The Republicans don’t want to fix the IRS. Here’s how to do it anyway.
with Natasha Sarin
The current moment is perhaps the most important for U.S. tax administration since the income tax was put in place more than a century ago.
Consider just the past six months: Congress has passed the largest-ever increase in IRS funding; repeal of that funding has become the first legislative priority of the new Republican House majority; and the IRS has been tasked with implementing major novel tax provisions to address the climate crisis. Now, the agency faces an imminent leadership transition.
We both have been engaged with issues like these as government practitioners and as analysts of tax administration (Sarin until recently as Treasury’s counselor for tax policy and implementation, Summers previously as deputy treasury secretary and treasury secretary, and in joint research). For those weighing the future of the IRS budget and those who would shape the agency in the years ahead, we offer five observations.
First, even after the $80 billion investment in 2022’s Inflation Reduction Act, the IRS is in much greater danger of being under- rather than over-resourced.
The IRS has the oldest IT system in the federal government — so much so that systems are written in COBOL and paper returns continue to be transcribed by hand. Each year, more than 260 million returns are filed, and the IRS serves every American household; in comparison, JPMorgan serves about half that but annually spends 28 times more on modernizing its already state-of-the-art technology. It is no surprise, then, that millions of returns filed during the pandemic still have not been processed.
Further, today the IRS has fewer field agents to do complex tax examinations than at any time since World War II. As a result, audit rates for millionaires went down by more than 70 percent over a decade. Providing the IRS resources was a vital first step toward improving the agency, but the task at hand is large.
Second, recent information has strengthened the case that the payoff for investment in tax collection is enormous.
In past work, we have shown that an investment in the IRS similar in size to that of the Inflation Reduction Act would generate more than $1 trillion in additional tax revenue over a decade by reducing the “tax gap” — the difference between owed and paid taxes. But this is, in fact, conservative, as recent research has emphasized a point left out of our calculation: Successful audit activity raises future collections from taxpayers who face enforcement activity. If their home office deduction is disallowed once, taxpayers do not attempt the same deduction again.
Third, improvements in tax administration promote fairness.
Reasonable people can disagree about how progressive the tax code should be. But we cannot see any logical argument for rules that operate differently for certain taxpayers. Most Americans have most of their tax liability automatically withheld and earn income in ways that are reported directly to the IRS — for example, interest income on the 1099-INT or dividend income on the 1099-DIV. But the most privileged Americans accrue income in opaque ways that are not subject to this type of reporting and, therefore, are a source of a large percentage of the tax gap.
A crucial priority for the IRS must be enhancing its capacity to ensure that the most financially sophisticated taxpayers meet their obligations. This would require making much greater use of data science, drawing to a greater extent on those with past experience representing these taxpayers and relying more on outside experts to help evaluate taxpayers’ claims.
Fourth, recent revelations from Donald Trump’s taxes underscore the inadequacy and inequity of current IRS capacity.
Obvious flags went unheeded in the former president’s taxes. Generally speaking, forgiven debt is treated as income because if a taxpayer no longer has to pay a creditor $1 million, he is $1 million richer. In his returns, Trump asserted otherwise, a position his own lawyers did not believe was likely to prevail in the face of an IRS challenge. Subsidiaries where sales and expenses exactly offset one another — a stunning coincidence if true — needed more attention, too. But with a single agent largely responsible for this complex case, the IRS reports that it simply did not have the necessary resources to do the work.
Trump is just one prominent example of a much broader issue. The IRS receives more than 4 million partnership returns annually, but opens audits of only 7,500 of them each year. That’s a rate of essentially zero — and an invitation to mischief for those seeking to evade their tax obligations.
Fifth, successful tax enforcement requires that the IRS have the respect and confidence of the American people.
Enhanced enforcement must never compromise strict adherence to the Taxpayer Bill of Rights. And the bipartisan Taxpayer First Act rightfully focused on the importance of improving customer service. This must be on the agenda. It is not acceptable that in 2022 only 13 percent of calls made to the IRS were answered, or that taxpayers have waited eight months for refunds, or that only 2 percent of taxpayers file their taxes for free each year.
With demands coming from many quarters, it will be essential in the years ahead that the IRS not be distracted from its core mission: “Provide America’s taxpayers top-quality service … and enforce the law with integrity and fairness to all.”
Just as the military needs to stay focused on protecting our national security and the Federal Reserve on price stability and full employment, the IRS must deliver on these crucial objectives: create a system of tax administration that is more effective in collecting legally owed taxes, reduce burdens on American taxpayers and uphold fairness for all.
What the Fed should do next on inflation
The debate over U.S. monetary policy is in a new phase. There is no longer any question that the Fed allowed itself to fall way behind the curve in the second half of 2021 and early 2022, calling its credibility into question. It is equally clear that, as its critics urged, the Fed has since moved aggressively to contain inflation by raising rates and quantitatively tightening. After these steps, along with the president’s releases from the Strategic Petroleum Reserve and some good luck, the Fed has regained its credibility as an inflation fighter.
Unfortunately, all major reductions in inflation in the past 70 years have been associated with recessions. It should come as no surprise that many economists, including me, expect a recession to begin in 2023. Historical experience as encapsulated in the proposition known as the Sahm Rule demonstrates that whenever U.S. unemployment rises by more than half a percent within a year, it goes on to rise by 2 percent. So, if recession comes it is very likely to lift unemployment to the 6 percent range.
What should the Fed do next? The choices from here get harder, not easier, as both the risk of a severe recession and enduring inflation make policymaking more challenging. Chair Jerome H. Powell was right in his Dec. 14 news conference to emphasize that there is no basis for confident economic prediction.
Some of the most stridently made arguments are also the silliest. Doves are wrong to argue that the Fed should obviously pause in raising rates since inflation expectations are low. Hawks who suggest the Fed must keep raising rates until they substantially exceed past inflation neglect the fact that inflation is coming down — much less the possibility that the economy could face a Wile E. Coyote moment in 2023, in which demand collapses.
This could occur as small and medium businesses hit a wall of high-interest refinancing, as markets suddenly focus on what a recession would do to corporate profits, as consumers’ covid-era savings are depleted, or as businesses that have been clinging to their workforces realize they’re no longer necessary. Alternatively, oil prices could spike or geopolitical risks could increase. In all these scenarios, policymakers will wish that monetary policy was not highly contractionary.
The Fed is seeking to balance the risk of stagflation caused by entrenched inflation expectations with the risk of dangerous downturn. It is being supported by the administration, which is doing an exemplary job of respecting the Fed’s independence. My instinct is that the Fed’s approach of stepping more gingerly as the situation becomes more problematic is appropriate.
It is very unlikely that we will have a recession so severe as to drive the underlying inflation rate below the 2 percent target. Hence, overshooting on inflation reduction is not the primary risk, and the Fed is right to emphasize its inflation objective going forward.
This judgment is supported by another consideration. There has been a transitory element in inflation’s recent deterioration caused by bottlenecks in sectors such as used cars. As these bottlenecks ease, and prices return to normal, there will be a transitory deflationary impact hitting the statistics. This must not be confused with enduring resolution of the inflation problem.
Wage inflation is now running at 5 percent or more, and labor markets remain exceptionally tight. Until wage inflation declines significantly or we get clear evidence of a productivity acceleration, there is no basis for assuming that any low rates of inflation observed will be sustained if monetary policy is eased.
Some suggest that a 2 percent inflation target is not appropriate in current circumstances, especially given the costs of meeting it. Powell was right, in my view, to firmly reject this idea. I doubted at the time that setting a numerical target for inflation was a good idea, but now is not the time to switch course. A shift now even to a 3 percent target, let alone a higher one, would set the stage for a stagflationary decade. The 3 percent target would devolve to a floor, as policy eases, with the economy turning down and 3 percent in sight.
A year ago, the policy imperative was altering a monetary policy that was way behind the curve. Today, the greatest low-hanging fruit for policy improvement lies in steps that the rest of the government outside the Fed can undertake. These include tariff reductions, measures to accelerate permitting for energy projects urged by Sen. Joe Manchin III (D-W.Va.), measures to contain health-care and college tuition costs, and procurement practices focused on buying at minimum cost.
Fiscal policy will need to respond if and when recession comes. There will not be room for massive, across-the-board efforts. But now is the time to put in place carefully targeted measures to refund child tax credits, strengthen unemployment insurance and be ready to pull forward federal spending on maintenance and replacement cycles to periods when overall demand is soft.
It is a tribute to the 2010 Dodd-Frank financial regulations that so much monetary tightening has taken place with so little market trauma. But regulators need to be alert to issues of liquidity in a number of markets and to the very substantial divergences that have opened in recent months between public market valuations and the value at which many assets are being carried on private balance sheets. They also need to be conscious of the possibility that well intentioned regulatory safeguards will interfere with liquidity in key markets.
The rest of the world will suffer greatly if the United States does not control inflation and rates ultimately rise far above current levels, as occurred in the early 1980s. Even recent increases in rates and the dollar along with geopolitical dislocations are creating serious problems for many developing countries. The United States should be leading global efforts to resolve sovereign debt problems more quickly and to catalyze much higher lending levels from the International Monetary Fund and World Bank.
Managing inflation and the risk of recession in a way that ensures a soft landing is likely not possible. But managing these risks with maximum care is profoundly important as a foundation for the long-term investment policies that will drive the inclusive prosperity that almost all Americans desire.
CDE Conversations | Lawrence H. Summers on are we heading for a global economic slowdown?
Ann Bernstein, CDE’s executive Director was in conversation with Dr Summers. The main topic of the discussion was: Are we heading for a global economic slowdown?
