Eight Tax Myths – Lessons for Tax Week Part II

As a matter of law, what we now call the IRS grew out of that same seismic 1862 revenue legislation I discussed in yesterday’s posts. It was at that time that Congress created the position of “Commissioner of Internal Revenue” and made that person the head of an office within the Treasury Department “to be called the office of the Commissioner of Internal Revenue.” The first Commissioner was the indefatigable George S. Boutwell, who took office in On July 17, 1862. He started with just three clerks but by the end of 1862 he had ramped up operations to 3,882 employees, all but sixty scattered throughout the non-rebelling states. The guy was an operator. As these numbers suggest, and as I have written in boring academic articles, tax administration was in large part a field operation involving what one member of Congress denounced as an “army” of tax collectors and another colorfully termed “pygmies.” Over time, this army of pygmies became known as the Bureau of Internal Revenue (BIR). The name changed to the Internal Revenue Service only some 90 years later, as part of a reorganization in 1952 following a real scandal. More on that tomorrow, in Myth #7.

If you go read the tax statutes, you will see something curious: they are written as if one single individual—the Secretary of the Treasury—is responsible for the entire tax system. For example, here is the foundational language Congress uses to empower the collection of tax: “The Secretary is authorized and required to make the inquiries, determinations, and assessments of all taxes…imposed by this title.” The tax statutes do not place duties or obligations or give directions to the IRS and rarely to the Commissioner. Everything is to be done by one individual: “the Secretary.” And so that is where the chain of command starts, with various duties delegated down from the Secretary to the Commissioner to various other offices within the agency. And so grows the myth: the IRS exists.

5. Returns are Rarely Reviewed

USA Today recently told its readers that “the audit rate, the percentage of individuals’ tax returns IRS revenue agents examined either in person or via correspondence, fell to 0.86% last year.”

That’s a true statement as far as it goes, but it does not go very far. It is generally combined with myth #3 (from yesterday) about self-assessment to create a myth that taxpayer returns are rarely reviewed.

In fact, all returns—yep, 100%—are reviewed, scrutinized, inspected, verified, analyzed, checked, checked out, checked over, investigated, looked over, probed, and otherwise studied, before the tax liability is assessed. And remember, an IRS employee makes the assessment not the taxpayer. Most of the review comes during what is known as “returns processing.” While this review is not as extensive as a full-scale audit, it is wrong to think that returns processing review rubber stamps whatever the heck taxpayers see fit to report on their tax forms.

The processing of returns subjects every return to various computer filters to decide whether that return is likely enough to be correct to be accepted as filed. If the computer flags the return, it gets kicked out and does not get processed through to assessment until passing through additional verification procedures. Nina Olson, the National Taxpayer Advocate makes this point nicely in describing the arduous journey that what she terms “every poor little refund return” must take before the IRS accepts it. During the 2013 filing season, says Ms. Olson, 12.3 million returns were kicked out of the processing flow because of potential errors identified during processing—meaning they were sent to “error resolution,” an office that requires taxpayers to present additional information to get their returns processed. All refund returns are run through an Electronic Fraud Detection System and suspicious returns selected by the computers are held until the income and IRS employees can verify withholding.

These automatic filters are by no means perfect. The latest hot issue is that the IRS got scammed to the tune of some $5.8 billion dollars by identity thieves. More on that in Myth #6. Of course, what is not as often noticed is that the filters did catch and stop some $24 billion in fraudulent refund claims.

Returns claiming certain types of credits are subjected to additional review over and above the series of computer filters. According to Ms. Olson, during the 2103 filing season some 358,000 Earned Income Tax Credit returns and 90 percent of returns submitting claims for the adoption credit were kicked out the regular processing stream by computers and given individualized review by IRS employees.

Ms. Olson takes a dim view of how the IRS processes returns because it holds up the refund process for many honest taxpayers. But whether one views the current process as benign or malignant, the fact remains that the process does not simply “accept” returns as filed and blindly or mechanically “assess” what the taxpayer reports.

6. The IRS Wastes Money on Erroneous Refunds

I love my yearly tax refund. I know I am not supposed to, but I do. Theorists argue that my refund represents an interest-free loan to the government and I am supposed to resent that, for reasons grounded in the obsessive individualism of our culture. But even accepting the argument’s premise, the value to me of that yearly manifestation of my forced savings outweighs the value of the interest I would theoretically earn in my checking account. I don’t worry, I be happy.

I am not alone. In FY2013, the IRS made lots of folks happy, sending out some $313 billion income tax refunds to individual taxpayers on gross collections of $1.564 trillion. Some folks get extra happy because their refunds were in error, either because of an IRS mistake or because their tax refund scam worked. No one knows the exact dollar amount of erroneous refunds issued, but the Government Accountability Office recently accepted $5.8 billion as a reasonable guess just as to the amount issued in FY2013 on account of identity theft.

Some folks use these numbers to propagate a myth that the IRS commits significant error in making refunds. Similar to the myth of the IRS Code, this is myth that seeks to fix the blame and not fix the problem.

For example, I was watching IRS Commissioner John Koskinen testify before the House Appropriations Subcommittee on Financial Services on March 18, 2015. There, Representative Tom Graves (R-Ga.) asserted that the amount of erroneous refunds was significant because it was “more than half, I guess, of your entire agency’s budget.” Graves also asserted that the IRS issued the $5.8 billion “knowing that $5.8 billion could go to defense, it could go to so many other needs within our country right now….but instead criminals all across the country, if not across the world, are receiving these tax refunds.” Using these comparisons, Graves was seriously concerned that the IRS was screwing up big time. Notice here the use of Myth #4: an entity called the IRS “knew” the erroneous refunds could go to other purposes.

Graves’ office was so proud of his performance that they posted his part of the hearing on www.peachpundit.com. They should not have. The excerpt makes Graves look like a clueless git.

First, Grave’s claim that the money erroneously refunded could have gone to some other program is fatuous. There is no direct linkage between money collected and money spent. Congress first must budget for an expense and then it must appropriate the money for the expense. Once it takes those two actions, the executive branch has to spend the money, and if there is not enough money to spend, the executive branch must borrow the money, again subject to broad controls by…Congress itself. It’s not like someone from the IRS says “hey, we found some extra money here!” and runs over to Congress with a check for Congress to immediately spend on those “other needs,” which—speaking of wasting taxpayer dollars—no doubt include many new bridges to nowhere. You would think Graves would understand that basic budget process, him being on the House Appropriations Committee and all.

Second, and more importantly, this excerpt shows that Graves sucks at numbers, which is pretty sad given his committee appointment. His comparison of the erroneous refund rate to the agency’s budget is nonsensical. As best as I can make out, he is suggesting that the agency gave away half of the money the Congress appropriated to it. Really? Is he really trying to say something like “hey, we gave you a budget of more than $10 billion and you gave half of it away”? If so, that’s really stupid because at the same time the IRS was erroneously refunding $5.2 billion it was properly collecting $1.56 trillion in individual income taxes alone (i.e. not counting corporate income taxes, excise taxes, “death” taxes, or employment taxes). So in Grave’s own terms, the agency was not giving away half its budget; it was collecting some 156 times its budget. If you really want to compare dollars collected to IRS budget, study after study shows that every additional dollar allocated the IRS results in multiple additional tax dollars collected. As the National Taxpayer Advocate reported in 2013: ““For virtually every other spending program, a dollar spent is just that – it increases the deficit by one dollar. But a dollar spent on the IRS generates substantially more than one dollar in return – it reduces the budget deficit.”

A more reasonable approach would start with the question “is the IRS collecting what it should?” I figure that $5.8 billion is about 0.04% of the $1.56 trillion properly collected. So one could as well say that the IRS properly collected 99.96% of what it would have collected if it had not sent out these refunds. Yes, $5.8 billion is a lot of moola, but it’s a 0.04% drop in the tax collections bucket.

Another reasonable approach would be to ask “is the IRS refunding what is should”? That is, measure IRS performance here by comparing erroneous refunds to all refunds made. In FY13 the IRS issued $314 billion in total refunds. I figure that the $5.8 billion in erroneous refunds is about 1.8% of all refunds made. So Graves is pounding on the IRS for correctly refunding 98% of all refunds instead of….what? 100%? Even measuring the IRS performance against what a perfect agency would do is far more reasonable than the budget baseline Graves hurls around.

By almost any measure, the IRS does a great job in getting the right refund to the right taxpayer in a timely fashion. But errors happen. Worse, given the huge amounts involved, even small error rates add up to large numbers. It remains true that the $5.8 is a large number and even a blemish can become cancerous, so the IRS management is appropriately concerned about this situation. It has diverted more than 3,000 employees out of its increasingly small workforce from other tasks to deal with the problem. But in the hearings I watched, Graves is so set on perpetuating the myth of IRS screw-up that he completely ignores the suggestions patiently and repeatedly offered by Commissioner Koskinen on how to fix the problem.

Tomorrow: Myth #7 (The IRS Abuses Taxpayers) and Myth #8 (The IRS is Run by Humans).