The IRS rarely prosecutes identity thieves, despite a steep increase in the number of fake tax returns filed as a result of the crime, a new report says.

The number of fraudulent tax returns stemming from identity theft increased by nearly 600 percent from 2002 to 2007, the Treasury Inspector General for Tax Administration (TIGTA) said.

"The IRS' policy is that identity theft will only be investigated if it is committed in conjunction with other criminal offenses having a large tax impact," J. Russell George wrote in his report, released one day before IRS Commissioner Douglas Shulman and National Taxpayer Advocate Nina Olson were to testify before the Senate Finance Committee on ID theft issues.

The report said that in fiscal year 2005, only 45 identity theft cases were recommended for prosecution; in 2006, there were 55.

Not only do ID thieves use another person's Social Security number (SSN) to file fraudulent tax returns, but they could use another person's name and SSN to get a job. The employer would report income to the IRS, making it look as if the lawful taxpayer did not include all of his or her income on their return.

"In 2007 alone, the Federal Trade Commission received 56,125 complaints of identity theft related to either the filing of a fraudulent tax return or the misuse of someone's identity to obtain employment," George said.

He said the IRS relies heavily on public outreach to combat identity theft, and that it does not notify employers if a taxpayer's name and SSN are used by another person.

But the IRS said it is restricted because the Internal Revenue Code restricts the IRS from sharing taxpayer or tax return information with third parties, except in very limited circumstances.

The report said, "The use of an incorrect Social Security Number for employment results in more government action to correct the problem than the use of someone else's complete identity (name and Social Security number), even though the latter causes much more burden to the lawful taxpayer. We believe the IRS should take a more active role in working to stem this problem."

The IRS also said it does not have the enforcement resources to address most of the cases, and that the taxes owed are usually not significant.

You can read the full audit report.