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High-Tech Pay Off

States are using tax compliance software to improve the accuracy of their audits and generate more revenue.

Where's the cash?

States want to know and in a hurry. Facing an unprecedented shortfall totaling nearly $40 billion, states are growing desperate in their search for ways to balance the budget. With tax increases still considered taboo by many legislatures, and fearful of making budget cuts that are too deep, some states are trying to tap new sources of revenue.

Enter technology and the tax audit. With as much as 40 percent of taxpayers underpaying their taxes - either through ignorance, by mistake or choice - states are turning to high-tech tools to crank up tax compliance. Some of the solutions involve better case-management systems coupled with simple but vigorous efforts to improve tax collections.

But most of the new projects also involve data warehouses, data mining, expert systems and risk engine software tools that make it easier for auditors to identify which taxpayer still owes money and is most likely to pay.

And the technology seems to be working.

Four states - California, Kansas, Hawaii and Virginia - have uncovered nearly $1 billion in unpaid taxes thanks in large part to technology, according to American Management Systems (AMS), an IT consulting firm that developed tax collection systems for the states. Michigan installed a new data warehouse and tax auditing tools from Bull Services and has increased tax revenue 7 percent in the first year of operation.

"The formula of marrying technology with auditors works," said Stan Barowski, deputy administrator of support at the Michigan Revenue Compliance Bureau. "We can plan who we want to audit and how we want to audit."

High-Tech Audit
Michigan first began work on its auditing system in 1997. Like many states back then, Michigan used to rely heavily on paper and a statistical scattershot approach to choosing and pursuing its audit candidates. But the process was slow, cumbersome and expensive. According to Barowski, the bureau was spurred on to change its operations by rapid advances in new technologies.

"We like to think we're a progressive agency working for a heavily industrialized state," he said, explaining why the bureau decided to invest in a host of technical solutions.

Auditing receives lots of attention, but it's just one component of the tax revenue stream for Michigan and other states. Actually, collections, the accounts receivable part of taxes, is the biggest source of potential revenue, according to John LaFaver, AMS' vice president of Public-Sector Tax and Revenue Practice.

"Based on our experience, using technology and BPR [business process reengineering] in collections is the fastest way to generate cash," he said.

Auditing taxpayers who have filed their returns is the next biggest source of revenue. But most states never audit more than 3 percent to 4 percent of taxpayers, and it requires using an agency's most expensive talent as productively as possible.

"They have to know how they are choosing their audit candidates," said LaFaver.

Otherwise, the returns can diminish. Good auditors can bring in anywhere from $600,000 to $2 million in unpaid taxes, according to state records.

Non-filers are the third component. Most experts agree this group is the hardest to go after and costliest in terms of effort.

"It can be very expensive because agencies may have tax data on non-compliers, but they don't have data on why they aren't paying their taxes," said Bob Hanks, Tax, Revenue and Labor Practice director of Unisys Corp.

Despite the risk involved, however, states have shown increased interest in chasing after the hardcore tax dodgers - with the aid of technology. Part of the reason is debt owed by individuals and businesses to states is at an all-time high, according to LaFaver.

Going After Likely Candidates
Michigan elected to build an integrated auditing and compliance system, called FARSTaR, or Field Audit Research, Selection, Tracking and Reporting, which includes a data warehouse built by Bull Services using NCR's Teradata hardware and relational database software.

The system takes in data from the department's legacy system and from the Internal Revenue Service. The data is mined using an expert system called Eskort, from W-M Data.

Auditors sift through four years of state and federal tax data for Michigan's business taxpayers, relying on 130 expert rules to find the most likely candidates for audits, according to Barowski.

"It takes the system 4.3 seconds to run the 130 rules through four years of tax history," he said. "The system then provides us with a list of taxpayers who are ranked by potential for tax recovery."

Treasury staff can select companies based on a number of factors, including geographic location, type of industry, income, sales volume, payroll size, expense factors and other criteria.

"We can change the focus on who we audit based on the economy, new legislation, or other reasons, all in a matter of days," added Barowski.

The $6.8 million system, which is secured using public key infrastructure, started operation January 2001 and was able to analyze 452,000 business taxpayers in nine months.

Eventually the bureau expects to review 125,000 businesses annually, up from just 6,000 per year prior to implementation.

Initially, the system was expected to increase revenue by about 10 percent, or $12 million to $17 million based on more accurate audits. But the rate during the first year is running between 5 and 7 percent, according to Barowski, who attributes the lower numbers to a first year operational shakedown and a steep learning curve for the auditors.

"Still, we expect to see a return on our investment in 12 to 18 months," he said.

The state of Washington's Department of Revenue is also building a data warehouse, but has elected to design its own data-mining program using Clementine software from SPSS Inc.

Like Michigan, Washington is trying to improve the accuracy of its hit list of noncompliant business taxpayers (the state has no personal income tax). The software, which cost $100,000, will be used to analyze the data in the warehouse and help auditors prioritize and select the best candidates.

The effort has just begun and so far the state doesn't have any results. But Sandra Hurley, the department's audit project manager, has seen the technology work for other states and is confident Washington will reap similar benefits.

"If the computer can predict better than a person who to audit, that increases our efficiencies and better uses our talent," she said.

Virginia Bets Big
Virginia is betting big on generating new revenue from improved tax collection and audits. The state started work in 1998 with partner AMS on building what it calls the most comprehensive public/private partnership ever undertaken by a state revenue agency.

Certainly, the project is one of the costliest, with a price tag of nearly $136 million. But its scope is just as breathtaking.

"We started with the notion of turning everything upside down," said Robert Schultze, Virginia's executive commissioner of customer relations in the Department of Taxation.

That notion included replacing the IT platform and reengineering the entire tax process.

Now in the fourth year of the five-year overhaul, the state has taken on some new projects in addition to what it originally set out to achieve. One project is an expanded presence for Internet-based services.

"We overlooked Web-based options for filing back in 1998," Schultze admitted. Similarly, using data mining as a tool to improve audits wasn't on the radar screen either when plans were originally drawn up four years ago.

The department added $6 million to the project for a new auditing system that will mine data stored in a compliance repository containing information from the IRS, sister state agencies, even private, third parties.

The tool used is AMS' Professional Audit Support System, or PASS, which runs a sophisticated risk-scoring model to identify the best method for bringing a taxpayer into compliance. Despite the increasing complexity of the state's audits, the new tools have reduced the time it takes to conduct an audit by nearly 13 percent.

Once all the applications are in place and reengineering is complete, the new system is expected to pull in an additional $40 million annually for Virginia. AMS will be paid in full for the project by 2004 from the new revenue stream.

Virginia is one of four states for which AMS has agreed to build new tax systems and accept payment through a unique benefits-based financing partnership.

For example, California paid for its new collection, auditing and case management system from the nearly $300 million in new revenue the system has uncovered so far, according to AMS.

In Virginia, the tax overhaul project has generated $88 million in new revenue to date, including $30 million from the compliance and audit portion of the effort.

Low Adoption Rate
The key to uncovering the cash, according to tax experts, is to go after the idle cash first. That means identifying those taxpayers who have filed and owe and are most likely to pay. AMS uses a risk-scoring engine called Strata to identify those likely taxpayers.

The next stage is to identify the likeliest candidates for an audit, followed by scrutinizing the hard-core non-compliers.

But even with the benefits of automation, only about 10 percent of states have launched projects that go after tax revenue using technology so comprehensively, according to AMS' LaFaver.

One reason adoption is so slow, said LaFaver, is that most states are satisfied with bumping up tax revenue just a few percentage points using stricter - and more automated - collection methods.

"Tax collectors also are very process-oriented people," he added. "They are aware of how the existing system works, but don't know what potential exists. It takes a fair amount of work to understand what the possibilities are."

But there may be other reasons tax revenue agencies aren't so eager to overhaul their collection and compliance systems.

First, finite resources have forced many agencies to put limited IT funds into Internet-based tax filing projects, which state politicians and their constituents want.

Second, some of the auditing technology on the market today runs on proprietary software, which government IT officials have become reluctant to use in recent years.

Finally, there's the issue of just how much revenue these systems will turn up in the long run.

"The problem with compliance is that once you get the database to identify where the tax money is, the revenue pool dries up after the first hit," said Hanks. "The tax agency has to keep changing what they are going after in terms of compliance, if they want the revenue to keep coming in."
With more than 20 years of experience covering state and local government, Tod previously was the editor of Public CIO, e.Republic’s award-winning publication for information technology executives in the public sector. He is now a senior editor for Government Technology and a columnist at Governing magazine.