Mr. and Mrs. L. L. Stewart Professor of Business Law, University of Oregon School of Law
The Internal Revenue Service faces many challenges: scandals, threats to impeach the Commissioner, increasing burdens from expanding responsibilities, and, of course, the tax gap. In 2015, Jon Forman and I published an article entitled “Making the IRS Work,” which discussed ways of making the IRS more efficient given likely continued budget cuts under a Republican majority Congress. We concluded that while the IRS could become more efficient, the best way to enhance compliance and protect taxpayers would be to increase the IRS budget.
Since then, the prospect of increasing the IRS budget has not improved. Commissioner Koskinen reported that the IRS budget is down by $900 million since 2010. While the Obama Administration requested $12.280 billion to be appropriated for the IRS in FY2017, representing $1.045 billion more than the amount enacted for FY2016, the House passed a bill providing $10.999 billion in appropriations for the IRS in FY2017, representing $236 million below the amount enacted for FY2016. The Senate bill maintained FY2016 funding in its appropriations for the IRS.
An underlying assumption of our analysis is that the IRS should continue to function as an effective revenue collector. With lower budgets, the IRS must become more efficient to continue to effectively collect revenue. Uncollected revenue leads to the tax gap, which in general terms is the difference between the revenue owed and the revenue collected. A large tax gap not only constrains revenue, but also can lead to reduced voluntary compliance. IRS budget cuts over the past several years have not yet significantly affected the tax gap, which the IRS updated in April 2016.
The 2008–2010 gross and net tax gap estimates ($458 billion, $406 billion) are 1.8 percent and 5.5 percent higher, respectively, than the 2006 estimates ($450 billion, $385 billion) described in our 2015 article. The net tax gap is “the amount of true tax liability that is not paid on time and is not collected.” The difference between the gross tax gap and the net tax gap reflects IRS enforcement activities, as well as other payments made late without enforcement (such as just before the extended due date or with a voluntary amended or delinquent return). The IRS concluded that the increases in the gross tax gap were driven by improvements in the accuracy and comprehensiveness of the estimates through updates in methods and the inclusion of new tax gap components. The estimated voluntary compliance rate (VCR) (81.7%) is lower than the previous 2006 estimate (83.1%). The IRS attributed about half of the 1.4 percentage point difference to the updated methods, and concluded that the small difference between the current and 2006 estimate did not mean that noncompliance had increased. However, we note that the IRS analysis spanned 2008 – 2010, and IRS budget cuts began in FY2011. Therefore, we anticipate that the effects of the budget cuts will become significant in future years if the decline in funding continues.
The tax gap is made up of underreporting, underpaying, and non-filing. Underreporting is by far the largest proportion of the tax gap—$387 billion (85 percent of the total $458 billion) for 2008 – 2010. Some $264 billion (68 percent) of the underreported tax gap was due to the individual income tax. The current tax gap analysis, like the previous analysis, showed that the compliance rate is much higher for income subject to third-party reporting and withholding. Income subject to substantial information reporting and withholding (including wages and salaries) had a tiny net misreporting percentage of just one percent. The next best category consists of amounts subject to third-party reporting but no withholding, such as domestic dividends, with a net misreporting percentage of seven percent.
Congress could help, but seems unlikely to take that road. Jon and I recommended increasing third party reporting, but noted that the legislative trend appeared to be against it. In 2011, for example, Congress repealed the expanded reporting requirement that had been added by the Patient Protection and Affordable Care Act (ACA) in 2010 as well as the expanded reporting requirement for landlords added by the Small Business Job Act of 2010. The ACA provision would have required all businesses to report payments to, and purchases from, any taxable entity totaling $600 or more in a calendar year, regardless of the payee’s corporate status or whether the payments were made for merchandise or other property. The Small Business Jobs Act would have subjected recipients of rental income from real estate to the same information reporting requirements as taxpayers engaged in a trade or business, requiring rental income recipients making payments of $600 or more to a service provider (such as a plumber, painter, or accountant) in the course of earning rental income to provide an information return to the IRS and to the service provider.
Congress could also help by taking some of the burden off of both taxpayers and the IRS by allowing pre-populated returns. Like a credit card statement, a pre-populated return would estimate tax liability based on information already known by the IRS from 3d party reporters. However, both the House and Senate appropriation bills prohibited the IRS from using any funds to design pre-filled or pre-populated individual tax returns, which was one of the bright ideas Jon and I listed (crediting Joseph Bankman) for increasing the efficiency of the IRS.
One legislative change that appears likely to occur is the repeal of the Affordable Care Act (ACA). Over the past three years, the IRS spent a billion dollars out of their general budget on information technology improvements related to the ACA. In short, Congress did not make a special appropriation for those IT improvements, so spending was reduced on enforcement and other activities of the IRS. A 2016 report from the Government Accountability Office (GAO) found that the IRS’s individual master file and business master file still rely on computer programming language developed more than 50 years ago. The IT improvements were required to collect data from large corporations and insurers on the insurance they provided to individuals month by month and to reconcile premium tax credit payments made by several million taxpayers. Commissioner Koskinen noted that a majority of that investment would be wasted if the ACA was repealed. Further, although many IRS employees were involved in implementing the ACA, now that it has been fully implemented, fewer employees will be involved, which is fortunate, because the IRS has fewer and fewer employees. Along with the decline in the IRS’s appropriations, the number of the agency’s employees has fallen over the past two decades—from 113,931 in 1995 to 79,890 in 2015.
Reduced IRS funding raises concerns about voluntary compliance, which is the most efficient way of collecting revenues. Increasing funding for compliance activities or an enhancement in enforcement tools can prevent more erroneous refunds from being paid out and enable the IRS to collect additional unpaid taxes, creating observably increased revenues. Holtzblatt & McGuire. Further, the presence of IRS educational, enforcement, and collection activities seems to inspire voluntary compliance, although the degree to which this is true is unclear. Changes in audit coverage are generally believed to affect voluntary compliance by altering taxpayers’ perceived risks of being audited: the higher the risk of being audited, the less likely a taxpayer is to evade taxes. This view is consistent with the classic economic theory of tax evasion, which holds that a rational taxpayer will evade taxes if the expected savings from tax evasion exceed the expected penalty for non-compliance. Holtzblatt and McGuire concluded that “nearly everything that the IRS does can be characterized as a way to improve compliance,” including: customer service, which can help taxpayers avoid errors on their tax returns that can result in either underpayments or overpayments; increasing enforcement through expansions of information reporting, audits, criminal investigations, and collection, which would lead to improvements in detection and deterrence; and computer modernization, which would support expansions of customer service and enforcement.
The IRS could also enhance compliance by coordinating its examination and collection functions. The Treasury Inspector General for Tax Administration (TIGTA) found that revenue agents did not always consider collectability when selecting cases for audit, document their collectibility evaluations when made, or discuss collectability issues with their managers. Furthermore, revenue agents did not always contact the Collection function when Examination function procedures required them to do so, refer required cases to the Collection function, or complete financial information needed to assist in future collection efforts. The IRS does not have the resources to audit every potentially productive case, and following collectability procedures and coordinating with the Collection function ensures that both Examination and Collection function personnel are using their limited resources efficiently. In many cases, revenue agents overlooked collectability because their managers instructed them that they should not limit the scope of an examination if doing so may have an adverse impact on voluntary compliance. However, TIGTA noted that voluntary compliance could be impaired if the revenue agent decides to audit a business that is defunct or a taxpayer that is experiencing an economic hardship for audit rather than selecting a productive audit (meaning one that will result in revenue). Moreover, for taxpayers who have agreed with an assessment but have limited ability to pay, a referral to the Collection function accelerates the collection process, which lessens the burden on taxpayers and provides the IRS a better chance of collecting revenue. In the same way, revenue agents can help Collection function employees by providing key information about the taxpayer, such as contact information and levy sources. Coordination enhances efficiency, and it is within the control of the IRS to enhance coordination between its functions.
There is some hope of tax reform in the next legislative session, which could aid the IRS if it results in tax simplification. Congressional action may be counterproductive, as exemplified by the mandate for private debt collection in the Protecting American Taxpayers from Tax Hikes (PATH) Act of 2015. Our article also discusses the problems with private debt collection in some detail. Forman & Mann, at 801 – 803. However, the IRS could take action itself to improve its guidance process.
Improving the transparency of the guidance process could improve compliance, according to a recent report by the GAO. In a pyramid chart charmingly like the food pyramid published by the USDA, the GAO outlined the hierarchy of tax guidance, with the Internal Revenue Code at the top, followed by Treasury regulations, IRS guidance published in the Internal Revenue Bulletin (IRB) (such as Revenue Rulings and Revenue Procedures), private letter rulings and technical advice memoranda (which only bind the IRS to the recipient), and “other” IRS guidance such forms and publications. These “other” IRS publications and information are described in the Internal Revenue Manual (IRM) as “a good source of general information.” However, the IRM states that these documents cannot be relied upon by taxpayers as authoritative or as precedent for their individual facts and circumstances since they are not binding on IRS. Courts have ruled that taxpayers cannot rely on IRS documents published outside the IRB to support a position.
The GAO noted several problems with IRS guidance. First, IRS practice differs from other federal agencies by referring to regulations as guidance, and by treating certain non-regulatory guidance as binding. Other federal agencies view guidance as non-binding. Taxpayers often do not understand that the IRS does not consider itself bound by types of guidance not published in the IRB. The IRS’s Taxpayer Bill of Rights states that taxpayers have the right to know what they need to do to comply with tax laws and further that taxpayers are entitled to clear explanations of the laws and IRS procedures in all forms, instructions, publications, notices, and correspondence. Just as taxpayers have the right to clear explanations in IRS instructions and publications, the IRS should alert taxpayers to any limitations that could make some IRS guidance less authoritative than others. If taxpayers make decisions after using guidance that is non-authoritative, those taxpayers’ confidence in IRS and the tax system could be undermined. Confidence that the IRS is fairly and uniformly administering the tax system helps further overall voluntary compliance and lowers IRS’s administrative costs.
Next, the IRS does not have documented procedures for selecting the type of guidance product to issue, other than definitions of guidance types in the Chief Counsel’s Directive Manual (CCDM). The definitions alone do not constitute policies and procedures, or factors to consider, when deciding whether to issue guidance as a revenue ruling, revenue procedure, notice, or announcement.
Finally, as Kristin Hickman has amply analyzed, the IRS does not view the regulatory process in the same way as other agencies. Treasury and IRS policies and procedures state that the notice and comment procedures under the Administrative Procedure Act (APA) do not apply to most tax regulations because tax regulations are almost always “interpretative” (as opposed to “legislative”). IRS and Treasury officials told the GAO that they rarely consider tax regulations to be major under the Congressional Review Act (CRA) or economically significant under Executive Order (E.O.) 12866 because of their view that any economic impact of a tax regulation generally comes from the underlying statute, and not the regulation. Some tax regulations and other guidance are also exempt from the requirements of E.O. 12866 under a 1993 agreement between OMB and Treasury. According to IRS and Treasury officials, most of the economic impact is rooted in the tax code and therefore beyond Treasury or IRS’s discretion to control. This decision means that tax regulations may receive less scrutiny and therefore be more likely to be challenged than regulations of other agencies. A more accurate review process would enable taxpayers to have more confidence in tax regulations. The GAO also recommended reevaluation of the 1993 agreement to ensure that it still reflects current requirements for reviewing regulations and guidance as well as the current environment for tax regulations and guidance (including an increased use of the tax code to accomplish economic and social objectives through the use of tax expenditures).
In conclusion, it looks like things will get worse for the IRS rather than better in the short run. But the IRS could still take some actions that could help enhance compliance, like improving the transparency of the guidance process and coordinating examination and collection functions. We can always hope for some tax simplification as well.