HD49 - Review of the Department of Taxation
Executive Summary: Virginia's tax system, like the federal system and other state systems, relies heavily on voluntary compliance. Voluntary compliance assumes that taxpayers voluntarily report and pay the correct amount of taxes due. However, JLARC staff estimate that Virginia filers underreported their true tax liabilities by more than $400 million in 1989. The Virginia Department of Taxation was created in 1927 to administer the State's tax system and is currently responsible for administering 20 State taxes. The revenue collected by the department for these taxes serves as the largest source of revenue for the Commonwealth. The tax commissioner oversees the tax department, a large and complex organization with an appropriation of $46.6 million and more than 845 staff during fiscal year 1992. The Code of Virginia empowers the department and the tax commissioner with broad authority regarding the administration of State taxes. The department is able to both determine tax liability through assessments and to reduce or eliminate the amount owed through abatements, write-offs, and discharges. Although these decisions can significantly affect the State's revenue collections, the department is not statutorily required to have these decisions reviewed by any outside source. The mission of the department is "to efficiently and effectively administer the tax laws assigned to its responsibility by the Code of Virginia." The department addresses its mission primarily by attempting: (1) to encourage the highest level of voluntary compliance and (2) to collect the correct amount of revenue due the State. The department encourages voluntary compliance through its services to taxpayers. Data from a recent statewide household survey indicate that 86 percent of the individuals who have used the services of the department were satisfied with them. The department seeks to collect the correct amount of taxes through its compliance revenue collections activities. However, in the same survey of households, more than 17 percent of the respondents indicated that they personally knew at least three individuals who are underpaying their true State tax liabilities. Such knowledge can, over time, undermine the belief that the tax system is equitable and fair, which may further reduce voluntary compliance in the State. Item 13 of the 1991 Appropriation Act directed JLARC to review the organization, management, and operations of the Department of Taxation. Given the complexity of the organization and the current financial position of the State, the scope of this review was a general management and organization review which focused on improving collections and compliance activities of the department. The findings contained in this report have substantial financial implications for State government. The report identifies new collections strategies which over time could potentially produce approximately $154 million annually in additional collections. Further, improvements to current collections activities conducted by the department could have produced more than $10 million in additional revenue in FY 1991. It is impossible to calculate with any certainty the revenue that has not been collected due to several other shortcomings in the collections activities conducted by the department. However, the changes recommended in these areas, if implemented by the department, could also produce significant increases in future collections. This report summary briefly references study findings and recommendations. Detailed explanations and discussion are contained in the text of the report. Virginia's Tax Gap Estimated to Be More than $512 million By 1992 The U.S. Internal Revenue Service (IRS) and many state tax departments have computed estimates of the difference in what they are collecting and what taxpayers actually owe. These differences are commonly referred to as "tax gap" estimates. These estimates have three basic components: • reporting tax gap - the difference between actual tax liability and amount voluntarily reported by filing taxpayers as due. • remittance tax gap -. the difference in the amount taxpayers voluntarily remit and the amount they actually owe. • non-filer tax gap - the amount owed by individuals and businesses who do not file returns. The Virginia Department of Taxation has not computed a tax gap estimate for Virginia. Such an estimate is a needed performance measure which can be used by the department to improve goal setting, target compliance activities appropriately, and internally monitor the department's performance. Further, the tax gap estimates can be used by the House and Senate Finance Committees and the House Appropriations Committee in providing external oversight of the department. JLARC staff estimate that Virginia's "reporting tax gap" - the difference in what individual and corporate taxpayers voluntarily report on their returns and the taxes that they actually owed the State - was more than $405 million in 1989. Assuming that the State tax gap increases at the same rate as the federal gap, JLARC staff project that the difference will be more than $512 million by 1992. Information needed to compute a remittance tax gap and a non-filer tax gap estimate for a given year was not available. However, a cumulative remittance gap is evidenced by the department's accounts receivable inventory of $404 million. The recently completed tax amnesty program provides further evidence of a correctible remittance problem as the department reported that $11 million of the $32 million collected was from the existing accounts receivable inventory. The goal of closing the tax gap is not simply one of collections; perhaps more important are the goals of taxpayer equity and promoting confidence in the State's tax system. The collection of taxes due from all entities should help increase taxpayer confidence in the State's tax system. The following recommendations are made: • The Department of Taxation should refine the JLARC reporting tax gap estimate. The department should estimate total gross and net tax gaps every two years. The department should include sales and use tax and the larger miscellaneous taxes in its estimates. Progress in closing the gap should be reported annually to the House and Senate Finance Committees and the House Appropriations Committee. • The department should review tax gap estimation methodologies used by the IRS and other state tax departments and the strategies used by these agencies to close their tax gaps. • The department should begin to analyze its abatement data to better determine the reasons for abatements, to better collect assessments, and to reduce the percentage of abated assessments. • The department should begin to better analyze its accounts receivable inventory. The department should use its analysis to: (1) develop a collectability assessment of the inventory; (2) develop guidelines and priorities for collecting the accounts receivable; and (3) experiment with and track the success of various methods of collections. • The department should fully analyze the information from its tax amnesty program to better focus its collection of the State's remittance tax gap. Unclaimed Withholding in 1989 More than $140 Million The JLARC calculations of the reporting tax gap include more than $140 million of revenue from unclaimed over-withholding. Some unknown portion of this revenue may not be due the State. As Virginia moves to accurate withholding, currently planned for January 1, 1993, this revenue will no longer be collected. Therefore, total collections may decrease. This change in withholding will result in a change in taxpayer behavior. More Virginians will need to pay additional taxes with their returns than do now. Currently, the majority of Virginia filers receive refunds. As of August 1991, the department had not begun planning how to modify their current collection strategies to address this change. The following recommendations are made: • The General Assembly may wish to consider amending § 58.1-642 of the Code of Virginia to delay the implementation of accurate withholding. • The department should develop strategies to collect taxes from individual taxpayers under a system of accurate withholding. Department Compliance Revenue Goal Not Appropriately Set Each year the department establishes its annual compliance goal and works to achieve that goal. The department does not use estimates of what could be collected (such as information from tax gap estimates) but establishes the goal primarily on prior year collections. This establishes the goal lower than it would be if tax gap estimates were used. The department periodically reports to the Secretary of Finance on the status of goal attainment. During 1991,the department counted and reported revenue, voluntarily paid by taxpayers but received late by the department, as compliance revenue. Compliance revenue is generally revenue which has resulted from enforcement actions, not from processing late payments. More than $43 million of the $240 million reported by the department as compliance revenue was from late payments. Reporting such revenue as compliance revenue overstates the effectiveness of the department's compliance enforcement activities. The following recommendations are made: • The department should revise its methodology for setting its compliance revenue collections goals. The department should base its goal on estimates of outstanding tax liabilities due the State. • The department should include only those collections which result from direct enforcement actions by the department as compliance revenue. Department Routinely Uses Compliance Staff to Provide Services to Taxpayers The department has approximately 51 staff dedicated to providing taxpayer assistance. However, the department routinely uses compliance staff, earning an average of $29,000 annually, to provide these services to taxpayers. These services include helping taxpayers fill out forms and resolve problems resulting from department processing errors. Using department estimates of productivity, compliance staff did not assess and collect more than $10 million in taxes due to time spent providing taxpayer assistance. This is an extremely conservative estimate since it is based only on the 287 district office compliance staff. The department does not maintain information necessary to estimate time spent on activities for the remaining 130compliance staff assigned to the central office. The following recommendations are made: • The department should not routinely use field representatives and auditors to provide taxpayer assistance. • The department should improve its capability to identify and correct tax return errors before a notice is sent to the taxpayer. Taxpayer assistance with these errors should be provided by taxpayer assistance personnel. Department Needs to Improve Its Audit Assessments Although the Department of Taxation has an audit manual, the department does not appear to have a formalized strategy for selecting returns for audit. Instead, the department relies on federal data and individual auditor judgment to select audit candidates. Federal data have limitations which adversely affect the quality of audit selection. In addition, the department does not receive the federal data until nearly two years after the tax liability has been incurred by the taxpayer. The department relies on individual auditor judgment to select corporate and sales and use returns for audit. This results in the selections being inconsistent and subjective. The department needs to develop and use standard selection criteria to select corporate and sales and use audit candidates. In addition, the department does not have standard procedures to ensure that quality audits are being performed. The department relies heavily on auditor discretion and cannot be certain of consistency and objectivity in the performance of the audits. The following recommendations are made: • The department should pilot test using selected Virginia data to supplement federal audit information. The department should analyze the pilot information to determine collectability. • The department should establish standard and objective criteria for selecting corporate returns for audit. • The department should establish and implement a retail sales and use tax audit selection strategy which is consistent and not subjective. • The department should develop standards for audit procedures. More Non-Filers Could Be Identified Using Available State Data The department does not sufficiently use available State data to determine non-filers. The department relies on federal data to determine individual non-filers and relies on voluntary tax registration information to identify business non-filers. Other states have been able to use State data to identify non-filers and collect revenue from them. Virginia has many sources of data which could be used for this including: motor vehicle registrations, driver's license registrations, professional boards, and employer registrations maintained by the Virginia Employment Commission (VEC) and the State Corporation Commission (SCC). The department needs to begin to examine these data and use them in innovative and creative ways to identify non-filers. The following recommendations are made: • The department should continue to use federal data to identify non-filers. However, the department should examine the feasibility and cost effectiveness of computer matches with State databases to identify and locate additional non-filers. Databases should include those maintained by the Department of Motor Vehicles (DMV), SCC, VEC, and professional registrations maintained by the State. • The department should prepare and implement strategies for systematically matching data in the business tax registration database with data from VEC, SCC, and other appropriate State agencies. The department should develop a systematic approach to evaluate the available data, the costs of matching, and the potential additional revenue from each source. Better Monitoring of Collections which Result from Assessments Is Needed The department does not adequately monitor its assessments. This lack of monitoring has resulted in the department: (1) overstating by more than 13 percent the collections which result from assessments made in 1989; (2) not being able to sufficiently monitor the quality of its assessments; and (3) during the last three years not converting more than $1.9 million in business assessments to individual liabilities. The following recommendations are made: • The department should track the current status of all tax assessments. The total amount of assessments which have been collected, abated, or discharged should be monitored. This information should be used to evaluate quality of assessments and collections activities. • The department should. ensure that all uncollected business tax assessments are converted prior to the expiration of the three year statute of limitations. STARS Beneficial to Department but System Limitations Need to Be Addressed The State Tax Accounting and Reporting System (STARS) was developed by the department to improve its abilities to process tax forms and better collect compliance revenue. The department is justifiably proud of its accomplishments due to implementation of STARS. While STARS has improved the efficiency of the department, the system appears to have significant limitations which have lessened the effectiveness of the department's collections. It was not possible to determine if these limitations are due to technical deficiencies in the system or are the result of inefficient utilization of the system. STARS is limited in its usefulness in collecting business taxes. Businesses can have multiple tax accounts at the department. Staff have not entered data necessary to link multiple accounts for many businesses. Further, even for the businesses for which the staff have entered the appropriate data, STARS is not programmed to link these multiple accounts for the same business. Therefore, tax refunds can be made to businesses which actually owe taxes to the State at the time of the refund. In addition, STARS does not allow business taxes to be "written off." Write-off capability would allow the department to suspend active collections while keeping the account in the refund set-off program for possible future collection. Instead, business taxes must be discharged which means that they are removed from the refund set-off program and eliminated from possible future collection. The following recommendations are made: • The department should enter the necessary data and modify STARS programming to ensure that all account balances for businesses are paid before refunds are issued. • The department should modify STARS programming to accommodate "write-off" capabilities for businesses. State Losing Interest Income from District Office Collections Revenue collected by the eight district offices cannot be deposited locally. Instead, these funds must be sent by courier to the central office in Richmond for processing and deposit. According to department staff, STARS is not programmed to allow direct deposit by district offices. JLARC staff estimate that the inability to deposit these payments directly may have cost the State approximately $122,997 in lost interest during FY 1991. The following recommendation is made: • The department should modify its procedures to enable district offices to make local deposits of State tax payments. Department Needs to Reassess STARS The department needs to fully ascertain its needs and uses for STARS. When STARS was implemented, the major concern was being able to process large amounts of data fairly quickly and easily. However, department staff are beginning to identify the need for computerized management reports which STARS is not able to provide efficiently. The department should determine the deficiencies in the current system and the long range needs of the department. In examining these needs, the department should utilize the suggestions of department staff regarding requested changes. The following recommendations are made: • The department should ensure that the information systems division consider and implement appropriately employee suggestions that have a direct and cost-effective impact on compliance collections. • The Secretary of Finance or the department should request that the Department of Information Technology (DIT) conduct a systems analysis of STARS to address the current deficiencies in the system and to determine long range requirements. Functional Organization Generally Sound but Recommended Changes Could Improve Operations The functional organization of the department appears to be more efficient than organizing based on type of tax administered. However, three changes could be made which could allow the department to function more efficiently and effectively. First, the deputy commissioner position should be filled. Given the size of the department, the importance of its function to State government, and the complexity of its responsibilities, it is imperative that the department have a recognized second in command. Second, the department should be somewhat reorganized. The purpose of the reorganization would be to eliminate the large number of small administrative units and to eliminate having two different divisions responsible for audit functions and having two different divisions responsible for collections. This should provide for a more collegial and less competitive approach to audits and collections. Third, it appears that staff could be better utilized. Many of the staff stated, and examination of their work assignments supported the assertions, that the workload was unmanageable. Other staff indicated that they usually had less than a full day's work to keep them occupied. Further, the department has been receiving additional auditor positions during this fiscal year. No apparent rationale has been followed by the department in placing these staff. The following recommendations are made: • The department should fill the deputy commissioner position. • The department should restructure its operations to accommodate filling the deputy commissioner position, to reduce the number of assistant commissioners to two, and to address organizational weaknesses. The reorganization should eliminate two different divisions having responsibility for audit activities and for collections activities. • The department should review all currently established positions to ensure that work responsibilities are commensurate with employee abilities and time. • The department should limit the number of delinquent individual tax accounts that are sent to the district offices. If these accounts accumulate, they should be handled by central office and additional delinquent business accounts should be sent to the district offices. • The department should involve the district office supervisors in the decision-making regarding the assignment of audit and collections staff. In assigning staff, the department should consider the availability of office space and support staff and the revenue potential in the district offices. • As part of the department's strategic planning process, the department should examine the physical working conditions in the district offices and the effect of those conditions on productivity. • The department should develop a preliminary staffing plan which indicates the number of staff necessary to implement additional collections activities recommended in this report and estimates revenue which would be collected. The plan should be submitted prior to the 1993 Session of the General Assembly. • The Secretary of Finance should direct the Department of Planning and Budget (DPB) to complete a comprehensive evaluation of the staffing needs and personnel practices of the Department of Taxation. • As a function of its reorganization, the department should review the position description for each management position and establish that each management position is needed and that there are no unnecessary levels of management. Identified Management Weaknesses Need Correction The review identified three management weaknesses which appear to be hampering effective operation of the department. These areas need to be addressed by department management and steps taken to improve them. First, the department's strategic plan is limited in scope, giving insufficient attention to compliance functions and the resources needed to maximize revenue collections. Attention should be given to estimating the State's tax gap and planning efforts to close the gap. In the absence of a well-developed strategic plan, the department's planning activities generally have been completed on a compartmentalized, as-needed basis. The department needs to develop a strategic planning process that integrates changes in Virginia's population, economy, and taxpayer assistance with changes in technology, staffing, policy, and information needs. These trends and changes should be related to department operations to determine what impact they will have. Second, the department lacks sufficient controls to prevent fraud and disclosure of confidential tax information. The department needs to better limit STARS screen access as the Auditor of Public Accounts (APA) has recommended each year since 1986. In addition, the department could conduct initial and periodic background investigations of employees. Tax departments in 14 of the 18 other states contacted conduct background investigations on staff as do 19 other State agencies in Virginia. These investigations are necessary given the revenue affecting decisions made by these employees. Third, it does not appear that the department management adequately addresses employee concerns which can affect department operations. Staff indicated that morale, salary levels, communication, management, and leadership were the most problematic aspects of the agency's operation. Such negative perceptions can adversely affect department productivity. The following recommendations are made: • The department should develop a strategic planning process that takes an integrated, comprehensive approach to planning for the agency. As part of this planning process, the State's tax gap should be estimated and strategies for closing the tax gap should be developed. The deputy director should be assigned responsibility for overseeing the process and developing and monitoring the plan. • The department should develop an equipment replacement schedule. • The department should follow the APA recommendations to review STARS access and limit that access as necessary. • The department should work with the Office of the Attorney General and the Department of Personnel and Training (OPT) to establish policies and procedures for conducting initial and periodic background investigations of employees. • The General Assembly may wish to amend the Code of Virginia to require the department to complete initial and periodic background investigations of its employees. • The Secretary of Finance should ensure that the department implements the recommendations made by other oversight agencies such as the APA, Department of General Services (DGS), and the State Internal Auditor in a timely manner. • The department should identify and implement approaches to address employee concerns and ideas. Department Needs to Ensure Better Internal Accountability Given the possible effect of department decisions on State revenue collections, it is imperative that the department maintain high standards of internal accountability. During this study JLARC staff examined more than 500 computer and hard copy tax files. This examination indicated that the department lacks necessary standards to guide documentation of decisions and staff decision-making on revenue affecting decisions, relies heavily on judgments of individual staff, and generally maintains inadequate documentation to support the decisions which were made. For the majority of decisions made by the department there are no statutory directives for documentation. However, the department is required by Section 58.1-105 of the Code of Virginia to maintain certain documentation for accepted offers in compromise. Review of a sample of department files on these offers indicates that the department is not in compliance with the statutory requirements which direct that all evidence on these offers be maintained. A majority of the files reviewed had not sufficiently documented evidence that verified taxpayers' claims. The following recommendations are made: • The department should ensure that determination of doubtful collectability is properly substantiated prior to accepting an offer in compromise as required by Section 58.1-105 of the Code of Virginia. At a minimum, the department should obtain and review a financial statement on the taxpayer. • The department should take immediate steps to ensure that complete and accurate documentation is provided for all adjustments for which the department requires supporting documentation. The department should work with the APA to develop the documentation standards. • The department should establish written procedures for audit documentation. Additional External Oversight of the Department Is Needed The department is granted broad authority for determining tax liability. The department can increase liability through assessments and can decrease or eliminate liability through abatements, discharges, or write-offs. Further, the department decides taxpayers' appeals resulting from department findings. There are no requirements for external review of the department's decisions. Therefore, other than through legal recourse, the department determines tax liability in Virginia. Many of the department's decisions were reviewed during the course of this study. Several of these decisions, based on available documentation, appeared questionable. Further, the department is abating large amounts of its assessments. This is especially apparent with larger assessments. A review of a sample of 30 of the largest assessments showed that the department originally assessed more than $28 million, collected $8 million, and abated more than $12 million. This is a small sample of the total number of assessments made by the department. However, the effects on revenue collections of abatements of this size indicate that additional review of large assessments is warranted. Other slates have more oversight of their tax departments than does Virginia. Eleven of the 18 states contacted had either independent review boards to hear taxpayer appeals or multiple commissioners overseeing the department. It appears that Virginia's tax department should receive additional oversight given the importance of tax revenue to the State, the department's lack of documentation of decisions, and the questionable decisions identified in this report. There are a variety of oversight options which can be considered. These include establishing an independent review board, employing multiple commissioners, imposing additional reporting requirements, and providing dedicated staff to the Secretary of Finance for department oversight. The following recommendations are made: • The General Assembly may wish to amend Section 58.1-105 of the Code of Virginia to require the department to submit documentation to the Secretary of Finance of any downward adjustment of more than 25 percent on any assessment larger than $200,000. • The General Assembly may wish to require the APA, as part of its annual review of the department, to review the documentation for downward adjustments of more than 25 percent of assessments of more than $200,000. • The General Assembly may wish to further examine options for increased external oversight of the Department of Taxation. |
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