THE POPULAR BELIEF THAT AUDIT RATES represent the statistical chances of being audited is not accurate.
Audits are a very important part of the IRS's efforts to assure compliance with Federal income tax laws. However, auditing returns is only one element of the IRS's compliance strategy. Two additional components are the use of nonrandom methods to select returns for auditing and the electronic matching of third party information documents (Form W-2s, Form 1099s, etc.) to returns.
The IRS classifies individual returns into ten categories based on total positive income (TPI) for nonbusiness returns and total gross receipts (TGR) for business returns. The audit rate for each category is computed by multiplying 100 times the number of audits performed during the year and dividing by the number of returns filed during the year. The number of audits performed is primarily for returns from one of the three prior years while the number of returns filed is for the current year. Table I reports audit rates by category for 1992 through 1996. As Table 1 shows, the frequently reported audit rate of one to two percent is not accurate for six of the ten categories. Table 1 also shows that audit rates for high-income, nonbusiness returns and business returns are about twice the 1.67% overall rate.
The U.S. General Accounting Office (GAO) reports that audit rates also vary by geographic location. The difference in rates across the United States is attributed to differences in compliance, with higher noncompliance in the western and southwestern regions and lower noncompliance in the central and eastern regions.
The returns selected for examination are not chosen randomly. The IRS's policy is to identify and audit those returns with the most potential for noncompliance. This policy better utilizes limited funds and helps avoid burdening compliant taxpayers with unnecessary audits. The IRS reports that its programs to identify and audit those returns with the most potential for noncompliance has helped to decrease its "no change" findings from more than 40% to approximately 15% of all individual audits. Nonrandom selection of returns means that the popular belief that audit rates represent the statistical chances of being audited is not accurate.
The IRS uses several nonrandom methods to select returns for auditing purposes. Table 2 reports the sources of audited returns for the preceding three years. It shows that unallowable items accounted for 42% of all audited returns for 1996 The second most important source (18%) of audited returns was discriminant function analysis (DIE), a sophisticated scoring system that relies on statistical data collected from the most recent Taxpayer Compliance Measurement Program (TCMP), which was last performed in 1988. …