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What Ails The IRS?

Internal Revenue Service Building/
The Internal Revenue Service Building, Washington, D.C. Photo by Carol M. Highsmith.

Few people feel sympathy for employees of the Internal Revenue Service. But as the government asks them to take on increasingly complex tasks with dwindling resources, the pressures on the agency are becoming obvious even to the least sympathetic observers.

Since 2011, Congress has dramatically slashed IRS funding. Larry Elkin observed as much in this space in 2015, and the trend has continued in the years since. According to ProPublica, the IRS enforcement budget is a quarter lower than it was in 2010 (adjusting for inflation). The IRS workforce is 21% below its level eight years ago, and the number of examiners who perform audits shrank by 38% between 2010 and 2017. Staff numbers for criminal investigators and collections officers are also down.

Part of this reduction has been strategic on the part of lawmakers. Many fiscal conservatives have touted the idea of “starving the beast” as a way to reduce government bureaucracy through budget cuts. Even today, certain legislators publicly question whether money spent on the IRS would yield any return on investment. The Service’s reduced funding also reflects the political reality that it is hard to sell voters on the idea of increasing the IRS’ budget once it has been cut back.

Tax professionals have noticed the consequences for years. I remember a time when you could reach someone at the Service by phone without too much trouble. These days, you can forget it. As far back as 2016, only 38% of callers trying to reach an IRS employee succeeded. Everyone else either gave up after a long hold time, found themselves disconnected or ran into the wall of a busy signal. Perhaps more critically, the IRS does not have the resources to meet its main objective: collecting the taxes that fund all other government programs. The U.S. is losing significant revenue due to IRS understaffing – $18 billion per year, by one estimate.

It is within this environment that Congress delivered a major tax reform package in 2017, including some complicated new rules. For instance, consider the deduction for qualified business income. The QBI deduction rules, as written, deliberately included large gray areas. As my colleague Anthony Criscuolo explained in our firm’s Sentinel newsletter, the rules governing specified service businesses and rental real estate are far from clear-cut. The new rules made for a very difficult tax season for most tax professionals. It may be even more difficult for IRS examiners to review tax returns that were affected by the new rules and to catch misstatements (whether intentional or unintentional).

In the meantime, audits of complex returns are falling, which means that proportionally more taxpayers with simple returns face audits these days. Low-income taxpayers who claim the earned income tax credit accounted for almost 40% of the IRS’ total audits in 2018. While mistakes involving the earned income tax credit are relatively easy to catch and are a form of low-hanging fruit for the IRS, correcting the improper credit claims doesn’t lead to significant additional revenues.

In contrast, auditing complex returns could lead to higher revenues, but these audits require many hours from experienced senior auditors. Those experienced auditors have been leaving at higher rates due to heavy workloads. It’s also worth noting that overall audits are down to a mere 0.59% of individual taxpayers, the lowest level since 2002. There may be more simple audits than complicated audits, but there are not a lot of either type.

IRS Commissioner Charles Rettig issued a report in September, responding to congressional criticism of the Service’s auditing practices. He expressed a desire to fix the imbalance lawmakers identified but said frankly that the IRS can do no such thing unless Congress restores its funding. While some proposals to increase enforcement spending have emerged in both the House of Representatives and the Senate, none would restore the budget to pre-2011 levels. So far, lawmakers are much less eager to increase the Service’s budget than they are to point fingers over its attempts to cope with its lack of resources.

The QBI deduction, like much of the 2017 tax reform, will expire at the end of 2025 if Congress does not extend it. But it seems unlikely that a simpler tax code is in our future. The candidates for the 2020 Democratic presidential nomination have begun unveiling tax plans, many of which would add new levels of complexity. Bernie Sanders has advocated adding more tax brackets for top earners and instating a wealth tax. Elizabeth Warren has also supported a wealth tax and has included enough details of her plan to get commentators discussing the array of complications it would introduce (assuming it is even constitutional, a proposition almost certain to be challenged). If a wealth tax became law and withstood legal challenges, it would require a massive increase in manpower at the IRS, along with significant investments in training and expanded infrastructure.

As time passes and it becomes clearer that the IRS is not doing its job of catching and fixing incorrect tax returns, more and more taxpayers will notice. They may feel less compelled to rigorously follow the letter of the law as a result. This could lead to a downward spiral in which people cheat on their taxes, leading to less revenue, leading to more IRS cutbacks, leading to even more people cheating on their taxes. Even if none of the complicated new tax proposals candidates are discussing become law, the combination of budget cuts and new complexities like the QBI deduction may create enough problems to shake the foundation of our tax system. In the future, if Congress makes taxes complex enough and cuts funding sufficiently, the IRS could simply fall apart.

Vice President and Chief Investment Officer Paul Jacobs, of our Atlanta office, contributed several chapters to our firm’s book, Looking Ahead: Life, Family, Wealth and Business After 55, including Chapter 12, “Retirement Plans;” Chapter 15, “Investment Approaches and Philosophy;” and Chapter 19, “A Second Act: Starting a New Venture.”

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