The IRS Should Fix Itself First

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I nearly fell out of my chair laughing when I read the dozens of news stories that appeared recently describing the Internal Revenue Service's new effort to cut down on errors and fraud by clamping down on tax preparation services. With their typical credulity, reporters at newspapers across the country, quoting IRS statistics and the agency's aggressive new commissioner, Doug Shulman, painted a portrait of taxpayers victimized by ill-informed tax preparers whose mistakes cost ordinary folks big-time penalties and interest payments.

What none of these gullible stories mentioned is that the IRS itself answered incorrectly about 2.5 million tax and account queries last year, according to the Government Accountability Office (the number would have been even higher except that only 70 percent of those who called the IRS looking for tax advice managed to get through to a real person). Nor did any of the stories note that the agency annually sends out probably millions of incorrect notices and assessments, or that the IRS has significant administrative problems that affect its performance, such as the one uncovered by a GAO study in December which found that in 78 percent of cases the agency awarded Individual Taxpayer Identification Numbers (issued to those who don't qualify for Social Security numbers) to people who weren't eligible for them. And then of course there was the report last October from the Treasury Department's Inspector General noting that more than 100,000 people who applied for the first-time home buyers tax credit were ineligible and probably scammed the IRS out of as much as $500 million, which the agency would have to go try and chase down.

Most of these facts rarely make it into the press (the housing credit fraud was one of the most underreported stories of 2009 in my humble opinion), which is one reason why when the IRS outlined how it plans eventually to license the nation's tax preparers, no one in the press seemed to pause and wonder whether there aren't underlying problems with our tax code and the politicians who design it which have created the mess that the IRS is now trying to solve with its heavy hand.

Shulman's aggressive stance is reflective of a default position in Washington which holds that there is massive tax noncompliance among Americans which, if we can just stamp it out, will yield hundreds of billions of dollars in new revenues. It's a position that ignores the role that the extraordinary (and still growing) complexity of our tax system plays in what the IRS and others view as noncompliance, which is often just confusion or disagreement about what Congress intended. And it's a position which consistently ignores the inability of even the IRS to deal with that complexity and with the many tasks that Congress keeps assigning to it. Indeed, there's no greater indication of how clueless Congress is in this respect than that current health reform legislation assigns the IRS responsibility for monitoring who has, and doesn't have, insurance, and for assessing penalties. As questions mount from taxpayers, who have become ever more confused about our tax code, just look at how difficult it has become to get through to the IRS now and imagine what nightmares the new health care law will present.

There's little question that our tax code is now far too complex. Some 80 percent of households now use tax preparers or tax software to figure out their returns, and collectively we spend 7.6 billion hours on tax compliance, according to the IRS Taxpayer Advocate, at a cost of nearly $200 billion annually. From 2001 through April of last year, Washington initiated 3,125 changes to the tax code, or more than one a day.

None of this is par for the course. Around the rest of the world, countries have been simplifying their tax code by flattening out rates, eliminating deductions and ending tax credits. One recent study ranked the U.S. tax code 122nd in complexity among 175 nations worldwide.
Our politicians have created this mess because rather than use our tax code for what it was designed, that is, to raise revenues, they now wield it as an instrument of social policy. Every politician whose campaign platform includes goals like increasing home ownership or lessening the financial burden of college tuition or encouraging more energy efficiency wants to do it through the tax code. Tax credits are also a way to reward donors and lobbyists for friendly causes.

But ultimately the complexity of this approach befuddles not only taxpayers and preparers, but even the IRS. One example is the mess created by the alternative minimum tax, which eliminates deductions for some filers as their income rises. Originally intended just to apply to the richest Americans when Congress enacted it in 1969, the tax, which for years wasn't indexed to inflation, now hits a few million households and is so complex that it has proved a nightmare even to the IRS. Several years ago, for instance, the IRS erroneously tried dunning thousands of people for additional taxes under the AMT because the agency miscalculated the complex interplay between the tax and state taxes. Accountants noticed a pattern and reported it to the IRS, which admitted to at least 21,000 letters sent mistakenly requesting additional taxes.

Given the complexity of the code, it was with a special amount of hubris that only Washington could display that Congress enacted something called an "accuracy-related penalty" provision in the IRS code. Under this provision filers must pay a penalty for mistakes on their returns for in addition to interest penalties on back taxes they owe. Of course, the government pays no such penalty when it mistakenly duns you for taxes that you don't really owe.

But the situation will only get worse because Americans both inside and outside of Washington and across the political spectrum now seem to accept as inevitable increasing tax complexity and the cost it brings. And so, for instance, in its 2009 audit, the GAO actually deemed it a ‘highlight' of the IRS performance that the agency answered correctly nearly 93 percent of tax queries, as if it's acceptable that the agency which is supposed to be the ultimate arbiter of our tax laws gets more than 7 percent of questions about its own code wrong. And of course, much of what the Obama administration and Congress are now proposing in the way of fiscal policy, from energy tax credits to health reform legislation, will only make the code even more complex because this Congress and this administration seem even fonder than recent ones of using the tax code as a vehicle for social policy.

As a result, to fix a problem that is largely its own creation, the government will now add a layer of licensing and oversight to the tax preparation business, the cost of which the IRS commissioner naively says will be borne by the preparers. Not surprisingly, many of the stories I read about his proposal quoted local tax preparers who approved of the commissioner's move, which alone should make journalists skeptical. (Memo to newspaper reporters: The next time someone tells you he supports more regulation of his industry, Google the term "rent seeker.")

Unfortunately, there is not much of an ‘tax simplification" constituency out there, so that even when the winds of political change blow again, it's likely we'll just get a whole new set of politicians looking to use the code to advance their causes. Even the so-called Tea-Party movement, with its strong anti-tax bias, is heavily focused on cutting taxes when, in truth, simplifying our tax code would probably produce the same benefits as knocking a few points off tax rates.

Steven Malanga is an editor for RealClearMarkets and a senior fellow at the Manhattan Institute

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