income tax tax administration

Fund the IRS

In a miracle of sorts, the phoenix-like revival of a much-slimmed down Build Back Better bill, now called IRA, has passed Congress (NYT paywall), and will provide a ten-year infusion of $80 billion to the IRS. IRA refers to Inflation Reduction Act (confusingly since IRA = Individual Retirement Accounts for most of us). I doubt it will materially reduce inflation in the near term (that’s CBO’s view as well), so the name is probably misleading. (The big direct attack on inflation – Medicare authority to negotiate drug prices – is delayed until 2026 and then phases in slowly.) Inflation reduction appear to be what got Joe Manchin onboard, although the real policy motivation of Dems lies elsewhere (ACA changes, negotiating prescription drug prices, climate change, yada yada). But so be it; whatever it takes.

Increased funding should help IRS to:

  • Modernize its antiquated tax processing system and customer service. Implementing big IT system changes is never easy – for government or in the private sector – so the service improvements are neither likely to be quick nor sure. But they are sorely needed.
  • Improve enforcement. This is the prime motivation, to yield revenues. Improvements here will also be a slow process because it takes years to hire and train revenue agents, implement new IT systems to improve compliance, etc. And the legislation does not include tools, like expanded information reporting. As I have repeatedly emphasized, better IRS enforcement and compliance will redound to the benefit of the states, since compliance with state taxes is closely linked to compliance with federal taxes. In many instances, plugging leaks in the federal tax will automatically plug leaks in state taxes.

IT modernization is needed

This WaPo op-ed (paywall) by Catherine Rampell lays out in excruciating detail how the IRS processes paper income tax returns and why modernization is crucial. It’s worth looking at for the pictures alone. I knew that the process was archaic and locked in the mid-20th century but did not really have an idea of how much so. I knew that the IT systems were old (e.g., some routines still use COBOL and some hardware uses Windows XP) and that data are typed in by IRS employees. But I had no idea how manually intensive the process was, including cutting open 3 sides of large envelops with a “nibbler,” candling envelops to make sure items are not left in them, marking returns up with red pens, hand renumbering lines when prior year returns are submitted, etc. It’s no wonder that processing a paper return often takes six months or more:

A single lap through this facility’s Pipeline is about a quarter-mile. The IRS warns on its website that the whole process can take six months or more. And that’s if no errors are detected.

Why does the IRS need $80 billion? Just look at its cafeteria (Washington Post, 8/9/22)

All this reveals just how crazy it was for Congress in the CARES Act to require thousands of amended returns that need to be filed on paper to claim NOL carrybacks. Supposedly that was to get money quickly to businesses with pandemic-caused losses and cash flow problems. It simply gummed up paper processing for everyone else without getting money to the businesses in a timely manner.

Predictable response from the right

The fiscal reason for the increased IRS funding is obvious: per Larry Summers and others, to raise revenue by restoring pre-2010 IRS enforcement resources, the point at which GOP Congresses put the agency on starvation wages while it was increasingly saddled with more responsibilities under the ACA, TCJA, etc.

It was no surprise that right wing commentators and politicians’ response was to decry the funding increase as hiring and unleashing 87,000 tax auditors (the administration’s estimate of the total number of hires, including IT and customer service employees who will ultimately be added by the legislation) on poor unsuspecting middle-income folks. A sample of two from WaPo, which are more measured and accurate than the nut jobs on cable shows, points out the political risks:

Janet Holtzblatt at TPC has a measured take on it and good advice for the IRS and administration (unlikely to be taken, of course): If the IRS Gets $80 Billion, Will Its Agents Come Gunning for You? She points out that the administration has not handled the PR aspects of this very well and there are some legitimate questions to be answered, despite the desperate need for the funding. Jacob Bogage, Democrats’ $80 billion wager: A bigger IRS will be a better IRS (WaPo, 8/6/22) also provides good context.

Will Dems suffer at the 2022 midterms as result of increased IRS funding? Hard to know since I haven’t seen polling on it and the election is still months away. But given how easy the rhetoric is to hurl, it won’t help them and might be the straw that breaks the camel’s back in some close races. They are likely to lose one or both houses of Congres anyway, so passing up the opportunity for partisan political reasons would have been foolish. In any case, they would have had to come up with alternative funding, which may have created even greater political liabilities or could not have cleared the Manchin/Sinema hurdles.

Addendum on Cato’s Take

A blog post at Cato (Chris Edwards, Senate Bill: IRS Funding Hypocrisy, 8/5/22) makes the point – legitimate as far as it goes – that the IRA’s increased tax compliance funding is hypocritical because its expansion of various energy credits for EVs and so forth increases complexity and noncompliance opportunities. It has a graphic to illustrate how this works. The closing paragraph makes the more general and much more questionable point:

Senate bill supporters don’t seem worried about growing tax‐​code complexity. They assume the bill makes sense because the $80 billion of IRS funding is supposed to raise $204 billion in government revenues. But that ignores the added costs and loss of civil liberties imposed on individuals and businesses. More aggressive IRS enforcement will mean more paperwork, more lawyer fees, more time wasted on tax planning, more anguish and uncertainty, less privacy, and less personal financial security. Government will win, but society will lose.

Chris Edwards, Senate Bill: IRS Funding Hypocrisy

My take:

  • Having just read a book on the Panama Papers, the idea that the tax gap is heavily a function of illegal use of tax expenditures is, at best, a stretch and more likely a flat-out distortion. Even the simplest tax (because of the necessary allowance of business expenses, including capital cost recovery) is necessarily complex, putting aside outright evasion (much of the reason for offshore entities). As an aside, I wonder where he stands on the differential rates for capital gain income, a feature that drives some of the most challenging complexity with debatable policy justifications for it. Verifying whether one purchased a qualifying EV is probably child’s play, by contrast.
  • My preference would be to stop littering the tax code with tax incentive carrots and to rely more on Pigouvian taxes, such as a carbon tax, to reduce carbon emissions. Because of its heavier reliance on market-like mechanisms, a Pigouvian tax would be more cost effective and efficient (in the economics terms). However, the Dems’ reliance on tax incentive carrots is understandable as political matter – the consistent drumbeat of anti-tax rhetoric on the Right (by the likes of Grover Norquist and probably Chris Edwards) is what drives, in my opinion, the use of tax credits and incentives. It’s the natural result and what they should expect because of the direction in which they have driven the political debate. It’s an illusion, of course. Handing out tax credits means revenues will be collected through implicitly higher rates on others.
  • There is a small group that cheats on their taxes. Crimping enforcement efforts, as has been done, simply emboldens them and increases their numbers as prospects for getting caught drops. Complexity has, at most, a minor role in this.
  • Suggesting that expanded tax compliance funding (as a general matter after what the GOP-controlled Congress has done to IRS resources) is a challenge to civil liberties is the definition of over the-top-rhetoric coming from a putative Think Tank. Good grief, get a grip.

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