Friday, April 11, 2014

Is the IRS Unravelling?

The central function of the Internal Revenue Service is intrinsically difficult. In 2013, the IRS processed  146 million individual income tax returns; 2.2 million corporate income tax forms, and overall about 10.5 million business tax returns (including C corporations, S corporations, and partnerships); nearly 30 million employment tax forms (on which employers, including the self-employed, report the income paid to employees and taxes withheld); 1.2 million excise tax forms from the businesses required to collect federal excise taxes on cigarettes, alcohol, and gasoline; and about 275,000 gift or estate tax forms. All of this needs to happen in a mobile and evolving U.S. economy, against the backdrop of an ever-more globalized world economy, and with a tax code that approaches 74,000 pages in length and changes every year.

Just in case this isn't enough, we have been loading up the IRS with additional major tasks, too. For example, a number of major income transfer programs like the Earned Income Tax Credit and the Child Tax Credit are now administered through refundable tax credits--that is, payments from the IRS to eligible families. U.S. policymakers count on the progressivity of the U.S. income tax--higher marginal tax rates on those with higher incomes--as a way to limit the rise in income inequality. The U.S. Department of Education often uses the IRS to withhold tax refunds as a way of repaying out-of-date student loans. The Patient Protection and Affordable Care Act was written to require that those who did not have health insurance would make a payment to the IRS, along with many other provisions affecting various business and investment taxes. The IRS is in the center of campaign financing issues with the decisions it makes (and how it makes those decisions) on what groups are eligible for certain kinds of tax-free status.

And while this is happening, funding and personnel levels at the IRS have been cut in the last few years. This combination of higher responsibilities and lower resources was a main focus of the Nina E. Olson, who holds the position of National Taxpayer Advocate, in the 2013 annual report of her office to Congress. The report goes into detail on many concerns, but for me, the heart of the report is that on one hand the IRS should follow a "Taxpayer Bill of Rights" which would enshrine the assumptions under which the tax collectors should operate, and on the other hand, the IRS needs to be funded and supported if it is going to operate to the desired standard.

Here's a list of what Olson would propose including in a Taxpayer Bill of Rights. She writes: "At their core, taxpayer rights are human rights. They are about our inherent humanity. Particularly when an organization is large, as is the IRS, and has power, as does the IRS, these rights serve as a bulwark
against the organization’s tendency to arrange things in ways that are convenient for itself,
but actually dehumanize us. Taxpayer rights, then, help ensure that taxpayers are treated in a humane manner."

Olson writes of difficulties the IRS faced in 2013, including the problems arising from the 16-day government shutdown as well as when the IRS found "itself mired in a scandal relating to tax-exempt organizations, resulting in the resignation or retirement of the acting Commissioner and other members of the IRS senior leadership." But she argues: "[A]ll of these short-term crises mask the major problem facing the IRS today — unstable and chronic underfunding that puts at risk the IRS’s ability to meet its current responsibilities, much less articulate and achieve the necessary transformation to an effective, modern tax agency. ... [W]ithout adequate funding, the IRS will fail at its mission."

Here are some statistics from inside the IRS to back up Olson's judgement. "Since fiscal year (FY) 2010, the IRS budget has been cut by nearly eight percent. Over the same period, inflation has risen by about six percent, further eroding the IRS’s resources. ... The IRS workforce has been reduced from nearly 95,000 full-time equivalent employees in FY 2010 to about 87,000 in FY 2013, a decrease of eight percent."

Between the increased in tasks and the drop in resources, standards of service from the IRS are slipping. Here's a figure showing the record on phone service. The blue line shows what share of calls reach a Customer Service Representative: it was 87% back in 2004, but now is 61%. For those who get through, the average waiting time is up from about 2 minutes in 2004 to 17 minutes.

What about answering the mail? "When the IRS sends a taxpayer a notice proposing to increase his or her tax liability, it typically gives the taxpayer an opportunity to present an explanation or documentation supporting the position taken on the return. Each year, the IRS typically receives around ten million taxpayer responses, known collectively as the “adjustments inventory.” The IRS has established timeframes for processing taxpayer correspondence, generally 45 days. During the final week of FY 2004, the IRS failed to process 12 percent of its adjustments correspondence within its timeframes. During the final week of FY 2013, the IRS was unable to process 53 percent of its adjustments correspondence within the timeframes. As a corollary, the number of pending pieces of adjustments correspondence in open inventory increased as well. At the end of FY 2004, open inventory stood at about 348,000 letters. At the end of FY 2013, it consisted of about 1.1 million letters."

What about ongoing training for IRS employees so that they can understand all the changes in tax law? As part of the budget cuts, the training budget has been cut, too. "Per-employee spending dropped from nearly $1,450 per full time equivalent employee in 2009 to less than $250 in 2013. Most of the IRS operating divisions that interact directly with taxpayers fared worse than the agency as a whole."

Other issues abound. [T]he IRS has abandoned return preparation in its walk-in sites, which was already limited to the most vulnerable populations of taxpayers — the elderly, the disabled, and the low income. It also has shut down tax law assistance on the phones after April 15, and has significantly limited the scope of questions it is willing to answer during the filing season. Thus, in the United States today, tax preparation and filing assistance is now, for the most part, privatized. That is, for a taxpayer to comply with his or her requirement to file a tax return, the taxpayer generally must pay for assistance, pay for software, and pay for advice. This is an unprecedented change in tax administration and it is not a good one. It is particularly devastating when one considers that over 50 percent of prepared individual returns are completed by unenrolled return preparers— the very preparers the IRS is now hamstrung over regulating because of pending litigation in the federal courts. So while we hash out this issue in the courts, millions of taxpayers are exposed to the risk of incompetent and even fraudulent return preparers."

Of course, no one weeps over budget cuts at the IRS. But such cuts are foolish. Those at the IRS point out that if they have more money, they can do more enforcement, and will collect greater tax revenue. While this point is probably true, it requires an extremely stunted sense of public relations to think that the citizenry will make a clarion call for more tax enforcement.

To me, the more central problem is that 98% of the revenue collected by the IRS comes from voluntary efforts by citizens, and only 2% from enforcement actions.  The IRS collected $2.86 trillion in revenue last year. The 98% that is from volnntary compliance would be about $2.8 trillion. If the poor and declining service from the IRS leads to a drop in voluntary compliance of even 1%, that would be a revenue loss of $28 billion--and the total IRS budget is about $11 billion. If the voluntary compliance system were to break down more thoroughly, the costs and difficulties of rebuilding that system would be enormous. Nobody needs to love the IRS, but it only can function if most people who are complying voluntarily believe that it is focused on its job in an even-handed way. Both by becoming enmeshed in politics, and through declining service levels, the IRS is in danger of losing that minimally necessary level of public goodwill.