The Build Back Better Act’s Investments in the IRS Will Substantially Reduce the Tax Gap
The Build Back Better Act would make transformational investments that improve the economic security of the nation’s families and advance solutions to the climate crisis that threaten the planet’s future. These investments would be fully paid for by sensible tax policies and budget savings that require the wealthiest Americans and largest corporations to pay their fair share. Preliminary White House estimates indicate that the Build Back Better Act will reduce deficits by $36 billion over the next decade and by more than $2 trillion in the subsequent decade.
The bill reduces the deficit because it includes three main sources of budget savings, or “offsets,” that total $2.15 trillion: 1) The bill includes about $1.5 trillion in tax increases on corporations and wealthy individuals, according to the Joint Committee on Taxation; 2) the bill lowers the cost of prescription drugs in ways that the administration estimates will produce $250 billion in budget savings; and 3) the bill would modernize the IRS to enhance the agency’s ability to crack down on tax evasion by the wealthy and corporate tax cheats while improving service for ordinary taxpayers.
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This column focuses on the third source of savings: investment in the IRS. The U.S. Department of the Treasury’s Office of Tax Analysis (OTA) estimates that increasing funding for the IRS will generate $400 billion in new revenue after accounting for the added cost. This estimate likely will not be included in the Congressional Budget Office’s (CBO) official score of the bill for reasons that this column will explain, but the savings are real and potentially much greater. Therefore, the Treasury’s analysis must be taken into account when assessing whether the bill is paid for.
Increased IRS funding would raise revenue, reverse long-standing neglect, and address inequities
The Build Back Better Act’s tax compliance effort would reverse years of budget reductions and neglect that have substantially eroded the IRS’ ability to enforce the nation’s tax laws. This neglect has had serious consequences: Estimates of the annual revenue loss from taxes that are legally owed but not paid range from the roughly $600 billion estimated by the Treasury Department to the more than $1 trillion identified by IRS Commissioner Charles Rettig in testimony before the Senate Finance Committee earlier this year. Absent additional resources, nearly $1 out of every $6 in taxes will go unpaid over the next decade.
The tax gap—the difference between taxes owed and those paid—worsens inequities in the tax code. Wage and salary workers typically pay taxes on virtually all of the income they earn because their earnings are reported to the IRS. Research shows that wealthy taxpayers are often able to avoid a large share of what they owe, with the top 5 percent of earners accounting for more than half of the tax gap. This disparity exists largely because high-income individuals are more likely to receive income that is subject to no or minimal reporting requirements and because of their use of accountants and advisers who help them avoid paying the taxes that they actually owe.
Diminished resources and staffing reductions—the IRS has lost 17,000 enforcement personnel over the past decade—have particularly affected the agency’s ability to examine complex tax returns and address new sources of evasion, such as the cryptocurrency sector. While reduced resources have caused a sharp decline in audit rates of large corporations and wealthy individuals, enforcement efforts targeting low-income workers—those who file simple returns but claim the earned income tax credit—have declined at a much slower rate so that they are now audited at roughly the same rate as the top 1 percent. This only further exacerbates inequities in the tax system. The Build Back Better Act would explicitly provide new resources for efforts that address this inequity, giving the IRS the capacity needed to tackle sophisticated tax evasion and targeting new efforts at high-income individuals and corporate taxpayers.
The CBO’s official score will likely exclude savings from tax enforcement due to scoring conventions
The CBO’s topline estimate of the Build Back Better Act’s impact on deficits will diverge from the White House estimates because of how the CBO scores IRS enforcement. The most basic reason for the divergence is that the CBO uses scoring guidelines that exclude savings attributable to program management efforts—such as the tax enforcement initiative included in the Build Back Better Act—but include the cost of funding appropriated to support such initiatives. Following CBO guidelines, the score of the Build Back Better Act’s tax enforcement initiative would include as a cost the approximately $80 billion in new budget authority for the IRS over the next decade but exclude the increase in revenue that would be generated by that investment. The CBO may provide an estimate of the revenue gain; if so, it would most likely not be incorporated into the final score.
Treasury estimates of tax compliance revenue err on the side of caution and should be taken into account, notwithstanding more conservative CBO analyses
The Build Back Better Act would enable the IRS to invest in modern technology along with the staff needed to build the agency and improve taxpayer services and enforcement. The $400 billion estimate of revenue that would be raised by the compliance initiative—released by the White House and based on an analysis prepared by the professional staff of the Treasury Department’s OTA—concludes that investments in IRS enforcement, which the Build Back Better Act targets at high-income individuals, complex partnerships, and large corporations, would accomplish the following: 1) provide a high direct return on investment; 2) generate increasingly more revenue over time; 3) have a beneficial effect on voluntary compliance when coupled with investments in technology and taxpayer services; and 4) have a large deterrent effect that is not included in many analyses of the revenue effects of IRS investment. The Treasury analysis concludes that the proposed investment in IRS capacity would lead to about $640 billion in added revenue but cautiously assumes a net benefit of $400 billion for budget scoring purposes consisting of $320 billion from direct enforcement activities and $160 billion from increasing voluntary compliance, minus $80 billion in added costs.
Other estimates, including a noted effort led by two former IRS commissioners, conclude that reasonable compliance efforts could generate as much as $1.4 trillion over 10 years—more than triple the Treasury’s Build Back Better Act estimate—through investments in technology, improved reporting requirements, and increased staffing. Moreover, the OTA analysis does not assume that the Build Back Better Act’s substantial investment in new technology will result in additional revenues, despite substantial evidence that modern technology and improved service boost taxpayer compliance. Lastly, an op-ed authored by five former Treasury secretaries, who served under both Republican and Democratic presidents, echoes the argument that President Joe Biden’s original enforcement proposal “if anything, is modest” and notes that former IRS commissioners have estimated that the agency could collect $1.6 trillion over a decade by investing in technology and enforcement.
The CBO has previously underestimated the revenues that increased enforcement would raise. Research by former Treasury secretary and Harvard economist Larry Summers and University of Pennsylvania professor and current Treasury official Natasha Sarin examine the reasons why past CBO estimates have come in below those of the Treasury Department and other efforts:
- Past CBO estimates do not account for a deterrence effect; that is, the CBO does not assume that stepped-up enforcement will lead to greater compliance outside of specific enforcement activity. Its most recent analysis dismisses the effects of investments in the IRS on deterrence, stating only that the effect on voluntary compliance would be modest. However, evidence suggests that deterrence has a substantial impact on tax compliance, with one study finding that taxable income reporting increased by an amount equal to 2.9 percent of average income following an audit.
- The CBO ascribes minimal—if any—gains from improvements to the IRS’ antiquated technology. The IRS’ software system, which was developed in the 1960s, is the oldest in the federal government, and the agency lags far behind the private sector with respect to information technology spending.
- The CBO assumes, without evidence, that the return on additional investment will diminish significantly over time. While at some point, returns would no doubt fall, the magnitude of the tax gap makes a large drop unlikely in the foreseeable future. The OTA estimate, for example, projects that the Build Back Better Act will close less than 7 percent of the gap in tax collections forecast for the next decade, leaving a substantial share of the gap left to be closed.
- A September 2021 CBO analysis of the Build Back Better Act proposal suggests that the CBO does not fully reflect the administration’s plans to target new enforcement activity to wealthy individuals and large corporations, where the decline in audit rates has been most severe due to limited IRS capacity. The percentage of individuals audited with incomes in excess of $10 million, for example, dropped by 8 percent between 2010 and 2018, compared with a 46.3 percent drop for individual tax filers as a whole. Reversing that trend will likely have a major impact on revenues: Each hour that revenue agents spend auditing the richest taxpayers generates more than $4,500 in tax adjustments, according to the Treasury’s inspector general for tax administration.
The CBO’s estimates are advisory in nature and are intended to help lawmakers assess the impact of legislation under consideration and determine whether it complies with congressional budget rules. Lawmakers can—and should—consider other sound evidence such as that provided by the Treasury Department’s professional staff.
Stronger reporting requirements would boost revenues further
Congress could raise even more revenue by including the Biden administration’s bank reporting proposal or similar measures to improve information reporting in the final Build Back Better Act. The administration’s simple proposal would require banks to report just two pieces of information to the IRS: the total amount deposited into bank accounts each year and the amount taken out. This would significantly strengthen the IRS’ ability to crack down on tax evasion and level the playing field between those whose income comes from wages and salaries and those whose income is less likely to be covered by reporting requirements. This provision was left out of the bill in the face of fierce and misleading lobbying by the banking industry.
Rebuilding the capacity of the IRS will provide a sound source of revenue that can support the ambitious and needed investments in climate, social and community supports, education, and health care found in the Build Back Better Act. Investing in the IRS will improve the agency’s ability to communicate with taxpayers on a timely basis and ensure that they receive the assistance and benefits they deserve. Importantly, by addressing long-standing problems of sophisticated tax evasion and other enforcement challenges, it will also foster a more equitable tax system that helps ensure that the wealthiest Americans and large corporations pay the taxes they owe.
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