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Will the Added IRS Funding Create Value?

Chris Edwards

The Inflation Reduction Act (IRA) of 2022 included $79 billion in added funding for the Internal Revenue Service (IRS) over the coming decade. The funding will roughly double the agency’s budget by 2031 in nominal dollars, with 57 percent of the added funding for enforcement but just 6 percent for business systems (computers) and 4 percent for taxpayer services. House Republicans are seeking to repeal most of the new funding as part the debt negotiations.

The $79 billion IRS funding increase is projected to raise tax revenues $180 billion over the coming decade, for a net gain of $101 billion. Supporters conclude this indicates a high “return on investment” from the funding, and thus is a beneficial policy change.

But such a return on investment is only a partial analysis. The IRS funding is a win for the government, but that does not mean it is a win for society. As best as they can, policymakers should try to compare the overall benefits to society to the overall costs.

Let’s look at the cost side. Costs will include the $79 billion in resources consumed by the IRS plus possibly higher compliance costs on the private sector from raising $180 billion. Income tax compliance costs may be about 8 percent to 10 percent of tax revenues, which suggests perhaps $14 billion to $18 billion in costs. There may be additional costs for tax planning, post‐​filing activities, tax lobbying, and other items. So rather than $79 billion, the IRS plan may consume close to $100 billion in resources.

Now let’s look at the benefit side. The government will raise a net $101 billion to be used for added spending. But this amount is not the net benefit to society because it will displace private spending. Let’s be optimistic and assume that the new federal spending will be worth 50 percent more than the private spending displaced. In that case, the plan to beef up the IRS will generate $51 billion in net benefits above the benefits of alternate private‐​sector spending.

So tallying up, IRS funding and added compliance costs may total $100 billion, but the added spending that is funded may generate perhaps only $51 billion in net benefits. With these assumptions, boosting IRS funding by $79 billion to squeeze $180 billion more out of taxpayers is not worthwhile.

An additional cost of the IRA plan may be an increase in deadweight losses from raising the $180 billion in taxes. These losses would stem from taxpayers changing their behavior in ways that undermined output, such as reducing their working and investing.

Let’s look further at compliance costs. The bulk of new IRS funding goes toward enforcement, which may increase compliance costs because individuals and businesses would be prompted to spend more on lawyers and accountants to defend themselves against the tax agency.

Compliance costs are also expected to rise because of the IRA’s 20 or so new and expanded energy tax breaks, many with complex rules for eligibility, benefit amounts, labor standards, content sourcing, and other features. The new IRS Strategic Operating Plan (SOP) mentions the complexity of the energy provisions and estimates that they will cost $3.9 billion to administer. Private sector planning, compliance, and lobbying related to the energy breaks will also likely consume billions of dollars given that there is $1 trillion in benefits at stake.

However, there is good news from the IRS SOP. The document discusses major improvements in business systems and taxpayer services. It promises faster, more convenient, and more accurate taxpayer interactions. Unlike spending on tougher enforcement, spending on these activities should reduce compliance costs. It would be a net win for society if the IRA’s $8 billion for business systems and taxpayer services reduced private‐​sector compliance costs by a greater amount than the funding total.

In addition, improving IRS efficiency and making it easier to pay the correct taxes would improve taxpayer compliance. This is a better way to reduce the tax gap than heavy handed enforcement under our hugely complex tax system. The past National Taxpayer Advocate testified that “Complexity begets more complexity, burden, and noncompliance, as it creates opportunities for abuse, which in turn spur more complex legislation that may alienate taxpayers,” and she noted that “Complexity promotes noncompliance and contributes to the tax gap.”

For these reasons, the House Republican plan to retain funding for business systems and taxpayer services while rescinded the added enforcement funding makes sense. Improvements in the former two areas promise to save taxpayer time and money, while also boosting voluntary compliance and reducing the tax gap.

Indeed, providing a further funding boost for business systems and taxpayer services could be a compromise between the parties in debt negotiations. The SOP says that the current IRA funding for these two functions will not be enough: “We will need an ongoing investment on top of the allocated IRA funding to deliver all of the transformation objectives outlined in this Plan in taxpayer service improvements and information technology modernization.”

Policymakers should pursue additional IRS reforms, and they should put major tax‐​code simplification on the agenda. In the meantime, there are many worthy initiatives in the SOP that the IRS should pursue and policymakers should closely oversee.

More on the IRS here, here, here, and here.

Data Note: The 8 percent compliance cost is based on Scott Hodge’s estimates here for just the individual and corporate income taxes. Compliance costs are rough estimates, and the average costs I’ve cited here don’t necessarily equal the marginal costs.

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