More aggressive tax collections pushed as deficit reduction tool

Not so long ago, the Internal Revenue Service was the public's pariah nonpareil. But today, the IRS seems to be enjoying image rehabilitation in political circles. Its comeback, like its earlier vilification, may have more to do with the needs of politicians than the reality on the ground at the service.

Back in the mid-1990s, the IRS was pilloried, from the congressional hearing rooms to the cover of Newsweek, as a combination of the Gestapo and the Keystone Kops. Egged on by a newly ascendant Republican majority and a phalanx of anti-tax groups, Congress codified its displeasure with the agency in the 1996 Taxpayer Bill of Rights II.

As the federal government has gone from budget surpluses to 12-figure deficits, however, Congress is now casting the IRS as a potential savior. The reason: the "tax gap." That's the term in vogue to describe the considerable difference between what Americans owe in taxes and what they actually pay.

The IRS' most recent estimate, made earlier this year, put the tax gap at $345 billion for 2001, compared with $1.8 trillion in taxes paid on time that year. The IRS eventually collected about $55 billion, or 16 percent, of the unpaid sum, leaving a "net gap" of $290 billion. The IRS' figures also suggest that Americans are paying about 84 percent of what they owe.

These numbers have, not surprisingly, fueled the congressional imagination. In April 2004, Sen. Max Baucus of Montana, the senior Democrat on the Senate Finance Committee, called for 90 percent voluntary tax compliance by 2010, saying that would generate "at least an additional $100 billion each year without raising taxes."

This year, he went further, noting that "collecting all taxes legally owed in this country would significantly reduce or wipe out America's annual budget deficits," which declined to $248 billion in the last fiscal year. The IRS itself has proposed trying to increase the compliance rate 1 percentage point to 85 percent by 2009.

Hurriedly and with scant debate, Congress passed a measure last spring requiring the government to withhold 3 percent of its nonwage payments to government contractors this year, a proposal that would have faced much tougher sledding in the political climate of the late 1990s.

The House Democratic leadership has already said it will reach into the tax gap to help finance its agenda, should the party retake that chamber.

In the Senate -- which this year held more than half a dozen bipartisan hearings devoted largely to the tax gap and tax evasion -- the issue has been driven mostly by the ranking Democrats on key panels -- including Baucus, Kent Conrad of North Dakota on the Budget Committee, and Carl Levin of Michigan on an investigative subcommittee.

Baucus has been the most vociferous. He puts out a monthly newsletter devoted to the tax gap, homes in on the topic early and often at hearings and in press statements, and has been escalating demands on the Bush administration to address the problem.

Baucus made the issue a focal point of confirmation hearings this year on Bush's choice of Henry Paulson Jr. as Treasury secretary. He blocked Eric Solomon's nomination as assistant Treasury secretary for tax policy until the department gave him its plan for closing the tax gap. Baucus then declared that the report lacked "specific benchmarks, timetables, and goals" and that he would keep Solomon's nomination on hold.

Treasury spokesman Sean Kevelighan said that the department believes it met Baucus' requirement. Narrowing the tax gap is "a multifaceted, long-term effort" that requires cooperation between the administration and Congress, and an aggressive approach that is also "sensitive to taxpayer rights," Kevelighan said. The failure to confirm Solomon, he added, has hampered Treasury's efforts.

Baucus and other crusading senators have some compelling talking points: The laggards not only are sticking honest taxpayers with an extra burden but also are undermining the whole system of voluntary compliance.

There's little question that enforcement efforts took a hit after the 1996 law was enacted. "Congress blasted the IRS out of its shoes, and the IRS responded by not enforcing the law," says Donald Alexander, IRS commissioner during the 1970s and now a partner at the law firm Akin Gump Strauss Hauer & Feld. Instead, based on what Alexander says was the naive notion that "an educated taxpayer will comply," the service began a big push to help taxpayers figure out what they owed.

Meanwhile, the percentage of individual returns subject to a "face-to-face" audit fell from 1.19 percent in 1984 to 0.72 percent in 1994, and to just 0.15 percent in 2004. IRS enforcement did get an infusion of money and people in the past two years, but the number of skilled personnel is expected to level off, and is still well below what the agency had in the late 1990s.

To find other ways to get Americans to pay more of what they owe, Congress has solicited reports and recommendations from the Government Accountability Office and the Joint Committee on Taxation, as well as from Treasury and the IRS. Having observed how little cheating happens when third parties -- such as employers, banks, and mortgage companies -- report details of taxpayers' income or deductible expenses, or withhold the amount that taxpayers owe, most studies recommend new reporting or withholding requirements.

Several have recommended pressing investment managers to report the original purchase value of stocks to more accurately determine capital gains and losses, for example. Some studies suggest that local governments should provide a more detailed breakdown of a homeowner's assessment, because any portion of property taxes used by a municipality for street or sewer projects that directly benefit the homeowner are not deductible.

But how much money Congress can reasonably expect to extract from the tax gap is far from clear.

For starters, the IRS estimate itself is shaky. The agency used to make estimates based on data gleaned from its most extensive, line-by-line audits, but the IRS stopped doing these unpopular audits in 1988. Until recently, the service was estimating the tax gap by extrapolating from the 1988 data. The IRS' latest estimates cobble together information from a variety of sources and apply some economic modeling techniques.

A report by the IRS' independent inspector general in April concluded that the service didn't have enough information to make an accurate estimate of the tax gap, and it warned that acting without good data could lead to "inappropriate decisions." Although the IRS report shed some light on the sources of the tax gap, for instance, it could not determine how much noncompliance results from willful cheating versus honest mistakes.

A recent GAO report noted that enforcement efforts that initially seem cost effective invariably get more costly as the IRS works from the easiest cases to the more difficult ones.

It's also not clear that the U.S. tax gap is getting worse -- IRS figures on compliance haven't varied substantially over time -- or that other industrialized countries do better. "Most countries would be thrilled to have a voluntary compliance rate of almost 84 percent," Mark Mazur, the IRS' director of research, analysis, and statistics, told the Senate Finance Subcommittee on Taxation and IRS Oversight in late July.

Moreover, IRS crackdowns invariably face some political push-back. Consider that the largest single source of unreported income is self-employed business people, aka mom-and-pop businesses and independent contractors. A whopping 57 percent of "nonfarm proprietor" income isn't reported, for a total of $68 billion -- accounting for more than a third of the total estimated underreporting for the individual income tax, according to IRS data.

Baucus suggests that the foot-dragging he sees from the Bush administration on the tax gap may in fact be political. "This may step on some toes, and that's not something [the Bush administration and Treasury] want to do," Baucus said in a mid-October interview.

But the same could be said of many members of Congress. No sooner did the IRS announce that it would scrutinize a random sample of a certain type of small business known as "S-corporations" than the House Small Business Committee called a hearing last April to berate the IRS commissioner for unfairly going after small businesses.

At the House hearing, the complaints against the IRS were bipartisan. Anti-tax crusader Grover Norquist says that Baucus' current standoff with Treasury suggests that Democrats don't want to lead a crackdown, either. "He knows that Democrats introducing legislation [to reduce the tax gap] is not likely to be a winner," Norquist says. "He wants the president to slit his own wrists and to impose measures on his own. I don't think the administration will fall for that."