Cracks in the System: The Consequences of Underfunding the IRS

Tax Day is a reminder of the urgent need to fund the IRS adequately. The yearly  appropriations process has produced a steep decline in the IRS’s budget since 2010, even while the IRS faces a larger population and economy, and new essential responsibilities. This year, the budget continued to fail to meet the agency’s severe resource needs. The IRS has made short-term patches in the face of inadequate funding, but such patches are not a sustainable solution and have costs that are showing. The cracks in the agency and the impacts for taxpayers will become larger unless lawmakers act to secure adequate long-term funding for the agency.

By Michael Kaercher and Chye-Ching Huang

Tax analysts, practitioners, business leaders, and officials have written (and written, and written) about the need to adequately fund the IRS. As we approach this tax day on Monday, April 18, what’s new since last Tax Day?

The cracks in the agency after a decade of cuts and underfunding are clearer. The agency has large backlogs in processing returns, and it does not have enough people to answer most phone calls. Its ability to perform its core function of collecting the revenues that fund the government has been weakened by severe funding cuts and attrition of enforcement personnel. Meanwhile, the agency faces new demands on its resources in areas where it is uniquely suited to play an essential role, from implementing pandemic emergency economic policies to tracing Russian oligarchs’ assets for sanctions enforcement. The annual appropriations process, which the IRS depends on for its budget, again this year failed to meet the IRS’s acute needs.

Lawmakers should provide predictable, sustained funding for the IRS, such as the proposal the House has already passed. That would enable the IRS to rebuild its depleted staff, upgrade its outdated computer systems, help filers understand and meet their tax obligations, and shrink the $600 billion per year (or more) “tax gap” of taxes owed but not paid.

Another year of inadequate appropriations

The annual appropriations process has starved the IRS for over a decade and precluded the long-term investments it needs to make to be more effective and efficient. Appropriations legislation for Fiscal Year 2022 was finally passed on a bipartisan basis on March 10. This most recent round of government funding provides modest improvements that fall far short of what is needed.

Compared to last year, total IRS funding increased by less than 6% without adjusting for inflation. (Within that, funds for IRS business modernization received a more substantial bump but make up a relatively small share of the overall IRS budget.) However, after adjusting for inflation, this year’s funding increase is substantially lower than 6% and leaves the agency overall with about 20% less funding in real terms than in 2010, including 24% less for its enforcement function. In addition, the IRS is in dire need of IT modernization and restaffing. These needs demand long-term certainty and investment, which ongoing mandatory funding is better able to provide.

More emergencies and responsibilities

The IRS is often uniquely suited to take on essential new responsibilities in times of emergency. The Service has direct contact with most households and businesses, and it is also set up to unravel complex financial arrangements when it investigates tax evasion, money laundering, and other illicit activities.

When the COVID-19 pandemic and recession hit, lawmakers turned to the IRS to implement brand new tax credits for businesses, and to distribute nearly a trillion dollars in cash assistance to families through three rounds of stimulus payments and monthly advance payments of the Child Tax Credit. Its pandemic-related responsibilities are far from over: this filing season will involve many filers and the IRS navigating new responsibilities related to claiming outstanding stimulus and Child Tax Credit payments on their 2021 tax returns.

The IRS is also integral to cross-government efforts to investigate fraud, such as identity theft related to pandemic relief for both individuals and businesses. IRS Criminal Investigations (IRS-CI) has already uncovered $1.8 billion in COVID-19 relief fraud. For example, in one case, stolen identities were used to secure Paycheck Protection Program loans — and the proceeds were used to buy luxury homes, gold coins, and designer handbags. While the IRS received one-time funding for some of these new responsibilities, the IRS is considering redirecting some of these resources to its other dire needs due to insufficient funding, IRS Commissioner Rettig testified recently.

Further, as our colleague Sophia Yan explained in a post for Just Security, IRS-CI is now working with other agencies to enforce sanctions against Russia, because of IRS-CI’s expertise in untangling complex and illicit financial flows (which are often intimately linked with tax evasion). But Congress did not supply the IRS with additional funds needed to undertake these activities.

More cracks showing: hurting honest filers and benefiting the unscrupulous

The severe under-resourcing of the IRS makes it unsurprising that recent stories include:

• A phone response rate as low as 11%. In fiscal year 2021, the IRS was able to afford just one customer service representative for about every 18,000 incoming calls.
• A lack of basic supplies like pens and staplers at certain sites.
• Only five licenses for all of IRS-CI to databases of public records needed for sanctions enforcement.
• A backlog of nearly 24 million unopened returns and other correspondence at the beginning of this filing season — due to underfunding and the pandemic.

Without adequate funding, the IRS must resort to short-term patches. For example, to help with the backlog of unprocessed returns and correspondence, it is temporarily reassigning staff and other resources from other parts of the agency, including resources previously set aside for critical IT upgrades. That might be the best option right now, but it means that for a time those staff won’t be doing their normal work in areas ranging from customer service to examinations, which could create future delays and pressures in these other operations. Indeed, part of the explanation for this filing season’s backlog is that last filing season, the IRS faced increased demand for phone service, which pulled staff away from addressing the backlog, since the IRS employees who answer the phones are often the same employees who process amended returns and taxpayer correspondence.

But while filers looking to the IRS to help them understand their tax obligations are having a smaller share of their phone calls answered, high-income filers who don’t pay the taxes they owe face a lower chance of being audited. Since 2010, audit rates on millionaires and large corporations have dropped by more than 70% and 50% respectively, due to the loss of about 40% of staff expert enough to audit the most complex returns. The weakened ability of the IRS to help honest filers do their tax returns correctly and efficiently, and to ensure that potential scofflaws pay the taxes they owe, are problems for the budget, for the rule of law, and for equity.

The tax system overwhelmingly relies on people voluntarily complying with their tax obligations. Research indicates that voluntary compliance depends heavily on filers believing that, broadly, people pay what they owe. A sense that the tax system allows other people to escape their tax obligations may make people less willing to pay taxes — leading to a vicious cycle of weakened enforcement and noncompliance.

Rebuilding the IRS requires adequate and stable funding

Rebuilding the IRS will take time. It is so severely depleted that there are limits to how many staff it can devote to hiring and training new staff without affecting current service and operations levels.

But before next Tax Day rolls around, lawmakers should take the first and most important step in rebuilding the agency, which is to give the IRS the predictable, sustained funding it needs to be able to plan and execute an orderly rebuild of its depleted staff, upgrade its outdated IT, serve filers, and address the tax gap. Specifically, lawmakers can enact the multi-year, mandatory funding stream included in the fiscal year 2022 budget reconciliation legislation marked up by the Ways and Means Committee, passed by the House, and introduced in the Senate. By any estimate, these measures would increase tax compliance in ways that generate far more revenue than the roughly $80 billion funding stream.

Lawmakers can also fund the President’s full request for 2023 appropriations, since every dollar of IRS enforcement funding more than pays for itself in increased revenue.

Some point to IRS inefficiencies and imperfections as a reason to continue to withhold funding. The IRS is not perfect, but there’s no sound basis to think that underfunding an agency to the point that it can’t afford personnel, technology, or basic office supplies would improve matters. Indeed, the lack of IRS funding is preventing the IRS from fully implementing the bipartisan Taxpayer First Act of 2019; while lawmakers intended it modernize the IRS and improve oversight, they didn’t provide the IRS enough funding to fully implement the law.

Others have argued that instead of adequately funding the IRS to do what the law requires of it, policymakers should just ask it to do less. But tasks like delivering tax credits that keep millions of children and households out of poverty and helping to enforce sanctions intended to achieve the nation’s foreign policy aims are critical needs that must be filled. Right now, the IRS is well suited to these tasks. Even aside from new responsibilities, funding for the IRS’s core revenue collection functions hasn’t kept pace with inflation, let alone population growth, or a larger and more complex economy. Calls to simplify some elements of the tax system make sense, but until lawmakers achieve that, the IRS must be funded to administer the laws that exist — and implementing simplifications would initially likely mean more work for the IRS, not less.

The IRS is the agency that the nation relies on to preserve the integrity of the tax system by assisting honest filers and ensuring that would-be tax cheats pay what they owe under the law. Let’s hope that by next Tax Day, lawmakers have adequately funded this critical government function.

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