The Biden government’s recent proposals rely heavily on revenue from better tax collections by the Internal Revenue Service (IRS) to fund spending initiatives. The American Families Plan takes several avenues to reduce the tax gap (or the difference between taxes paid and taxes owed), from increasing the IRS’s tax budget to improving information technology to broadening reporting requirements. The Treasury Department estimates the changes would raise nearly $ 700 billion over the next decade.
As I wrote in a newspaper in July, the changes would generate additional revenue, although it is unclear whether they could raise the $ 700 billion promised. In addition, some changes could increase compliance costs for taxpayers overall and put a burden on taxpayers who are already in compliance. The increased likelihood of an audit could result in a compliant taxpayer wasting time making sure they are complying with the law or deciding not to take advantage of a benefit they are entitled to, because he fears that he is not entitled to do so. In addition, some evidence suggests a tradeoff between voluntary and enforced compliance: a more aggressive tax collector will decrease trust in the institution, resulting in lower voluntary compliance rates.
Politicians and policy analysts often cite the cost-benefit analysis of enhanced tax enforcement as a comparison between the budgetary costs of a new program (e.g., the Washington Post published a comment in March this year entitled, “For every dollar invested in the IRS the government could get $ 6 back. ”But generally, direct budget increases aren’t the only costs: New IRS programs often mean increased compliance costs for taxpayers Weigh the budget and compliance costs against the additional revenue a program would generate.
Tax enforcement can be imagined using what is known as a confusion matrix. The first dimension is whether someone is being audited and the second is whether someone pays in full the taxes they owe. Tax enforcement should minimize two types of errors:
- Type I error does not scrutinize those who fail to pay their tax debt in full, which increases the tax gap and leads to a loss of income
- Type II error audits those paying their full tax liability, which increases compliance costs and decreases trust in the IRS.
| Checked | Not checked | |
|---|---|---|
| Don’t pay full liability | Correct conclusion | Type I error (causes tax gap, loss of income) |
| Pay full liability | Type II error (increases compliance costs, decreases trust in the IRS) | Correct conclusion |
Some policy options, such as enhanced information technology (IT), can help minimize both types of errors. For example, the Return Review Program detects fraud in individual tax returns by looking for anomalies. From 2015 to 2017, the program generated fraudulent refunds of $ 6.51 billion, compared to a total cost of $ 419 million (including development). Going forward, the program will only cost around $ 100 million a year. The program significantly reduces the Type I error by absorbing unlawful tax cuts. It also reduces Type II errors by making the IRS better at identifying which explanations are suspicious – and indirectly which are not – saving many taxpayers the cost of unnecessary scrutiny.
We can contrast IT investments with an increase in tax enforcement activity, which generally increases audit rates. This would likely reduce Type I errors as more audits would inevitably lead to catching additional non-compliant taxpayers. However, a mere general increase in the number of audits would also subject many legally compliant taxpayers to audits and thus increase the Type II error. This increases compliance costs for taxpayers and damages the IRS’s public credibility.
Beyond the nuts and bolts of IRS administration, simplifying the tax law itself would help reduce both compliance costs and tax losses. For example, converting recoverable tax credits, which often have complex eligibility rules and high error rates, into conventional spending programs would reduce compliance costs for taxpayers and allow the IRS to focus on its tax collection task rather than welfare administration. Likewise, the abolition of special deductions while lowering marginal tax rates lowers compliance costs and reduces the incentive to hide income.
The existence of compromises does not necessarily mean that stricter tax enforcement is a mistake. However, policy makers should consider such tradeoffs when considering ways to improve tax collection. Policies like better information technology are less likely to increase compliance costs for honest taxpayers. Finally, policymakers should not neglect structural reforms of the Code as an option to reduce the tax gap and lower compliance costs for taxpayers.
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