Harley Duncan, Executive Director

Federation of Tax Administrators

 

January 30, 1997

 

I. Introduction

A. Background on the Federation of Tax Administrators

1. The Federation is an association of principal tax administration and collection agencies in each of the 50 states, District of Columbia and New York City.

2. The Federation pursues a four-part mission -- Research and Information Exchange, Training, Intergovernmental and Interstate Coordination, and Federal Representation.

3. Federation has no adopted policy on merits or demerits of "restructuring" the Internal Revenue Service (IRS), changes in its governing structure, or on any specific administrative changes which should be adopted with respect to the IRS.

 

B. Importance of the Commission’s Work

1. Commission is to be commended for the effort it is undertaking and the manner in which it is doing so as well as the thoroughness of its information-gathering efforts and the professionalism of its staff.

2. State tax administrators have a substantial interest in the work of the Commission and appreciate the opportunity to appear before you. State tax administration agencies work closely with the IRS and rely extensively on the IRS for administration and enforcement of certain taxes. As a result, recommendations made by this Commission may well affect working relationships with our tax administration partners. In addition, those working relationships, we believe, can be expanded in a fashion which may aid the Commission’s efforts to improve the operations of the IRS. Finally, state tax administration agencies may well be able to convert recommendations you make regarding the Service into operational improvements for themselves.

 

C. Purpose of Remarks

1. My purpose today is to highlight and discuss various approaches states are taking to modernizing their tax administration processes and systems so as to be able to meet the needs of the public and to administer their tax systems in an efficient and effective manner. The emphasis will be on highlighting trends and approaches being taken in areas that should be analogous or transferable to the IRS experience and context. I want to emphasize, however, that my purpose is to be "descriptive" not "prescriptive" regarding actions which should be recommended by the Commission or undertaken by the Service.

2. I also want to highlight the nature of the working relationships which exist between tax administration at the federal and state levels to aid the Commission in appreciating the importance of its work to states generally and state tax administrators in particular. As part of this review, I will also identify certain initiatives or approaches to cooperative tax administration that the Commission might consider in its deliberations.

3. Should note that the initiatives identified are not exhaustive in sense that they include all the efforts of all the states in the identified areas or that they cover all the functional areas in which states are undertaking initiatives. Instead, my intent is to highlight initiatives in areas in which I believe the state experience can be instructive to the Commission and the Internal Revenue Service. Neither have they been determined by any objective method to be "best practices." Instead they are what I believe to be leading practices and initiatives among the states based on my observations and analysis.

 

D. Topics to be Addressed

1. Return or input processing

2. Systems modernization efforts

3. Performance of non-tax functions

4. Outsourcing of tax administration functions

5. Federal-State cooperation in tax administration

 

II. Return and Input Processing

A. Introduction

1. States have undertaken a variety of efforts to revamp their return and remittance processing systems to include both the manner in which they receive the returns and remittances as well as the manner in which they capture the data from the returns. These efforts are intended to serve one or more of several objectives: (1) reduce the cost and burden of processing paper returns and remittances; (2) improve the timeliness and accuracy with which data is uploaded to taxpayer account files and thus available for compliance and customer service efforts; and (3) reduce the cost and burden imposed on taxpayers for filing returns and remittances.

2. Generally speaking, the steps taken by state tax administration agencies in this area involve the aggressive use of emerging technologies, including: (1) aggressive use of imaging, scanning and intelligent character recognition for the capture of data from tax returns; (2) use of electronic data interchange technology to assist the electronic filing of returns; and (3) aggressive use of "telefiling" applications.

 

B. Imaging Initiatives

1. In the past several years, at least 12 states have implemented or have begun to implement imaging technology, primarily for the processing of individual income tax returns. This technology runs two distinct processes -- creating and cataloging an optical image of the return for examination, reconciliation, exception processing, customer service, archival and other purposes as well as converting selected taxpayer information and return data into a machine-readable format such that it can subsequently used in the computer processing systems of the agency.

2. Successful deployment of the technology has obvious advantages including faster processing of returns (and refunds) and more accurate and timely data capture. In addition, imaging technology minimizes the need for substantial editing of the return and "heads-down" key entry of the return information as well as subsequent costly handling, storage and retrieval of the paper return.

3. Beyond this, successful imaging applications can substantially improve customer service by enabling work and process flows to be re-engineered. Front-line workers can be provided with ready access to an image of the return to aid in resolving taxpayer issues, and adjustments can be made in "real-time" if desired. In addition, the use of imaging allows problem-free returns to be processed through system, while leaving "exception" returns to be dealt with individually. The substantially reduces the "cycle-time" for error free returns.

4. Imaging technology has been (or is in the process of being) implemented in at least the states of Delaware, Georgia, Indiana, Louisiana, Maine, Maryland, Massachusetts, Mississippi, New York State and New Jersey. As indicated, to date the applications have focused on individual income tax processing, but several states have plans to extend the application to other tax types. Of the states employing imaging technology, Delaware, Massachusetts, Maryland, New York State and Louisiana have the most established operations.

5. States unanimously consider imaging to be a cost-effective means of processing tax returns. In conversations with various states, they have identified several factors which they believe have contributed to the "success" of their imaging initiatives. Among the factors cited by one or more states are:

a) Relying on commercial vendors of imaging technology (cameras, software, etc.) with a proven record in other sectors. States have, in fact, used at least three different primary imaging vendors.

b) Using purchasing and contractual practices and procedures that are conducive to creating a "partnership environment" between the state and the vendor, including incentives based on performance.

c) Making difficult strategic choices regarding the data to be captured (i.e., converted into machine-readable form) and accompanying those choices with substantial tax forms redesign to accommodate the imaging. Imaging, particularly the correct interpretation of hand-written data, is not without problems. The amount and nature of the data to be captured will drastically affect the complexity of the software required as well as the "through-put" capacity of the system.

 

C. Electronic Filing Initiatives

1. In addition to imaging, states have begun to move aggressively to use electronic filing and electronic data interchange technology to reduce the paper and labor intensive nature of processing traditional tax returns in the traditional manner. In an electronic filing environment, the tax return information is not transcribed to paper for submission. Instead, it is communicated directly from the taxpayer’s (or his/her representative’s) computer to the tax agency’s (or its representative’s) computer via telecommunications.

2. With respect to the electronic filing of individual income tax returns, states have largely coupled their efforts to those of the Internal Revenue Service. Of the 42 states with an individual income tax, 34 of them participate in the FedState Electronic Filing program in which an electronic state tax return is submitted to the IRS along with the federal return. This FedState partnership has worked well (at least from the state perspective) in that it has eased the requirements imposed on states to implement an electronic filing program and enabled them to "piggy-back" on a substantial federal effort. In addition, the joint program has advantages for practitioners and electronic return transmitters in that it has effectively allowed them to deal with one program (from a format, standards and submission standpoint) for both state and federal filing purposes.

3. In addition to the FedState program, another six states have implemented an independent, stand-alone electronic filing program for individual electronic returns. [Three of these states also participate in the FedState program.] There does not appear to be a substantial difference between these stand-alone programs and the IRS or the FedState effort.

4. Beyond the individual income tax, states have also begun to implement electronic filing programs for a relatively broad range of other tax types. According to the latest count, some 30 states are engaged in some electronic filing initiative beyond the individual income tax. Among the tax types for which programs have been implemented are motor fuel excise, motor fuel use (interstate carriers), income tax withholding, retail sales and use, gaming excises, and partnership information returns (K-1’s).

5. These electronic filing initiatives are all voluntary to the taxpayer, and for the large part, they have not yielded large numbers of participants. States generally attribute the lack of participation to the absence of a mandate to file electronically, the general lack of commercial software with electronic filing capabilities, and questions about the benefits of the electronic filing to the taxpayer. They have been trying to address these deficiencies by working with commercial software developers and with taxpayers to convince them of the reciprocal benefits of such efforts. It is important to note, however, that even the small proportion of taxpayers who do file electronically can provide noticeable relief to the paper processing system.

6. In addition, two states are undertaking initiatives which may yield insights regarding attracting participants in electronic filing. Florida has recently passed a requirement that sales and use taxpayers with an annual liability in excess of a specified threshold will be required to file electronically beginning in mid-1997. Pennsylvania has developed electronic filing software for its sales and use tax return and is distributing it free of charge to taxpayers in an effort to stimulate interest in the effort.

7. There are three other features of these state filing initiatives which may be of interest to the Commission and others looking to expand the use of electronic filing at the federal level.

a) Outside the individual income tax arena, state programs all use approved electronic data interchange (EDI) standards rather than proprietary formats and protocols for exchanging the data as in the IRS individual income tax program. In non-technical terms, this means their programs are speaking a more or less common language. The IRS individual income tax program uses its own proprietary formats and protocols for exchanging the data. The use of EDI standards is important to taxpayers because it reduces the burden imposed on them in complying with multiple filing programs. It also eases the transferability of filing initiatives among states or between levels of government.

b) Beyond the use of standards, states have taken the initiative to work with taxpayers and among themselves to achieve consistency and uniformity in the manner in which the programs and standards are implemented. This eases the burden on a taxpayer with multiple electronic filing obligations and eases the transfer of programs from jurisdiction-to-jurisdiction.

c) Virtually without exception, states have chosen to use third-party Value Added Networks (VANs) (at least four different ones are in use among the states) in their programs. VANs provide a variety of services to the states, but they essentially serve as the communications link for communicating with the taxpayer, receiving the taxpayer’s data and delivering the data to the state in the format it desires. This set of services obviates the need for a state to invest in the hardware, software and human resources necessary to accomplish such tasks. It does, however, require a payment to the vendor, money that must be appropriated through the budget process.

 

D. Telefiling Initiatives

1. Like the IRS, states have begun to implement "Telefile" programs which use Interactive Voice Response (IVR) technology and a touch-tone telephone as a device for the taxpayer to enter limited amounts of data which is then processed similarly to an electronic return. Massachusetts has been the most aggressive state in using Telefile for individual income tax return filing. Through a variety of measures, including aggressive marketing, approximately 40 percent of the eligible Massachusetts taxpayers filed using Telefile. This amounts to nearly 15 percent of all taxpayers in the Commonwealth. Massachusetts is also beginning to examine the use of Telefile in conjunction with a wage and withholding data base to develop a "return-free" filing system in which the state could compute the return for the taxpayer based on information available to it.

2. A number of other states have implemented Telefile programs for individual income tax (or are in the process of doing so), including Kansas, California, Louisiana, Oklahoma, Montana and Arkansas.

3. States have also begun to use the IVR and telefile technology for other tax applications. Examples include sales and use tax returns for which no remittance is due, withholding returns, filing extensions, and other excises in which the data required to be supplied is limited. In addition, Oregon and South Dakota will soon be implementing programs which combine a telefile tax return (withholding in the case of Oregon and sales tax in the case of South Dakota) and an electronic tax payment.

4. States exhibit a "mixed bag" in terms of their reliance on third parties in deploying IVR and telefile technology. The majority of states using this approach have chosen to acquire the IVR hardware and to manage much of the communications and other parts of the operation themselves. The remainder have chosen to use a third party to supply the hardware, software, communications lines and the like.

 

E. Conclusion

1. States have moved aggressively to deploy new technologies in the return filing and processing parts of the tax administration process. In a number of cases, these initiatives are similar to those employed by the Internal Revenue Service. By way of contrast, however, states have expanded the approaches to a broader range of tax types. They also have made greater use of commercial vendors as "partners" in deploying the new technologies.

 

III. Systems Modernization Efforts

A. Introduction

1. As with the IRS, most state tax agencies entered the late-1980’s and early-1990’s with computer systems that were in need of significant revision. The systems generally relied on mainframe processors and used outdated software development approaches. They were expensive and time-consuming to maintain and update. Most importantly, the systems were "stand-alone" or "stovepipe" in that they generally dealt with an individual tax type (e.g., sales tax, income tax, etc.) and could not be related to one another or easily share information among the systems.

2. As a result, states have over the last 5-10 years invested considerable time and resources in upgrading or modernizing their computer systems. At this time, at least one-half of the states undertaken such efforts in the last 10 years. These implementations have come in three rough phases: (1) 3-5 states from 1986-1990; (2) 3-5 additional states from 1990-1992; (3) at least 15 additional states from 1992 to the present.

 

B. Integrated Tax Processing Systems

1. The primary defining characteristic of the new systems is that they are "integrated" processing systems. That is, the system treats the taxpayer as a unified entity and is capable of providing information on all different tax types for which a taxpayer is registered in a consolidated or integrated fashion. This, of course, enables the state to provide improved taxpayer or customer service because complete information can be provided to the "front-line" worker when it is needed. In addition, the systems enable new compliance programs and improve the effectiveness of existing programs because of their integrated nature and their ability to provide taxpayer information in a useable format.

2. Other key characteristics of the systems being installed include:

a) The central features and primary components of the system are the same regardless of the type of tax at issue.

b) The software utilizes state-of-the-art development approaches which minimizes the resources required to maintain and update the systems.

c) The systems have been migrated to "client-server" technology from mainframe-only systems.

d) The systems are primarily concerned with the tax processing, audit, error correction, adjustment and taxpayer auditing components of the tax administration process. The system is not dependent on any particular type of return input, and return input or filing initiatives are generally undertaken independently of the integrated tax administration system.

e) Similarly, the systems are sometimes implemented independently of the accounts receivable management or delinquent collections systems.

3. In conversations with states, they have identified a number of considerations which they believe are important in their perceived ability to successfully undertake these modernization efforts. They include:

a) States have utilized extensively the services of private vendors in developing and installing the system. There are two major vendors involved in installing such systems. As a general matter, states have determined that the resource requirements and expertise necessary to develop and implement such systems (while at the same time maintaining current systems) is beyond their capacity without outside assistance. Only three states (Delaware, Florida and Texas) have undertaken substantial parts of the development effort on their own.

b) Substantial preliminary planning efforts are required before a state can begin the modernization effort. These include development of a ‘strategic information plan’ (essentially a high-level resource requirements definition) as well as a data architecture plan and system. In addition, a detailed requirements definition is necessary before actual development can be done to insure there is a single agreed upon plan of attack. In some cases (e.g., Illinois, Kentucky, California, and Connecticut) outside vendors have been used for these efforts.

c) Openness to a redesign of the entire operating process is essential.

d) Sustained executive support and multi-year financial commitments are critical to successful implementations.

e) Even with private vendors, it is necessary to devote substantial in-house resources to the development effort. They are necessary for defining requirements, reviewing outputs and testing various components.

f) The human resource requirements (training, job ‘re-orientation,’ etc.) imposed by a modernization effort cannot be underestimated.

 

C. Modernized Procurement Processes and Performance Contracting

1. Another matter which has become apparent in these modernization efforts is that traditional procurement processes which rely on the development of a detailed "Request for Proposal" (RFP) and evaluating those proposals with a heavy emphasis on price do not work particularly well in this environment. They place too great a premium on specifying what is desired and required ‘up-front’ and provide inappropriate incentives to contractors. They do not promote a partnership between the state and the vendor.

2. States have taken a couple of avenues to overcoming the shortcomings in the traditional procurement process. Some states (Mississippi, Kentucky, Connecticut) have used outside vendors to aid them in developing the RFP. Others have essentially made the process a two-step one. (California, Kansas) Vendors are first screened based on their qualifications and experience. The successful vendor is then required to undertake a requirements definition phase to develop a proposed ‘solution’ for the state. Development work will proceed if a successful contract can be negotiated.

3. In addition, several states have developed a "performance contracting" approach to acquiring systems modernization services. That is, instead of entering into a "fixed-price" contract, states are entering into contracts with vendors in which the amount (total and individual) and timing of payments are determined on the basis of additional revenues generated by implementation of the system. Such a contracting system is being used for systems modernization efforts by California , Kansas, Hawaii and the District of Columbia.

4. In their preliminary evaluations, states are enthusiastic about the results of the performance contracting approach. It has a number of desirable attributes including easing the difficulty of achieving the support of elected officials, creating appropriate incentive structures for vendors, and being a significant aid in creating the appropriate partnership between vendors and state tax administration agencies.

 

D. Conclusion

1. A number of states have implemented modernized computer tax processing systems which utilize state-of-the-art computer and data processing techniques to replace their traditional "stovepipe" systems. They provide a variety of lessons for enterprises engaged in similar efforts. Primary among these are the steps necessary before the development effort begins, the role of outside vendors, and the advantages of a modernized procurement process.

 

IV. Performance of Non-Tax Administration Functions

A. Introduction

1. Commission staff has asked that we provide information on the extent to which state tax administration agencies are being asked to perform non-tax administration functions as part of their charter.

2. As a general matter, it is not uncommon for state tax administration agencies to be required to perform functions that fall outside the purview of tax administration. Primarily, these functions fall in the debt collection area. In addition, there are several efforts aimed at consolidating the tax administration components of unemployment administration in the revenue agency.

 

B. Delinquent Child Support Enforcement

1. The largest and most visible non-tax function being performed by some state tax agencies is the collection of delinquent child support. In recent years, upwards of 10 states have moved parts of the child support enforcement function to the state tax administration agency. This has been done primarily as a means of removing the function from the public assistance benefits administration and providing a greater ‘enforcement’ focus to the program.

2. Among the states in which the tax administration agency is also responsible for at least part of the child support program include Alaska, Massachusetts, Florida, California, Minnesota and Michigan.

3. As a general matter, these states have not found, at least to my observation, that the addition of this function has been detrimental to tax administration in their minds. Certain aspects of the operation bear a close resemblance to the collection of delinquent tax debts, e.g., locating the debtor, managing information about the debtor and his/her resources, managing information about contacts with the debtor and debtor account maintenance. In addition, there has been some spillover from child support to improvements in tax administration in that certain levy and garnishment procedures developed in the child support area have also begun to be applied in the delinquent tax field.

4. It should be noted that the functions transferred to the revenue administration agency are generally only those regarding collection of the delinquent support payment and not other activities such as client services, establishing paternity and the like. (Florida offers is an exception to this general rule.) In addition, the child support function is generally administered in a separate division of the revenue agency and is not integrated (at least at this time) into the department fully, in part because of confidentiality issues raised below.

 

C. Collection of Other Non-tax Debts.

1. There is also some movement among the states to consolidate the collection of other debts owed the state (and in some cases certain local government debt) in the state tax administration agency. Again this is a somewhat natural outgrowth of their role in collecting delinquent state taxes. These other debts might include such matters as student loans, university system debts, amounts owing state hospitals, unemployment insurance, etc.

2. Three states deserve mention here. The Michigan Bureau of Revenue has for some years been responsible for administering a consolidated collection program for all state debts, including child support as noted above. Minnesota, after a substantial analysis of debt collection in state government, also established a consolidated debt collection function, the administration of which has been assigned to the Department of Revenue at this time. Finally, the California Franchise Tax Board has been given authority to begin using certain of its programs and authority to collect certain debts owed local governments in that state.

3. Beyond this, nearly all income tax states operate a "refund offset" program for the collection of non-tax debts. Under these programs, the names of persons owing debts or obligations to other state agencies (or owing other types of approved debt) such as student loans, university hospitals, child support, etc. are matched against those entitled to income tax refunds. The debt is deducted from any refund before the refund is sent to the taxpayer.

 

D. Unemployment Insurance Tax Administration

1. Historically, state unemployment insurance taxes have been administered independently from other state taxes because of their close ties to the federal unemployment insurance administration and their dedicated nature.

2. Some states are now looking to consolidate at least certain aspects of the administration of that tax with the administration of other taxes. Montana and Maine have begun programs to consolidate the administration of the unemployment insurance tax (not the benefits administration) into the state tax agency. Pennsylvania has developed an integrated tax administration and unemployment insurance registration operation although the administration of the taxes remains separate.

 

E. Conclusion

1. It is not uncommon for state tax administration agencies to perform administrative functions that fall outside the strict purview of administering general purpose taxes. For the most part, these extraneous activities have fallen in the debt collection arena. They have not proved to be detrimental to achieving the mission of the tax agency -- either in terms of resource utilization or public confusion -- and have generated some side benefits in certain instances.

2. Importantly, the non-tax functions required of tax administration agencies have not involved the use of confidential tax return information for non-tax purposes. Even in cases where the tax administration agency is involved in debt collection for other agencies, the use of taxpayer information is not allowed in the non-tax collection work. Instead, it is the human, computer systems and other resources of the tax agency which are used in such efforts. Likewise, tax agencies have not generally become involved in the administration of other programs in which taxpayer information might be of assistance (e.g., verification of income to determine eligibility for assistance programs or other similar purposes), and tax administrators routinely resist such efforts and suggestions. Using taxpayer information for such purposes could well and jeopardize the ability of the state to receive federal return information under the Internal Revenue Code as well as restrictions in the Social Security Act. Equally as relevant, public support of the tax system will likely be undermined if there is a perception that confidential return information is used for non-tax administration purposes and is not being appropriately safeguarded.

 

V. Outsourcing Tax Administration Functions

A. Introduction

1. As have public and private agencies across the country, state tax administration agencies have taken a number of steps to "outsource" or contract the administration of certain aspects of their operation to private sector, third parties. Primarily, these have been in the area of delinquent tax collection, but some states have also contracted out substantial parts of the return processing function, and one state is experimenting with contract audits.

 

B. Outsourcing Delinquent Tax Collection

1. In April 1996, the Federation of Tax Administrators conducted a survey on the use of non-government collection agents for the collection of delinquent state tax debts. The key findings of that survey are presented below.

2. Types of Taxes. There are 39 states which use private or non-government agents in the collection of delinquent taxes. The oldest of these programs dates to 1975; most were instituted in the mid-1980s. About one-third of the states use outside agencies for the collection of individual income taxes only, while two-thirds have programs for the collection of all taxes, including individual income taxes.

3. Types of debtors. A slightly higher number of state use outside contractors for out-of-state accounts than for in-state accounts, but my personal perspective is that this gap is shrinking. Fifteen states use outside agents for collecting certain types of debt pertaining to all tax types for both in-state and out-of-state accounts, and four others use it for both in-state and out-of-state individual and business income accounts and sales tax receivables.

4. Contracting Agents. Most states contract with private collection agencies, although four states also have contracts with independent or prosecuting attorneys. We identified two states that contract with county sheriffs. States commonly employ more than one contractor for incentive and comparison purposes.

5. Contractor Fees. While almost all states contract on a contingency or percentage-of-collection basis, there are programs for flat fees -- that’s usually reserved for collecting bounced checks -- and two states tell us they add a collection fee to the total tax, penalty and interest.

6. Activities Contracted. States contract out for a wide variety of collection activities, including skip tracing, sending collection letters, making phone calls, and even receiving and processing payments. The activities that are least frequently contracted for are face-to-face visits, lockbox services and asset location. A synopsis of the types of activities for which states use outside agencies is presented below.

 

Activity (by number of states)

In-State

Out-of-state

Skip Tracing

17

20

Collection Letters

20

23

Collection Calls

22

27

Face-to-Face Visits

4

6

Receiving Payments

17

20

Lockbox Services

1

1

Asset Location

7

9

Litigation

9

15

Telephone Dunning

25

32

Asset Seizure

4

7

Issuing Liens/levies

6

5

Wage Garnishment

7

9

Negotiating Pay Plans

23

27

Approving Pay Plans

19

24

Negotiate Compromise

9

11

Approve Compromise

1

1

7. Contractual Constraints. It’s important to remember in viewing this listing that outside collectors do not have a carte blanche authority. There are extremely important operational details that must be addressed by anyone entering into such an arrangement. Each state writes a contract with its outside collection agents that spells out such things as limitations, tolerances, calling hours, tone of messages, training, oversight, supervision, disclosure restrictions, and even the quality of employee. The tax agency will strive to make sure, through the contract, that it has as much confidence in and control over the actions of a non-government collector as it will over its own employees.

8. Referral Criteria. There is no quick, easy and accurate to summarize the types of debts that are referred to the non-government collectors in terms of age, size, etc. It is however, fair to say that in a majority of states, they tend to be the older, smaller-dollar accounts, perhaps those that are not being worked or that have been unsuccessfully worked inside the tax agency. However, this generalization does not hold in all cases. There are states which have rather extensive programs where the outside collection agencies are considered as a more of a partner in the collection process and even a collector of first resort. Primary among these are Michigan, New Jersey, Delaware, and Pennsylvania.

9. Collection rates. The differences in approach to the use of outside agents makes it impossible to effectively compare collection rates across states. Clearly, the rate of collection has a direct relationship to the quality of debt that is referred. Beyond this, some general observations can be made. For many, actual collections (as a percent of amounts referred) -- before fees are subtracted -- will be in the 5-8 percent range. These numbers will go higher -- but probably never reach 50 percent -- as a state expands its program and sends to the non-government collector newer and easier-to-collect debts.

10. Disclosure Issues. In the large majority of states, non-government collectors generally have access only to the information necessary to collect the delinquency -- the taxpayer’s name, address, Social Security number (which is used for account control as well as locating assets and skip-tracing), the tax type, and the tax due. Other information may, but not always, be released to the non-government collector at the taxpayer’s request. This is usually information necessary to resolve an account dispute. Also, an account collection history may be available to the collector.

11. Public Perception. Respondents to the survey indicated that there was not an abnormally adverse reaction from the public to contact by non-government contractors. That is, there was not an appreciable difference in the public reaction to contact by a non-government collector and contact by a government collector.

12. State Perspectives. As a general matter, states view the use of private collectors as a useful adjunct to their debt collection activities. Sixteen states said the use of a non-government collector was a useful component of their collection program, and an additional 10 states reported their program was very successful. Four states told us they felt their programs were not very successful.

 

B. Outsourcing Tax Processing

1. States have for a number of years "outsourced" parts of the tax return processing function. In particular, a large number of states (over 20) use financial institutions to provide lockbox services and remittance processing services. In addition, some states (e.g., Indiana) use private contractors for the key entry and imaging of individual income tax returns.

2. The most aggressive use of outsourcing in this area is in New York where the State Department of Taxation and Finance has contracted its entire individual income tax processing to a third party. Beginning with the 1995 process year, the state contracted with a financial institution for processing individual income tax returns to include receiving returns, processing remittances, and the capture of required data (including imaging, verification and entry where required) from the returns. In other words, the contractor is responsible for processing the return up to the point of delivering machine-readable data to the tax agency. The state then proceeds to perform the various examination and compliance functions and processing of any required refunds.

3. Key factors driving the decision to outsource the income tax processing function in New York were the potential for substantial cost savings and for improvements in "quality of service" through faster refund processing and more complete data capture.

 

C. Outsourcing the Audit Function

1. Only Florida has undertaken efforts to use third-party contractors to perform taxpayer audits. In response to a legislative requirement, Florida has for approximately two years conducted a test of using private auditors on an hourly fee basis to perform sales and use tax audits. Florida’s evaluation of that test can be summarized as follows:

a) The pool of potential outside vendors is necessarily limited because of the limits which must be imposed on engaging in other business which might create a possible conflict of interest or enable the outside auditor to use information obtained during the audit for other purposes.

b) The state must make a substantial investment of resources in training the outside auditors (and keeping them current) on the particulars of state tax law and changes therein. There is also substantial overhead involved in administering the program and maintaining quality control and the like.

c) The cost per hour for a state-employed auditor is less than for an outside auditor.

d) Taxpayers have some reservations regarding contract audits. They are skeptical that their confidential tax return information is protected from disclosure or misuse by the third-party auditor to the degree that it is by a state employee auditor.

2. Florida will continue the contract audit program for the next budget cycle. To overcome some of the taxpayer concerns, Florida is contemplating a "certified audit" program. Under this program, if a taxpayer has an audit performed by a firm of its choosing that meets standards established by the state (standards for both the firm and the audit), the state will certify that audit and accept it in lieu of performing an independent audit with state auditors.

 

D. Conclusion

1. States have not been reluctant to utilize outside vendors to perform various tax administration functions. In particular, they have been aggressive in using contractors for debt collection purposes, and certain states have outsourced parts of the return processing system. Outsourcing the audit function, which concerns core issues of determining the correct tax liability and use of confidential information, has proved somewhat of a mixed bag.

 

VI. Federal-State Cooperation in Tax Administration

A. Introduction

1. There is a substantial history of cooperation between state tax authorities and the Internal Revenue Service, deriving from the fact that they are organizations involved in essentially the same business as well as from the interrelationships in the structure of taxation at the federal and state levels. These relationships are critical to the ability of the states and the IRS to secure compliance with the tax laws and to provide quality services to the taxpaying public. There are also opportunities to expand the nature of the cooperative tax administration activities that might be considered by the Commission.

2. For this reason, among others, the work of the Commission is of great importance and interest to the Federation and its members. The Federation would urge the Commission bear in mind the importance of the relationships between federal and state tax administration as it makes its recommendations as well as to consider opportunities to expand those relationships. Effective intergovernmental cooperation and coordination can be instrumental in improving tax compliance, reducing the burden imposed on taxpayers and providing quality services to the public at both the state and federal levels.

3. Both IRS and the states have resources devoted to coordinating and supporting the Federal-State cooperative relationship. For the states’ part, that is one of the prime responsibilities of FTA. On behalf of the Service, there is the FedState Relations Division. The foundation and great strength of the FedState relationship, however, is found in the day-to-day operations at the level of each IRS District office and its counterpart state tax agency. We would encourage the Commission to recognize the value of fresh ideas, diversity and pinpointing activities to local geographic and business conditions that result from this direct relationship. FedState was never structured to be a "top-down" activity, with directives flowing from the national office to the states and districts.

4. This section of the testimony summarizes some of the key areas of cooperation at the present time and identifies certain opportunities for improvement that deserve exploration.

 

B. Federal-State Exchanges of Information.

1. The cornerstone of cooperative tax administration has been and continues to be an active exchange of information between federal and state tax authorities to support enforcement of the personal and corporation income tax. Federal law (IRC §6103) authorizes the Internal Revenue Service (IRS) to provide federal tax return information to state tax agencies, provided it is used solely for tax administration purposes and is properly safeguarded against unauthorized disclosure or release.

2. All states have entered into an exchange of information agreement with the IRS through which they routinely receive an abundance of tax information. Information exchanged includes copies of all federal audits or other adjustments to a taxpayer’s return, identification of taxpayers filing a federal income tax return with an address in the receiving state, extracts of items of income and expense reported on the federal tax return, and information reports filed by third-party payers (e.g., banks, brokerage firms, and employers) with respect to taxpayers in a particular state.

3. Given the basic level of conformity between state and federal income tax bases, state adjustments can often be made directly from the federal information. In addition, states use comparisons and matches of federal and state data in their enforcement programs.

4. Federal data and federal audit reports are among the primary enforcement tools used by the states for individual income tax purposes. The rates of state individual income taxes (generally 5-8 percent of taxable income) are such that it is not cost-effective (particularly compared to the yield on audits of state corporation income taxes and retail sales taxes) to maintain a substantial cadre of state revenue agents to conduct on-site audits of individual income tax returns.

5. States also use the results of federal corporation tax audits for enforcement. Since the computation of state tax generally begins with federal taxable income, states rely extensively on federal examination activities for verification of the tax base and the proper treatment of various transactions, particularly those involving international operations. State agencies devote their audit activities primarily to verifying the apportionment of income across states, examining the taxpayer's treatment of certain types of transactions, and other factors unique to state income taxation.

6. Historically, the flow of information was largely from the federal government to the states. In recent years, however, states have begun providing more information to the IRS. In particular, federal administrators use state lists of registered sales taxpayers to identify potential non-filers of federal employment and corporation taxes and to cross-check reported receipts. They also use files maintained by other state agencies that license individuals (including driver licenses) engaged in various trades and professions as a source of leads (e.g., on non-filers). In addition, state and federal data are used in many ‘market segmentation’ research and analysis activities.

7. In addition, states assist the IRS directly in collection of delinquent federal taxes through their "refund offset" programs. Over 30 states include delinquent federal tax debts in their offset programs, an effort which yields $50-80 million annually to the U.S. Treasury.

 

C. Joint Filing Activities

1. As noted above, states and the IRS have made a substantial investment in the joint electronic filing of individual income tax returns. Under the program, the federal and state individual income tax returns for persons using a participating tax preparer can be filed in a single electronic transmission with the IRS, which in turn provides the state return to the appropriate state tax authority. Over 30 states are participating in the program, and in 1996 approximately 4 million joint returns were filed.

2. The FedState filing program has proved important to states in enabling them to move into electronic filing, and it has been felt to add to the attractiveness of the federal program for practitioners and taxpayers. It does serve to reduce the burden that would be imposed on practitioners and taxpayers if each state were to maintain its own individual filing program.

3. IRS and the states are currently analyzing the prospects for extending the FedState electronic filing model to a joint electronic filing of "941’s" (quarterly withholding reconciliation) and to a joint Telefile program for individual income tax returns.

 

D. Other Areas of Cooperation

1. State and federal tax authorities have undertaken a wide range of cooperative taxpayer service and education activities. Of particular note are cooperative or joint programs for providing training and education to tax practitioners and preparers as well as providing cooperative registration and filing assistance to new businesses. It is also not uncommon for state and federal authorities to offer on-site taxpayer assistance at a single site.

2. Additionally, there is substantial collaboration between state and federal tax authorities in training personnel. This may take the form of state employees participating in IRS-sponsored training seminars or vice versa. In addition, states and the IRS have at times jointly developed training programs for personnel at both levels.

3. The Federal Highway Administration has provided funding for a series of regional federal-state task forces on motor fuel compliance and investigation. The task forces bring together all agencies (not just tax administration agencies) involved in dealing with motor fuel evasion cases, and have proved successful in promoting cooperative activities and joint investigations and compliance activities.

4. Finally, there are a wide range of compliance, service and education efforts that operate in a particular area on an individual state-to-district level rather than being national in scope. These are commonly organized around issues or initiatives that are local in nature and may consist of special education efforts, compliance initiatives for a particular market segment and the like. These activities are spawned through regular consultations and liaison sessions between state and federal administrators at the local level.

 

E. Areas for Further Examination

1. In its deliberations, the Federation would urge the Commission to consider that state tax administration agencies are capable of serving as contractors or providers of service to the Internal Revenue Service for particular tax administration functions. They could potentially be used as an avenue for "outsourcing" some of the processing, examination, collection, and other functions of the IRS. If implemented successfully, this approach could serve to effectively augment the resources available to the Service and at the same time improve compliance and service to the taxpayers.

2. There are several areas in which it would seem that a "state contractor" program might be effective.

a) Primary among these is probably the collection of delinquent tax liabilities. As noted, states devote substantial resources to delinquent tax collection, and it would come as a surprise to no one that many of the same taxpayers are delinquent for federal taxes as well. At the present time, however, there is very little in the way of joint or cooperative activity (at least partly because of reasons discussed below) in the collection of those delinquencies. In fact, there is more likely to be competition for the collection. It does not seem unreasonable that a program could be structured to contract the collection of some delinquencies to a state tax administration agency or to develop other joint working arrangements.

b) While the FedState Electronic Filing program (where IRS is essentially a contractor delivering electronic tax return data to the states) has worked well, it does have some shortcomings. Particularly, state actions are largely constrained by the necessity to conform to the IRS electronic filing program. This limitation thwarts innovation and experimentation. what the IRS does which thwarts innovation and experimentation. If states were contracted to deliver electronic tax return data to the Service (whether obtained from electronic returns or otherwise) a variety of different approaches with a variety of different types of taxes and taxpayers could be tested and developed.

c) Other areas in which a contractual arrangement would seem to work would include examination or audit of particular types of taxpayers or returns, on-site or telephone taxpayer assistance and specific taxpayer education efforts.

3. There are, of course, a number of impediments (at both the state and federal levels) that would need to be overcome to implement such a concept, including philosophical/attitudinal barriers, legal constraints and operational concerns. Of particular relevance to the Commission are the legal considerations.

a) IRC § 6103 (governing the safeguarding and disclosure of federal tax return information) would need to be reviewed and potentially revised to accommodate these types of arrangements. This section can be interpreted in a manner that frustrates joint federal-state by suggesting that all information relating to any joint undertaking, even if it would otherwise be considered to be state information, becomes "federal return information." This interpretation imposes separate safeguarding procedures and places restraints on the use of the data by the states. Therefore, state data which flows from a state-only project would have to be treated differently from data which flows from a cooperative project. This is not to suggest that states have no interest in maintaining the confidentiality of taxpayer information because they certainly do; the issues arise if the information becomes described as information disclosed to the states under §6103.

b) In addition, federal statutes governing the collection of delinquent taxes would need to be substantially revised. At the present time, those statutes do not allow a "sharing" of the proceeds from a joint collection activity; such sharing would have the effect of compromising the debt. Moreover, statutes governing the priority of liens and claims to delinquent taxpayer assets would need revision to avoid the "trumping" and competitive situation that now exists. State statutes would, in all likelihood, also have to be revised because of similar concerns.

4. The Commission should likewise consider that the IRS is capable of acting as a contractor for states for certain functions. Some states have indicated a desire to consider having the IRS provide certain services on their behalf (e.g., tax return processing) under certain conditions. A number of the considerations that would arise if the state were to be a contractor to the federal government would also arise here.

 

F. Conclusion

1. Federal and state tax administration authorities have developed a number of important working relationships over time. These relationships are important to each level in achieving its purposes and mission. The Federation would urge the Commission to keep these relationships and their importance in mind as it deliberates the future of the IRS.

2. Moreover, state tax agencies believe that there exist a number of opportunities to expand these working relationships. In particular, state tax agencies can in certain instances serve as an avenue for "outsourcing" certain IRS functions in a manner which could improve effectiveness at both levels of government.

3. The central point is that state and federal tax agencies are essentially performing the same functions for the same clientele. As a result, careful consideration should be given to legal and institutional structures that will allow the development of flexible working arrangements between them. In this fashion, the resources available to each level of government can be used most effectively, services to the taxpaying public can be maximized, and the compliance burden on the taxpayer can be reduced.