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The State of IRS Administration and Our Tax System in General

By
Mortimer Caplin

Mortimer M. CaplinWith IRS Commissioner Mark W. Everson now firmly in place, and new programs being announced with impressive frequency, it seems timely to examine the general state of our tax system and, in particular, the Internal Revenue Service’s recent performance to ensure fair taxpayer compliance.

Attitude towards Paying Taxes

Former Supreme Court Justice Oliver Wendell Holmes once said, “I like to pay taxes. With them I buy civilized society.” Not that many truly enjoy writing tax checks to their government; but, if a high level of taxpayer compliance is to be maintained, respect for this basic obligation of citizenship is crucial. Simply put—without a strong and sound federal tax system, we are unable to provide for national defense, health care, social security, and the other public services due our citizenry. Acceptance of this fundamental truth is vital to the proper functioning of government and to this end, our legislative and executive leaders are uniquely positioned to strengthen public support. Their daily words and actions clearly shape national thought. Continuous IRS bashing does little to encourage taxpayer compliance; in contrast, repeated emphasis on the tax system’s significance to the well being of our democracy does have a positive and meaningful effect.

Let me suggest that use of the terms “customer” and “customer service” is hardly appropriate in referring to the American taxpayer’s relationships to his or her government. U.S. taxpayers are responsible co-partners in the conduct of our self-rule society; and, of course, they are always entitled to receive quality “taxpayer service”—honest, fair, courteous, helpful and efficient. But “customers” they clearly are not; and it is demeaning to refer to them in this manner.

Voluntary Self-Assessment System

Our ability to raise trillions of dollars annually rests primarily on a voluntary self-assessment system, backed by a regime of tax withholding. At our system’s core is the willingness of taxpayers to honestly and accurately report their income as well as deductions. And, despite sharp criticisms and diminishing confidence in our entire tax process, some encouragement can be found in that 98 percent of IRS collections continue to be received voluntarily and free of any IRS enforcement action. This willingness to comply depends in no small part on taxpayer comfort in knowing that neighbors down the street are paying their fair share of taxes, too. Yet, word of an annual $311 billion tax gap—from underreporting, underpayment and non-filing— hardly provides reassurance. IRS Commissioner Mark W. Everson recently underscored the key role enforcement plays in meeting this problem by quoting from President John F. Kennedy’s 1961 tax message to Congress: “For voluntary self-assessment to be both meaningful and productive of revenues, the citizens must not only have confidence in the fairness of the tax laws, but also in the uniform and vigorous enforcement of these laws.”

In recent years, however, this essential ingredient in effective voluntary compliance has been shockingly weakened. If we are to preserve the vitality of our existing system, enforcement resources must be enhanced markedly.

Balanced Enforcement

The dangerous shrinkage of enforcement capability and its adverse impact on voluntary self-assessment have been deplored by almost every gatekeeper charged with IRS oversight. Only recently Commissioner Everson, pointing to the significant “diminution of resources,” noted particularly that the number of revenue agents, revenue officers, and criminal investigators had each declined “over a quarter” during the five-year period beginning in 1997, and that for the same period “audit rates declined, as did criminal prosecutions and enforcement revenues accruing to the government.” Even more forcefully, his immediate predecessor, Charles O. Rossotti, voiced urgent warnings of the “continuing deterioration” and the “dangerous downtrend in the tax system”; the decline in “real resources, as best represented by the reduction of 20,000 FTE staff from 1992 through 2001”; and the IRS’s inability to “perform its minimally required workloads of servicing compliant taxpayers… and of enforcing the law on even known non- compliant taxpayers.”

Both the General Accounting Office and the IRS Oversight Board are sounding similar alarms, with great justification. For without expanded audit coverage, without additional collection officers, and without sufficient criminal investigators, our voluntary self-assessment system breaks down. As has been said before, “Large continued avoidance of tax on the part of some has a steadily demoralizing effect on the compliance of others.” And that is happening today.

With thin allocations of resources to enforcement, smaller percentages of returns are being examined and a growing number of taxpayers and tax advisers are quite willing to enter the game and play the “audit lottery”—taking riskier and riskier chances to escape detection; cheating by outright omission of income or overstatement of deductions; engaging in wide variations of blatant fraud; and using extremely borderline tax avoidance schemes that at times approach criminal tax evasion. The need for a major expansion of enforcement efforts is well illustrated by a comparison of certain past IRS audit rates for the examination of individual tax returns. Today, it is in the neighborhood of 0.57 percent; in the 1960’s, it was between 5.0 and 6.0 percent. In other words, the individual’s current chance of being audited is slightly more than 1 in 200; in the 1960’s, it was about l in 20.

While information reporting and matching of Form 1099 and Schedule K-l help close part of the tax gap, hands-on return examinations by trained IRS personnel are required if we are to accurately uncover income omissions, excessive deductions and other misstatements taxpayers are prone to make. Also to be considered is the positive impact on voluntary compliance that flows from taxpayers’ awareness of the reasonable likelihood of being audited. This is akin to the notable reductions in driving speeds tied to the prominent presence of highway police “white cars” parked along the road. Unless major additions are made to IRS enforcement efforts, it is difficult to see how our present tax system can remain effective.

Code Changes for Administration

The 1998 IRS Restructuring and Reform Act (“RRA 98”) made a number of improvements in tax administration. Recognition must be given, though, that it was adopted in a severe anti-IRS atmosphere stimulated by widely televised, largely unsubstantiated testimony suggesting widespread IRS misconduct and bullying of innocent taxpayers. The bulk of these allegations were subsequently proven unfounded or overblown—discredited in court proceedings and in investigations by both the General Accounting Office and the Treasury Inspector General for Tax Administration. Mistakes had been made, certainly; but few of the IRS horror stories were ever confirmed. In brief, there was overkill in a number of legislative provisions, and, as Commissioner Everson tells us, it has led to “a considerable reticence to enforce the law.”

With close to six years’ experience, it is timely for Congress to review the more restrictive provisions of RRA 98 and give thought to the advisability of some modification or repeal. As one example, let me suggest full repeal of section 1203, which provides for mandatory employee termination for any one of a series of specified violations— the so-called “l0 Deadly Sins.” Some IRS personnel, concerned over possible exposure to complaints by disgruntled taxpayers, are hesitating to enforce the law regardless of its proper application in a given case. This in terrorem effect of the legislation hardly creates the proper atmosphere for sound and balanced tax administration.

Simplification of Law and Administration

How often do we hear the anguish of taxpayers and tax professionals: “If only the tax law and tax administration could be simplified!” This same message is heard in the 1997 Report of the National Commission on Restructuring the Internal Revenue Service and in section 4022 of RRA 98. The Report, for example, states in part:

“The Commission found a clear connection between the complexity of the Internal Revenue Code and the difficulty of tax law administration and taxpayer frustration…

“…The Commission found that significant noncompliance—both inadvertent and intentional—results from various obstacles within the current system, including the cost of compliance and the complexity of the tax law. Reducing taxpayer burden by simplifying the tax laws and administration must start with the Congress and the President.”

It is hard to agree that these challenges have been met even partway. Complexity reports required by the statute have done little to ease the problem and the frequency of changes in the tax law continues. Complex laws lead to both complex administration as well as a highly displeased and angry public, resulting ultimately in serious damage to the nation’s fisc. Until greater efforts are made to address the basic roots of the problem, the IRS is left “holding the bag”—with loud criticism and a highly unpopular reputation. Taxpayers repeatedly throw up their hands in disgust, voice disdain for the entire tax system as well as the government itself, and frequently take advantage of every opening conceivable.

In a complex and ever changing society such as ours, Congress is confronted with a monstrous task in attempting simplification. A starting point, however, might well be the appointment of a special commission charged with the responsibility of analyzing the underlying principles governing our tax system and outlining an entirely new income tax law. This obviously would be an extraordinarily difficult undertaking—one of lengthy duration and certain to be sharply challenged by a quagmire of political, economic and other considerations. But it would be a worthwhile beginning and Congress should give it careful consideration. As a preliminary guideline for such a study, some good advice may be found in Senator Robert Bennett’s remarks before the Tax Foundation expressing hope of developing a new tax system based on the premise that “the purpose of taxes is to raise money to run the government,” not to pick winners and losers. A pretty good starting point for any commission.

Business Systems Modernization and E-Filing

The installation of IRS’s national computer system— along with a taxpayer master file plus account numbering authorized by statute—dates back to my years as Commissioner (1961-1964); and essentially the same system, albeit largely extended, continues today, some 40 years later. Since that time, IRS’s workload has increased exponentially while staffing increases have lagged far behind. IRS is being seriously squeezed—with outdated equipment and insufficient personnel. It keeps striving for increased productivity, but more help from Congress is badly needed. Business systems modernization (“BSM”) is an activity that must be kept very high on the priority list. As the General Accounting Office reports, “BSM is important for IRS’s future because it has the potential for long-term efficiency gains without major increases in staffing or other resources.”

Also important to greater efficiency and accuracy is the expansion of the electronic filing of returns. In 2003, some 53 million individuals filed electronically, with an increase of over l0 percent anticipated for 2004. RRA 98’s target of 80 percent e-filing by 2007 is not likely to be met; but the IRS is making impressive headway for individual returns and most recently for corporations as well. Every encouragement and support should be given to expand these efforts. The potential here is impressive and certainly merits sharp focus.

Tax Lawyers and Accountants

The proper functioning of our tax system is largely dependent upon the quality and responsible involvement of tax practitioners— primarily tax lawyers and tax accountants. With well over half of the public employing outside professionals for tax return preparation and tax advice, the standards and integrity of this group have nationwide impact on taxpayer compliance and on the soundness of the entire self-assessment process. In the main, the ongoing cooperation between the IRS and leading practitioner groups has brought sizable benefits to both the government and the public at large. The American Bar Association Section of Taxation, the American Institute of Certified Public Accountants’ Tax Executive Committee, and the Tax Executives Institute are all noteworthy in this regard; and it serves the IRS well to continue this joint effort for improving overall tax administration.

On the down side, however, is the recent fall out from IRS tax shelter investigations which identified extremely questionable practices by a number of otherwise well-regarded tax practitioners. In response, Senator Charles Grassley, Chairman of the U.S. Senate Finance Committee, caustically observed: “At the heart of every abusive tax shelter is a tax lawyer or accountant.” In total agreement, Senator Max Baucus, Ranking Member of the Committee, stated: “Let’s stop these unsavory practices in their tracks by restoring integrity and professionalism in the practitioner community…” Directly on target is their recent letter to Treasury Secretary John Snow calling for a reinvigoration of the IRS Office of Professional Responsibility (“OPR”), for proper funding, and for the extension of the authority of its new head, Cono Namorato. This demand for policing tax practitioners by OPR and “pursuing unscrupulous practitioners” is roundly hailed and supported by a large community of responsible tax practitioners.

* * * * *

Senator Grassley’s and Senator Baucus’s public recognition of the need for balanced and vigorous tax enforcement is especially encouraging. It is a strong endorsement of the new direction now underway in the IRS—a new emphasis rightly owed to the taxpayers of this nation who, year after year in overwhelming numbers, report honestly and accurately and who meet their tax obligations in full. To the extent that some are allowed to cheat and beat the system, we unfairly foist on the honest taxpayer the need to pay for others “the price of citizenship”— owed by each of us for the privilege of sharing in our democratic form of government.

Commissioner Everson and the IRS are to be applauded and supported for their new enforcement programs aimed at calling a halt to this inequity. Additionally, however, is the need for Congress to play a more affirmative role—to back up its many criticisms by granting sufficient funds to allow the IRS to fulfill its commitments. History over many years tells us that for every dollar invested in IRS enforcement the government is very likely to receive 10 and even as high as 20 dollars in return. Not a bad investment to assure the nation that the tax law is being fairly and equitably administered.

Beyond that, it still will be up to Congress to provide further assurance to the public by seriously addressing the complexity issue. An approach to demystifying income tax returns is available in a tax policy true to principles along the following lines: (1) Curtail the use of the tax law as the first responder for solving our social and economic problems; (2) eliminate the bulk of special preferences and special rates and thereby create a sizably broadened tax base; (3) restore a straightforward graduated rate structure, free of hidden tax increases inherent to floors, phase outs, clawbacks, and the like; (4) repeal the alternative minimum tax for individuals as well as corporations; and (5) lower rates across-the-board and apply them on the same basis to all types of income, regardless of source. Such a policy on its face provides equal tax treatment for persons with equivalent dollar incomes; and, fundamentally important, establishes a tax system that the public will find simpler, fairer and more equitable.

Other tax simplification formats obviously come to mind and deserve full consideration. But whatever the choice, Congress would do well to keep at the forefront Senator Robert Bennett’s already-mentioned wise words, reminding us again that “the purpose of taxes is to raise money to run the government,” not to pick winners and losers!

Statement of Mortimer M. Caplin
Caplin & Drysdale
Washington, D.C.

Hearings before Ways & Means Subcommittee on Oversight
U.S. House of Representatives
June 15, 2004

"TAX SIMPLIFICATION"

My name is Mortimer Caplin, of the Washington law firm of Caplin & Drysdale.

I served as U.S. Commissioner of Internal Revenue from 1961 through 1964, during the Kennedy and Johnson administrations, and have specialized in tax law for over 50 years—as a professor at the University of Virginia School of Law and as a lawyer, representing a wide variety of business and individual taxpayers.

It is a privilege to appear before the Oversight Subcommittee and I commend the Chairman for focusing on the issue of “tax simplification.” It is an effort owed to all taxpayers of this country who, year after year, are overwhelmed by complex tax laws, complex returns, and complex administration as they struggle to meet their annual tax obligations. At the very least, they are entitled to the hope and expectation that some relief is at hand.

Our nation’s ability to raise trillions of dollars annually to support the functioning of our government rests primarily on a voluntary self-assessment tax system—one dependent upon the willingness of taxpayers to honestly report their incomes and deductions and accurately compute their taxes. Their willingness to comply depends in no small part on their trust in the system and their belief that the law is being administered fairly and across-the-board, with their neighbors down the street paying their fair share of taxes, too. Will Rogers once opined that people want “just taxes” more than they want lower taxes, wisely adding: “They want to know that every man is paying his proportionate share according to his wealth.” American taxpayers do not like to feel they are suckers.

However, word of an annual $311 billion tax gap—from underreporting, underpayment and non-filing—hardly provides reassurance and hardly encourages compliance. To counter this, IRS Commissioner Mark W. Everson, while still striving for improved taxpayer service, is now placing heightened emphasis on the enforcement aspect of tax administration, particularly focusing on tax shelters, tax fraud and other tax abuses. He often quotes President John F. Kennedy’s 1961 tax message to Congress, “Large continued avoidance of tax on the part of some has a steadily demoralizing effect on the compliance of others.” And this is the very condition that we face today—lack of confidence in our tax laws, disrespect for the administration of these laws, tendencies to play the “audit lottery,” and a ready willingness to engage in extreme tax avoidance and evasion schemes of all sorts.

While our tax laws and the IRS will never be loved, the respect of our citizenry must be earned and public confidence in the system restored. At the very least, the public is entitled to reassurance of the law’s fairness, honesty and openness; and, to this end, the issues of complexity and the difficulties of compliance come to the forefront.

Complexity and Alternatives

. How often it is that we hear the anguished cries of taxpayers and tax professionals, “If only the tax law and tax administration could be simplified!” This same theme is heard in the 1997 Report of the National Commission on Restructuring the Internal Revenue Service as well as in RRA 98 section 4022, “Tax Law Complexity Analysis.” The Report, for example, states:

“The Commission found a clear connection between the complexity of the Internal Revenue Code and the difficulty of tax law administration and taxpayer frustration.”

“…The Commission found that significant noncompliance—both inadvertent and intentional—results from various obstacles within the current system, including the cost of compliance and the complexity of the tax law. Reducing taxpayer burden by simplifying the tax laws and administration must start with the Congress and the President.”

These challenges have not been met even partway. Complexity reports required by the statute have done little to ease the problem. Frequent changes and added complexity continue.

Needless to say, complex laws lead to complex administration and a highly dissatisfied public—hardly the atmosphere for steadfast compliance. Taxpayers repeatedly throw up their hands in utter defeat, voice disdain for both the tax system as well as the entire government, and frequently follow up by deciding in their own favor every conceivably uncertain question that may arise. Until greater efforts are made to address basic roots of the problem—extraordinary complexity and murky transparency—the nation’s fisc suffers and the IRS is left “holding the bag,” with unfair criticisms and a highly unpopular reputation.

Congress is confronted with a gigantic task in seeking fundamental simplification. Some suggest that the income tax be scrapped in its entirety and replaced with a complete substitute—perhaps some form of consumption tax, a federal sales tax or value added tax. And then there are those who ardently back the very simple “Flat Tax”—widely heralded to require only a postcard return, with no itemized deductions, and only a single rate of tax to be imposed on income from wages but not from capital (whether interest, dividends, rents or capital gains).

Such an entirely new system of taxation, however, is not likely in the foreseeable future—particularly with its uncertain revenue-raising capacity, the risks at stake in a large and complex economy like ours, and the sweeping transitional problems that would confront individual and business taxpayers as well as tax administrators. Some form of consumption tax might well be suitable now to complement our income tax system, but not to substitute for it.

Realistically, to significantly ease complexity, Congress must think in terms of modification of the income tax law and then contemplate its complete revision.

Overhaul the Income Tax

“Simplification” and “fairness” must be kept at the heart of any new proposal. Congress, in my view, could provide unprecedented relief to taxpayers and, at the same time, could help revitalize public faith in the running of our government by focusing on a broad-base, low graduated rate income tax system.

Today, our tax laws are riddled with a vast array of targeted tax preferences and incentives that complicate compliance, erode our tax base and necessitate increased tax rates to meet the nation’s revenue demands—special deductions and credits, exemptions and exclusions, deferrals, special rates and other preferred treatment for particular industries, groups or individuals. Aside from issues of fairness, such provisions create unbelievable complexity often leading to distortion of normal decision-making and encouragement of tax-motivated, non-economic behavior. Tax avoidance and abuse are inevitable byproducts.

We also see the tax laws excessively used, again and again, to promote a wide variety of social and economic objectives. The result: tax base erosion, shifting of the tax burden, added complexities, and further fueling of taxpayer frustration. Much too often, Congress finds this “backdoor financing” route significantly more convenient, albeit more revenue costly, than the better-monitored process of direct appropriations.

A meaningful simplification effort would be an extraordinarily difficult undertaking, one of lengthy duration and certain to be sharply challenged by competing forces of all dimensions—business, political, economic and otherwise. Forceful Presidential leadership, as in the Reagan years, clearly would be needed; and appointment of a carefully chosen commission undoubtedly would be required, with adequate staffing and preparation to undertake extensive hearings. Regardless of the final outcome, the related studies and analyses would produce long-range benefits to future enactments of the country’s tax laws.

Some 40 years ago, Senator Russell Long, who became Chairman of the Senate Finance Committee, took it upon himself to lead a charge to provide true simplification for individual taxpayers. He offered bold legislation that called for an across-the-board “Simplified Tax Method.” It was close to a tax on gross income (“simplified taxable income”)— no personal deductions; lower rates; capital gains to be taxed in the same manner as other income. And its special charm was that the program was optional. A taxpayer had the choice of using the regular income tax (“the old way,” with all its complexities), or the new simplified method. All you had to do was to make a 5-year renewable election, with the right to terminate in the event of bankruptcy, disability, or adverse changes in the Code or regulations. While the legislation was never adopted, it did illustrate how individual income tax compliance could be made truly simple with hardly any recordkeeping. An instant tax return was a real possibility. And, in honor of the Senator, I’ve always liked to refer to it as “The Long Short-Form”!

Close to 20 years ago, one of the most successful efforts for basic income tax reform was achieved in the TaxReform Act of 1986, under the leadership of President Ronald Reagan, with the full backing of Chairman Dan Rostenkowski of the House Ways & Means Committee and Chairman Bob Packwood of the Senate Finance Committee. Subsequent legislation has whittled away many of the 1986 Act’s achievements on fairness and simplification. But the legislation still stands as a monument to “the art of the possible”—broadening the tax base by eliminating many tax breaks and loopholes, lowering the rate structure, taxing capital gains in the same way as ordinary income, and embracing the principle that “those with similar amounts of income should pay essentially the same amount of taxes.”

In the same tradition of the 1986 Act, Congress could begin the process now to simplify tax reporting, ease administration, and restore taxpayer confidence in the entire tax system. To this end, I suggest setting in motion the enactment of tax changes along the following lines:

2. Curtail the use of the tax law as the first responder for solving our social and economic problems.

3. Eliminate the bulk of special preferences, creating a sizably broadened tax base.

5. Tax capital gains in the same manner as ordinary income

6. Lower all graduated rates across the board.

We as a people would be better served by a broad-base, low rate income tax system, with only the most limited of tax favors. Such a straightforward regime, aimed at treating all forms of income alike and providing equal tax treatment for persons with equivalent dollar incomes, would clearly be simpler, fairer and more efficient for the people at large.

Such a transparent system, free of bells and whistles, would go a long way to restore faith in the integrity of a sound tax system that is so vital to the security and well-being of our nation.