When It Comes to the IRS, Bigger Is Not Better

W hile Democrats are aiming to pass President Biden’s giant Build Back Better plan in the House, their efforts will likely meet significant resistance in the Senate. Indeed, they’ve already been forced to scale back their proposal for Internal Revenue Service snooping on personal bank accounts after that provision’s rollout went less favorably than expected. That feature, however, was only part of their $80 billion IRS-expansion plan — one that threatens to raise taxpayer compliance costs and undermine civil liberties.

Under the plan, the IRS would be built back bigger. It would double the IRS workforce, with three-quarters of the expansion directed toward increasing enforcement. Supporters contend that more enforcement is justified because it would raise government revenue, but they ignore the costs that this would doubtless impose on the private sector. More aggressive IRS enforcement would mean more paperwork, more lawyer fees, and more anguish for many law-abiding taxpayers. It could also threaten our financial privacy and security.

Reducing the number of tax cheats in the U.S. is a good goal, but more aggressive enforcement would also cause collateral damage. If we wanted to cut cheating to zero through enforcement, we could hire an army of IRS agents to routinely search every home in the nation and impose root-canal audits on everyone. But a free people do not want such government intrusion, and so every democratic country has a “tax gap” between what is owed and what is paid.

The U.S. tax gap appears to be low by international standards. One study estimated that our tax gap, at 3.8 percent of gross domestic product, is lower than the average tax gap in Europe of 7.7 percent. Another study estimated that among 157 countries, we have the second smallest shadow economy — that is, economic activity outside the government’s tax and regulatory net.

Since the U.S. tax gap is already quite low, the cost of reducing it even further by means of enhanced enforcement is probably high. That is true of the Democratic proposal to grab data from millions of household bank accounts, which would be highly intrusive and likely impose large compliance costs on financial institutions.

Another enforcement provision in the bill would repeal taxpayer protections against unfair IRS penalties. In response to IRS abuses in the 1990s, Congress enacted tax code section 6751, which requires supervisors to sign off when IRS employees are seeking punitive 20 percent penalties. The National Taxpayer Advocate said that this “provision protects a taxpayer’s right to a fair and just tax system.” But the Democratic plan would repeal this important procedural check on the powerful tax bureaucracy.

The IRS is not staffed by angels — nor is any government department, for that matter. But this agency is particularly prone to making mistakes. As the tax-litigation specialist Dan Pilla recently noted in these pages, “[the] IRS’s audit results are incorrect between 60 and 90 percent of the time.” More enforcement would mean more audits, many of which may produce “false positives” — or the targeting of taxpayers who are innocent. Individuals and businesses would have to invest more time and money in lawyer fees to defend themselves. The income tax already imposes compliance costs on taxpayers of more than $400 billion a year; increased enforcement actions would only push those costs higher still.

Enforcement advocates want the IRS to collect more data from individuals and businesses, but they do not sufficiently consider how such databases are ideal hacking targets for criminals and foreign governments. The IRS experiences “1.4 billion cyberattacks annually” and has a “track record of data breaches,” including data from 724,000 returns leaked in 2016.

Earlier this year, ProPublica published information on high-income taxpayers gained from thousands of stolen tax returns it had obtained. A leaky IRS computer system could induce a rash of tax-return theft from other well-known figures with the aims of making a media splash, selling information, or extorting payoffs.

If more IRS data-grabbing and enforcement is not the answer, what is? Major tax reform to simplify the code. That would make the system harder to manipulate and IRS administration much easier. The Tax Foundation estimated that a simple flat tax with no loopholes would slash taxpayer compliance costs by about 90 percent.

Unfortunately, the Democratic tax plan would go in the opposite direction by adding dozens of narrow tax breaks for energy, housing, manufacturing, education, and other items. That would make it harder for the IRS to administer the system and induce more errors and fraud by taxpayers.

Consider the record of current narrow tax breaks. The earned-income tax credit suffers from a huge 24 percent error-and-fraud rate, while the low-income-housing tax credit is plagued by abuse from developers because the credit is so complex and IRS oversight is minimal. Adding more tax credits and other breaks to the code would increase the tax gap.

So while on first blush increased IRS enforcement might sound appealing, it would in practice deliver a damaging blow to the private sector. Simplifying the tax code serves as a legitimate alternative that would create wins all around. Taxpayers would enjoy lower compliance costs and fewer civil-liberties intrusions, while the IRS would benefit from easier administration and a lower tax gap.