Identifying and Quantifying Rates of State Motor Fuel Tax Evasion (2008)

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14 2.1 Introduction Over a 10-month period from October 2004 through August 2005, the project team conducted 35 interviews with state and tribal tax administrators, industry representatives, federal agents, the American Petroleum Institute (API), the Ameri- can Trucking Association (ATA), the FTA and the Petroleum Marketers Association. The list of target interviews was devel- oped with diversity and geography in mind. The organizations targeted for interview represent a diverse set of interests that all have a stake in the collection of motor fuel excise taxes but may have different concerns and approaches for minimizing evasion. Figure 2-1 shows the geographic spread of states (typically Department of Revenue or Transportation repre- sentatives) that were represented in the interview process. The states represented in the fuel tax interviews cover each U.S. region and a broad spectrum of motor fuel tax enforcement characteristics. Collectively, these characteristics include: a) high, moderate, and low tax rates; b) taxation at every point in the distribution chain; c) international borders; d) a broad range of enforcement program levels; e) significant Native American concerns; and f) vastly different penalty and fine levels. In addition, interviews were conducted with the rep- resentatives from the Office of the Navajo Tax Commission and the Canadian Fuel Tax Council. Interviews that were conducted with petroleum industry representatives included Sinclair Oil Corporation, Chevron Corporation, National Biodiesel Board, American Petroleum Institute, and the Petroleum Marketers Association. Federal government interviewees included the FHWA, the IRS, and the Office of the Inspector General (OIG). Other organizations interviewed included the FTA and the ATA. The objective of the interviews was to document current state motor fuel tax administrative and enforcement practices and to identify notable problems, policies, and issues that must be addressed in the modeling phase of this research program. Interviews and follow-on data collection efforts were under- taken to achieve the objective. Before conducting the inter- views, an interview protocol was developed and tested on tax administrators in Oregon and Washington. Experience with these interviews along with comments and suggestions from the review panel were used to revise the protocol. Discussion questions are included in Appendix B. The interviewees were given a copy of the protocol and informed that the questions were to be used as a guide to ensure consistent coverage of topics; however, interviewees were not bound by the questions and were encouraged to discuss all relevant issues, regardless of whether they were included on the protocol or not. Initial interviews were conducted at the October 2004 FTA Motor Fuel Tax Section meeting in Boston, Mass. Interviews were conducted over a two-day period, mostly with tax admin- istrators. Remaining interviews were conducted by phone. The interview results were used to develop a preliminary list of topics for the issue papers that could potentially provide insight to developing methods to quantify state motor fuel tax evasion. The remainder of this chapter focuses on evasion methods and on the issues raised in the interviews. Interview responses are summarized in Appendix C. 2.2 Methods Used to Evade Motor Fuel Taxes The rise of elaborate schemes to evade motor fuel excise taxes was seeded by the unprecedented increases in state and federal fuel tax rates experienced during the 1980s and early 1990s. Between 1980 and 1994, federal and state fuel tax rates ascended steadily, from 4 and 9.8 cents per gallon to 18.4 and 20.8 cents per gallon, respectively. The state average tax rate is weighted on a volumes-taxed basis. During the same time period, the passage of the Surface Transportation Assistance Act (STAA) of 1982 doubled federal fuel tax rates within just a few years. Motor gasoline tax rates are depicted in Figure 2-2. State tax rates in the figure are averaged over all U.S. states, C H A P T E R 2 Perspectives on State Fuel Tax Enforcement Practices

weighted based on taxed volumes. Diesel taxes have had equiv- alent rate increases. With these significant motor fuel tax rate increases, evasion of motor fuel taxes became a lucrative venture. In the mid 1980s, the IRS and state agencies discovered that organized crime was running large volume schemes known as daisy chains. In this scheme, paper transactions are run through several dummy corporations, with fuel entering the first com- pany as nontaxed and exiting the last company as tax paid. Before federal agents can detect the scheme and eradicate it, one dummy company in the chain, known as the burn company, would dissolve along with any tax liability. However, tax eva- sion schemes detected to date have included more than large conspiracies involving organized crime. Fraudulent practices were discovered at many levels and scales throughout the motor fuel supply chain. While large organized crime operations were involved in elaborately concocted evasion schemes, small retail- ers and distributors simply could not report all or some of their gallons sold. Even motor fuel consumers had profit opportu- nities through tax fraud. For example, consumers could easily purchase tax-exempt fuel and use it on-road. Federal and state agencies found themselves hard pressed to keep up with these multilevel and multifaceted evasion tactics. As federal and state agencies have changed their administra- tive practices and motor fuel excise tax programs to cope with enforcement problems, the character, magnitude and variety of fuel tax evasion schemes have changed as well. It does not take long after steps are taken to curb motor fuel tax evasion for new ways of evading fuel taxes to be devised. Predominant tax evasion schemes prior to the tax at the rack policy adopted by the federal government and many state governments 20 years ago consisted of daisy chains, nonfiling and underreporting scams. Since some states still tax at the distributor level, these states continue to be susceptible to the aforementioned tech- niques. Tax at the rack jurisdictions are more likely to experi- ence evasion through bootlegging across jurisdictional borders, large unreported imported bulk shipments, blending, and refund schemes. To understand fuel tax enforcement challenges facing states, several motor fuel tax evasion schemes were examined by describing how these schemes are accomplished, where they occur in the fuel distribution chain, and what techniques have been used to cope with each form of evasion. Further, actual case examples have been provided wherever feasible. 15 Shaded States were interviewed. (Alaska interviewed, but not shown) Figure 2-1. Geographic representation of states represented in fuel tax interviews. 0 5 10 15 20 25 30 35 40 45 19 18 19 23 19 28 19 33 19 38 19 43 19 48 19 53 19 58 19 63 19 68 19 73 19 78 19 83 19 88 19 93 19 98 Year Ta x R at e (ce nts ) Federal Taxes State Taxes Federal & State Total Source: American Petroleum Institute, 2002 Figure 2-2. Historical federal and state gasoline tax rates, 1918–2002.

2.2.1 Use of Dyed Fuel On-Road 2.2.1.1 Description Business operations using off-road vehicles (e.g., farming, logging and construction) purchase tax-free dyed diesel. Dyed diesel is often delivered to these businesses and transferred into private storage tanks for use in off-road vehicles. To evade fuel taxes, diesel fuel in these tanks is used to fuel on-road vehicles owned by the business or individuals associated with the business. Another common way perpetrators fuel their on-road vehicles with dyed diesel is by using card-lock systems at retail stations that allow registered customers to access tax-free fuel by swiping a card. These stations are generally unmanned and a person with an access card can fill their on-road vehicles fuel tank or fill a container for later use in their highway vehicles. 2.2.1.2 Case Example This scheme is thought to be extremely common and gen- erally occurs on a small scale by many separate individuals, particularly individuals who own or work for businesses oper- ating off-road vehicle equipment. One northwest television news group created a team of seven investigators to follow the misuse of dyed fuel in Washington State (Halsne, 2002). This team uncovered an extensive enclave of truckers, loggers, con- struction crews, and fruit growers using dyed fuel on-road. Here is a portion of the video transcript recounting an incident when the news team investigation crew caught up with an owner of a trucking and excavating business in Washington State who had just been seen filling his truck with dyed diesel: Investigator: “Is this truck yours?” Driver: “Yup.” Investigator: “You own it?” Driver: “Yup.” Investigator: “We have videotape of you filling up your side tank here with red fuel.” Driver: [Shrugs] “I don’t see any harm in it, just a pinch to do it. We pay thousands of dollars in taxes ever day for this kind of stuff. Yah, it’s wrong, but if you’re in a pinch, I’d say go ahead and do it.” 2.2.1.3 Point of Occurrence in the Distribution System This scheme occurs below the terminal rack at the retail level. 2.2.1.4 Evasion Curtailing Methods The use of dyed fuel on-road can be deterred by changing the incentives to cheat such that the benefits of tax evasion are far outweighed by the risk of penalization. This can be accom- plished by instituting considerable financial penalties while simultaneously implementing a vigorous on-road fuel inspec- tion program. Often, due to resource constraints, the level of on road enforcement required cannot be achieved. Further, on-road enforcement may be constrained in some jurisdictions due to the fact that law may prohibit state agents from perform- ing on-road inspections in the absence of probable cause. Another technique to curtail the use of dyed fuel on-road is to register, license, and require reports from entities purchasing dyed fuel. To lessen the administrative burden of this approach, a state does not necessarily have to register all dyed fuel users. Instead, a limit can be placed on the number of gallons that can be purchased tax free. If individuals or businesses wish to purchase above this limit, they must be registered and licensed. In this manner, entities using tax-free fuel will be under the radar of collection and enforcement agencies (Reistma, 2005). Another technique would be to require an undyed fuel usage report to be filed by individuals purchasing undyed fuel. Usage significantly above the business norms for the vehicles by industry standard would be sent a bill for taxes on that portion above the average for their particular industry. This would require the purchase of undyed fuel licenses, which would require the paperwork indicating the hours of usage by vehicle. If implemented at both the state and federal level, the added paperwork would be inconsequential for the right to use undyed fuel. 2.2.2 Abuse of IFTA Return Process 2.2.2.1 Description IFTA is an agreement between jurisdictions that simplifies fuel tax remittance for multi-jurisdictional operating taxpayers by allowing them to file with one base jurisdiction. The base jurisdiction collects and disperses fuel taxes to other jurisdic- tions. The International Fuel Tax Association is a not-for-profit organization that receives dues from each jurisdiction and serves as support staff to aid communication and organiza- tion between these jurisdictions. The presence of differentials between state tax rates generates incentives to evade motor fuel taxes by defrauding the IFTA system. The following are examples of ways motor carriers can evade tax collections (Alderman, 2005): • A motor carrier who buys fuel in a high-tax state can falsify information on IFTA returns claiming that more miles were driven in a low-tax state than actually were. The carrier receives a credit or refund, thus avoiding a higher tax bur- den and the high-tax state is underpaid. • A motor carrier can purchase fuel in a low-tax state, do much of their driving in a high-tax state, but falsely claim lower 16

miles driven in the high-tax state. Thus, they avoid having to pay extra taxes to the high-tax state on the fuel they bought in the low-tax state. • A motor carrier who obtains untaxed fuel can provide forged receipts for their IFTA return claiming taxes were paid on the fuel. • A motor carrier, who actually bought fuel in a low-tax state, can provide forged receipts claiming that the fuel was pur- chased in a high-tax state while also claiming those gas miles were driven in the low-tax state. The motor carrier would receive a credit or refund, the high-tax state would issue a refund where none was deserved, and the low-tax state would receive road funds that were not warranted. • Motor carriers can avoid tax liability by simply not regis- tering with IFTA and not filing IFTA returns. One way of getting away with this is by illegally obtaining IFTA decals. These decals could be stolen somehow, but in some states, carriers may have extra decals that they could pass on to unregistered carriers. This technique is enabled by some states, which allow motor carriers to obtain more IFTA decals than the number of vehicles in their fleet, so that they do not have to obtain new decals every time they wish to expand their operations. To the extent that these decals are sold to evading motor carriers, these motor carriers can avoid on-road detection of noncompliance with IFTA, pur- chase fuel in low-tax states, and fail to reconcile tax payments with tax liability, thus increasing profits by an amount equal to the difference between the tax paid on gallons purchased and taxes owed to the states where the fuel is consumed. IFTA evasion generally was not viewed as a widespread prob- lem by the tax administrators surveyed for this study; however, there is evidence to suggest that IFTA evasion may be a more significant issue than realized (Balducci et al., 2006). Further, IFTA audits could be used to detect other forms of motor carrier evasion unrelated to IFTA. 2.2.2.2 Case Example States are required to conduct audits on a minimum of 3 percent of all IFTA returns for motor carriers. Some states may audit at a higher rate, but due to resource constraints, most are not able to do so. Further, jurisdictions often find that assessments are minimal for the given audit effort. Thus, high profile criminal cases of IFTA abuse are not common and IFTA audits are generally viewed more as a deterrent than as a revenue-generating procedure. Tommy Mitchell Thompson: Thompson was ordered to pay a $1,000 criminal fine and $22,000 in restitution to the State of North Carolina after he was sentenced for failing to correctly file his mileage and fuel purchases throughout the United States. This was an unusually high assessment (NCDR, 2002). 2.2.2.3 Point of Occurrence in the Distribution System This scheme occurs below the terminal rack. 2.2.2.4 Evasion Curtailing Methods There are many methods for approaching IFTA non- compliance. One way of preventing motor carriers from operating without IFTA registration is to increase on-road enforcement. Further, jurisdictions are not always able to cross check IFTA decals with the actual company or name that the decals are registered under (Alderman, 2005). This leads to the ability of motor carriers not registered with IFTA to obtain and use decals of other registered carriers and not get caught. One way of preventing this method is to have a system that enables enforcement officers to link the actual decal with the registered party. Elevating the effort to audit motor carriers is also another and obvious option for improving compliance. This may not be a very favorable option for many jurisdictions, however, because of financial constraints and also because IFTA audits have not led to very sizable assessments. A number of tax administrators interviewed for this effort noted that IFTA audits yielded a negative return on investment. Increasing penalties for IFTA nonpayment or nonregistra- tion may improve the return on investment for audits. To improve the efficiency of and speed at which existing audits take place, substantial penalties can also be imposed for inadequacy of records kept by taxpayers. 2.2.3 False Refunds or Credits 2.2.3.1 Description The extent that fuel tax evasion through refund and credit schemes is a significant compliance issue depends on the point of taxation and how elaborate the exemptions are within a jurisdiction. For instance, tax systems with a point of taxation high in the distribution chain (e.g., the terminal rack) tend to generate higher rates of refund and credit filings as taxpayers recover payments made on taxed fuel used for nontaxable pur- poses. Also, the more exemptions a jurisdiction allows, the more refund claimants it is likely to have. There are generally two types of claimants: a user who buys or a vendor who sells fuel to be used for a nontaxable purpose. Contingent on the types of exemptions that a jurisdiction allows, the following reasons that refunds or credits may be claimed by a buyer or seller of taxed un-dyed fuel might include: • Fuel used in agricultural equipment, • Fuel used by a government agency, • Fuel used in commercial off-road equipment, 17

• Fuel used in marine vehicles, • Fuel used in home or business heating, • Fuel used in certain intercity buses, and • Fuel stolen, accidentally destroyed, or contaminated. A buyer or seller may falsely claim on their refund or credit application that fuel was sold or bought for one of the above purposes, thus evading the tax owed. It also is possible under certain circumstances for a wholesaler to apply for a refund or credit as well. Under a tax-at-the-rack system, a wholesaler can claim to export or sell for export previously taxed fuel. The fuel, in turn, could be sold within the jurisdiction with the wholesaler keeping the refund as profit. 2.2.3.2 Case Example Samuel Yakabowicz Case: Yakabowicz, owner of Twenty- Four Hour Fuel Corporation in Brooklyn, NY, was found guilty of filing false tax returns and obstructing an IRS audit. Yakabowicz managed to evade $684,318 on more than 2.8 mil- lion gallons by fraudulently claiming tax refunds for fuel that was purportedly sold to a tax-exempt railroad but was actually sold to gas stations selling to the general public for on-road use. He also, on numerous occasions, delivered tax-exempt home heating oil to a railroad and claimed that it was taxed diesel fuel. For these misdeeds, Yakabowicz was sentenced to 5 years in prison and ordered to pay $750,000 in restitution (OIG, 2003). 2.2.3.3 Point of Occurrence in the Distribution System Schemes involving refunds and credits occur in the nonbulk distribution system. 2.2.3.4 Evasion Curtailing Methods Most jurisdictions that tax at the terminal rack do have significant refund programs, which lead to opportunities for abuse. One way to manage these compliance difficulties is to eradicate refunds all together (i.e., clear diesel used for farming equipment will not be entitled to a refund), though this option is generally politically infeasible. For jurisdictions that continue to allow refunds, information from electronic reporting by industry and motor fuel tracking systems can be used to trace refund requests back to suppliers so that phony receipts can be identified (Anders-Robb, 2004). Some states estimate the appropriate rate of fuel use for agri- cultural purposes on a per-acre basis and compare the estimate to the amount claimed for refund to ensure that farmers aren’t claiming vast volumes relative to their farming needs. Similar approaches could be used to estimate the usage per dollar of revenue for other industries claiming a refund. Estimates of gross revenue could be found on income tax statements in most states. States without income taxes could request copies of Federal 1040 filings to get estimates of fuel used and gross rev- enue for purposes of checking refund claims. Refunds would not be approved for claims above industry averages. In addi- tion, to further reduce refund fraud as noted in the case exam- ple above, requirements for permits and signatures for each purchase would reduce the incentives for fraud if random audits of sellers could improve the chances of being caught. 2.2.4 Bootlegging Across State Lines 2.2.4.1 Description When bootlegging fuel to evade motor fuel excise taxes, the fuel is first purchased in a state with a low-tax rate. Without filling out the proper export documentation, it is then exported to a border state with a higher tax rate and sold at retail stations without remitting the tax in the high-tax state. The tax evader yields extra profit equal to the difference between the tax rates for each gallon illegally imported. Bills of lading can be forged to avoid detection while the fuel is being transported. 2.2.4.2 Case Example It is generally perceived that this is a problem for bordering jurisdictions with a significant tax rate differential. However, no case examples were identified. 2.2.4.3 Point of Occurrence in the Distribution System This scheme occurs below the terminal rack. 2.2.4.4 Evasion Curtailing Methods Many jurisdictions share import and export information, which can help identify any discrepancies. This information can be analyzed more efficiently when electronic reporting and uniformity exists. When bordering states have fuel tracking systems that allow total fuel accountability and these systems are uniform, importing or exporting across state lines without knowledge of both jurisdictions becomes very difficult. 2.2.5 False Claim of Export 2.2.5.1 Description Perpetrators buy fuel within one jurisdiction and file paper- work claiming it is tax exempt because it will be delivered to another jurisdiction. However, the fuel is actually sold within the jurisdiction where the fuel was purchased, thus avoiding the tax. This scheme occurs between states and across inter- national borders. Tax evaders go to extreme lengths to mask their crimes. For example, there is evidence to suggest that 18

perpetrators have dumped their fuel within a state and refilled the carrier tank with water so that a weigh station would assume that there is fuel inside the tank (Turner, 2004). 2.2.5.2 Case Example Nicholson Brothers Case: Bruce Norman Nicholson and Brian Lynn Nicholson were convicted in 2001 of evading more than $12 million in motor fuel taxes in Texas and New Mexico for several types of fuel tax evasion schemes. The brothers owned and operated a series of companies (e.g., J&R Mercan- tile, Rogers Oil, Allstar, and Sunwest-C). One scheme they organized was a false export scam. The brothers purchased gasoline and diesel tax free from refineries in Texas and claimed that the product was to be exported from Texas. The fuel was not exported but instead distributed to 25 convenience stores that they operated throughout Texas (Billstone, 2005). 2.2.5.3 Point of Occurrence in the Distribution System This scheme occurs below the terminal rack. 2.2.5.4 Evasion Curtailing Methods As is the case with fuel tax fraud via bootlegging across state lines, false exports also can be detected when bordering states have total fuel accountability through fuel tracking systems and uniformity. 2.2.6 Illegal Importation of Fuel from Foreign Refineries 2.2.6.1 Description Untaxed fuel is smuggled into the country and sold to retail- ers at taxed rates. Perpetrators of this scheme take advantage of the fact that state and federal agencies have no jurisdiction over foreign fuel supply operations. Thus, fuel can be purchased from foreign entities and brought into the United States and distributed under the radar of the IRS and state tax agencies. Fuel is bought from a foreign refinery or bulk dealer and transported to the United States by truck or shipped by ocean vessel. By truck, fuel can be illegally imported and delivered to retail stations or perpetrator-owned terminals or bulk plants. If fuel is delivered to terminals or bulk plants, required reports are not filed. At border crossings, truckers are required to present, if requested, a bill of lading (BOL) to U.S. Customs. These BOLs can be forged. Further, there are border crossings not routinely manned by customs agents that these trucks can pass through. Even when U.S. Customs or state police patrol borders, there is evidence to suggest that tanker operators effectively com- municate with each other to avoid such stings or checkpoint operations. One study designed to detect cross-border smug- gling examined the operations of petroleum tankers crossing from Canada into Washington State through two international border crossings [Washington State Legislative Transportation Committee (WSLTC), 1996]. To establish a benchmark, in- spectors from U.S. Customs counted the number of petroleum tankers crossing into the United States daily over a seven day period. During this time, an average of 1.6 petroleum tankers crossed into the United States on an hourly basis. Next, uni- formed Washington State Patrol (WSP) enforcement officers and IRS diesel compliance officers were dispatched to the inter- national border crossings to weigh and inspect trucks, and to dip tanks. During the three-day inspection, there was a marked decline in the number of petroleum tankers passing through these international border crossings, thus demonstrating the ability of tanker operators to communicate with each other to detect and bypass inspection operations (Figure 2-3). For fuel brought by ocean vessel, there are a few possible ways of unloading fuel from a ship without being detected. A perpetrator could simply not file Customs Form 3461, which contains shipment details such as when a shipment is scheduled to arrive and other data regarding the cargo, and Customs Form 7501, which is a statement of arrival of the shipment. However, there is a risk of being discovered unless the offloading happens at a hidden or remote location. A perpetrator could file the appropriate import documents, under-declaring the quantity of fuel actually imported. When the shipment arrives in the United States, the perpetrators only offload the amount of fuel claimed on Form 3461 in front of the gauger (customs officer inspecting bulk loads). After the gauger has signed the paperwork and left, the illegally imported fuel could then be offloaded. Alternatively, the gauger could be a part of the scheme (CBPP, 2004b). The fuel could then be delivered to the terminal or bulk plant, which would be owned by one of the perpetrators of this scheme. The gallons are not reported on federal and, if required, state terminal or bulk plant reports at delivery. Upon sale of the fuel, the perpetrator avoids the tax by not reporting the gallons on IRS Form 720 and equivalent reports at the state level. Also, these gallons also are not recorded as disbursements on terminal reports. 2.2.6.2 Case Example While these cases have been suspected by state and federal fuel tax administrators, no cases of criminal prosecution were identified for this study. 2.2.6.3 Point of Occurrence in the Distribution System This scheme affects points throughout the distribution process, both bulk and nonbulk. 19

2.2.6.4 Evasion Curtailing Methods A system of total fuel accountability can disable perpetrators from selling illegally imported fuel if distributors or retailers are required to report the source of those volumes. Information exchange among foreign jurisdictions that require detailed reporting from their refineries and terminals also may be help- ful in identifying any leakages. Finally, border interdiction efforts can detect and curb evasion of motor fuel taxes due to smuggling. Certain technology can be applied as well to detect the move- ment of fuel loads across borders. Remote sensing devices can be used to track truckers crossing borders and allow inter- diction on remote border crossings. Further, Global Position- ing Systems (GPS) devices can be required to be attached to fuel tanker trucks to track truck movement and identify both miles and location of trucks entering the United States for IFTA. Not having an operational GPS device could, in turn, be an offense that could result in a penalty of a magnitude that would stop offenders. In addition, the comparison of GPS miles to truck odometer miles would be an easy check of compliance. 2.2.7 Abuses Due to the Presence of Native American Reservations 2.2.7.1 Description The issues faced by tax agents and compliance officers due to the presence of the Native American exemption are significant. According to the Bureau of Indian Affairs, there are 562 fed- erally recognized tribal governments in the United States. These governments are spread out geographically over the United States from Alaska to Florida and from Maine to California. There are concentrations of Native American tribal govern- ments in New Mexico, Arizona, Colorado, and Nevada. Fig- ure 2-4 presents a map of the Native American Reservations in the continental United States. The presence of retail motor fuel outlets on Native American reservations, therefore, presents two problems for federal and state tax agents and compliance officers: • Nonreporting or inaccurate reporting of the quantity of fuel sold, which leads to lower returns of fuel tax dollars to the state from the federal highway trust fund than should be the case. • Evasion of motor fuel excise taxes by motorists who pur- chase motor fuel on Native American reservations, but are not enrolled members of a Native American Tribe. As noted in FTA’s Survey of Native American Issues, there are a number of states that have entered into agreements for the collection of taxes with Native American Tribes (Arizona, Louisiana, Minnesota, Montana, Nebraska, Nevada, Oklahoma, South Dakota, Utah, Washington, and Wisconsin), states that are in active negotiations with tribes (Arizona, Connecticut, Montana, Nebraska, Nevada, North Dakota, Oregon, Utah, and Wisconsin) and states that are currently embroiled in litigation with tribes over the issue of motor fuel taxation (Idaho, Kansas, Minnesota, Nevada, and Pennsylvania) (FTA, 2002a). While some states do have agreements about administer- ing state fuel taxes in place with tribes, court cases in other states have determined that taxation of fuel in these lands 20 Source: WSLTC, 1996 0 0.2 0.4 0.6 0.8 1 1.2 1.4 1.6 1.8 US Customs (Average Petroleum Tanker Trucks Crossing per Hour) WSP - Day 1 WSP - Day 2 WSP - Day 3 Figure 2-3. U.S. Customs versus WSP truck check.

would violate the sovereignty of these nations. In many states, Native American retail outlets may purchase tax-free fuel or obtain a refund for fuel distributed to reservation residents. One evasion scheme arises from the fact that fuel can be imported from Canada and delivered directly to Native American reser- vations without being reported. Perpetrators can, instead of actually delivering the product to the reservation, divert it to be sold for taxable purposes. If fuel is imported without filing correct customs paperwork, it would be very difficult to detect the diverted gallons since reporting to tax agencies isn’t required. 2.2.7.2 Case Example While abuses of this kind are often suspected, the federal government and states are restricted in how to respond as a result of the pervasive court cases and legal issues related to this problem. The IRS has filed tax liens totaling $79.3 million against three St. Regis Mohawk distributors for importing over 400 millions gallons from Canada; however, the liens have not been enforced (CBPP, 2004b). Nicholson Brothers Case: Gasoline and diesel was purchased tax free from refineries in New Mexico under the false claim that it would be delivered to the Navajo Nation. Instead, the fuel was delivered to New Mexico and Arizona truck stops and convenience stores that were operated by the Nicholson’s. The Nicholson brothers were not Navajo themselves, but had Navajo connections (Billstone, 2005). 2.2.7.3 Point of Occurrence in the Distribution System Abuses resulting from the presence of Native American tribes can occur in the bulk and nonbulk distribution system. 2.2.7.4 Evasion Curtailing Methods Some states have memoranda of understanding with Native American tribes, which can help to curb motor fuel tax evasion. These agreements can encompass provisions for fuel tracking, tax collections remitted to the state, refunds, and retailer licens- ing. If fuel is falsely imported to a Native American reservation, customs reports—if filed—may be compared to fuel transac- tions on reservation land to detect illegal diversion. Taxing motor fuel at the rack limits exposure to evasion as Native Americans must apply for refunds, which can be checked for 21 Source: Bureau of Indian Affairs. Figure 2-4. Native American reservations in the continental United States.

reasonableness, on all fuel delivered from local refineries and terminals. Some states have instituted policies where refunds are capped based on the number of enrolled members of a tribe and an assumption regarding a reasonable average number of gallons consumed per person for the time period each refund claim covers. 2.2.8 False Product Labeling 2.2.8.1 Description The fact there are fuel products that have dual purposes or that there are other nontaxable products that can be used as a substitute for taxable product (e.g., kerosene, used oil, aviation fuel, off specifications fuel, and dyed fuel) creates opportunities for tax evasion. Fuel tax evaders can falsely label a taxable prod- uct as a nontaxable product at the point of taxation but even- tually sell it for a taxable purpose. Mineral spirits is one form of fuel that is not taxable but can be used as a substitute for diesel. In some states, kerosene is not taxable and so a per- petrator can label diesel as kerosene and avoid state fuel taxes. Another scheme involves dyed diesel being acquired and delivered to retail stations under the false presumption that it is taxed fuel. Darker oils, such as waste oils, can be blended in with the dyed fuel to mask the apparent color. For these schemes, a perpetrator can minimize the risk of being caught by forging a BOL that specifies that the fuel had been taxed. 2.2.8.2 Case Examples William S. Nappo Case: Nappo owned Eagle Oil Company in New York and was sentenced to 21 months in prison and ordered to pay $1.3 million dollars to the federal government in February of 2001 for fuel tax evasion. In 1994 and 1995, Nappo sold 5.7 million gallons of diesel fuel for on–road vehi- cles without remitting tax on those gallons. He accomplished this through falsified documents claiming he was selling home heating oil (U.S. Department of Justice, 2002). 2.2.8.3 Point of Occurrence in the Distribution System This scheme occurs below the terminal rack, at the distrib- utor level. 2.2.8.4 Evasion Curtailing Methods False labeling may be detected by having a fuel inspection program that includes collecting samples from distributors and retail outlets. In addition, a requirement to have signatures and permits for undyed fuel usage would significantly reduce the potential for false labeling of fuel. Spot checks of signatures and delivery addresses could quickly identify fraudulent mis- labeling of product. 2.2.9 Cocktailing 2.2.9.1 Description Many products, not taxable or tracked by states or the IRS, can be used in gasoline or diesel engines. By blending these products with taxable fuel, fuel volumes can be extended. Perpetrators can either blend these products for their own use or they can profit from the tax collected on sales of the number of extra gallons created through blending. The actual process of combining the fuels can occur anywhere below the terminal rack (e.g., in a tanker truck, storage tanks at a bulk plant, or in storage tanks at a retail station) (CBPP, 2004a). Many potential products can be blended with gasoline and diesel. One indicator that products have been blended is that some blending products will cause the overall blend to be darker in color. Further, some products, depending on the ratio of blend, will affect engine performance and may cause damage to the engine. Products that can be blended with diesel include: aviation fuel, bio-diesel, waste oils, used motor fuel, alcohol, transmix, and alkylates. Gasoline can be blended with transmix, or a number of blending stocks, which include toluene, alky- lates, naphtha, and natural gasoline (Anders-Robb, 2004). 2.2.9.2 Case Examples Richard Straka and Augustine Pesaturo Case: Pesaturo owned the Massachusetts-based company Covenant Oil and Straka was an employee. Both men were convicted of blending untaxed kerosene and home heating oil with diesel and not reporting tax on the blend (IRS 2005). 2.2.9.3 Point of Occurrence in the Distribution System This scheme occurs below the terminal rack. 2.2.9.4 Evasion Curtailing Methods Cocktailing schemes can be discovered through fuel sam- ple collection and testing from tanker trucks and retail sites. 2.2.10 Tampering with Fuel Dye Equipment 2.2.10.1 Description Many terminals with dye injection equipment have card systems in place so that registered drivers can load fuel with- out assistance. Further, these terminals are sometimes un- 22

manned at certain times of the week. A perpetrator can pull up to the loading rack, order a load of dyed diesel, tamper with fuel dye injection equipment, and leave with undyed and untaxed fuel. 2.2.10.2 Case Example John M. Baker Case in Indiana: Baker operated Baker Oil Company and managed several truck stops in Orleans, Indiana. Based on an affidavit filed by an Indiana Department of Rev- enue investigator, Baker was arrested in September 2003 for tampering with fuel dye equipment. Baker was seen on sur- veillance videos rigging fuel dye injector equipment during the night at two unmanned terminals using a card lock system to enter and load fuel from the facility. The particular system that Baker bypassed had a 3-valve injection system (e.g., an intake valve, an injection valve, and a test valve). He was seen lifting the seals enclosing the valves and opening the test valve and closing the injection valve with a crescent wrench. The fuel was loaded, but instead of the dye being injected into the load of fuel, it was emptied into a separate bucket. An audit of his truck stops suggested that Baker collected over $500,000 in federal and state fuel taxes, which was not remitted to these agencies (CBPP, 2004b). 2.2.10.3 Point of Occurrence in the Distribution System This scheme occurs at the terminal rack. 2.2.10.4 Evasion Curtailing Methods States can adopt certain dye injection equipment standards to prevent easy access rigging of dye injection. Such standards can direct the installation of anti-tampering mechanisms (e.g., seals, sealed handles, and sturdy padlocks) on fuel dye injection equipment. Increased surveillance also can help to catch or deter those who tamper with dye injection systems. 2.2.11 Failure to Splash Dye 2.2.11.1 Description Terminals that do not have dye injection equipment, or do but the equipment is malfunctioning, are allowed to permit dye to be splash blended (i.e., directly poured into the tanker truck). A tanker truck operator can purchase the fuel as tax free but fail to splash dye it and then sell it as tax-paid fuel, pocketing the amount of the tax. Suspected cases have involved a truck pretending to pour dye into the tanker truck and mod- ified tanker trucks with internal storage containers that dye is poured into so as not to mix with the fuel (CBPP, 2004b). 2.2.11.2 Case Example While this type of scheme has been suspected, no prosecu- tions resulting from such cases were identified for this report. 2.2.11.3 Point of Occurrence in the Distribution System This scheme occurs at the terminal rack. 2.2.11.4 Evasion Curtailing Methods This scheme can be stopped by disallowing the splash dye method and by requiring terminals to obtain and maintain operating dye injection equipment. 2.2.12 Illegal Removal of Dye from Exempt Fuel 2.2.12.1 Description Dyed fuel is purchased and the dye is removed. The fuel is then sold at the retail level at taxed prices and the perpetrator pockets profit equal to the tax. There are many possible ways of ridding apparent red color from fuel (e.g., bleaching, masking, adding sulfuric acid, filtration, and re-refinement). These methods are discussed in further detail below: • Bleaching: Household chlorine bleach is added to dyed non- taxed fuel to eliminate the visible red color (Marley, 1994). • Masking: Green dye is added to red dyed fuel to conceal the appearance of red. The mixture of the red and greed dye produces a grey color that can not easily be identified (Taylor, 2005). • Sulfuric Acid: Sulfuric acid can be added to dye to remove perceptible red color similar to using household bleach. The major problem with this method, however, is that this concoction is extremely volatile and dangerous to its han- dlers (Taylor, 2005). • Filtration: Dyed fuel is transported to a warehouse where a charcoal filtration system has been set up. The fuel is run though the filtration system until no apparent red color is present. • Re-refinement: Dyed fuel is bought and transported to a leased or owned, and most likely small, refinery and then refined to remove the dye. There already exist refineries that carry out the process of extracting red dye from trans- mix (i.e., the interface between dyed and undyed diesel in a pipeline) (CBPP, 2004b). 2.2.12.2 Case Examples Hall Foster Case: Foster owned and operated Liskeard Transport, a fuel delivery company in Ontario, Canada. He was 23

caught, after being flagged for investigation when an inspector saw him purchasing tax-free fuel with cash, dumping a carton of green dye into the fuel tank on route between pick up and delivery. Ontario was able to test the fuel to ensure that it had originally been untaxed dyed diesel because of an invisible chemical marker that is injected into the fuel along with the dye. Foster had been delivering five to six loads of fuel a week, making $8,000 to $9,000 in profit weekly. Foster was assessed $16 million in fines in 1996, three times the amount of tax it was believed that Foster evaded (Taylor, 2005). Murry Bowes and John Sangalia Case: Bowes and Sangalia bought tax-free, dyed diesel and brought it to a warehouse where they removed the dye. They had several large cylindrical containers that contained charcoal. The fuel was emptied into the first tank, filtered and then pumped into the next tank where it was filtered again. This process continued over sev- eral tanks until all visible signs of the red dye were gone. The charcoal could only be used for a limited duration of time, and the perpetrators dumped it into an adjacent field. This oper- ation was estimated to have persisted for eight years. Bowes did not go to trial due to ailing health. Sangalia was sentenced to two years in prison in 2002 for fuel tax evasion and other offenses such as environmental pollution (Taylor, 2005). 2.2.12.3 Point of Occurrence in the Distribution System This type of evasion scheme occurs during the nonbulk distribution process. 2.2.12.4 Evasion Curtailing Methods A few jurisdictions have adopted the use of chemical markers integrated with fuel dye. Processes that are used to remove apparent red color from tax-exempt fuel do not remove the invisible marker. This scheme can be detected through the use of the invisible marker and a fuel dye inspection program that incorporates laboratory testing of fuel. 2.2.13 Failure to Remit Tax Payments 2.2.13.1 Description The IRS and many states allow distributor registrants to pur- chase fuel untaxed. Perpetrators either obtain a registration legally or illegally or forge the registration documentation. Tax-free fuel is purchased and then sold as tax-paid fuel to other wholesale distributors or retailers. They evade the taxes by simply failing to file returns with the state and the IRS. A perpetrator may get away with this for some time before enforcement agencies can come after them due to long time periods between the filing of reports and remittance of tax. Further, the state agency must check the evading company’s reports against other businesses to detect discrepancies or must find irregularities in the tax filings during the auditing process. 2.2.13.2 Case Example Eugene Slusker: Slusker forged a registration and used an alias to purchase untaxed diesel, which he then sold to truck stops all over Ohio. He pled guilty to federal charges of diesel conspiracy in which he was able to evade over $88,000 in federal diesel taxes and over $117,000 in Ohio taxes in 1990 over a period of six months (FHWA, 1995). 2.2.13.3 Point of Occurrence in the Distribution System This scheme occurs below the terminal rack. 2.2.13.4 Evasion Curtailing Methods This scheme can be more quickly discovered by the imple- mentation of a fuel tracking system that matches terminal dis- bursements with distributor reports. This type of scheme could be deterred through increased penalties as well. 2.2.14 Daisy Chains 2.2.14.1 Description In this scheme, a ring of dummy corporations transact several fallacious purchases of fuel without remitting tax pay- ments. The fuel is eventually sold at taxed rates to a legal retail operation. When investigators track the purchases of the fuel in an effort to track tax liability, one of the dummy companies— known as the burn company—dissolves along with any tax liability (Figure 2-5). This scheme received a great deal of attention in the mid 1980s as mafia operations were using it to evade federal and state fuel taxes and earn profits in the millions. It relies on laws that allow licensed distributors to sell fuel to other licensed distributors, which was a characteristic of federal law before the points of taxation on gasoline and diesel were moved up to the terminal rack (in 1988 for gasoline and 1994 for diesel). The possibility of this scheme being employed still persists in some states that have not moved the point of taxation for gasoline and diesel to the terminal rack, though it is made much more difficult due to the movement of the federal point of taxation up the distribution chain. 2.2.14.2 Case Examples Ammar Tabbaa and Khaled Tabbah Case: The Tabbahs pled guilty in 1997 for defrauding California of $8.5 million in fuel taxes and attempting to defraud the federal government of 24

approximately $25,325. The California charges were from a daisy chain scheme that operated between 1992 and 1995. The federal charges resulted from the sale of over 1 million gallons of jet fuel as diesel fuel between July and September of 1995. Larry Iorizzo, Michael Franzese and the Colombo Organized Crime Family. The most well known tax evasion case, and certainly the most notorious use of the daisy chain, involved Larry Iorizzo, Michael Franzese and the Colombo crime family during the 1980s on Long Island, New York. Iorizzo broadened his reach and by 1983 had evasion schemes operating in New York, New Jersey, Connecticut, and Florida (CBPP, 2004b). Following capture, Iorizzo became an informant for the fed- eral government and testified before Congress that the scam generated $8 million in illegal profit per week at its height. Iorizzo later dropped out of the Witness Protection Program and was arrested for developing tax evasion schemes in Texas and Washington State. 2.2.14.3 Point of Occurrence in the Distribution System This scheme occurs below the terminal rack within the nonbulk system. 2.2.14.4 Evasion Curtailing Methods Many jurisdictions have moved the point of taxation to the terminal rack specifically to deter this type of scheme. 2.3 Issues Related to the Point of Taxation and Refunds Motor fuels are taxed at a variety of points in the distribution system. There are substantial differences among states about when taxes are due, and they often differ from the point of federal taxation. When the federal government moved the point of taxation for motor fuels to the rack, there were sub- stantial increases in tax collection (Baluch, 1996). A number of states also have reported increases in tax collections when they moved the point of taxation to the rack. This has led other states to consider this move as well. There are, however, a number of issues to address in trying to evaluate the effectiveness of this change on tax evasion. First, the federal government and most states made other changes at the time the point of taxation was changed. These are likely to account for some of the noted tax increases. Second, move- ment to the rack increases the number of refunds that must be made. This may complicate the estimation of the tax gains from moving to the rack, and refunds may create their own opportunity for tax evasion. Third, taxation at the rack may make it more difficult to monitor the movement of fuel coming from outside of the state. Fourth, taxation at the rack typically means that the firms paying the taxes are larger and have larger tax liabilities than firms further down the distribution chain; this raises the potential for large tax losses due to bankruptcy. This section discusses these issues and their implications for detecting fuel tax evasion. The first section provides a general comparison of fuel taxes with other excise and sales taxes to help clarify key issues in the fuel tax collection process that may increase the likelihood of tax evasion. The next section discusses the evidence that tax collections increase when the point of taxation is moved to the rack. This is followed by a discussion of tax refunds and the potential problems created by increased refund activity. Appendix C contains a summary of many of the interview comments related to these topics. 2.3.1 Comparison with Other Excise Tax Systems All tax systems have certain issues in common: administra- tive costs, enforcement cost and effectiveness, and compliance cost imposed on the taxpayer. In addition, fuel tax systems have some unique issues. While tax systems are designed to raise revenue, there are other aspects that often complicate the system. The biggest complication for fuel tax systems is that the system is tied to use of the roads, which may be difficult to measure. An excise tax is levied on all sales of a good, and it is often identified as an indirect tax since it is effectively levied on the seller rather than on the consumer. Unlike the income tax, the motor-fuel tax is an indirect tax that is collected from citizens by vendors selling or distributing 25 PAYMENT TRAIL PRODUCT TRAIL PAPER TRAIL WHOLESALE DISTRIBUTOR “A” WHOLESALE DISTRIBUTOR “B” WHOLESALE DISTRIBUTOR “C” WHOLESALE DISTRIBUTOR “D” Burn Company WHOLESALE DISTRIBUTOR “E” WHOLESALE DISTRIBUTOR “F” SALE SALE SALE SALE SALE TAX FREE TAX FREE TAX FREE STATED TAX PAID Retail Station Retail Station Retail StationRetail StationRetail Station PRODUCTPAYMENT STATED TAX PAID PA PE R CO MP AN IE S Figure 2-5. Structure of the daisy chain (FHWA, 1992).

fuel. While some individuals may successfully evade the fuel tax, most fuel tax evasion occurs after the tax is collected from the citizen and before the tax is remitted to the state. This is a principal- agent problem between the government collecting agency and the vendor responsible for remitting the tax to the state. In this regard, the fuel tax is similar to other excise taxes such as sales, tobacco, alcohol, and luxury taxes, with similar incentives and methods of fraud (Denison and Eger, 2000). Fuel taxes also have unique characteristics. Many excise taxes have certain users who are exempt from the tax; however, this typically relates to the user rather than the use. For fuel taxes, there are users who are exempt from the tax and there are specific uses that are exempt. The latter complication makes the fuel tax relatively more difficult to administer and more subject to evasion than other excise taxes. When a fuel tax is levied based on the tax status of the user, there are clear parallels with other taxes. If the tax is levied at retail sale to the final consumer, then the retailer can be charged with ascertaining the tax status of the consumer. The retail sales tax has a variety of tax-exempt purchasers so many sales are tax-exempt. While this creates the potential for tax evasion, it is typically not considered a large problem. Since tax-exempt users are often similar for the fuel tax and retail sales taxes, e.g., local governments, analysis of sales tax experience is likely to offer some guidance as to the potential for tax evasion asso- ciated with tax-exempt users. The sales tax experience is less relevant as the tax is moved up the distribution chain since it becomes more difficult to make tax-exempt sales and more common to rely on refunds for the tax-exempt users. While retail sales taxes work well when the tax is levied at the time of sale, it is much less effective if the consumer is able to purchase an item without paying the tax (e.g., out of state). States levy a use tax to supplement the sales tax in such instances. If a person purchases an untaxed item for use in the state, they are supposed to pay the sales tax that would have been levied if the sale had occurred within the state. This is known as the use tax, and collecting the tax due is a significant issue. For example, the State of Washington (2003) finds that the noncompliance rate on the use tax was 27.9 percent in 1998 while the noncompliance rate on the sales tax was only 1.3 percent. The high rate of noncompliance for the use tax illustrates the potential problem for collecting tax on fuel pur- chased out of state and brought into the state. Unless the state has an effective method to monitor such fuel movements, there is likely to be an evasion problem. Alternatively, where states can monitor the activity, there is much less tax evasion. States find that they can collect the use tax when they have a method of tracking the item. In particular, the use tax can be effectively levied on automobiles purchased out of state because they must be registered for use in state (Due and Mikesell, 1983). The more difficult problem is the use of fuel in both taxable and tax-exempt or low-tax uses. The user typically determines the tax-exempt uses, and must specify how much fuel was used in taxable versus nontaxable activities. There is typically a refund for tax-exempt uses if the fuel has been subject to taxation. In this case, it is necessary to determine the use of the fuel, and this may be difficult to verify. States can avoid most of the problem by requiring that fuel used for tax-exempt purposes be dyed, but this is often resisted by the fuel users. While refunds may be a problem, many of the more sub- stantial problems are associated with large volume movements of fuel between road use and other uses. Diesel is similar to if not identical to a variety of other high volume fuels, such as home heating oil, kerosene, and aviation fuel. Since it is possible to either convert or blend many of these tax-free or low-tax products into road use, there is substantial opportu- nity for tax evasion. Other taxes typically do not address this problem of a product that can be converted among different taxable categories with relative ease. The gasoline tax is less subject to evasion than the diesel tax because there tend to be relatively few tax-exempt uses for gasoline while there are many off-road or nonroad uses for diesel. Hence, there tend to be fewer objections to taxing all uses of gasoline than restricting the tax exemption to spe- cific users. Thus, FHWA (2001) reports that 17 states tax nonhighway use of gasoline while only two states tax agri- cultural use of gasoline. Hence, 17 states do not have to deter- mine whether claims of off-road use for gasoline are valid. Nevertheless, tax exemption for off-road use is the most common situation. Eliminating refunds for exempt uses substantially reduces the potential for refund fraud. The use of dyed fuel makes it possible to levy the diesel tax without a use exemption, with all undyed fuel subject to the tax without refund; however, most states and the federal government allow for refunds on undyed diesel if used for tax-exempt purposes. Tax-exempt uses typically include agriculture, off-road use, state and local gov- ernment use, and federal government use. Some states also exempt use by transit systems and a variety of other uses. Limiting exemptions to specific entities rather than uses eliminates much of the refund problem, but it does not solve all problems associated with the point of taxation. From a state perspective, movement of fuel among states creates the pos- sibility of tax evasion either by not paying any state tax or by paying the tax of a low-tax state and delivering the fuel to a high-tax state. This topic is covered in the section of this chapter covering coordination and will not be discussed in this section except in relation to the point of taxation. For administrative ease, the tax may be levied on sellers rather than on consumers directly, with the seller becoming an agent for the government in collecting the tax. The specification of the taxpayer and the collection system create a variety of problems and potential for tax evasion. If the tax is ultimately a tax on the consumer and it is levied on the seller, then there 26

must be a mechanism for the taxpayer to get a refund. In some cases, the government will allow the seller to claim that a sale was made to an exempt user or for an exempt use and file directly for the refund. In other cases, the end user must file directly. When the seller can file, there are fewer returns filed but it is harder to determine if the final use was indeed a tax- exempt one. However, if the end user must file, there is more opportunity to determine the actual final use of the fuel, but the number of refund claims increases. Hence, even the spec- ification of who is eligible for a refund can create issues with respect to the potential for tax evasion. Refunds also create problems for sellers and consumers. The need to file for a refund creates an extended need for record keeping on the part of the exempt user and uses. It also creates a float issue, since the government is getting use of the tax funds for a period of time. Balancing the different priorities of the government, the sellers, and the consumer leads different states to substantially different systems. These have implications for the type of evasion possible. Refunds create the potential for several types of tax evasion. First, there is the possibility of false refund claims associated with using tax-paid fuel in taxable uses but claiming it was used in nontaxable uses. Second, there is the possibility of several types of outright fraud, where refunds are claimed for fuel on which no tax was paid or where false claims are gener- ated. On the other hand, moving the point of taxation closer to the retail level reduces the possibility of refund fraud but increases the possibility of daisy chains and other types of eva- sion. A point of taxation closer to retail also increases collection problems, since the entities closer to the retail level tend to be less financially stable than the ones up the distribution chain. In interviews conducted for this study, a number of states complained of the difficulty of collecting bad debts from firms down the distribution chain. On the other hand, large firms have larger tax liability, so when there is a problem, the amount of tax at risk may be much larger when the tax is levied at the rack. Also, large firms tend to deal with a larger variety of products and may have more potential for misreporting or under-reporting of tax liability. There is some feeling that better coordination among the states, with all taxing at the same point, would reduce the chances for evasion; however, there also are difficulties with this approach. In particular, states with different tax rates still would have to be able to track the fuel to its ultimate destina- tion and, in many cases, the fuel would have to be taxed in one state for payment to another. This runs into what is known as the nexus problem. A state can only levy a tax on a business with a presence in the state. Hence, a terminal in an adjacent state that simply sells fuel for delivery into the state would typically not be judged to have nexus in the destination state. Thus, the destination state cannot force the terminal to col- lect tax for it. States find that businesses will not collect sales taxes for them if they do not have nexus in the state. However, this is less of a concern for fuel taxes. The problem for a business collecting a sales tax is that the customer typically would not pay the tax if the seller does not collect it. While the customer is liable for unpaid taxes when the product is brought into the state, as a practical matter it is very difficult to enforce this tax. Hence, the customer would not want the seller to voluntarily collect the tax. However, movements of fuel are tracked more closely than movements of individual consumer items. Fuel imported into a state is likely to be taxed as it enters the state. To avoid the need to file separate tax returns, importers may prefer that the tax be collected at the terminal, and terminals are more amenable to collecting taxes for other states if it sim- plifies the taxation system and allows them to provide a service for their customers. Consistent tracking of fuel would alleviate many problems with differences in collection systems and points of taxation but this also has drawbacks. One issue is the amount of reporting required and the compliance cost imposed on the industry. While tax collectors would prefer to have detailed records of all movement of fuel, this imposes a compliance cost and cre- ates ill will when the taxpayers perceive that the information is not used by the taxing agency. 2.3.2 Moving the Point of Taxation as a Strategy for Decreasing Evasion Moving the point of fuel taxation to the rack has an impres- sive set of empirical arguments, with virtually all tax juris- dictions that have made this move reporting increased tax collections following the move. In addition, most report other benefits and limited problems. The Texas Department of Transportation collected a variety of quotes relating to moving the point of taxation to the rack, and they offer some inter- esting perspective on the benefits of such a move. These are presented in Appendix C. However, movement to the rack does not work well for all states, and several seem satisfied with nonrack tax systems. While it is common to identify tax as being at a particular point in the distribution chain, the reality is more complex. For example, a tax on a distributor when the fuel is removed from the rack is very close to a tax at the rack, and this is very different from a tax on the distributor at sale to retail or final use. A number of other characteristics are important when examining the point of taxation and its effect on tax evasion. Figures 1-2 and 1-3 show the nominal point of taxation as reported by states in a survey. Of the 22 states that list the dis- tributor as the point of taxation for diesel fuel, they are about evenly split between whether the tax is levied on receipt or sale by the distributor. The specifics are even more complicated due to various other provisions about when taxes must be paid. 27

It is apparent that not all distributor taxes are the same and that there is a mix of agents and taxpayers. While the distinction is not universal, an agent for the state does not bear ultimate liability for the tax and is often credited with a collection allowance or other compensation for serving as an agent. When taxation is moved to the rack, it is assumed that the increase in revenue is due to reduced tax evasion. However, there are other possible reasons to expect to see such an increase. First, when the point of taxation is moved up the distribution system, there will be a brief period of time when the tax is being col- lected from both the higher and lower point on the system. This period of “double taxation” typically would last a short time, but empirical analyses that did not take it into account would overstate the revenue impact of moving the point of taxation. The second reason is that fuel previously not taxed would now be taxed but subject to a refund. Hence, initial collections would increase but net future revenue would go back down due to the subtraction of refunds. The IRS estimated increased revenue of $1.23 billion in 1994 associated with moving to the rack and instituting the dyed fuel requirement, but this was reduced to about half of that amount when refunds, credits, and economic growth were taken into account (Baluch, 1996). A final concern is that while some fuel that should have been taxed was not taxed under the old system, fuel that should be tax-free may now be taxed. This could occur if the user of tax-exempt fuel finds the cost or bother of filing for a refund to be greater than the expected refund amount. There is ample evidence of this phenomenon in the private sector with rebates. Rebates have several attractions from the perspective of the seller. One is that they get the use of the funds for a period of time without any interest payment, and the second is that some percentage of the eligible users will fail to file for the refund. This raises the net proceeds from the sales. This may be occurring with fuel sales. Some users who would purchase tax-exempt fuel if it were available will fail to file for refunds if the fuel is purchased with tax paid. This is complicated by the different interpretations of who can and should file for such refunds. Differences among the states in determining who is or is not eligible for a refund may increase the amount of tax collected that should have been refunded. States show substantial differences in exemptions and refunds for fuel taxes. While increased revenue is a benefit when viewed from the tax collection perspective, the move typically encounters tax- payer resistance due to concerns of lost “float,” increased refund requirements and other factors. Because of these concerns, anecdotal evidence of revenue increases when the point of taxation is moved should be viewed with caution. The amount of tax increase may be overstated due to the confounding effects of refunds and double taxation, and due to the fact that most states make other changes when moving the point of taxation that may influence the rate of tax collection. Attempts to esti- mate the impact of moving to the rack on tax evasion should take account of alternative causes for revenue increases to get an accurate estimate of the impact of this change alone. The biggest benefit from taxation at the rack is the reduction in the number of taxpayers and the increase in their stability. Moving lower in the distribution chain, the tendency is to find many smaller firms and more entry and exit. This creates two problems for the tax collector. The first is there are more firms to deal with. While the cost of the audit for a small firm will be less than one for a large one, the difference is typically not proportionate to the size of the firm. More resources are needed to maintain the same number and intensity of audits with many smaller firms. The second problem with many small firms is that they tend to go out of business much more frequently. The State of Washington (2003) finds that non- compliance is higher among smaller firms. This creates legit- imate problems for the tax collector with bankruptcy and related matters, but it also creates the potential for daisy chains and related schemes. On the other hand, some consideration should be given to the larger potential tax losses associated with large taxpayers. While they are less likely to default on taxes owed at any one time, any default could lead to large tax losses. While movement up the distribution chain can reduce the potential for daisy chains, there are other actions that states can take as an alternative to moving the point of taxation. One item is to make the owners of the company liable for any taxes owed. By stripping away the corporate shield, it is possible to greatly reduce the incentive for daisy chains. The other major form of protection against daisy chains is to require the tax be paid at the first transaction. By eliminating the possibility of multiple tax-free sales of fuel, the potential for evasion is limited as well. The disadvantage of this approach is the higher cost to the industry in the form of reduced float and increased need for refunds. Industry values float because it is essentially an interest-free loan. Many states require that the tax be paid some time in the month following the fuel sale. This means that the taxpayer has use of the money for up to two months in some cases. While this seems like a trivial issue to many people (amounting to about 1 or 2 percent of the tax), it is highly valued in the industry. Fuel is typically taxed either at the rack or the distributor level. Three states tax diesel at the retail level, and a number of states have local options that allow counties to add their own fuel taxes. The latter typically requires some differentiation of tax at essentially the retail level. Interview responses generally confirm that points of taxation vary by state based on differences in industry structure, admin- istrative preferences, and political climates among states. Some have considered moving the point of taxation to the terminal rack as a strategy to reduce evasion. Industry representatives resist the movement of taxation to the rack due to its perceived cost. When the tax is on the distributor, payment to the state 28

may be delayed for almost two months, allowing for interest- free use of the funds, known as the float. Distributors view loss of the float as a cost increase to them. Several states have addressed this issue by allowing the distributors to withhold payment of the tax to the supplier until the time the tax must be paid to the state. A number of states have moved the point of taxation to the rack. Some report an increase in revenue associated with the move, but some do not. For example, Texas shifted the point of taxation to the rack in January 2004, but has not seen a spike in collections since moving the point of taxation. However, the point of taxation was already close to the rack. On the other hand, Idaho reports that the state experienced a 19 percent increase in revenue by moving the tax to first receiver and that it has not moved it to the rack due to industry resistance. Florida reported that taxing at the rack has made an improve- ment in revenue collection, but it makes it easier to bootleg fuel from Georgia. Also, it is harder to catch untaxed kerosene coming into the state. The benefit of taxing at the rack, accord- ing to Florida, is that it has essentially eliminated bad debt and failure to file. Florida used to lose $2 or $3 million per year in bad debt. A number of states reported that attempts to move taxation to the rack have run into industry opposition. For example, Alaska basically taxes at the distributor level and has done so since 1970. Changing the point of taxation has been discussed internally, but issues with refunds, as well as quirks in the physical distribution system and the problems they would create, prevent a shift. Another conclusion from the interviews seems to be the ability to make tax-free sales at the distributor level that creates the potential for daisy chains. Limitations on tax-free sales seem to have many of the effects that occur with completely shifting the point of taxation to the rack. However, they also have many drawbacks, such as an increase in the amount of refunds. Nevertheless, it appears that it would be a significant error to look simply at the point of taxation. In particular, taxes at the distributor level can be very different in the potential for evasion based on the ability to sell tax-free fuel among dis- tributors. The other issue when such sales are allowed is the ability of the state to recover taxes in the event of bankruptcy. Several states indicated they require directors of a corporation be personally liable for taxes in the event of a bankruptcy. Hence, careful monitoring of the directors and/or the use of bonds can limit the potential for daisy chain-type evasion. 2.3.3 Refunds Several issues arise in analyzing refunds. From the perspec- tive of the tax collector, the major issue is that refunds should only be issued for legitimate tax-exempt uses of the fuel. How- ever, taxpayers want a simple, quick method of getting their refunds. These two objectives are often contradictory. For example, Alabama has a relatively simple refund form. The form requires little more than the allocation of fuel to non- taxable activities. On the other hand, Florida has a fairly com- plex refund claim form. The form requires information on fuel purchase and use by county. In addition, with complicated forms, there may be incorrect information or ambiguities regarding who may file or which uses are exempt from taxa- tion. The potential for tax evasion is associated with the pos- sibility of refund claims in excess of actual tax-exempt use or of fraudulent claims of exemption. Further, there are suggestions that claims for refunds have been made on fuel that was not taxed. For example, GAO (1996) reports on several refund fraud schemes detected by the IRS. States vary on their policies regarding refunds, the documentation needed, and the party entitled to the refund. The differences can be quite significant. For example, in Canada and in Texas, all diesel fuel is either dyed or taxed. This significantly simplifies the refund process. However, there are substantial objections to this requirement. Diesel is either equivalent to or compatible with a variety of other uses, such as home heating oil or jet fuel. There are benefits to main- taining the option of converting between the different uses. However, if there is the potential that the fuel will be used in taxable road uses, it must remain undyed. This requires that either potential road fuel is untaxed or that the fuel be taxed and then allowed a refund. Neither option is particularly appealing, but most states opt for the use of refunds for direct end users. Fuel in the bulk system is typically not taxed if iden- tified for a tax-exempt or lower tax use. Most states exempt fuel for use by other governments, by agriculture, and for other off-road uses. However, a number of states levy a sales tax on fuel for off-road uses but not on fuel for on road uses. When the price of fuel is relatively low, the fuel tax is likely to be high relative to the sales tax, since the fuel tax is typically specified per gallon while the sales tax is specified as a percentage of the sales price. However, when the price of fuel is relatively high, there may be little incentive to apply for a refund for off-road use since the net difference in taxation from the taxpayer perspective is small. At high enough prices of fuel, it may actually be advantageous to the taxpayer to pay the fuel tax rather than the sales tax. States vary substantially on the amount of refunds and the methods of verification. Some states contacted for this study report very high levels of refund claims while others report few if any. Some differences, such as the degree of agricultural activity, contribute to this, but much of the difference appears to be due to differences in state policy. Some states require substantial verification for a refund while others have less restrictive requirements. Refunds are a large concern for North Carolina, amounting to more than $50 million annually. The state requires receipts 29

and an explanation of the operation for which the fuel was used. There are a number of companies/individuals who can claim refunds. In the last five years, the number of refund applicants has grown significantly. There are a number of exemptions and North Carolina views this as a significant source of evasion and wants to shift to the tax or dyed scenario. At the other extreme, North Dakota does not consider refunds a problem at all. North Dakota representatives audited three years of refund applications but stopped doing so because the audit returns were so insignificant. There were only two assessments during the three years. However, they only allow refunds for gasoline. Diesel must be dyed or taxed. Florida integrates its process for fuel tax refunds with its sales tax. Refunds are issued for diesel but not gasoline. The refund process has two primary categories. There is an ultimate vendor credit that allows vendors to sell fuel tax-free, e.g., for sales to farmers, kerosene for home heating, sales to the fed- eral government, or for export. However, some users purchase taxed fuel and file for a refund. For example, if a construction company buys clear fuel, there is a tax return that they can file (refund document). It requires a schedule of all fuel purchased. A use tax is deducted from the fuel tax refund since the sales tax is due on off-road use of fuel. Some states require payment of the sales tax before processing the refund, but Florida has all of the taxes in the same department. They also can transfer the money between funds for payments to local governments. When a refund application is filed, they can require receipts but they usually only look at them during an audit. The refund schedule has the Federal Employer Identification Number (FEIN) of the vendor so they can track the purchase if there is a question. They believe that paper receipts are of questionable value since they can be forged easily. Industry representatives had relatively uniformly negative views of refunds. One oil industry representative interviewed for this study called it a huge issue because in some states the supplier has to give a refund to the customer and then file with the state. If the supplier must apply, it limits the number of entities the state must deal with, but the suppliers think the end consumer should be applying. The focus is on what the end user did with the fuel. The opinion was expressed that refunds are a mess nationwide and may be one of the great sources of tax evasion. An example was cited of a case in Texas where a state employee created fictional refund claims. Often only the first refund claim is checked carefully, so the state employee would then enter false ones. The respondent believed this type of evasion has likely happened in other states as well. Issuing refunds as an income tax credit reduces fictional ones, but not all states have income taxes. The Biodiesel Board finds refunds a significant issue. Most of the biodiesel is used for non-taxable uses. Thus, the issue of refunds is significant. Sales are lost because consumers do not want to have to file for refunds. Filing for refunds at the state level is a large concern for trucking companies. There is an occasional complaint that the IRS can be slow to make a refund but it does not seem to be a large issue. It was asserted that most major carriers farm out state refund claims to third parties, who charge a percentage. The size of what they let collectors keep is an indication that filing state refund claims can be difficult. Thus, states likely over-collect fuel taxes in some cases due to the difficult process for refunds. 2.4 Issues Arising from the Lack of Coordination and Uniformity in State Taxing Systems Coordination of state tax systems is one of the most signif- icant issues affecting tax evasion at the state level. Coordination issues arise due to a lack of uniformity in tax rates and systems, methods of communication across state and international borders, and, where it is a problem, coordination between state and Native American Tribes where consumers are pur- chasing untaxed fuel. Each of these issues directly affects the methodology for estimating state-level tax evasion. Uniformity of tax systems and rates could provide substan- tial benefits from the perspective of taxpayers and tax collectors. Uniform tax rates remove the incentive to pay tax in one state rather than in another state; and with uniform tax systems, it is more difficult to misrepresent the movement of fuel. The FTA Uniformity Committee has promoted a variety of actions that states could take to improve coordination, such as uniform definitions and reporting schedules. In addition, JFSMFTCP has promoted regional cooperation. However, individual states have a variety of reasons why they have dif- ferent tax rates and structures. Given these differences, there are methods to mitigate the problems that different tax rates and structures create. This section examines differences in tax rates and systems between states and then discusses the similarities and differ- ences that occur at international borders as compared to state borders. This is followed by a discussion of the issues raised by Native American reservations in a state and the differences in opinion about how fuel sales on Native American reservations should be taxed. Within each section, the main issue is dis- cussed followed by a summary of what interviews with state administrators and other interested individuals contributed. Appendix C contains a more detailed summary of the interview responses related to these issues. 2.4.1 Lack of Uniformity in Tax Systems There is substantial discussion about moving the point of taxation to the rack for states that currently tax below the rack. While those states moving the point of taxation have gener- 30

ally reported higher tax collections and other improvements in the administration of the fuel tax, many states have other points of collection. The federalism system in this country allows each state to develop their unique system for road fund revenue collection. As a result, the structure of a state’s road fund may differ from others in response to the unique characteristics of the industry in their state and the different views of its citizens regarding fair and equitable tax and revenue and tax base differences (Eger and Hackbart, 2001). At the state level, points of taxation vary widely due to a com- bination of the differences in administrative conditions facing states and the actions of the different legislatures. Figures 1-2 and 1-3 in Chapter 1 illustrate graphically the differences in point of taxation by state. While political differences clearly affect decisions related to uniformity, administrative issues are important and provide some insight into state differences. Some states have many refineries while others have none. A few states have a small number of terminals or no terminals at all and import their fuel from other states and foreign locations (CSG&CGPA, 1996). Many states now collect fuel taxes at the terminal level but some still tax at the retail level. Taxation at the rack makes the most sense for states with refineries and terminals. States with no terminals effectively have no method to tax at the rack, and some argue that retail taxation is the most effective when fuel comes into the state from many out-of- state sources. Differences in the point of taxation create problems with tracking fuel. While it is possible for states to collect and trade information regardless of their own point of taxation, there is some tendency to collect information relevant for the par- ticular point of taxation in that state. Hence, a state with a retail-level tax may not be particularly concerned with tracking fuel before it gets to the retail level. However, a neighboring state that has the tax at the rack may want to know when fuel that is headed for the second state leaves the terminal in the first state. If the first state does not collect this information, then there is a potential for movement of untaxed fuel from the first to the second state. Some states require that diversions of fuel from one state to another be submitted to a national registry (e.g., Alabama). However, it does not appear that there is substantial use of the registry nor the diversion information. As noted in the section covering the point of taxation issue, there is widespread agreement that moving the point of tax- ation to the rack has reduced tax evasion for most states that have made the change. However, this section focuses on the coordination problems associated with differences in the point of taxation; these remain significant since many states still do not tax at the rack. States also vary widely in their tax rates and applicable taxes. Figures 2-6 and 2-7 illustrate the differences among states for tax rates on diesel and gasoline. There are a number of low-tax states surrounded by high-tax states. Further, these maps show fuel taxes only, and many states levy other taxes that may further magnify the differences between states. The tax rates may be effectively zero, as in Oregon where diesel fuel for heavy vehicles is not taxed, or it may be a combination of fuel and other taxes, such as sales taxes. In addition, some states have local options, allowing county governments to add their own fuel tax to that imposed by the state. Hence, fuel tax rates can vary substantially across and even within states. 31 Source: FTA, 2002 Figure 2-6. State rates of taxation for diesel (cents per gallon). Source: FTA, 2002 Figure 2-7. State rates of taxation for gasoline.

Tax rate differentials make payment of the tax in a low-tax state and sale of the fuel in a high-tax state very attractive. While states can take actions to deter such activity, a large tax differential may make it very profitable. “Evading just the federal tax on an 8,000-gallon truckload of diesel fuel would yield an illicit profit of $1,920. Thus, although the govern- ment has taken steps to better assure compliance with motor fuels taxes, a strong incentive to evade these taxes remains” (GAO 1996). In general, tax evasion is subject to economic incentives; the greater the reward for evasion, the more likely it is to occur. In addition, if incompatible reporting systems and limited border enforcement make it difficult to detect the evasion, it becomes more worthwhile due to the lower prob- ability of being caught. The level of penalties for evasion will also enter into the calculation. The interviews conducted for this study generally confirmed that lack of uniformity in both the point-of-taxation and the rate-of-taxation creates evasion opportunities. Some states have taken specific actions to deal with such problems while others are aware of the problem, but do not feel they have the appropriate resources to deal with it. Several of the states interviewed noted that while states may exchange information on imports and exports, this informa- tion is not exchanged if the fuel is not declared for export. For example, Arkansas noted that Missouri and Tennessee only report exports to the state designated, so Arkansas may not receive a report if the destination is changed. Also, both states charge their own tax if an exporter is not licensed but the fuel may be exported anyway. The type of information needed, as well as the type of information collected, is shaped by the tax system. If neighboring states have different systems, then they may not be able to share useful information. Most states per- ceive the need for sharing and processing of information but many are not satisfied with existing arrangements. A number reported that neighboring states simply do not collect the infor- mation needed by the reporting state. The ability to track fuel depends on this sharing of information across borders. Analy- sis of how well each state can do this given their data needs and the data available should highlight the potential for fuel ship- ments across borders to go undetected. Tax rate differences were noted by several interviewees as being a substantial problem. States that border low-tax states, especially if the low-tax state taxes at the rack, face a significant potential for bootlegging. Methods mentioned in interviews as being effective in dealing with tax rate differences are a clear listing of which taxes are paid on BOLs, requirements that exporters and importers be licensed, substantial penalties for diversion of fuel from a low-tax to a high-tax state without pay- ing the appropriate tax, and laws that are enforceable, e.g., by making the in-state retailer responsible for the appropriate tax being paid rather than the out-of-state distributor. As expected, many states do not find tax differentials to be a problem, either because the states around them have similar rates or because of isolation. For example, Alaska finds that this is probably not a problem due to the cost of shipment. 2.4.2 International Borders A number of issues have been identified with the potential for movement of fuel across international borders to result in tax evasion. The general issues are not different from those associated with movement of fuel across state borders, but many specific issues differ. For example, movement of fuel across international borders typically requires a customs declaration and more information on the product being trans- ported than would be collected in interstate movements. The potential for evasion is likely to be lower than it is for move- ment between states; however, international movements also would allow for evasion of the federal fuel tax, which is not accomplished by many of the interstate schemes. Hence, tax evasion may be more profitable across the international borders. “The IRS has found that abusive situations exist with regard to the entry of taxable fuel into the United States. For example, some enterers are not registered and are not paying the tax on their entries” (Federal Register, 2004). Aside from simply not paying the tax, there are reports of fuel being brought into the United States that is labeled nontaxable. There are also reports of imported fuel illegally being taken off barges; however, we have not been able to document any cases or obtain any estimates of the potential magnitude of the tax evasion. Another complication for states is that the customs infor- mation may be more detailed than other information on fuel movements but states may not have easy access to the information. While some states expressed concern about the ability to track fuel movement across international borders, it is unlikely to be an issue for the majority of states. Potential for an evasion problem also depends on the price and tax differentials. There is some indication that the problem is more likely to be for neighboring countries than for fuel coming from those coun- tries into the United States since the Canadian tax is higher than the United States tax and fuel prices in general are higher in Canada and Mexico than they are in the United States. How- ever, states with international borders should be modeled for fuel tax evasion just as they would be for adjacent states, with the rate differences, distances, and information systems affect- ing the potential for tax evasion. Also, states with imports by ship have a large but undocumented potential for evasion. 2.4.3 Intra-Governmental and Inter-Governmental Coordination Different agencies within a state government may or may not cooperate in terms of exchanging information or taking 32

actions to support each other when it comes to tracking fuel, detecting and prosecuting tax evasion, or other actions. Sim- ilarly, coordination between states and the federal government has been raised as a potential issue in tracking fuel, detecting evasion, and collecting taxes. Within states, there is often a separation of duties among various departments. For example, the Department of Revenue (DOR) may be responsible for col- lecting and auditing fuel taxes while the Department of Trans- portation (DOT) is responsible for administering the IFTA reporting. In addition, criminal investigations and prosecution may involve the State Police and other agencies. Cooperation and exchange of information among these agencies may be problematic since they have different objectives and functions. Failure to cooperate and coordinate may increase the potential for tax evasion and reduce the ability to detect and prosecute such evasion. There are few studies of the coordination issue but some authors comment on aspects of the problem: Functionally, an advantage to administering motor fuel taxes through a revenue department is the ability to exchange tax- payer information. States have long recognized the need to share information with their neighboring states to avoid fuel tax evasion. However, many states have confidentiality statutes in their tax administration laws that protect the privacy of taxpayer data thereby prohibiting the release of information to non-tax agencies. Revenue departments have several tools available to enable the sharing of confidential taxpayer data. The FTA Uniform Exchange of Information Agreement, signed by 45 states, the District of Columbia and New York City, provides a means of sharing taxpayer data among other revenue departments. Also, state rev- enue departments have access to Internal Revenue Service (IRS) data by utilizing Internal Revenue Code (IRC) sec/6103 (d). Furthermore, separate agreements have been signed to facilitate exchange among other states that administer motor fuel taxes through a non-tax agency. These agreements reduce the efficiency arguments portrayed by those who argue that revenue agencies should be the only collectors of taxation (Eger and Hackbart, 2001). While it may be possible to exchange information among tax collectors, other exchanges within a state may be prohibited. States face certain legal issues regarding the sharing of informa- tion as well as the more mundane issues of coordination. Similarly, the federal government and the state governments have a joint interest in preventing tax evasion and in investi- gating and prosecuting it. There are good examples of such cooperation; however, there also are a number of obstacles to it. For example, federal disclosure rules may prevent the IRS from sharing certain information with state governments, and the IRS may not care about movement of fuel among states since it does not affect the federal tax. There are widely different levels of inter-governmental and intra-governmental cooperation regarding sharing informa- tion. As noted earlier, the sharing of information between states is likely to be very important for fuel tracking. However, there appear to be a variety of other types of information and cooperation that could be effective in combating tax evasion. These could be as simple as sharing information on firms that are having problems and the types of evasion being investigated. Intra-governmental cooperation also varies substantially. Some agencies note that poor cooperation with other agencies in their own government creates opportunities for evasion or difficulty in tracking potential evasion. In general, the interviews confirm that there are many areas where additional cooperation and coordination may reduce the opportunities for fuel tax evasion. 2.4.4 Native American Fuel Sales The federal fuel tax is collected at the rack and any fuel on a reservation not used strictly by the tribal government is tax- able at the federal level. In general, states cannot tax the tribes, but there are differing approaches to the sales of fuel on Native American lands. Some states treat all such sales as taxable, especially if the tax is levied at the rack, same as the federal government. However, most allow some form of tax exemp- tion for sales to the tribal government and many exempt sales to tribe members (See Table 2-1). There is a jurisdiction dispute between several states and the Native American tribes. The major area of controversy is sales to nontribal members that occur on Native American lands. Some tribes view all such sales as being exempt from state taxes. There are several cases in the courts that may change the relationship between the tribes and state governments. However, the issue with respect to tax collections is to deter- mine the current amount of tax revenue not being collected by the states for fuel sold on reservations to nontribal members for use on roads in the state. The dispute between the tribes and the states is more compli- cated with respect to diesel fuel than for gasoline. IFTA requires that appropriate taxes be paid to each state regardless of where the fuel is purchased if it is used in a truck for interstate com- merce. Thus, even though taxes may not be paid at Native American stations, the taxes may be assessed through IFTA. The net loss to the states may be overstated by the gross esti- mate of fuel sales that are not taxed at tribal stations since interstate trucking firms may then be required to pay such taxes through IFTA. The gross estimate would have to be adjusted for tax collections that occur through IFTA if this turns out to be a significant number. There was a perception expressed by tax administrators interviewed for this study that fuel sales by Native Americans are a substantial source of fuel tax evasion, and there are several states where this appears to be a significant problem. For example, Idaho estimates that evasion due to Native Ameri- can sales is $2.2 million per year, an amount equal to roughly 1 percent of statewide fuel tax collections. However, many states either have minor amounts of fuel sales on reservations 33

34 State Tribal Exemption from Fuel Tax Tribal Agreement with State for Fuel Taxation Mechanism in Place to Ensure Tribal Sales to Tribal Members Not Subject to Tax Alabam a No No Agreem ent No Alaska No Not Reported No Arizona Yes Agreem ent/Negotiation Yes Arkansas No No Agreem ent No California No No Agreem ent No Colorado Yes No Agreem ent No Connecticut No Negotiation No Delaware No No Agreem ent No Florida No No Agreem ent No Georgia No No No Hawaii Not Reported Not Reported Not Reported Idaho No Litigation No Illinois No No Agreem ent No Indiana No Tribal Lands No Tribal Lands No Iowa Yes No Agreem ent Yes Kansas No Litigation/No Agreem ent Not subject to taxation Kentucky No No Tribal Lands Not applicable Louisiana For one tribe Agreem ent No Maine No No Agreem ent No Maryland No No Agreem ent No for gasoline. Yes for diesel. Massachusetts Not Reported Not Reported Not Reported Michigan Not Reported Not Reported Not Reported Minnesota Yes Agreement/Litigation Yes Mississippi No No Agreem ent No Missouri No No Agreem ent Not Applicable Montana No Agreem ent/Negotiation No Nebraska Yes Agreem ent/Negotiation Yes Nevada Yes Agreement/Litigation/ Negotiation No New Ham pshire No No Agreem ent No New Jersey No No Agreem ent No New Mexico Yes No Agreem ent No New York Not Reported Not Reported Not Reported North Carolina No No Agreem ent Yes North Dakota Yes Negotiation Yes Ohio No No Agreem ent No Oklahom a Yes Agreem ent Yes Oregon No Negotiation Yes Pennsylvania No statutory exem ptions Litigation Not Applicable Rhode Island No No Tribal retail operations No South Carolina Not Reported Not Reported Not Reported South Dakota Yes Yes, som e agreements Yes, sales on reservation to tribal members Tennessee No No Agreem ent No Texas No No Agreem ent No Utah Two tribal agreem ents Agreem ent/Negotiation No Verm ont No No Agreem ent No Virginia Yes No Agreem ent No Washington No, unless by agreement Agreement No Washington D.C. No No Agreement No West Virginia No No Agreement Not Applicable Wisconsin Yes Agreement/Negotiation Yes Wyoming No No Agreement Yes Source: FTA 2002a Table 2-1. Fuel tax issues for Native Americans by state.

or have agreements with the tribes in their jurisdictions. For estimating evasion, sales on Native American lands are relatively visible since it is more a question of jurisdiction than of pur- poseful evasion. Hence, it should be possible to identify the states where there is a conflict between the state and the tribes regarding fuel tax liability. In these states, it should be possible to generate reasonable estimates of fuel sales on the reservations and the impact on state tax collections. FTA (2002a) reports estimates from several states of the amount of tax not collected due to Native American sales. It also might be possible to get information from states with agreements on the amount of tax revenue generated through the agreements and use this infor- mation in estimating losses to states without such agreements. 2.4.5 IFTA IFTA requires trucks operating in interstate commerce report their mileage in all member jurisdictions to their home state or province (hereafter referred to as states). They also report all tax paid on fuel by state. The tax due to each state is calculated and compared to the tax paid to each state and appropriate payments or refunds by state are made. The infor- mation is supplied on a fleet basis. The IFTA regulations require that each state audit 3 percent of the returns each year. Eger and Hackbart (2005) investigate the effect of audits on tax assess- ments and estimate that each additional auditor results in $415,219 in additional revenue. However, they do not differ- entiate between IFTA and other audits. Many states complain that the IFTA audits are not very productive and apparently do not complete the required audits. This may be because the audits cover operations in all jurisdic- tions, and the money coming to a state from such an audit might only be a percentage of the additional tax money collected, with the remainder going to other jurisdictions. Hence, there appears to be a conflict between the self-interest of the states and the enforcement of the tax system. Most tax administrators interviewed for this study indicate that IFTA appears to be one of the clearest examples of coordination among states that sim- plified the process for most taxpayers, reduced opportunities for tax evasion, and increased tax revenue. However, it should be noted that it was effectively created by a federal mandate. While most observers believe that it is an effective system, there are concerns about the amount of tax evasion from truck- ing companies’ misreporting of mileage by state and failure to report. One concern is that trucks may get illegal IFTA decals and never report their mileage. While there is widespread agreement that IFTA has been effective, there are substantial disagreements about whether and how it could be improved. The biggest area of disagreement seems to be the audit requirement. Some believe it focuses too many resources on an area with little return, while others believe individual states are lax in looking out for tax collections that may accrue to other states. There appears to be some potential for tax evasion associated with the way miles are reported. The obvious incentive is for truckers to report more miles in low-tax states and fewer miles in high-tax states. Also, use of illegal decals may allow trucks to travel in high-tax states with- out ever declaring the mileage. Large trucking companies find IFTA to be a benefit by reducing the number of tax returns required. However, smaller and in-state firms may find that it represents an increase in paperwork. Another important point expressed by tax administrators interviewed for this study was that with all its faults, IFTA was a required element of a motor fuel tax program and in its absence, evasion would be as simple as filling up in low-tax states and driving through high-tax states without remitting any taxes whatsoever. Thus, while some argued that the 3 percent audit- ing requirement did not yield positive returns on the state’s investment, all agreed that IFTA auditing was necessary and lax IFTA enforcement could lead to significant reductions in diesel tax payments in high-tax states. Further, some admin- istrators argued that IFTA audits also offer an effective means to detect other forms of motor fuel tax evasion perpetrated by motor carriers (e.g., purchase of tax-exempt fuel, cocktailing). 2.5 Issues Related to Fuel Tracking, Bonding, and Licensing An important part of enforcement for any tax system is the ability to track activity. For example, most analysts believe that the income tax system works well for wage and salary income because employers are required to report this income to the federal government. Since the government has the infor- mation, the ability to under-report it is severely limited. In addition, the income tax typically requires payers to file a vari- ety of information returns to inform the government of income items that the recipient should report for tax purposes. “The more comprehensive a state tax department’s information- return system and the more usable the data, the better equipped the department is for enforcement” (Penniman, 1980). Conversely, for types of income not reported, the expectation is that substantial amounts are under-reported for tax purposes. Similarly, for sales tax, where the tax is paid at the time of a retail transaction, the taxpayer has no opportunity to avoid the tax, although there may be problems with the government getting the tax revenue from the retailer. However, if a person buys a taxable good outside of the state and brings it back into a state with a sales tax, there is typically a requirement that the consumer must report the item and pay a use tax that is equivalent to the sales tax. This requirement is widely ignored because the government has no way to track most out-of-state purchases. However, where there is a method to track the pur- chase, e.g., if the consumer must register an automobile, the government has a much higher rate of collection on the tax. 35

A tracking system can allow a state to determine whether fuel movements are appropriately reported with taxes paid. How- ever, a tracking system cannot cause payment to be made from an organization that has declared bankruptcy or is otherwise insolvent. Hence, monitoring the financial viability of those engaged in fuel distribution is another important issue when considering fuel tax evasion. A taxpayer that disappears with- out having paid appropriate taxes has engaged in a form of tax evasion. Whether this is intentional, as in the daisy chains or simply the result of poor business decisions, the state loses tax revenue. To avoid the loss of revenue associated with firms declaring bankruptcy, a state can impose restrictions on who can engage in the fuel distribution system. These restrictions are typically either licensing requirements and/or bonding requirements. States differ substantially in both regards, and this is likely to affect the potential for tax evasion. 2.5.1 Tracking Systems The purpose of a tracking system is to monitor whether appropriate taxes have been paid. If the government has good ability to track the movement of fuel, then there is a much higher probability of compliance with the tax. Tracking fuel has become a major concern for those trying to reduce fuel tax evasion, with a number of states adopting sophisticated tracking systems with mandatory reporting of all fuel pur- chases and sales. Table 1-2 in Chapter 1 shows 15 states that have adopted tracking systems. Several types of systems have been adopted. Most states opted for commercially provided systems, but five states chose to develop their own systems. All tracking systems require that information on fuel movement be provided on a load-by-load basis and that all participants in the distribution chain file timely reports. The filing requirement, however, puts a burden on the tax- payers to make these reports to the government and on the government to process the information. It is not always nec- essary that the government actually use the information sent to them. There is evidence from the income tax that compliance for reported items is high even when the government does not have the capability of matching the reported information with the tax return. However, this rests on the taxpayer believing that the government does indeed match the information. If it were widely known that the information is not matched, compliance would likely be lower (Bloomquist, 2004). From the perspective of both the taxpayer and the tax collector, it is helpful if the same information in the same form is collected by all states. This tends to reduce the compliance cost for the taxpayer and makes the information more useful when traded between states. Table 2-2 shows reporting require- ments by various agents in the fuel distribution system for Virginia. Note that most high-volume transactions must be reported electronically. The use of electronic reporting sub- stantially increases the ability of the state to match activity. Where reports are filed on paper, the information must be keyed into the system to allow for tracking, or the cross match- ing must be done by hand. The careful tracking of fuel from point to point in the distribution chain limits the possibility 36 License Type Required Reports Aviation Consumer Aviation Consumer's Report (FT465) Aviation Consumer's Schedule of Disbursements (FT466) Aviation Consumer's Schedule of Receipts (FR467) Blender Blender's Report (FT471) Blender's Schedule of Receipts (2B) (FT472) Bulk User of Alternative Fuel Alternative Fuel Report (FT445) Alternative Fuel Schedule of Disbursements (FT446) Alternative Fuel Schedule of Receipts (FT447) Distributor Distributor's Report (FT448) Distributor's Schedule of Disbursements (FT449) Distributor's Schedule of Receipts (FT450 Fuel Alcohol Provider Fuel Alcohol Provider's Report (FT441) Fuel Alcohol Provider's Schedule of Disbursements (FT442) Fuel Alcohol Provider's Schedule of Receipts (FT443) Importer Electronic Filing Required Motor Fuel Transporter Motor Fuel Transporter's Report (FT461) Motor Fuel Transporter's Schedule of Deliveries (FT463) Provider of Alternative Fuel Alternative Fuel Report (FT445) Alternative Fuel Schedule of Disbursements (FT446) Alternative Fuel Schedule of Receipts (FT447) Retailer of Alternate Fuel Alternative Fuel Report (FT445) Alternative Fuel Schedule of Disbursements (FT446) Alternative Fuel Schedule of Receipts (FT447) Supplier Electronic Filings Required Terminal Operator Electronic Filings Required Source: <http://www.dmv.state.va.us/webdoc/commercial/taxact/reports.asp> Table 2-2. Virginia fuel activity reports.

of fuel tax evasion, but, as noted in the interviews, this may not be sufficient to track all potential evasion. In particular, fuel that originates outside the reporting system can evade taxes. One issue raised in the interviews is the ability to track potential blending fuels, e.g., alcohol or kerosene. In cold cli- mates, diesel might be as much as 50 percent kerosene. This issue was addressed in a GAO report: Fuels such as No. 1 fuel oil (No. 1 furnace or heating oil), No. 1 diesel fuel, and jet fuel, may be formulated to satisfy all of the requirements for kerosene, as well as all of the requirements spe- cific to these fuels the many legitimate on and off-highway uses of kerosene make its taxation in the case of highway use difficult to regulate and enforce (GAO, 1996, pp 6–7). A tracking system will make it less likely that such blending occurs without tax being paid, but if the blending items are not tracked themselves, there is still potential for tax evasion. Table 2-2 shows that Virginia requires reports from blenders and for alternative fuels and fuel alcohol. Information on the tracking of blending stocks was not gathered for this report, but it appears to be less likely to be tracked than the motor fuel itself. Where there is tracking of fuel at all levels, then blending will require appropriate reporting; however, if fuel is not carefully tracked, blending may be an issue. Blending is probably not an issue for states that tax at the retail level because even blended fuels will be taxed there unless the retailer also is evading taxes. With respect to motor fuel tracking systems, there are two basic data issues. The first is the level of detail that must be reported and the scope of reporting requirements. FTA uni- formity guidelines call for load-by-load detail for fuel ship- ments, but some states still do not obtain or cannot process this information. Information must be filed by all fuel handlers if the state is going to track all movement of fuel but many states only require that the actual taxpayer files reports. A related issue is the form of the data, and most states indicate that they at least try to follow uniformity. However, some indicate that either because of state laws or other concerns, they are not able to completely comply. Lack of uniformity is most often a problem when states trade data, but it also can be a burden on those required to report. Inconsistent data definitions create a compliance cost for the industry. The second data issue is whether the returns are filed elec- tronically or by paper. Few states require all information elec- tronically, but most agree this is important for complete cross checking of fuel reports. A few states report they receive the data on paper and either key the data into an electronic system or cross check manually, but this is rare. Most states that receive paper data report they do not process it completely. In the interviews, New York, Oregon, and Utah reported that they receive all or most of the data on paper. Only New York reports that it inputs all of this data into an electronic form. Several states reported having tracking systems that work well. Several others either had new systems they have not evaluated yet or are in the process of installing new systems. A few problems were reported, such as getting inconsistent data from sellers and buyers, or not obtaining data on fuel originating out of state; but most users gave favorable reviews. Oregon reported that it had considered obtaining a system but decided it was not cost effective. This may be because Oregon does not collect diesel fuel taxes on motor carriers operating vehicles weighing in excess of 26,000 pounds. In general, states that have fuel-tracking systems and obtain all of their data electronically believe that the tracking systems significantly deter tax evasion. However, a number of states are still in the process of developing and testing their systems, and some report problems with either the form of the data or the method of filing. 2.5.2 Bonding and Licensing Licensing can be an important enforcement mechanism with respect to fuel tax evasion. If a license is necessary to take part in the distribution chain for fuel, then a state gains two advantages. The first is it can set standards for a license that allow it to check for problems that have occurred in other states and other indicators of potential tax evasion problems. The second is that suspension of the license becomes a penalty since it then restricts the licensee’s ability to conduct business in the state. Related to the licensing requirement is a bonding require- ment. A bond is either a direct deposit or an insurance policy that guarantees payment under specific circumstances. A bond imposes a cost on the business, and hence businesses prefer to keep bonds at low levels or avoid them altogether. However, the bond serves as a form of insurance for the state against certain types of tax evasion. One form of tax evasion is to simply go out of business with large amounts of unpaid taxes due. This is effectively how the daisy chain works. However, if the business has posted a bond, then the state can collect taxes up to the bond amount. Hence, bonds limit the ability of tax evaders to gain from certain schemes. In particular, if the bond is high enough, the state can still collect taxes owed. Even if the bond is insufficient to cover all taxes owed, there is some recovery by the state. Low bonding requirements will not serve as a deterrent. The state must be able to collect some substan- tial portion of the tax owed for bonding to be a deterrent. This typically means that the bond must be set based on the volume of fuel handled, but it is not necessarily easy to determine this in advance for a new company. States vary substantially in the types of licenses required. Some will allow purchases and sales by unlicensed vendors while others have stringent licensing requirements for all participants. Some states have extensive licensing requirements 37

based on the particular activity for a business. For example, Virginia has 17 licenses posted on its web site. However, other states report that they allow substantial amounts of fuel activity for unlicensed entities. In addition, some states use the threat of suspending licenses as a form of enforcement. Several states indicated that their efforts to make licensing more rigorous resulted in improvements in their ability to enforce fuel taxes. In particular, background checks, including checks for license suspension in other states, appear to be an effective deterrent. In addition to licensing, many states require the posting of a bond for those responsible for paying taxes. The bonding requirement can be quite effective against certain types of evasion if the bond is sufficiently large. For example, daisy chains would not cost the state money if all fuel purchasers were required to obtain bonds equal to the highest amount of tax that the company might owe. Few comments from the interviews directly relate to bond- ing requirements, but representatives of Idaho noted that they would like to raise their bonding requirement. The present bonding requirement caps out at $200,000 and some distrib- utors may have monthly liabilities substantially above that. They noted that Nebraska has a good system. Nebraska requires a bond of three months of tax liability if the company has been in operation less than one year. There were some comments that it is difficult to determine the appropriate amount for bonds since the tax liability can vary over time. Also, it was not mentioned as a good enforcement mechanism. This may be due to the way the interview questions were asked but it suggests that bonding is not considered an important method to curtail tax evasion. 2.6 Issues Related to State Enforcement of Motor Fuel Tax Collection All taxes must have various enforcement measures to ensure that taxpayers make appropriate payments and are treated fairly in the collection process. The relative emphasis on differ- ent aspects of tax collection will vary by tax since the potential for evasion also varies by tax. Fuel taxes, particularly special fuel taxes, tend to be use taxes. A use tax is typically defined as one based on activity within a state. The most common type of use tax is a supplement to a state sales tax. If a person or business buys an item outside the state that would normally be subject to the sales tax, that item is subject to a use tax when it is brought into the state. For fuel taxes, the use tax is typi- cally associated with use of the fuel on roads in the state. Use taxes create more substantial collection problems and more opportunities for evasion than most other taxes. This section discusses the various stages of tax compli- ance activity for a state along with information from the in- terviews related to these activities. More detailed interview results are presented in Appendix C. The topics covered in this section include (in order addressed): education and outreach, information, verification, audits, and fines and punishment. Enforcement related to dyed fuel is covered in another sec- tion of this report and will not be discussed extensively here. 2.6.1 Education and Outreach The degree of compatibility with other states is a significant issue in education and outreach. The FTA Uniformity Com- mittee promotes uniform forms, stating: Uniform Reports and Schedules serve two purposes in support of the 11 Point Plan. First, uniform reports and schedules provide a uniform reporting mechanism for industry and government to record motor fuel tax transactions. Second, the forms facilitate information exchange between states by ensuring each state collects similar data. If an oil company uses all of the forms, the company could account for all fuel transactions by reporting the same types of data in a similar format for each state’s fuel tax reports. Industry will understand what is required and will be better able to comply with each state’s requirements. The state will be more likely to get the data it needs in the desired format from all taxpayers. In addition, any taxpayer could easily format the uniform summary page for computer reporting. Since the reporting would be similar for all states, more taxpayers may move to computerized reports (FTA, 2004c). There are recommended reports for each segment of the industry. States that adopt these forms make it easier for busi- nesses operating in more than one state to complete the paper work and facilitate the trading of information between states. However, adoption of standard forms still means that new firms in the industry must know what information is required, when it must be filed, and so on. Similarly, when there are changes in state tax laws, the taxpayer must be informed. As noted in the Washington State report, ignorance is a significant reason for noncompliance. Whether or not states adopt uniform forms, it is impor- tant to provide information to the taxpayer on what infor- mation is required and how it should be reported. States vary significantly in the amount of public information and out- reach they provide. The interviews found that some make information available, e.g., on their web site, and expect the taxpayers to be aware of their obligations and seek out needed information and forms. Others are actively involved with the industry and with public outreach. Most who engage in the education and outreach efforts believe that they are success- ful, but there is little direct evidence on the effectiveness of various outreach efforts. One area where there seems to be some effort among a num- ber of states is with programs for the public to turn in others using dyed diesel on the roads. Having an 800 number and pro- 38

viding some outreach seems to be the most common method. The expectation is that honest taxpayers themselves feel cheated by those avoiding taxes and value the opportunity to turn in cheats. This may lead to a positive outcome in a number of ways, since people who feel others are getting away with cheat- ing are more likely to cheat themselves. There is also a widespread perception that people are more likely to follow the tax laws when there is ongoing visibility. Hence, public service announcements along with publicity regarding crackdowns on evaders are thought to be effective. 2.6.2 Information The ability to collect and synthesize taxpayer information is essential to enforcing fuel taxes, especially when some uses are exempt from the tax. This is true no matter where the tax is collected. If the tax collector can track all fuel, whether taxable or not, from movement into the state until final distribution, then the opportunities for tax evasion are limited. However, any areas absent reporting create opportunities for evasion. Hence, the ideal system from a tax collector’s position is one where every load of fuel is reported with origin and destina- tion. This information is then cross checked to make sure that all purchase and sales records coincide. Information gaps create opportunities for evasion. For example, if fuel is not tracked after it leaves the rack, state taxes can be paid for a low-tax state while fuel is delivered to a high-tax state. Gaps occur either because the data are not collected or because the data is not used. States generally find they can more easily use electronic data, but that processing paper data can be costly and may not be feasible. FTA uniformity guidelines have promoted consistency between states in methods of identifying taxpayers, definitions of key terms, and the way information is filed. Consistency among states makes traded information much more valuable. Nevertheless, several states in the interviews noted that there are differences in state laws that may make complete adher- ence impossible even for states trying to follow the uniformity guidelines. While tax collectors want more and better information, taxpayers often have a different perspective. They view the filing requirements as a burden and the enhanced tracking that it allows may impose additional costs on the industry associated with late payments or other errors. The compliance cost on the industry is increased when different states require different information or information in different forms. For example, costs are higher if some states require electronic submission while others require paper. We also heard from industry that electronic transfer protocols vary from state to state and that they tire of receiving discrepancy notices due to state error with respect to entering or interpreting data. 2.6.3 Verification of Information All states audit tax returns and taxpayers. However, the audit activity is affected by a number of other characteristics. Perhaps the most important is the point of taxation. The higher the point of taxation, the lower the number of taxpayers, but each taxpayer will represent a more complex set of transactions. A higher point of taxation often is offset by an increase in the number of refunds. Since many states also audit refund requests, there may not be a large net impact on the need for auditing from moving the point of taxation up the distribu- tion chain. Other factors also affect the audit function. States differ in the amount of information they collect; some collect extensive information on all fuel transactions and carefully track all fuel while others require only summary information reported with their tax forms. Table 1-2 provides a list of states with tracking systems and Section 2.5 presents some information on states without formal systems that appear to track fuel effectively. Section 2.5 also notes that some states simply require summary information or require detailed information on paper and then fail to enter this information into a tracking system. States also differ in their approach to audits, with some treating it largely as an information gathering and error cor- rection process while others view it as somewhat adversarial. This highlights one of the key issues in audits: the distinction between errors or delays in payment versus true attempts to evade the tax. Some states are reluctant to use the term tax evasion when discussing audit results. Rather, they focus on monitoring tax collections to be certain that taxpayers are aware of the taxes due, timetable for payment, and paperwork requirements. From this perspective, most enforcement efforts are focused on simply maintaining compliance with the law. There is often a vast difference between the dealings with ordinary taxpayers who may have made errors or delayed payment versus those working complex schemes to avoid tax payment and who are likely to face criminal charges if caught. Enforcement related to the latter may involve field investigation, surveillance, and the development of a case for prosecution. 2.6.4 Audits Auditing is widely recognized as an important part of any tax system. Audits are important for identifying errors in tax payments and attempts to evade taxes. While audits are fre- quently associated with evasion attempts, most audits focus on errors and omissions. All states have some type of audit function that examines the tax returns for errors and for con- sistency among taxpayers. This may be limited to desk audits that may range from a simple review of supporting documents to complex cross matching of fuel purchases and sales to make 39

sure that all fuel can be tracked and that appropriate taxes were paid. These types of audits are more focused on detection of daisy chains, inappropriate sales of tax-free fuel, or attempts to avoid taxes by claiming exports for fuel that does not leave the state or related schemes. Most states also conduct field audits, which usually entail examination of documents that a company keeps but is not necessarily required to file with the tax return. Beyond the audits are actual investigations related to criminal activity. Criminal investigations may arise out of tax audits but they have a different focus since they may involve multiple states, other crimes, and much more restrictive rules of evidence than are needed for auditing. There are significant differences in the number and types of audits performed by different states, with some relying almost exclusively on desk audits while others put more resources into field audits. Systems based on extensive electronic report- ing may be able to effectively desk audit all returns as they come in. Where the information is not complete or where substantial amounts arrive by paper, the desk audits are more labor intensive and less complete. Field audits are typically much more thorough than desk audits and may cover multi- ple time periods. It is worth noting that Eger and Hackbart (2001) found that: “for an increase of one auditor, on average a state will receive an additional $1,232.09 per million miles traveled per truck.” This is based on a statistical model explor- ing survey data. A variety of other estimates exist regarding the impact of auditing on tax collections. Many states can determine what they collected by comparing audits with what they spent, but this information may not be very helpful in determining how much could be collected with additional audit efforts since it represents an average return and incre- mental returns to audit efforts are likely to be lower than the average. There are substantial differences across states in the methods of tracking and auditing fuel taxes. Table 2-3 shows the state- by-state differences in the taxpayers and the tax collectors. The tax collection and audit function is typically in either the DOR or DOT. The tax collection agency for special fuels is typically the same, and a detailed listing can be found at <http:// www.fhwa.dot.gov/ohim/hwytaxes/2001/pt2.htm>. Eger and Hackbart (2001) found that the vast majority of states admin- ister the motor fuel tax through their DOR: Forty-two states and the District of Columbia administer the motor fuel tax through a department of revenue, finance, or administration while eight states administer motor fuel tax through transportation (the major tax collecting agency). This places motor fuel excise tax administration under the control of the same agency collecting other types of taxes, which separates the collection of revenues from the management of highway appropriations. The unique characteristic of the tax as a use tax creates more of a distinction in this area than would be noted for more gen- eral taxes. DOR is generally focused on issues of tax collection and audit of the state’s broad-based taxes that supply most of the revenue. Many conduct audits of several taxes at once. A fuel company may owe both sales taxes and fuel taxes and may be audited for both at the same time. States also can find advantages to making their DOT respon- sible for collection of motor fuel taxes. DOTs tend to have a vested interest in the collections that fund their operations and they have more expertise in the system. There is some potential to combine fuel tax enforcement with weight and safety inspections of heavy trucks. On the other hand, DOTs tend to have less expertise in tax collection and auditing. Where the collection and auditing function is housed seems to have some potential for influencing the rate of evasion. Some state representatives interviewed for this study ques- tioned whether DOR collection techniques were effective, particularly when audits cover multiple tax systems. Specifically, it was asserted that general auditors may not have expertise in fuel distribution systems and the taxable versus nontaxable fuel uses. In addition, fuel taxes represent a small part of a state’s tax collections and seem to receive less attention from DOR staff because of the importance of other taxes. Finally, it was asserted that general taxes tend to receive more attention because they go into the general fund, while increased fuel tax collections are deposited in an HTF or DOT account. Thus some argue that the DOT should be the collector of fuel taxes. At the very least, some argue that a specialized unit within DORs should be established specifically for the collection of motor fuel taxes. Few states conduct joint audits either with other states or with the IRS. One problem with joint audits is the differences in tax structures. Joint audits with the IRS are problematic for states that do not tax at the rack since they are interested in different information. Even states that do tax at the rack may have problems with a joint IRS audit since the IRS is not focused on which state the fuel ultimately is deposited. This problem was noted a number of times, either as the reason for not doing joint audits with the IRS or as the result of trying to do a joint audit. A final concern expressed about joint audits with the IRS is that the IRS has first claim on revenue in the event of insolvency, so the state might receive less revenue than if they had audited on their own. Even when joint audits are completed with other states, there do not seem to be many positive outcomes. The major benefit noted was to keep open lines of communication between the states and to make auditors aware of what is happening in other states. Industry representatives noted that joint audits typically are involved with interstate commerce issues and that state auditors are typically not well versed on this topic. 2.6.5 Fines and Punishment The economic analysis of crime focuses on the expected return to the crime versus the expected penalty. The expected 40

41 State Tax Paid in First Instance By Tax Computed on Basis of Tax Collected and Administered by Alabam a Distributors, refiners, retail dealers, users Quantities sold Departm ent of Revenue Alaska Dealers and users Quantities sold, transferred or used Depart me nt of Revenue Arizona Distributors Quantities sold Depart me nt of Transportation, Motor Vehicle Division Arkansas Wholesale distributors (first receivers) Inshipm ents or receipts Depart me nt of Finance and Adm inistration, Motor Fuel Tax Section California Distributors, ma nufacturers, and importers Quantities distributed State Board of Equalization Assesses, and State Controller Collects Accounts Receivable Colorado Distributors and refiners Gross gallonage Depart me nt of Revenue, Motor Carrier Services Division Connecticut Licensed distributors Quantities sold and used Departm ent of Revenue Services Delaware Wholesale distributors Quantities sold and used Depart me nt of Transportation, Motor Fuel Tax Adm inistration Dist. of Col. Licensed im porters Quantities sold and used Departm ent of Finance and Revenue Florida Im porters, term inal wholesalers, suppliers, and blenders Quantities rem oved through term inal rack, im ported, or blended Depart me nt of Revenue Georgia Licensed distributors (wholesalers, retailers) Quantities sold and used Depart me nt of Revenue, Motor Fuel Tax Unit Hawaii Manufacturers, producers, refiners, importers and distributors Quantities manufactured, produced, refined, im ported and sold or used Depart me nt of Taxation Idaho Licensed distributors Quantities received Tax Co mmi ssion, Motor Fuels Division Illinois Licensed distributors Quantities sold and used Department of Revenue Indiana Licensed distributors Quantities received Depart me nt of State Revenue, Special Tax Division Iowa Licensed suppliers, restrictive suppliers, and blenders Quantities received as shown by lading or ma nifest Depart me nt of Revenue and Finance Kansas Distributors of first receipt (defined as loaded at the term inal rack) Quantities received or imported Depart me nt of Revenue, Custom er Relations, Oil, Gas, Petroleum Seg me nt Kentucky Licensed gasoline dealers (wholesalers, refiners, im porters, certain retailers) Quantities received Revenue Cabinet, Motor Fuel Tax Section Louisiana Manufacturers, refiners and importers Quantities sold and used Depart me nt of Revenue, Excise Tax Division Maine Wholesale distributors Quantities sold and used State Tax Assessor Maryland Licensed dealers Quantities sold and used Comptroller, Motor Fuel Tax Division Massachusetts Licensed distributors and importers Quantities sold and used Depart me nt of Revenue Michigan Supplier, term inal or refinery Quantities sold Depart me nt of Treasury, Motor Fuel Tax Division Minnesota Licensed distributors In shipm ents Depart me nt of Revenue, Petroleum Division Mississippi Wholesale distributors and producers Quantities received State Tax Co mmi ssion Missouri Suppliers Q uantities rem oved fro m De p artm ent of Revenue, Business Tax term inals Bureau Montana Distributors Im ports plus refinery distribution Depart me nt of Transportation, Adm inistration Division Nebraska Distributors and Im porters Gross gallons received or imported Depart me nt of Revenue Nevada Licensed dealers (distributors) Quantities distributed Depart me nt of Taxation, Revenue Division New Ham pshire Im porters, producers or refiners Quantities sold Depart me nt of Safety, Road Toll Adm inistration New Jersey Im porters, distributors or jobbers Quantities sold or used Depart me nt of the Treasury, Division of Taxation New Mexico Distributors Im ports plus production Depart me nt of Taxation and Revenue, Returns Processing Division New York Registered distributors on first import or production Quantities imported or produced Depart me nt of Taxation and Finance Table 2-3. State taxation of gasoline. (continued on next page)

penalty in this sense is a combination of the probability of being caught, the probability of being convicted if caught, and the magnitude of the punishment. Increases in either the proba- bilities of apprehension or conviction or increases in the mag- nitude of the punishment reduce the incentive to commit the crime. This may induce a call for harsher penalties to deter crime. However, arguments for fairness, as well as many other issues, typically enter into the decision as to the level of punish- ment. The probability of being convicted once apprehended also is subject to public policy adjustment based on the rules of evidence and related matters. Hence, the impact of fines and punishments cannot be viewed in isolation. States with high fines may find they have little impact because of low probabilities of apprehension or conviction. Other states with lower penalties may have more of a deterrent effect because of higher probabilities of apprehension and conviction. Penalties for late payment or for errors in filing give the taxpayer an incentive to get the payments in on time and to file correctly. If the penalties are small, it may be in the best interest of the taxpayer to purposely delay payment and to pay the penalties. Hence, most states try to make the fines and penalties for late payment and for errors sufficiently large that taxpayers have an incentive to send payments in on time. From the taxpayer perspective, the late payment or errors may seem minor, but with high penalties and interest payments they may be seen as punitive. Penalties for fraud or other criminal activity are typically much higher than those for errors and omissions. States differ both in the level of penalties for fraud and in their willingness to classify an action as fraud or to prosecute the cases. Table 2-4 shows the differences in penalties for southern states. They range from no criminal penalties in Arkansas to a fine of $10,000 and imprisonment for two to 10 years in Texas. Denison and Eger (2000) noted that the trend in recent years had moved towards harsher punishments. In the southern states, a wide variety of penalties are associated with the criminal aspects of the motor fuels tax. Recently, a change has occurred in this arena. A misdemeanor penalty was formerly associated with failure to pay the motor fuels tax, but in the last few years this minimal deterrent has evolved toward felony pun- 42 State Tax Paid in First Instance By Tax Computed on Basis of Tax Collected and Administered by North Carolina First person in State who sells or uses fuel (distributor) Receipts or sales at distributor's option Depart me nt of Revenue, Motor Fuels Tax Division North Dakota Wholesale distributors Quantities sold and used Tax Co mmi ssioner, Motor Fuel Tax Section Ohio Wholesalers and Distributors of Motor Vehicle Fuel Quantities distributed, sold, or used Tax collected by the State Treasurer Motor fuel laws adm inistered by the Depart me nt of Taxation Oklahom a Suppliers when rem oved from term inal rack Quantities imported or rem oved from the term inal rack Tax Co mmi ssion, Audit Division Motor Fuel Section Oregon Licensed dealers Quantities sold or used Departm ent of Transportation Pennsylvania Registered distributors Quantities used or sold and delivered Depart me nt of Revenue, Bureau of Motor Fuel Taxes Rhode Island Distributors Quantities sold or used Depart me nt of Adm inistration, Division of Taxation, Excise Tax Section South Carolina Supplier at term inal rack Quantities sold or used Departm ent of Revenue South Dakota Suppliers and im porters Gallons rem oved from the rack at fuel term inal Depart me nt of Revenue, Motor Vehicle Division Tennessee Wholesale distributors Quantities received and stored Depart me nt of Revenue, Accounting Division, Petroleum Tax Division, Gasoline Tax Section Texas Person ma king first sale or use in State Quantities sold or used Com ptroller of Public Accounts Utah Licensed distributors Quantities distributed Tax Commission Verm ont Licensed distribut ors Receipts or sales Depart me nt of Motor Vehicles, Co mme rcial Vehicle Operations Virginia Im porters, producers, refiners, and som e dealers Quantities sold or used Depart me nt of Motor Vehicles, Motor Carrier Services Washington Supplier (term inal rack) or importer Quantities sold or imported Depart me nt of Licensing, Prorate and Fuel Tax Division West Virginia Distributors Actual mete red gallons sold Depart me nt of Tax and Revenue Wisconsin Licensed suppliers Quantities received Departm ent of Revenue Wy om ing Supplier (term inal rack) Quantities sold Departm ent of Transportation. Source: Highway Taxes and Fees: How They Are Collected and Distributed - 2001. Table 2-3. (Continued).

ishment. Some of the southern region’s legislatures are looking carefully at motor fuels tax evasion and reinterpreting failure to pay as a felonious crime. This trend has led to harsher penalties and punishments. It should be noted that there is considerable debate regarding the effectiveness of penalties as deterrence to tax fraud (Denison and Eger, 2000). The inability in some cases for penalties to effectively act as a deterrent, as noted by Denison and Eger, relates to the difficulty of proving fraud and to the lack of willingness of investigators and prosecutors to pursue criminal action. Many states are relatively uniform in their late payment penalties. Table 2-5 shows the fines reported by the states inter- viewed. Typically, there is a 5 to 10 percent penalty for late payment plus interest of about 1 percent per month. Of course, there are substantial differences in both the application and enforcement of these penalties. However, the bigger differ- ence is in the treatment of fraud. As noted above, some states have little possibility to levy criminal sanctions while others have active fraud units with heavy penalties. In the interviews, many respondents felt that existing penalties were too light for true tax evasion but the industry representatives also thought that the penalties were too large for late payment and other minor infractions. In particular, the tax collectors viewed penalties and interest for late payment as a strong incentive for taxpayers to make prompt payment of taxes due, while the industry sees late payment due to errors in paperwork as almost unavoidable. Hence, they perceive the penalties and interest charged as being excessive relative to the action. Administrators interviewed for this study noted the larger problem was tied to the prosecution of criminal cases and not to the penalties. Several administrators indicated that they have substantial penalties for fraud at their disposal but their 43 State Criminal Penalty Alabama Misdemeanor and shall be punished by a fine of not less than $50 or more than $300. Each month that payment is due a new misdemeanor is applied. Arkansas None. Delaware Class E felony and shall be punished by a fine of not more than $11,500 or by imprisonment not exceeding five years, or both. Florida Felony of the third degree and shall be punished by a fine of not more than $5,000 or by imprisonment not exceeding five years, or both. State reserves the right upon conviction to revocate or suspend fuel tax license. Georgia Misdemeanor and shall be punished by a fine of not less than $1,000 nor more than $10,000 or by imprisonment for a term not less than 30 days nor more than 12 months, or both. Kentucky Class A misdemeanor and shall be punished by a fine of $500 or by imprisonment for a term not less than 90 days nor more than 12 months, or both. Louisiana Misdemeanor and shall be punished by a fine of $500 or by imprisonment for one year, or both. Maryland Misdemeanor and shall be punished by a maximum fine of $1,000 or imprisonment not exceeding six months, or both. Revocation of license after noncompliance of 60 days. Mississippi Misdemeanor and shall be punished by a fine of not less than $50 or more than $100. North Carolina Class 1 misdemeanor and shall be punished for a term not less than one day or more than 45 days community punishment. Oklahoma Felony and shall be punished by a fine of not more than $10,000 or three years in the state penitentiary, or both. South Carolina Felony and shall be punished by a fine of not more than $5,000 or imprisonment not exceeding five years, or both. Tennessee Revocation of license. Class E felony and shall be punished by a fine of not more than $3,000 or imprisonment for not less than one year nor more than six years, or both, for evasion of excise tax. Texas Felony in the third degree and shall be punished by a fine of $10,000 or imprisonment for not less than two years nor more than 10 years in the state penitentiary, or both. Virginia Class 1 misdemeanor and shall be punished by a fine of not more than $2,500 or imprisonment of not more than 12 months, or both. West Virginia Misdemeanor and shall be punished by a fine of not less than $100 nor more than $1,000 or imprisonment of six months in jail, or both. Source: Denison and Eger, 2000. Table 2-4. Criminal penalty for conviction of motor fuels tax fraud in the southern states.

44 State Civil Penalties Criminal Penalties Alaska 5% per month for late payment to a maximum of 25%. Negligence is 30%. 50% or $500 added if fraud proven. Criminal evasion is a class C felony. Arkansas 10 % or $50 for late payments. Negligent penalties of 10%. Fraud penalty of 50%. Florida Delinquency is 10% per month (or any part of a month) up to a maximum of 50%. Also lose collection allowance. Fraud penalty is $10 per gallon. This was expanded from the IRS dyed fuel penalty to apply to all tax evasion. Idaho There is a 5% negligence penalty, 10% if it is a serious reporting problem (e.g., 10- 25% under reporting). Interest is applied on an amended return and all late payments. 50% fraud penalty (dyed diesel and proved intent). Kansas Dyed fuel penalties are a minimum of $1,000 and max of $10,000 for first violation ($10 per gallon subject to the minimum and maximum). In addition, they collect the tax due on the fuel. Five times as much for second violation. Can file liens and tax warrants against property. 5% penalty and 1% per month interest for late payment. There are criminal penalties that could result in jail time but to date these provisions have never been used. Minnesota 10% late payment, 25% late filing, 50% civil fraud. None. Montana Late payment – 10% of the tax due. Penalty for fraudulent activity related to diesel taxation is 25% of the taxes due plus 1% interest per month of underpayment. Fraud is the revocation of the distributor’s license. State can seize assets. Nebraska Late filing is $50 within 10 days. Later than that it is an additional 10% or $100, whichever is greater. Many are class four felonies with potential prison time. New Jersey The interest on any late payment of Prime + 3%, 10% penalty. Fraud is turned over to the criminal investigation unit and the criminal penalty is based on the amount of the fraud. New York Not reported Fraud is assessed a 50% penalty. North Carolina Late filing is 5% per month with a maximum of 25%; late payment is 10%; 50% fraud penalty. There may be a $1,000 penalty (e.g., failure to maintain records ) to $15,000 ( e. g ., 2nd diversion ) . Not reported In addition, the tax due is collected. North Dakota A late report results in a 5% penalty + 1% per month interest charge on any balance. Also, ND can go back six years rather than three if the shortfall exceeds 25%. They have not caught any fraudulent activity but it would result in the group turning the investigation over to the state’s attorney. Oregon There is a 10% penalty and 12% interest on all forms of noncompliance relating to unpaid tax. Taxes are reported on a monthly basis. Not reported Pennsylvania Late reporting results in a 10% penalty. Not being compliant with electronic reporting procedures results in a $500 penalty. Not reported South Carolina Late payment is 5% per month not to exceed 25%. $5,000 per month for failure to file appropriately. Not reported. South Dakota Late return, 10% of tax due or $10 (minimum) and monthly interest at 1.5%. In addition, the taxpayer could lose allowance for shrinkage. Dyed fuel penalties are $250 for pickup or $500 for semi-truck on first offense and double for repeat offenders. There are civil and criminal penalties in statutes but these have not been extensively used. Table 2-5. Civil and criminal penalties for late payments, fraud and other forms of noncompliance by state.

state has never prosecuted a case. This seems to be due more to the difficulty of prosecution than to the absence of fraud. 2.7 Issues Related to Motor Carrier Enforcement Fuel tax evasion that is likely influenced by motor carrier enforcement is the use of illegal dyed fuel by heavy trucks. Evasion that involves transporting fuel from a low-tax state to high-tax state using fraudulent or modified bills of lading is not likely to be deterred by motor carrier enforcement efforts (cargo inspections in this issue paper) in the vast majority of states. The problem of estimating the effectiveness of any of these efforts (motor carrier weight, safety, and dyed fuel enforcement) on illegal use of dyed fuel is similar to overweight trucks since there is little confidence in any estimates of the total amount of use. Because enforcement and fine amounts work in conjunction to influence illegal activity, both need to be considered when developing methods to estimate evasion. The rest of this section highlights how some motor carrier enforcement and dyed fuel enforcement activities may be useful in the overall model to estimate fuel tax evasion. Motor carriers have long been subject to size, weight, and safety regulations. These regulations have evolved over time and include a complicated assembly of both state and federal regulations including so-called grandfather rights. Enforcement of motor carrier regulations is primarily the responsibility of each individual state. Federal involvement began with the passage of the Federal-Aid Highway Act of 1956 and was expanded and strengthened with the Surface Transportation Assistance Acts of 1978 and 1982 (FHWA, 2000b). Currently, the federal government has oversight responsibility but no enforcement capabilities (with the exception of the IRS’ ability to inspect vehicles for dyed fuel use). The objective of motor carrier size and weight enforcement is to limit infrastructure damage caused by illegal overweight vehicles while safety enforcement activities are intended to improve safety per- formance of motor carriers. The primary areas where motor carrier enforcement efforts may have measurable effect as deterrents on motor fuel tax evasion are: • illegal use of untaxed dyed diesel fuel on public highways; and • illegal transportation of motor vehicle fuel (as part of eva- sion schemes). Little literature relates motor carrier enforcement efforts to the above issues primarily because the objectives of the enforce- ment programs are not associated with fuel tax evasion. This section focuses on describing weight, safety, and dyed fuel enforcement efforts with the objective of illuminating trends, issues, or data as they relate to fuel tax evasion issues. 45 State Civil Penalties Criminal Penalties Texas There is a 10% penalty for errors plus interest. If noncompliance involves fraud, there is an additional 75% penalty. Another $200 is added if dyed fuel is involved. It is a Class C misdemeanor for using dyed fuel on road. Utah There is a 10% late and nonpayment penalty, 10% negligence, 15% intentional disregard. 50% or 100% fraud penalties, plus interest. There is a criminal investigation unit that responds to criminal activity. Washington Regular underpayment results in a special fuels 10% penalty, 1% monthly cumulative interest; motor fuel 2% penalty and 1% monthly cumulative interest. Fines can reach up to 25% for significant negligence. There is a 100% penalty on evasion. Wisconsin 10% late filing fee and graduated penalty of 5% per month to 25% max. Delinquent interest rate is 18%. Nonfilers receive estimated tax bill, with penalties. Fraud penalty is 50%. Navajo Nation Tax, interest, and penalties. Penalties are No criminal penalties. No criminal 5% for initial nonpayment and 0.5% per month (penalties plus interest). code on Navajo Nation. IRS Not reported If can prove fraud, criminal penalties apply. If convicted, there is a 50% penalty on any tax owed. Source: Interview Responses Table 2-5. (Continued).

2.7.1 Motor Carrier Enforcement The enforcement of motor carrier regulations requires the cooperation of state DOTs, which build, operate, and construct the highway infrastructure, and the law enforcement agencies responsible for commercial vehicles within that state. Typically, these enforcement agencies are the State Police or equivalent. In some cases, the state DOT may have its own enforcement personnel who conduct weight, safety and dyed fuel enforce- ment activities. Local law enforcement agencies also may have enforcement responsibilities. Weight enforcement can take place at fixed (static), weigh- in-motion, or mobile scales. At fixed and mobile scales, the vehicle is usually stopped (or nearly so), while weigh-in-motion (WIM) can be done at highway or slow speeds. Typically, weight enforcement efforts are coupled with motor carrier safety inspection efforts at the fixed weigh station locations because of the availability of space to conduct the inspections. Depend- ing on a host of factors, supplemental safety inspections can be conducted that may include the vehicle, driver, or both. Dyed fuel inspections require the tank be dipped to inspect for the presence of red dye. The sample may be sent to the lab- oratory for verification of dyed diesel. The following sec- tions describe weight, safety, dyed fuel, and cargo enforce- ment activities. 2.7.1.1 Weight Inspections The motivation and focus of weight enforcement activities is directed at limiting the damaging effects of overweight vehicles to highway infrastructure. The damage caused by overweight trucks is not insignificant; TRB’s Truck Weight Limits study estimated that nearly $160 to $670 million in highway pave- ment costs could be saved if all overweight axles were eliminated (Special Report 225, 1990). The range of the estimate reveals that the extent of overweight trucks operating on highways is not readily known. In contrast, the actual number of trucks weighed is fairly well known. In 2003, nearly 177 million trucks were weighed in the United States as reported to FHWA. As recently as 10 years ago the majority of vehicles were weighed with fixed scale technologies. However, as shown in Figure 2-8, the most recent FHWA data (2003) indicate that a majority of trucks are now weighed by WIM devices. WIM can be done at highway or slow speeds; however, WIM scales have not been certified by the National Institute for Standards and Technology (NIST) for weight enforcement practice, and thus, they typically serve to screen and identify potentially overweight vehicles for weighing at a fixed scale. Accordingly, nearly half of all vehicles weighed were weighed at fixed scales located off the mainline highway at a dedicated facility. Trucks must depart the main highway, slow to a rela- tively low speed or stop, and be weighed. The stations are fixed in location, are typically in high-volume truck corridors, and may be open limited hours of duration. Mobile weight enforce- ment uses portable scales, and allows enforcement on poten- tial diversion routes for trucks evading fixed scales. It can be targeted to seasonal or other patterns where known weight violations are likely to occur. WIM devices are part of larger Intelligent Transportation Systems (ITS) (for commercial vehicles) aimed at improving the efficiency of the weight and safety inspection activities. Commercial vehicles that participate in these programs can be equipped with a transponder or electronic license plate. As the vehicle approaches the fixed weigh station, the tag can be read and the vehicle identified. That information, along with the vehicle gross and axle weights can be used to decide if the vehicle should bypass the scale, or be required to pull in for further inspection. In this manner, the overall operating effi- ciency of the system can be improved and more trucks can be weighed. Limited enforcement resources are directed toward the most likely violators. Static scales provide a visible reminder of enforcement and a deterrent effect for overweight trucks. However, largely because scale locations are fixed and it is relatively easy for overweight vehicles to evade the weigh stations, the number of overweight citations or violators is relatively low, on the order of 0.7 percent of the total trucks weighed. As shown in Table 2-6, this violation rate has stayed relatively constant over time. Portable scales or targeted mobile enforcement efforts have much higher violation rates, but these activities are more expensive to conduct. They have the added advantage of being able to target seasonal or known bypass routes. While generalizations are difficult, the primary trucking industry segment thought to be operating near- or over-weight limits are those transporting dense, bulk commodities such as agricultural, mining, or construction materials products 46 Fixed Scales, 81,276,662 WIM, 95,078,759 Semiportable Scales, 522,758 Portable Scales 491,198 Figure 2-8. Number and location of trucks weighed (2003).

(Special Report 267, 2002). Interestingly, these may be the same industry segments with the easiest access to dyed fuel. Long haul interstate trucks have less incentive to operate overweight since their routes (interstates) have higher en- forcement presence and their commodities are less dense. Fines levied for overweight violations vary substantially from state to state. No current inventory of overweight fines was found (though our search was not exhaustive). Downs (1981) cites a dated 1979 FHWA summary of overweight penalties of which there may be a more current version available. There is substantial evidence that overweight fine structures are well below marginal revenues from overloading, as well as esti- mates of the marginal cost of road damage from overloading (Bisson and Gould, 1989; Casavant and Lenzi, 1993; Church and Mergel, 2000; Euritt, 1987). In a sense, it could be argued that the fines are often too low for a sufficient deterrent effect. In addition, there is also the issue that the judicial process may undermine the weight enforcement programs by regularly reducing the fines. Jessup and Casavant (1996) found that, for all cases contested in court, typically only 63 percent of the original fine is paid. Finally, the state differences include whether citations are civil or criminal offenses and which fund receives the fine revenues. In some cases, not all revenue generated is returned to the maintenance of highways, which may have an effect on motivation of enforcement, particularly for highway agencies. 2.7.1.2 Safety Inspections Motor carrier safety inspections provide perhaps the most direct link between potential fuel tax evasion and motor carrier enforcement activities. Because the vehicle is stopped, enforce- ment actions such as fuel tank dipping are more easily con- ducted. As part of the inspection procedure a host of vehicle and driver items can be verified or inspected depending on the type of inspection. In all cases, the vehicle is stopped and an enforcement officer is present. Inspection procedures are standardized and any criterion that doesn’t meet a standard can place a driver or vehicle “out of service.” When these violations occur, the violation must be corrected before any additional activity can take place. The Commercial Vehicle Safety Alliance provides standard- ized inspection procedures and training through the North American Standard Inspection (NASI) program. Inspections are targeted at violations that are more likely to cause a crash, although some argue that the link has not been established definitively. This program is designed to improve commercial motor vehicle safety and promote uniformity in compliance and enforcement, while minimizing duplication efforts and unnecessary operating delays for the motor carrier industry. Motor carrier safety inspections are categorized by the depth of inspection, with Level 1 inspections being the most complete. The following are descriptions of each (FHWA, 2004): LEVEL I: North American Standard Inspection. An inspec- tion that includes examination of driver’s license, medical examiner’s certificate and waiver, if applicable, alcohol and drugs, driver’s record of duty status as required, hours of service, seat belt, vehicle inspection report, brake system, coupling devices, exhaust system, frame, fuel system, turn signals, brake lamps, tail lamps, head lamps, lamps on pro- jecting loads, safe loading, steering mechanism, suspension, tires, van and open-top trailer bodies, wheels and rims, windshield wipers, emergency exits on buses and hazardous material (HM) requirements, as applicable. LEVEL II: Walk-Around Driver/Vehicle Inspection. An exam- ination that includes each of the items specified under the North American Standard Inspection. As a minimum, Level II inspections must include examination of: driver’s license, medical examinees certificate and waiver, if appli- cable, alcohol and drugs, driver’s record of duty status as required, hours of service, seat belt, vehicle inspection report, brake system, coupling devices, exhaust system, frame, fuel system, turn signals, brake lamps, tail lamps, head lamps, lamps on projecting loads, safe loading, steering mechanism, suspension, tires, van and open-top trailer bodies, wheels and rims, windshield wipers, emergency exits on buses, and HM requirements, as applicable. It is contemplated that the walk-around driver/vehicle inspection will include only those items that can be inspected without physically getting under the vehicle. LEVEL III: Driver-Only Inspection. A roadside examination of the driver’s license, medical certification and waiver, if 47 FY 2000 Trucks weighed (Excluding WIM) 100,103,108 Trucks weighed by WIM scales 92,888,114 Weight citations 653,310 Violation rate FY 1985 97,331,000 7,903,000 664,000 0.7 % FY 1989 124,687,000 22,263,000 692,700 0.6% FY 1995 111,620,000 57,948,000 655,000 0.6% 0.7 % Source: FHWA (2000a) Table 2-6. Selected national truck weight violation data.

applicable, driver’s record of duty status as required, hours of service, seat belt, vehicle inspection report, and HM requirements, as applicable. LEVEL IV: Special Inspections. Inspections under this heading typically include a one-time examination of a particular item. These examinations are normally made in support of a study or to verify or refute a suspected trend. LEVEL V: Vehicle-Only Inspection. An inspection that includes each of the vehicle inspection items specified under the North American Standard Inspection (Level I), without a driver present, conducted at any location. States report most of their inspections activities to the Fed- eral Motor Carrier Safety Administration (FMCSA) as part of the Safety and Fitness Electronic Records (SAFER) System. As shown in Table 2-7, there is a relatively even split between the number of level 1, 2, and 3 inspections performed in 2003. Level 1 and 2 inspections are more likely to be associated with dyed fuel inspections (if conducted). There are a very small number of level 4 and 5 inspections done compared to the others. Fines may be assessed for safety violations determined at the state level. It should be noted that a summary of these fine levels has not been found, but the primary penalty associated with the safety inspections is the threat of being placed out of service. Vehicles placed out of service must remain so until the repair is completed. As shown in Table 2-7, the violation rate is relatively high with approximately 20 to 30 percent of the vehicles inspected having some sort of violation. This is indicative of targeted enforcement efforts, and one would assume, a strong deterrent effect. 2.7.1.3 Dyed Fuel Inspections Fuel to be used for exempt or off-road use is currently dyed red per IRS standards that require Solvent Red 164 be added at a concentration spectrally equivalent to 3.9 pounds per thousand barrels (PTB) (11.13 mg/liter) of solid dye standard Solvent Red 26 (Chevron, 1998). The concentration can be measured according to American Society for Testing and Materials (ASTM) D 6258—Determination of Solvent Red 164 Dye Concentration in Diesel Fuels. The dye is usually added at the terminal with dye injectors that should be tamper proof. These sites may be inspected by IRS or state enforcement officers. Diesel fuel dyed red is not subject to highway use tax and, as such, if used on public roads is considered fuel tax evasion. It should be noted that some states allow the use of dyed fuel legally by government vehicles, school buses, or other exempt uses. The likelihood of being caught with dyed fuel depends on how active an effort is made to catch those who illegally use dyed fuel. One important measure of enforcement activity is whether the state has its own dyed fuel statues. Not all states have dyed fuel statutes; those that do may have differing civil and criminal penalties. Unofficial data from FHWA indicate that 38 states have corresponding dyed fuel statutes. These states are shown in Figure 2-9. Presumably, many of the states with dyed fuel statutes have enforcement activities dedicated to dyed fuel use. For those that choose not to enforce it, this enforce- ment effort is primarily left to the IRS. The IRS currently has approximately 150 officers nationwide devoted to dyed fuel enforcement activities (Burwell, 2005). Each state may tailor its dyed fuel enforcement program differently, and it may be conducted independently of motor carrier safety inspections. While inspection of the fuel system is required in some levels of motor carrier inspections, checks for dyed fuel usage are not required as part of the NASI pro- cedure. The interview analysis and our research indicate that weight and safety inspections are not systematically combined with dyed fuel inspections. Washington state commercial vehicle enforcement division indicates that all Level 1 motor carrier inspections include a fuel dip as a matter of policy (Estes, 2005). Oregon DOT does not do any fuel inspections as part of its enforcement program. Any dyed fuel inspections done in Oregon are done by the IRS although they may at times use ODOT weigh station facilities (McKane, 2005). Oregon’s prac- tice likely reflects the state’s reliance on weight-mile rather than diesel fuel taxes levied on motor carriers. The Minnesota Department of Public Safety has an aggressive dyed fuel en- forcement program that includes roving patrols and inspections at weigh stations. Much of the focus is on agricultural vehicles (Bergstrom, 2005). Additional searches of state commercial vehicle enforcement web sites find that a number have a focus on dyed diesel fuel, while others do not. An official source for dyed fuel inspections nationwide was not found; however, FHWA maintains an unofficial source of 48 Inspection Activity With no violations With violations Total Inspections I. Full Number 263,766 755,691 1,019,45 7 % 25.87 74.13 33.90 II. Walk-Around Number 216,715 888,076 1,104,79 1 % 19.62 80.38 36.74 III. Driver Only Number 301,079 525,563 826,642 % 36.42 63.58 27.49 IV. Special Study Number 9,966 12,452 22,418 % 44.46 55.54 0.75 V. Vehicle Only Number 19,809 13,802 33,611 % 58.94 41.06 1.12 Table 2-7. Motor carrier inspection activity by inspection level (2003).

dyed fuel inspections data in the United States. From these data, it appears the violation rates for dyed fuel inspections are similar to the overweight citations. The majority of violations rates are near 1–2 percent of total samples taken. A few states report dyed fuel inspection activities in their annual reports or newsletters. Some of those found are sum- marized in Table 2-8. These data closely resemble the FHWA unofficial tabulations. In a 2004 report for the Nevada High- way Patrol, the agency reported 530 dyed fuel inspections and no violations issued in October 2004, 626 in October 2003 with no violations, and 521 in September 2004 with no violations. Revenue Canada, as part of the Canadian/USA Motor Fuel Tax Northeastern Compliance Initiative, conducted fuel sample inspections at U.S. and Canadian border crossings as well as locations in the northeastern United States. A total of 3,894 sam- ples were taken and 6 fuel violations were discovered as well as 11 “bleached” fuel samples. A 2004 report by the Nebraska Department of Revenue cited 7,198 inspections and 42 viola- tions. The report states that the trend has been declining over the years since the number of violations was down from 100 in 1997/98. Finally, the California Air Resources Board conducted 23,829 inspections in 2003, sent 171 samples to the lab, and found 114 violations. Fines and penalties for dyed fuel use at the federal level are $10 per gallon or $1,000, whichever is greater, plus payment of the tax. Illegal use of dyed fuel also may be subject to a fine of $25,000 per day per violation of the Clean Air Act since the dye also is applied to fuels with high sulfur content. States may impose additional sanctions and penalties on top of the federal ones. 2.7.1.4 Cargo Inspections A few of the tax administrators interviewed for this re- port suggested that motor carrier inspections or stops by enforcement personnel could result in BOL inspections for fuel transporting vehicles. The intent would be to verify declared weight with the measured weight in an effort to capture possible evasion schemes that involve transporting fuels. Additionally, it was suggested that enforcement could verify that the vehicle was reasonably on a path to the declared delivery point. 49 Inspections Violations Violation rate Nevada Oct 04, Oct 03, Sept 04 1,677 000 0% Northeastern Canadian/USA Duration Unknown 3,894 17 0.4% Nebraska Fiscal Year 2003- 2004 7198 42 0.5% California 2003 23,829 114 0.4% Sources: Nevada Highway Patrol (2004), Sansfaçon, Georges (2004), Nebraska Department of Revenue (2004), and California Environmental Protection Agency, Air Resources Board (2004) Table 2-8. Sample dyed fuel inspection data. Source: Federal Highway Administration States shaded grey have dyed fuel statutes Figure 2-9. States with dyed fuel statutes.

Opportunity for other future enforcement techniques (i.e., cargo tracking of fuel to destination) is certainly a pos- sibility. In fact, this technology has been proposed and tried at a few international border crossings where cargo is tagged and tracked to a final destination to increase the speed of border crossings. The TransCorridor project allows container- ized in-bound cargo to travel from the ports of Seattle and Tacoma north into British Columbia (BC) to be tracked with automated vehicle identification (AVI) readers at the port and the border crossing at Blaine, Washington. This information can be used to expedite transit through the border crossing or to detain vehicles for further inspection if unnecessary travel time is encountered. Further efforts will include electronic seals on containers to verify that transshipments bound for Canada are not tampered with while in the United States. Other ports have similar efforts underway. 2.7.2 Effectiveness of Motor Carrier Enforcement Enforcement’s influence on motor carrier behavior works mainly through the principle of deterrence. Deterrence affects human behavior by making punishment for certain actions credible and certain. The associated penalties need to be sufficiently high to provide a disincentive but not too high to be considered punitive. Each motor carrier enforcement efforts has a deterrence element. More discussion on the effects of fines and punishment on behaviors can be found in Section 2-6. There is a body of literature suggesting that the fines for overweight vehicles are proportionate to the effectiveness of the enforcement. However, there is a wide variety of fines and penalties for overweight violations in each state. In fact, one recommendation of TRB’s Special Report 267 is for some con- solidation or uniformity in penalties (TRB, 2002). Bisson and Gould (1989), Hildebrand (1990), and Paxson and Glickert (1982) conclude that current penalty and fine structures have a minimal effect on carrier behavior. At current penalty levels, total vehicle operating costs per ton-mile decrease dramati- cally, while the cost per mile increases slightly as load weight increases. Depending on the probability of detection and level of enforcement the economic gain to truckers who are risk- inclined is consequential. Market revenue from overloading can exceed the cost of detection by as much as a factor of 10 (Bisson and Gould, 1989). However, empirical studies have found that enforce- ment activities can reduce the number of overweight vehicles. Grenzeback et al. (1988) in an NCHRP study estimated that 15 percent of large trucks would exceed axle or gross vehicle weight on Interstate highways with no enforcement and that the minimum value of violations would be 6 percent with enforcement. Cunagin et al. (1997), Grundmanis (1989), Fepke and Clayton (1994) and the FHWA (2000a) assess the effective- ness of fixed location versus portable scales and recommend mobile safety and weight enforcement activities as a stronger deterrent to avoidance behavior. Observed levels of weight violations, at fixed scales, range from 0.8 percent to 4 percent at various enforcement levels. At portable scales, the level of weight violations varied from 3 percent to 58 percent. Evidence indicates that portable scales are more effective at capturing weight violators. Mobile and portable scales are more costly to operate than fixed-scale facilities per vehicle and suffer from poor safety characteristics for the enforcement officer, drivers, and vehicles. Nevertheless, portable scales are highly flexible in terms of secondary and bypass route deployment. The primary measure of effectiveness for motor carrier safety inspections is in terms of reduced motor carrier collisions. The motor carrier safety inspections are directed and targeted at likely violators as evidenced by the high violation rates found in the inspections. FMCSA has developed a methodology to estimate the effectiveness of the motor carrier inspections (FMCSA, 2004). The report attempts to quantify the outcomes of safety inspections on number of lives saved, crashes avoided, and injuries avoided. Their methodology indicates that in 2003, motor carrier safety inspections avoided nearly 12,000 crashes and saved 500 lives. The report states that FMCSA intends to measure the indirect effects of enforcement—the deterrent on likely or repeat violators for improving safety—by comparing overall trends of out of service rates. In other work, Lantz (1993) summarizes numerous studies that have related the quality of inspections (either maintenance or roadside) to a decline in truck accident rates. One study by Jack Faucett and Associates (1992) found that there was a 12 percent reduction in truck defect-related crashes following an increase in the number of safety inspections upon starting the MCSAP program. Another study by Lantz (1994) found that the violation rate for antici- pated inspections and those considered spontaneous (not at fixed scale locations) found nearly similar violation rates. There does not appear to be any literature relating the effec- tiveness of dyed fuel inspections to the amount of illegal use of dyed diesel. Anecdotally, many of the interviews suggest that the dyed fuel enforcement effort is perceived to be effec- tive but it has not been quantified. The penalties for dyed fuel violations are substantial and when compared to overweight fines may be considered extreme. Alternatively, just the practice of dyeing fuel may be an effective way to reduce evasion. In fact, after the dyed fuel program was introduced in 1993, the U.S. Department of Treasury estimated that $600–700 million more in diesel fuel tax receipts were received after adjustments and refunds (FHWA, 1999c). Other states have reported sim- ilar revenue gains in the interviews. 50