Alexis Leondis Bloomberg Opinion
No matter what you think of the IRS — whether it’s dysfunctional, underfunded, or both — there’s one basic point that’s hard to argue with: The current system for spotting wrongdoers sucks. House Republicans voted Monday to block new funding for the agency from the previous Congress, a move that only made matters worse.
Consider that the annual tax gap, or the difference between what taxpayers owe and what they actually pay, averaged $496 billion from 2014 to 2016 (the agency’s most recent estimate). Even audits and enforcement actions managed to recover only 14% of what was owed but not paid, or $68 billion.
Part of the problem is that there is little auditing of those who owe the most. The agency does not have the funds to conduct such audits due to funding cuts over the past decade. For individual taxpayers with income of at least $1 million, the audit rate dropped from 8.4 percent in 2010 to just 2.4 percent in 2019. Nearly all of the largest companies were audited in 2010, compared to just half in 2019.
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And when it comes to conducting audits, the IRS often picks the wrong targets or finds itself outmaneuvered by seasoned lawyers. According to congressional testimony by Janet Holtzblatt, a senior fellow at the Brookings Center for Tax Policy in the city, nearly 40 percent of large companies audited in 2019 had “no change,” meaning tax returns Anything reported above has been confirmed. About 38 percent of individual taxpayers with income over $1 million had “no change” or received a refund. This means that money spent on audits has not recovered any revenue.
Worse, the audit won’t have much impact in terms of future behaviour. Studies have found that some taxpayers become more brazen about tax evasion after being audited because they believe being targeted will reduce their chances of being investigated again.
Republicans are using these facts to say the IRS is incompetent and should not get more money to mishandle – so one of the top priorities for House Republicans is to undo the agency’s $80 billion grant from Joe Biden’s administration funds. Republicans would allow the IRS to keep $4.8 billion to upgrade its aging technology, but that money would be useless without the $25 billion allocated to support continued operations.
In addition, the Congressional Budget Office estimated this week that House Republicans’ bill would cut government revenue by nearly $186 billion over the next 10 years and increase the budget deficit by $114 billion.
Serious, long-term tech funding is the only thing that can help the IRS overhaul its auditing system and have a chance at recouping billions, if not trillions, of dollars in uncollected taxes each year.
That’s because the key to improving tax compliance doesn’t just come from doing more audits — it has to come from using taxpayer data more wisely. When the IRS can match tax returns with third-party income data, such as W-2 tax forms sent to it by employers, compliance rates approach 99%. If not, the compliance rate drops to 50%.
The biggest culprits of underreporting are often business owners. It is difficult, not to mention time-consuming, for the IRS to verify what they report with its current audit process and technical systems. And I’m not talking about husband and wife small business owners. According to IRS Commissioner Charles Rossotti, it is estimated that a significant portion of the tax gap comes from experienced pass-through business owners (sole proprietors who report business income on their individual tax returns) who Reported income is well above the $400,000 of the late 90s.
Remember, better technology doesn’t mean the IRS will get any new data. That’s all the information the agency already has, but doesn’t have the capacity to sift through. Rossotti estimates that the IRS currently has about 2 billion tax information reports representing about $18 trillion in revenue, but uses only a fraction of that data because of funding constraints and outdated technology.
For example, the IRS has about 30 million K-1 forms showing income from partnerships, totaling $1.2 trillion in income, but largely ignores it. If it had the technology to systematically use the data on the K-1 and match it to that reported on the income tax return, it could go a long way toward identifying tax offenders.
These changes have a deterrent effect. If high-income business owners and savvy tax planners knew the IRS was starting to exploit its data, they would change their behavior.
Yes, there will always be smart tax lawyers and accountants who will be able to manipulate the tax code and minimize their clients’ tax bills in gray areas, and while it’s not tax evasion, it’s not quite fair either. That’s the responsibility of lawmakers, not the IRS. But in the meantime, give the agency the money it needs to enforce the laws that are already on the books.
Alexis Leondis is a personal finance columnist for Bloomberg. Previously, she covered tax coverage for Bloomberg News.
