Probe Urged of Alleged Income Tax Fraud : IRS: Key congressmen charge that abuses may cost the government up to $9 billion a year. Refunds under earned income provision are targeted.

Angry leaders of the House Ways and Means Committee, charging that rapidly growing income tax refund fraud could cost the government as much as $9 billion annually, are demanding that the Clinton Administration investigate the Internal Revenue Service’s flawed detection system.

The chief source of the fraud, the legislators said, is abuse of the earned income tax credit, which was designed in 1975 to supplement the wages of millions of low-income workers.

Overall refund fraud--”detected and undetected, paper and electronic”--is far greater than the several millions of dollars officially estimated by the IRS in February, the lawmakers of the tax-writing committee said in a letter to top Administration officials. A copy of the letter was obtained Monday by The Times.

In a severe rebuke to the IRS, the committee leaders asked Treasury Secretary Lloyd Bentsen and Budget Director Leon E. Panetta to create an independent government task force to investigate the magnitude of the refund fraud and to develop tighter controls for the 1995 and 1996 filing seasons.

The letter was signed by Ways and Means Chairman Dan Rostenkowski (D-Ill.); Bill Archer of Texas, the committee’s ranking Republican; J. J. Pickle (D-Tex.), chairman of the oversight subcommittee; and Amo Houghton of New York, the subcommittee’s ranking Republican member.

Abuse of the earned income tax credit is likely to be especially onerous to the Clinton Administration, which considers it one of the most effective anti-poverty programs in the nation--when used properly. The tax bill passed by Congress last year will expand the credit substantially.

Unlike most other kinds of tax abuses, which typically are committed by individuals who lie about deductions or income to reduce their tax liability, the refund fraud involves taxpayers working in concert with criminals and agreeing to divide the ill-gotten gains, Archer said in an interview Monday.

“When you have massive programs of dollars, inevitably enterprising criminals will take advantage of them,” Archer said. “Criminals can enlist thousands of other people to pick up easy money.”

Fraud cases from the earned income tax credit average $1,800 each, Archer said. Overall, the magnitude of all refund fraud “could approach $8 billion or $9 billion very easily,” he said.

Although abuse of the earned income tax credit accounts for the largest portion of the tax refund fraud, other forms include:

* Unscrupulous tax return preparers who submit claims for fraudulent refunds using the names and Social Security numbers of unsuspecting workers who had not filed returns.

* Prisoners who use other prisoners’ Social Security numbers, names and false W-2 forms to file fraudulent claims for refunds.

* Preparers who mismatch names and Social Security numbers and submit joint returns on behalf of people who are not married and may not even know each other.

The Treasury Department, which oversees the IRS, acknowledged Monday that fraudulent refund claims are a serious and rapidly growing problem.

Joan Logue-Kinder, Treasury’s assistant secretary-designate for public affairs, said that the department “is taking this very seriously and is examining exactly what kinds of options we want to pursue to correct this difficulty.”

She said that the problem is “not something we can wave a magic wand over and cure overnight.”

A congressional hearing in February indicated widespread problems with fraud in electronic filing of tax returns. Because refunds are processed quickly, compared with ordinary returns filed on paper, there is less time for the IRS to check whether fraud has been committed.

However, the letter from Congress chastising the IRS went beyond the issue of electronic filing and called the refund fraud an “epidemic.”

Furthermore, the letter charged, the losses are “invisible” to the IRS, whose “fraud prevention and detection systems are seriously flawed.”

The earned income tax credit is an easy target for fraud because it is used by people with very low earnings who often do not have regular jobs, such as self-employed neighborhood hairdressers or repairmen. They are not subject to regular income tax withholding requirements and do not receive the W-2 forms so familiar to full-time employees of most businesses.

The credit is applied against taxes owed or withheld and typically will produce a refund.

The basic credit for a family with two children earning between $7,750 and $12,200 is $1,511. Taxpayers earning less than $23,050 are likely to qualify for some credit.

The abuse can occur in several forms.

In one scenario, a taxpayer without children would use the taxpayer identification numbers from someone else’s under-age children. The taxpayer, aided by a scam artist, would list the children as dependents and claim to have earnings low enough to qualify for the maximum benefit.

If the return is filed electronically, the refund would arrive within three weeks, and the taxpayer and the partner would split it.

The taxpayer also might falsely claim that he or she spent money to buy health insurance--which could result in a credit of as much as $465. As with many legitimate deductions, no documentation is required.

The earned income tax credit is claimed on about 14 million returns a year. The government estimates that taxpayers will legitimately qualify for $20 billion in earned income credits this year alone.