So beware? Keep your eye out for the next economic boom?

That's our job. We've got to be vigilant through all the circumstances of different business cycles.

In some of your testimony last year, your confirmation and other hearings, you talked about the tremendous stake there was in combating abusive shelters. What is the stake? Should ordinary taxpayers be concerned about these?

Our whole premise of the tax system is it's a voluntary self-assessment. It depends on your or my willingness to pay taxes determined by you or me. We fill out the numbers -- the numbers are not filled out for us -- and people are only going to do that if they have the faith that their neighbor is also doing that.

So, particularly when you have sophisticated players -- large corporations or high net-worth individuals -- who aren't paying their share because they're gaming the system, that undermines the confidence on the part of individuals that they ought to pay their share and that it's a good thing to do.

So you're talking here about potential loss of money. You said billions. I recall, last year, there was a study put forward where we were talking about $10 billion, $15 billion a year.

There are various estimates. Some of the disclosures we received do get well over $10 billion. That's correct.

A year?

In total for some of the periods that we looked at for particular transactions.

So you've got money at stake. But are you talking about jeopardy to the integrity of the tax system -- public faith and confidence in the tax system?

Absolutely. We've done some recent surveys. In 1999, 11 percent of the populace believed that it was OK to cheat on your taxes. That percentage has now increased to 17 percent. Obviously, we can't continue on that trajectory and fund the government. That's the first point.

But more broadly speaking, I would suggest to you that respect for the system is fundamental to the notion of the rule of law. We can't afford to let our tax system get to where our respect for immigration laws and drug laws have gotten in this country -- where some believe they're important, and some do not, and there's that kind of lack of respect for the law.

Are you suggesting here that, in the problem of tax shelters, there's sort of a willful manipulation of the law or a disrespect for the law and even the IRS?

I think there's an element of that. Some people have pushed the limits of what they've done, perhaps believing that they are fully law-abiding. But I do believe that, in certain instances, we've seen indications that professionals took business decisions as to whether they would comply, say, with registration requirements based on the size of the penalties associated with not complying with the law. They took a business decision whether or not they would follow the law. That's really a very serious erosion in our professional standards.

Yes. Through Senate hearings and otherwise, we've seen internal documents from accounting firms in which you have high executives saying, "We don't think we should register, even though the IRS and the law require us to, because if we get caught, we're going to pay a penalty of $10,000, or something like that. We're going to make ten to a hundred times more than that. So the economics say, 'Let's go ahead and try it. Maybe we'll get away with it. But even if we get caught, we're not going to get penalized much.'"

Right. That's clearly been a factor. That's why the administration's been supporting increasing the penalties in this area. But the lack of penalties has clearly undermined the regulatory scheme.

I've been shocked, coming back into this position -- I started my career in public accounting in the mid-1970s. The first obligation of the accounting firms at that time was to help their clients comply with the law and professional standards. Then, if you could differentiate your firm on service, well, you did so.

There clearly was, in more recent years, an inversion of those responsibilities. Firms sought to do their best for the client to create wealth, and then where they found the law, they pushed right up against the edge of it. In some cases, as you've indicated, because of a lack of penalties, they've said, "Well, we can run that red light."

I think you used the term at one point that the lawyers and the accountants were the "pillars" of our legal system, our tax system, and their role had been perverted. What was your point?

What I've said is that accountants and lawyers need to be the pillars of our system of taxation, not the architects of its circumvention. All I'm indicating is that the IRS -- it's a large governmental agency, but it's only 100,000 people. We don't touch everyone. We rely on the integrity of the taxpayer to self-assess his or her obligation, and they rely on professionals to help them understand what they need to pay.

So if the accountants and the lawyers aren't doing their share to steer people to pay no more than what they owe, but what they owe, the system won't work.

What happened in the 1990s to the professionals who work on the tax system, the tax professionals who advise us all … that caused the kind of problem with promoting and selling and marketing abusive shelters that we've seen?

I think at the core of it was the way people viewed their services. When I started out, there was a clear pecking order in these kinds of things. There were investment bankers who made lots of money, but they took personal equity risk in a lot of these transactions. Then you had lawyers further down the hierarchy, and then at the bottom, accountants. I was one of them.

But you billed for your time, both lawyers and accountants. What's happened here is, somewhere along the line, the accounting profession took a different view of itself and said, "We're just as good as those investment bankers and those lawyers, and we ought to earn just as much as they earn," which was not the expectation 20 or 30 years ago.

So they started to try and view their job as value creation, instead of helping their clients comply with the law and with professional standards. They brought transactions that created value -- or in this case, what we're talking about, minimize taxes to the clients. That generated larger fees, because it was worth more to the clients. That was a change, and a dangerous and damaging change for the ethic of the profession, I would suggest.

Are you talking about a bottom-line mentality, which is both driving the professionals in the tax business and the corporations and wealthy individuals who are using these abusive tax shelters?

I think there's no doubt that that happened, and that it reached a peak in the late 1990s and towards 2000, as we've all seen, with the great run-up of the equity markets. But I think there has been some corrections in some of these firms. People have stepped back and had a more sober appreciation of a rebalancing, if you will, and -- I hope -- a return to the more traditional role of the accountant in terms of propping up the integrity and supporting the integrity of the system.

Is there a cost, a financial cost, to the ordinary honest taxpayer in the use of abusive tax shelters by corporations and high net-worth individuals?

Certainly, over time. If a high-end individual or a corporation who pays more because they earn more is not paying their share, the rest of us are going to end up carrying that burden. [It] doesn't happen right away. But over time it happens as the government works to fund its activities.

Now let me ask you about the efforts of the IRS to combat abusive tax shelters. What have been the most effective strategies that you have found you've been able to use?

Over the last several years, the Treasury Department and the IRS have put together a regulatory scheme that relies on disclosure of these transactions, according to rules, as to the benefit or the cost of the transaction, the benefit that the taxpayer is receiving; establish[ed] clear registration requirements for the promoters of these transactions; and list[ed] maintenance requirements.

What we're doing there is basically saying, "If you show us what the transaction is, we'll be able to identify it, respond to it and treat it accordingly."

So one of the problems here, then, is that people are not showing you the transaction -- that they're camouflaged, concealed, buried, whatever -- in a tax return? It's a bit of a cat-and-mouse game as to whether or not the IRS can find them?

There is a real element of that. Transparency has not been a fine point. In fact, I would suggest to you that, in many instances, people who've designed these transactions have relied very much on the density, if you will -- just the sheer volume of transactions associated with a scheme.

Complexity.

The complexity is great, and it's a function of the code, too. One of the underlying causes of all this is that the tax code has grown so very, very complex. There's always a line that somebody can approach from the other side and push up against, because there are so many different elements of the code at this time.

We've talked to people in some industries, and they say, "People know [about the shelters]." … Yet, when we talk to some people inside the IRS, they're saying, "No, it's a much bigger problem. In the first place, corporate returns are massive in their size. In the second place, if they're not labeled or flagged for our attention, they have to be ferreted out, and they're deliberately camouflaged."

One of the things we are doing is we are working to refine our audit processes to make sure that, in addition to the disclosures and the things that are brought to us, we're asking the right questions.

I'm also insisting that we speed up our audit processes. Right now, it takes us five years on average to examine the returns of some of these complex multinational firms. That's just too long, because we don't actually get to a point where we're seeing some of the ramifications of these emerging shelters until the participants have turned to something else.

So we're working to speed up our processes [and] reengineer our enforcement and audit processes, much the way we've done as taxpayers would be familiar on the service side. Now you can file a return electronically as an individual, or you can get a question answered by some pretty sophisticated telephone routing technology that we have.

We have to do the same thing on this enforcement side, in addition to strengthening the disclosure elements, through putting some pretty stiff penalties for those who fail to comply.

You were talking earlier about strategies. It seems as though one of the focuses has shifted a bit -- not to exclude taxpayers, but to put more emphasis on going after the promoters, the people and institutions that are generating these abusive tax shelters, and going on and then marketing them to multiple clients.

We're doing both. We have a healthy audit program looking at both corporations and high-income individuals. But as you indicate, we very much have identified a pool of promoters. We have over 100 active promoter investigations under way -- accounting firms, investment advisors and law firms. We are compelling them to produce information, which in turn gives us information about the transactions, but also the names of the investors.

We've been very well supported by the Department of Justice, where last year, for the first time, actual legal actions were taken against law firms and accounting firms to compel the production of the information we need to do the audits.

Take the accounting field. Some prominent accounting firms -- PriceWaterhouse, Ernst & Young -- have been cooperative, have reached settlements with the IRS. And you've got others, like KPMG, that are fighting you in the courts over what they'll disclose. How do you deal with these two different categories?

From my point of view, there definitely is a benefit from having a transparency here as to who is trying to work with the IRS to develop a system that recognizes these are tough issues. Because of the complexity, finding the right lines is hard to do.

Ernst & Young -- you mentioned the settlement. That's a settlement that was fully and publicly disclosed, whereby they allow us to come in and take a look at their books and records to see that they are complying with all the appropriate standards for registration and list maintenance. That's a good model, and we would wish that others would follow that.

As to people [or] entities that are actively fighting us, I would hope that an investor, a taxpayer, or a corporation, would take a look and say, "Who is actually cooperating with the IRS and trying to get this right? And who, on the other hand, is fighting the IRS?" Then, I believe that that dynamic will have a corrective influence in the market itself.

Do you expect a continuing flow of legal cases to sort of get the word out that the IRS is being aggressive in watching this field?

Litigation is not a desired tool, but it's a necessary tool to demonstrate that the government will, where appropriate, take every step it needs to, to assure compliance with the law. We believe that the underlying strength and guidance, together with the fact that most people do want to comply, will help people understand what transactions are the best to do, or [are] allowable to do. But we're not going to shy away from litigation where we have to.

You mentioned a little while ago that one of the things that happens is that, when you start to go after one particular shelter, or if you take your audits and they're too slow -- five years -- by the time you finally get to a particular kind of transactions that you find unacceptable, or at least questionable, people have moved on to the next generation. Talk about that problem for a moment here. …

Look, you've got some of the best talent -- legal, accounting, financial talent -- that money can buy working to try and develop ways to minimize tax. In some instances, this has gone too far.

We need to be speedier and more agile. I think the IRS is a highly reliable organization that addresses issues like this, but we are not fast enough, and we are not focused enough. I think we're taking changes to do a better job here. Certainly, the Treasury Department and the IRS, over the last several years through the introduction of this regulatory regime that relies on disclosure and registration of these transactions, gets us the information faster to identify what's happening in the marketplace so we can respond. But we need to do more here.

We issue a lot of guidance to taxpayers. We need to do that more promptly, and we've made great strides at doing that. And we need to, as you indicate, get our audits done more rapidly. …

On the other hand, if you have a firm that is pushing the limits of the law, they're just as happy to see the clock run out, because at that point, it's harder to go after them and, frankly, they've turned to something else.

When you're playing this catch-up game, what are the most important techniques for getting the IRS as close to the market and as close to the latest kinds of abusive shelters there are?

We have to approach it from two directions. One is to understand what the promoters -- the accountants and the attorneys -- are actually out there peddling. The second is to be working on the base returns, the returns of the high-end individuals who are actually investing in the shelters, or the corporations that have these complex transactions. …

Is there a need for some kind of an across-the-board approach? The method heretofore has been to issue a tax notice about an individual kind of shelter. There is an argument, as you well know, up on Capitol Hill, promoted by Senator Grassley among others. It says that maybe we need to pass a general rule that says transactions that don't have a clear business purpose, clear economic substance and, therefore, appear to be done primarily -- if not exclusively -- for tax benefits, that those are ruled out. Where do you stand on that?

That's a policy call. As we've looked at that, while there are certain attractive elements to it, the people here who've looked at it have told me that they're convinced that that would be a very fact-intensive discussion that would be difficult to litigate. What they prefer is very clear guidance where you draw bright lines based on fact patterns, as we've done with some of the listed transactions.

So I understand why there's a move to talk about that. It's referred to [as] the "economic substance doctrine," and it is attractive conceptually. But I think it may prove to be difficult in terms of actually executing and making it effective in the courts.

What's the kind of fix that we need? Do we need legislative fixes? Do we need policy fixes? Or do we simply need to implement the compliance program more effectively?

We need a combination of all of those. We need stronger legislation that increases penalties, that will deter these promoters from failing to inform the IRS of the transactions that they are promoting, or for taxpayers to fail to disclose to us these transactions. So there's some legislative element that needs to be attached or attended to in here.

[Do] you need laws to stiffen the penalties, as a deterrent to abusive shelter promotion and use?

Absolutely. The administration put forth a basket of penalty changes, if you will, in early 2002, and they've been stuck in the Congress. They've gotten active support by many of the people in the finance committees and others, but they need to get through. We need to do that.

We also need to continue to strengthen enforcement at the IRS. It is clear that, back in the late 1990s, we had a situation where the credibility of the service was called into question on the service side. Was it being fair to taxpayers? Was it helping taxpayers understand their obligations?

A new law came in that reorganized the Service. For a period of years, the IRS really devoted its attentions almost to the exclusion of other issues to improve services. It's been successful doing that. Over 50 million people filed their tax returns electronically last year. There is a much higher level of service. People can get online now and check the status of their refunds.

But at the same time during that period, which was the same period when we had this tremendous run-up in equity valuations and a deterioration in some corners of professions -- of professional ethics -- we were drawing down, if you will. We reduced the number of revenue agents, the people who do audits. We reduced the number of revenue officers, the people who collect the moneys, and we reduced the number of criminal investigators in each category between 28 percent and 30 percent. That's a very significant change in our posture.

We are rebalancing now. What I have said is that service plus enforcement equals compliance. You have to have both elements of the equation. You can't have one to the exclusion of the other. It all has to be based on taxpayer rights, which we always have to respect, but enforcement is an element of it. So, yes, the IRS has to do a lot more in this area.

Does the IRS have the resources it needs? Does it have the manpower? Does it have a pay schedule that will attract the talent from the marketplace? Does it have a modern computer system that can keep up with however people are operating in today's world, the 21st century?

We're working to modernize our technology, and we've made strides in that area. As to people, we have a challenge because of the fact that, as we've talked about, there are so many folks on the other side out there buying the best talent. We've got a lot of very competent people, professionals, who work at the IRS, and no one should underestimate our resolve or their competence or their knowledge.

But you talk about resources. The blunt reality is that, under presidents and Congress -- Republican and Democratic alike -- the IRS struggles to get funding from the Congress. If you look at, again, what's happened in fiscal year 2004, we're hundreds of millions of dollars short of what the president requested for the IRS.

We're not an agency like something to do with highways that gets topped up in the legislative process. That causes a real challenge for us in terms of making sure we devote enough resources to the frontline.

So when you say you're "millions of dollars short," in the end, that means people; people means your ability to follow and track the abusive shelters, as well as other things.

Right. In the end, that has an impact on people, no doubt, because the president requested money for this fiscal year that we're in now, Fiscal Year 2004, to support enforcement. The principal priority of the president's budget was to support enforcement in the corporate arena and for high-income individuals. That's what President Bush asked for.

But Congress cut the funding by hundreds of millions of dollars. In the end, what that does is it hurts our ability to pay for the technology that will improve our processes. It also causes a real squeeze in terms of how many people we can afford to have on the job. …

We get an argument from people who are in the tax business, or in other related businesses that are working on the complexity of the code. They're saying, "Look, what we're doing -- even though the IRS challenges it -- is legitimate. This is all because of the complexity of the tax code. There's a huge gray area, and we take the position what we're doing is legitimate. They disagree. If the government wants to deal with this problem, the government's got to fix it. It's got to make the code simpler."

I agree that the code needs to be simpler. That's clearly one of the root causes of this problem. But at the same time, we need to return to a model where professionals help people and businesses pay no more than what they owe, but what they owe.

So you're saying it's not really fair of them to toss it all on the government's back? They're responsible, too?

They have a big piece of this. They've pushed out the lines and crossed the lines. In some cases, they've done so because they feel that the penalty for doing so is really not that significant.

You come from the world of public accounting. Here you have accounting firms that are involved in auditing corporations, auditing tax returns for individuals. In fact, in some of the cases we've looked at, they're preparing the returns for the individuals who're using shelters marketed by the same firm. What does it do to accountant and auditor independence if the same firm is marketing shelters to a client and then turning around and auditing that client's income tax return?

It clearly influences the independence issue, which is at the essence of the relationship between the auditor and the public who's relying on that audit opinion to give a "Good Housekeeping" seal of approval, if you will. The trick here, though, is drawing the line between legitimate tax compliance advice, and tax planning in this more aggressive arena that generates the big fees.

From the public standpoint, to a certain extent, an auditor is a cop. How can you be the cop on the beat -- the corporate audit beat -- and do your job right, at the same time you're selling a service to the person you're supposed to police?

It's very hard. I think that these firms have struggled and, in some instances, failed to live up to their audit responsibilities for just the reasons you suggest. The revenue stream can become very great, or if an auditor's signed off on the accounting treatment of a tax transaction, it's very hard to revisit that later if the IRS is questioning it. It's a complicated cocktail that does, for sure, diminish the purity of that audit role.

Is it a "complicated cocktail," or is it a flat-out conflict of interest?

I think that there can be a conflict of interest. It depends on the way the that firms engage in that role. It also depends on where you're drawing the line, again, between legitimate advice that is tax compliance advice and some of the more aggressive tax planning. It's very hard to draw that line.

If you're an accounting firm and your audit business is netting you $3 million and your tax shelter business is netting you multiples of that, what are the incentives? What are the competitive pressures?

I think that raises a great deal of difficulty, and obviously, some potential pressures on the auditors to recognize that relationship on the tax side of the firm. So it is troubling. …