The Debt Collection Improvement Act of 1996 (DCIA) allows the federal government to collect state debts from federal payments to contractors. However, before a state can participate in this program, DCIA requires that the state enter into a reciprocal agreement with the Department of the Treasury that would require the state to collect unpaid federal debt from state payments if Treasury collects unpaid state debt from federal payments. In February 2004, we reported that Department of Defense (DOD) and Internal Revenue Service (IRS) records showed that over 27,000 DOD contractors had nearly $3 billion in unpaid federal taxes as of September 30, 2002. In a hearing before the Senate Permanent Subcommittee on Investigations on February 12, 2004, we noted that many of those contractors also had unpaid state taxes. Based on the issues raised in that hearing, Congress requested that we determine (1) the extent to which Financial Management Service (FMS) and the states have entered into reciprocal agreements to collect unpaid state and federal debt from their payments to contractors and (2) whether additional opportunities may exist for the Department of the Treasury's FMS to collect unpaid state taxes from federal contractors. This report responds to that request by providing information on (1) the extent of states' participation in FMS's debt collection levy and offset programs, (2) the potential benefits to states of participation in those programs, and (3) the level of state participation in, and the benefits states derive from, the collection of state tax debt from federal income tax refunds.

Neither the federal government nor the states have as yet pursued potentially beneficial reciprocal agreements authorizing the collection of debt from nontax payments, including payments to contractors. According to FMS officials, no state has expressed interest in such agreements, and FMS has not actively pursued avenues to encourage state participation. None of the officials in the 17 states we contacted said they were aware of the reciprocal agreement provision in DCIA, and all expressed interest in pursuing this debt collection opportunity. Our comparison of FMS disbursements with the database of state income tax debt that FMS maintains found that thousands of federal contractors paid through FMS have unpaid state tax debt. In fiscal year 2004, FMS disbursed a total of about $1.8 billion to over 4,600 federal contractors that had approximately $17 million in state tax debt owed primarily by individuals. According to our analysis, if states had participated in FMS's program that collects debt from nontax payments to contractors, they could have collected over half of the outstanding state tax debt from these federal contractors in fiscal year 2004. On the other hand, the experiences of the federal government and the states in working together to collect unpaid tax debt from state and federal tax refunds demonstrate that reciprocal agreements to collect tax debt from nontax payments, including contractor payments, have had a significant impact. The federal government and most of the states with income taxes collect tax debt on behalf of one another through the offset of income tax refunds, which has resulted in millions of dollars in collections. In fiscal year 2004, although most states submit only personal income tax debt and not business income tax debt to FMS for collection, FMS still collected over $217 million on behalf of various states through offsets of federal income tax refunds to pay state income tax debt. Conversely, IRS received over $77 million from states' levy of state income tax refunds to pay delinquent federal taxes.

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