Last week, the Internal Revenue Service (IRS) was inundated with millions of returns from taxpayers who received a brief reprieve with the 30-day extension of the tax filing deadline to May 17. While nobody professes love for the IRS, it is important to recognize the government agency that has been working tirelessly since the beginning of the COVID-19 pandemic and has shouldered a much-expanded workload. While more than 158 million American households wait for the latest round of stimulus checks administered by the agency, the IRS also continues with its usual tax administration duties. Not surprisingly these herculean tasks have highlighted the agency’s prior struggles and needs, drawing the attention of both the Biden administration and Congress.
Over the years, even before the pandemic, various reports have discussed how recent budget and staffing cuts have impacted the effectiveness and quality of certain IRS services. According to some estimates, the agency’s budget has fallen by 20 percent in inflation-adjusted dollars since 2010, resulting in the elimination of 22 percent of its staff. At the same time, the number of taxpayers has grown, and shifts in global economic structures have resulted in changes to the mix of income sources the agency has to deal with. These changes have made it more difficult for the IRS to effectively carry out its core function of revenue collection. A just-released paper by the American Council for Capital Formation highlights some of these issues.
Why do we care about the agency’s resources? To answer this question, we need to remember three important duties the agency is tasked with: Tax return processing, taxpayer service and enforcement. They have additional duties such as drafting regulations, conducting criminal investigations and overseeing tax-exempt organization and qualified retirement plans. But among all these, probably the most important duty is revenue collection and enforcement, to which the IRS devotes a big chunk (almost 40 percent) of its operating budget. The agency’s goal is to collect the revenue due within the legislative framework provided and ensure that the appropriate level of revenue is collected by minimizing under-reporting and tax evasion.
However, in line with budget cuts, the chances of being audited has decreased over the years, increasing the tax gap (the difference between tax liability in a given tax year and the amount paid) and potentially missing out on a significant amount of revenue. According to most recent figures, when all the taxes are factored in, the tax gap was estimated to be $441 billion for tax years 2011-2013, before enforcement. In a recent three-hour appearance before the Senate Finance Committee, IRS Commissioner Charles Rettig reiterated the importance of enforcement by estimating the tax gap in coming years. Partly due to the growth of cryptocurrencies and foreign source income, the estimated tax gap may be much larger than previously estimated, potentially passing $1 trillion per year in the coming years.
Another paper, published by the National Bureau of Economic Research, highlights the importance of the tax evasion, especially at the top of the U.S. income distribution. The data show that random audits underestimate tax evasion at the highest income levels, especially due to the prevalence of offshore accounts and income from pass-through businesses in this income group. If the unpaid federal income tax of the top 1 percent were to be collected, the authors estimate that an additional $175 billion in annual tax revenue could be generated.
These various figures show the importance of an efficient and well-functioning auditing system. They also have implications for current proposals to increase taxes on higher income individuals and the effectiveness of these proposals in the presence of sophisticated evasion strategies.
As the taxes paid by high-income individuals and corporations get special attention from the current administration, the issue of enforcement has taken center stage in President Biden’s recent proposals. Specifically, his budget proposal calls for an approximately 10 percent increase for the IRS.
The administration is also planning potential tax reforms, especially for business taxes, in addition to the social policies that it wants to run through the IRS. This would further increase the agency’s workload. The question then boils down to whether a 10 percent increase would be large enough to deal with past budget shortfalls and future increases in workload. And we have not even delved into the agency’s struggles in taxpayer services and information system security, an issue that the energy sector and American households are currently dealing with given the recent cyberattack on Colonial Pipeline.
As the administration moves forward with various economic and tax proposals, we will hear more about the IRS’s struggles and budget issues. There will be further discussions about both potential increases and the amount of additional funds that the agency needs. But rather than focus on expanding the agency’s budget and scope, perhaps the attention should be focused on making the IRS better at its core mission of collection, processing and enforcement.
Congress should make sure the agency has enough funds to effectively perform its core duties first and should think carefully before assigning additional tasks to an overworked agency without considering the ramifications for revenue collection and taxpayer service. And next time you talk to an IRS agent, please be kind.
Pinar Çebi Wilber is executive vice president and chief economist of the American Council for Capital Formation.