GAO examined nine case studies to determine "the kinds of third-party compliance costs that may result from merchant payment card reimbursements."²⁵ GAO obtained some of its information through structured interviews. GAO interviewed five companies that it selected "from lists of vendors, IRS approved efilers, and Information Reporting Program Advisory Committee members. . . ."²⁶ GAO also interviewed four organizations volunteered through International Accounts Payable Professionals or the National Federation of Independent Business.²⁷ GAO found the following:

IRS's Ability to Process Additional Information Returns

GAO found that the IRS could process additional information returns. For FY2008, IRS budgeted $8.0 million for programming and start-up costs for the payment card proposal. The IRS estimated administrative implementation costs after FY2008 would be $12.7 million.³⁰

Accuracy of Revenue Estimates

Some opponents of the proposal question the accuracy of the estimated revenue yield.

In addition, the effect on revenues of a possible behavior response are unknown. Some merchants may require or encourage their customers to pay them in cash rather than by payment card, in order to prevent the IRS from obtaining full information about their payment card sales.

Privacy Concerns

Some opponents are concerned about possible reductions in privacy from the proposal. For example, a spokesperson for the NSBA (National Small Business Association) stated that "NSBA fully supports efforts to collect legally owed tax revenues, but not at the undue expense of the privacy and integrity of honest, hard-working entrepreneurs."³²

High Private Compliance Costs

GAO found that new information-reporting requirements for payment card reimbursements would impose new compliance costs such as "(1) merging separately stored taxpayer and merchant identification numbers, especially in the case of multiple locations or franchises; and (2) more generally, new systems and added customer service requirements."³³ But some of these compliance costs could be mitigated. For example current systems and procedures that generate and report related data could be extended.³⁴

Administrative Issues

Some opponents argue that before the proposal can be formulated into legislation, numerous potential administrative issues need to be addressed such as definitions of terms, reporting of transactions, timing of transactions, and administrative procedures.³⁵ The actual settlement process for payment cards can be complicated.

In its report, GAO indicates some policy options to mitigate potential problems. In its description of the proposal, the Treasury does state that

Second, a gift card may be sold in one time period but used to purchase a product in a latter time period. If the initial sale of the gift card is reported as a transaction then the seller's "gross reimbursements" may be overstated. The proposal does not address the issue of gift card sales.

GAO indicates several possible methods of mitigating charge backs, gift cards, and other items that may cause payment reimbursements not to match merchant receipts. For one of its methods of mitigation, GAO states, "Since IRS is not planning an exact match anyway, it could announce it was developing industry norms of net-to-gross ratios to evaluate information, although norms may not be foolproof or always possible."³⁸

Disproportionate Burden on Small Businesses

Some critics argue that the proposal would impose a disproportionate burden on small businesses.³⁹ First, the proposal would require payment card processors to verify a business's Taxpayer Identification Number (TIN). If the payment card processor fails to verify the TIN then the processors would be required to withhold 28% of the gross receipts of the business. The President of the National Small Business Association maintains that this provision would impose a disproportionate burden on small businesses who may have to prove to the IRS that their TINs are correct.⁴⁰ Second, the Senior Policy Counsel of the Center for Democracy and Technology states that small businesses would have greater privacy concerns because they are more likely to use their Social Security numbers as their merchant taxpayer identification number.⁴¹ Third, the Executive Director of the National Association of the Self-Employed (NASE) argues that some administrative costs of the proposal on payment card processors may be passed onto businesses through higher fees for accepting payment cards, and these higher fees would disproportionately affect small businesses.⁴²

The proposal was also included by the Senate as a revenue offset in H.R. 3221, the Foreclosure Prevention Act. This offset would raise an estimated $9.8 billion over 10 years. On July 11, 2008, this bill was passed by the Senate and returned to the House.

Nina E. Olson, National Taxpayer Advocate at the IRS, supported a proposal for reporting payment card reimbursements that was similar to a proposal in the FY2008 Budget. In 2007, she recommended legislation should

² U.S. Treasury, General Explanations of the Administrations's Fiscal Year 2009 Revenue Proposals, February 2008, p. 65. Available at [http://www.treas.gov/offices/tax-policy/library/bluebk08.pdf], visited July 10, 2008.

³ Ibid.

⁴ Ibid.

⁵ This term is defined on page 3.

⁶ Ibid.

⁷ Ibid., p. 66.

⁸ Ramon P. DeGennaro, "Merchant Acquirers and Payment Card Processors: A Look Inside the Black Box," Federal Reserve Bank of Atlanta Economic Review, First Quarter, 2006, p. 28. Available at [http://www.frbatlanta.org/filelegacydocs/erq106_degennaro.pdf], visited July 10, 2008.

⁹ American Bankers Association, White Paper on the Administration's Proposal to Require Information Reporting on Merchant Payment Card Reimbursements, June 8, 2007, p. 2.

¹⁰ Indiana University, Office of the Treasurer, "Glossary of Payment Card Terms," p. 1. Available at [http://www.indiana.edu/~iutreas/pmtcardterms.html], visited July 19, 2008.

¹¹ Ibid., p. 5.

¹² DeGennaro, p. 31.

¹³ American Bankers Association, White Paper on the Administration's Proposal to Require Information Reporting on Merchant Payment Card Reimbursements, p. 2.

¹⁴ Ibid.

¹⁵ Ibid.

¹⁶ U.S. Treasury, General Explanations of the Administration's Fiscal Year 2009 Revenue Proposals, p. 65.

¹⁷ Ibid.

¹⁸ Ibid.

¹⁹ U.S. Treasury, Internal Revenue Service, February 2007, Tax Gap Data for 2001, p. 2. Available at [http://www.irs.gov/pub/irs-utl/tax_gap_update_070212.pdf], visited July 10, 2008.

²⁰ Ibid.

²¹ U.S. Congress, House Committee on the Budget, Hearing on IRS and the Tax Gap, Testimony of Mark Everson, Commissioner, Internal Revenue Service, February 16, 2007, Washington, U.S. Govt. Print. Off., p. 20. Available at [http://budget.house.gov/hearings/2007/02.16eversontestimony.pdf], visited July 10, 2008.

²² Ibid.

²³ Ibid.

²⁴ U.S. Government Accountability Office, Tax Administration: Costs and Uses of Third-Party Information Returns, GAO-08-266, November 2007, summary page.

²⁵ Ibid., p. 2.

²⁶ Ibid.

²⁷ Ibid.

²⁸ Ibid., p. 3.

²⁹ Ibid., p. 2.

³⁰ Ibid., p. 65.

³¹ Carla Balakgie, Executive Director of Electronic Transactions Association, Statement before the House Committee on Ways and Means, Subcommittee on Oversight, Hearing on Internal Revenue Service Operations and the Tax Gap, April 3, 2007, p. 3. Available at [http://waysandmeans.house.gov/hearings.asp?formmode=printfriendly&id=5919], visited July 10, 2008.

³² Paul Hense, Immediate Past Chairman of the National Small Business Association, Statement before the House Small Business Committee, Hearing on Closing the Tax Gap Without Creating Burdens for Small Businesses, April 26, 2007, pp. 5-6.

³³ U.S. Government Accountability Office, Tax Administration: Costs and Uses of Third-Party Information Returns, p. 15.

³⁴ Ibid.

³⁵ Many of these difficulties were examined by the American Bankers Association (for example, see American Bankers Association, White Paper on the Administration's Proposal to Require Information Reporting on Merchant Payment Card Reimbursements, pp. 8-11. Another source for an explanation of administrative difficulties is Martin A. Sullivan, "Treasury Expects Billions from Credit Card Reporting Proposal," Tax Notes, vol. 115, no. 10, June 4, 2007, pp. 890-892.

³⁶ U.S. Treasury, General Explanations of the Administration's Fiscal Year 2009 Revenue Proposals, p. 65.

³⁷ American Bankers Association, White Paper on the Administration's Proposal to Require Information Reporting on Merchant Payment Card Reimbursements, p. 9.

³⁸ Government Accountability Office, Tax Administration: Costs and Uses of Third-Party Information Returns, p. 42.

³⁹ For a congressional testimony on this issue, see House Committee on Small Business, Electronic Payments Tax Reporting: Another Tax Burden for Small Businesses, June 12, 2008. Available at [http://www.house.gov/smbiz], visited July 10, 2008.

⁴⁰ Testimony of Todd McCracken, President of the National Small Business Association, before the House Committee on Small Business, June 12, 2008, pp. 3-4.

⁴¹ Testimony of David Sohn, Senior Policy Counsel for the Center for Democracy and Technology before the House Committee on Small Business, June 12, 2008, pp. 1-2.

⁴² Testimony of Kristie L. Darien, Executive Director of the National Association of the Self-Employed (NASE) before the House Committee on Small Business, June 12, 2008, pp. 2-3.

⁴³ House Ways and Means Committee, The Alternative Minimum Tax Relief Act of 2008, June 17, 2008, p. 1.

⁴⁴ Joint Committee on Taxation, Description of H.R. 6275, The "Alternative Minimum Tax Relief Act of 2008", June 17, 2008, p. 27. Available at [http://www.house.gov/jct/x-50-08.pdf], visited July 10, 2008.

⁴⁵ Joint Committee on Taxation, Estimated Revenue Effects of H.R. 6275, JCX-51-08, June 17, 2008, pp. 1-2. Available at [http://www.house.gov/jct/x-51-08.pdf], visited July 9, 2008.

⁴⁶ Internal Revenue Service, National Taxpayer Advocate's 2007 Annual Report to Congress, vol. 1, sec. 2, 2007, p. 501. Available at [http://www.irs.gov/pub/irs-utl/arc_2007_vol_1_legislativerec.pdf], visited July 10, 2008.

⁴⁷ American Bankers Association, White Paper on the Administration's Proposal to Require Information Reporting on Merchant Payment Card Reimbursements, p. 11.