The IRS: Necessary evil, but thwarted

  • Article by: PAUL GUTTERMAN
  • Updated: June 30, 2013 - 5:25 PM

Let’s face it; tax collectors have never been popular. The Bible puts them in the same category as extortioners and adulterers. Historically, they often enforced collections with arms. The American Revolution was born out of a tax rebellion. So it is hardly a surprise that the IRS is not a very popular institution. Recent physical threats against IRS employees involved in the Tea Party controversy attest to the enmity.

Yet tax collection is a necessary evil. The first attempt at American democracy ended in failure under the Articles of Confederation because the federal government had no power of taxation. However, the power of taxation alone is insufficient without the power to collect what is owed. The tax gap is defined as the difference between what is owed vs. what is actually paid. In 2012, the tax gap was likely more than $500 billion, almost enough to balance the budget. Those of us who pay what we owe under the law are subsidizing those who don’t.

The scandal is not that the IRS was giving extra scrutiny to Tea Party applications for exempt status but that the IRS doesn’t have the resources to give the requisite scrutiny to all such applications. Certainly the granting of tax-exempt status to any organization should require full vetting. Congress keeps asking the IRS to do more with less. The resources that the IRS must put into the new provisions of Obamacare are staggering. Nonetheless the IRS budget is 8 percent less than in 2010. The sequester takes away additional resources from the agency.

The paradox is that if you are a budget hawk, you want to give the IRS more money. It is the only part of the government where additional investment is actually recouped. Estimates are that for every additional dollar used for IRS enforcement, the Treasury will receive about $10 back in additional revenue from audits. Obviously there are eventually diminishing returns, but we are nowhere close to the break-even point. Some of that extra return can then be used for better taxpayer service.

Can you imagine any private business that would refuse to earn a 10 to 1 return on additional investment? Only our government puts money in military bases that the military doesn’t want and take away money from the IRS that will bring back much more to the Treasury.

None of this is particularly new. In 1998, Congress paraded taxpayers in front of hearings to testify all kinds of terrible things the IRS did in enforcing the tax laws. Congress then passed a major act limiting the IRS’ ability in auditing and enforcing such laws. The fact that almost all the testimony was later found to be either fabricated or in error didn’t seem to matter. Congress loves bashing the IRS because it plays so well politically.

The truth is that the IRS is a huge organization with more than 90,000 employees. That is more employees than Apple has worldwide. The “scandal” involves a handful of employees trying to prioritize and interpret unclear laws passed by Congress. If the result is that the IRS is given less resources to cut into the tax gap, then the American public is the loser.

Those taxpayers with income consisting primarily of wages, interest and dividends have an extremely high compliance rate. That is due to the IRS having information from payers that they can match with what is reported on returns. However, compliance rates plummet when that is not the case, such as with many self-employed taxpayers, those with their businesses and especially those who deal with cash.

The IRS is well-aware of ways to better monitor these areas, but Congress has thwarted its efforts to attack noncompliance. For example, it has refused to require greater reporting of credit-card transactions. It has greatly limited IRS use of audit techniques that would compare taxpayers’ lifestyles (such as cars and house) to reported income to look for unreported money. Congress even prevented the IRS for many years from doing audits that helped compile statistical norms.

To some extent, the IRS uses “data mining” to determine who isn’t paying taxes in the same way that the NSA uses data to try and prevent terrorist attacks. In both cases, there must be a balancing between getting the necessary information and preserving rights and liberties. In the case of the IRS, the question is how much additional scrutiny we allow.

Personally, I’m not a big fan of actions that primarily serve to protect tax dodgers. No one may love the tax collector, but you would think we could agree he is a necessary evil.

Paul Gutterman is director of the Masters of Business Tax Program at the University of Minnesota’s Carlson School of Management.

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