New York State tax department attacks fraud on new front

Thu Sep 6, 2012 3:03pm EDT

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(Reuters) - New York State, a pioneer at catching tax scofflaws in the digital age, has a new weapon in its arsenal - data collected from debit and credit card purchases that will help it detect retailers who are under-reporting sales.

By checking customer data against retailer tax returns, wholesaler records and other sources, the state hopes to find retailers who either fail to collect or remit the sales taxes due.

Sales taxes made up 25 percent of the $101 billion in taxes collected by New York on behalf of the state and local governments during the fiscal year ended March 31, 2012. With tax revenue slowly recovering from the housing bust and recession of 2007-2009, states are under greater pressure to collect every dollar owed.

The sales-tax campaign is the latest in a series of New York actions cited by others as an electronic-era model for cracking down at a time of tight budgets, smaller staffs and an increasingly sophisticated population of tax cheats.

The overall conversion to e-filing - 87 percent of the 9.2 million state income tax returns New Yorkers filed last year were electronic - has opened the doorway to new forms of cyber tax fraud.

"You close down one scheme and that opens up another one," said Thomas Mattox, New York commissioner of taxation and finance who, prior to joining the department in 2010, was global head of operational risk management for Goldman Sachs.

Analysis of 2011 U.S. Census data by Oracle Corp showed that states collected approximately $760 billion in revenue last year, but lost out on another 18 percent - $136 billion - due to non-compliant taxpayers.

Verenda Smith, assistant director of the Federation of Tax Administrators, said 80 percent of the national group's discussions on tax compliance focus on data and better use of it.

NEARLY A DECADE OF MINING DATA

New York's approach to mining data began in 2003 with a goal of improving tax return audits. In the near-decade since, its systems have saved the state more than $2 billion, of which $442 million came in during 2011, the Taxation Department said.

Over the years the systems have expanded to include fact-checking of withholdings information reported on income tax returns against that reported by employers, and helping the collections department focus on cases with the best chance of significant recovery for the state.

"New York has had a great success with this," said Michael Bryan, director of neighboring New Jersey's Division of Taxation.

Historically, auditing has been a paper-intensive business, conducted in large rooms filled with bins where staff hand-sorted returns for audit. Even today, many states and the federal tax-collecting Internal Revenue Service cannot review every return.

In May, the IRS reported in congressional testimony that new screening and fraud filters have improved its record of spotting false federal returns before refunds are sent out. In New York State, every tax return filed is reviewed by its Case Identification and Selection System (CISS).

By comparing the sales reported by credit card companies with those a retailer reports on state tax returns, CISS hopes to build models of industry trends that will help it to detect fraud.

The state already tries to validate sales tax payments from largely cash businesses such as bars and pizzerias, with information from wholesalers and distributors, but the more third-party data, the better, Mattox said.

Shaun Barry, who leads IBM's anti-fraud consulting practice and works with New York State, compares CISS's ability to pick up patterns and make predictions to a tax version of Netflix or Amazon. Instead of suggesting movies or books to enjoy, CISS predicts problematic returns, and what kind of collection action will be most effective with a certain taxpayer.

FLAWS IN THE SYSTEM

It's not perfect. Cash transactions are especially ill suited to data analysis, since there is little third-party verification in the cash economy.

The department has seen a climb in merchants demanding cash payments already in the few months since New York started mining credit card sales tax trends, Mattox said.

Another area where cash plays a big role is the Earned Income Tax Credit (EITC), a federal, state and local income tax credit for low- to moderate-income working taxpayers. Many who claim the credit earn a living in cash, and often pay with cash for such needs as childcare. With no substantiating third-party sources verifying those transactions, many legitimate claims are being kicked out, taxpayer advocates said.

"A computer is good, but it's not a human being. You need judgment in some of these things," said Jack Trachtenberg, a lawyer who served as the state's taxpayer rights advocate from 2009 until February this year, and who fielded many complaints about legitimate credits that were denied.

Of New York's 9.2 million 2011 individual tax returns, 1.7 million claimed an EITC credit, and the state paid out nearly $1 billion in credits. About 7 percent of the EITC returns were flagged for review, and half of those got some or all credit.

New York cannot retreat on EITC review because it has been a persistent target of fraud, with prison-based criminal rings trying to abuse it, as well as many more run-of-the-mill tax cheats, Mattox said. Neighboring New Jersey and Connecticut have implemented programs based on New York's.

Last year, the federal government paid out more than $15 billion in EITC credits to ineligible people or for ineligible services, according to the U.S. Government Accountability Office.

(Reporting by Nanette Byrnes in Chapel Hill, North Carolina; Editing by Howard Goller and Leslie Gevirtz)

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