TaxProf Blog op-ed: Are We Ready for a Federal Ready Return System? Or Who Ya Gonna Call?, by Bryan T. Camp (Texas Tech):
This is the time of year where thoughtful people raise what seems like a very basic question: why does preparing taxes have to be so complicated? For example, in a recent New York Times op-ed [Filing Taxes in Japan Is a Breeze. Why Not Here?], Mr. T.R. Reid opines that our government should be able to what governments in other countries do: pre-populate tax forms. Mr. Reid says that in these other countries (Japan and the Netherlands are the two he cites),
[t]he taxpayer just has to check the numbers. If the agency got something wrong, there’s a mechanism for appeal. Our own Internal Revenue Service could do the same for tens of millions of taxpayers. For most families, the I.R.S. already knows all the numbers — wages, dividends and interest received, capital gains, mortgage interest paid, taxes withheld — that we are required to enter on Form 1040.
I am totally sympathetic to the basic thrust of Mr. Reid’s op-ed (which is also the thrust of his new book [A Fine Mess: A Global Quest for a Simpler, Fairer, and More Efficient Tax System (Apr. 2017)]: the Service should be able to help taxpayers by pre-populating tax forms for them. Professor Joseph Bankman has been a leading voice for such a program and, thanks in part to his advocacy, the State of California has what it calls a “Ready Return” system. NPR did a nice podcast about it on March 22, 2017. So if these other countries can do it, and if California can do it, why cannot the federal government do it?
I’ll tell you why. There are three significant operational barriers the IRS must overcome to help taxpayers by pre-populating forms online. And there is also one good normative reason why the IRS should hesitate to go as far as Mr. Reid and others advocate.
Congress is a Barrier
The first barrier is Congress itself. By that I do not mean simply that evil industry lobbyists are blocking legislative action. There is certainly some truth to that, as explained here. And Professor Les Book has a good post about Senator Warren’s legislative efforts here. But one also sees efforts in Congress to require the IRS to do what Mr. Reid and others advocate for low-income taxpayers who face particular difficulties in completing their tax returns. For example, Sections 2004 and 2005 of the 1998 IRS Restructuring and Reform Act (found at 112 Stat 726) required the IRS to “develop procedures for the implementation of a return-free tax system” and to “develop procedures under which a taxpayer filing returns electronically...would be able to review the taxpayer's account electronically, but only if all necessary safeguards to ensure the privacy of such account information are in place.”
And one sees the IRS actually trying to move towards what Mr. Reid, Professor Bankman, and others advocate. For example, in 2011, Commissioner Shulman initiated what the IRS called “Real Time Tax System Initiative” which would have taken the data the IRS had received from third parties (employers filing W-2’s, banks filing 1098’s and others filing 1099’s) and matched those numbers in real time when a taxpayer submitted an electronic return. If the numbers did not match, the taxpayer would need to take additional steps to verify that the information on the taxpayer’s return was correct. As the eminent Professor T. Keith Fogg noted in his testimony supporting the initiative: “Returning to a partial pre-assessment review of returns based on technological advances brings back many of the benefits that existed in the original practice [of IRS conducting audits prior to assessment].” For those with insomnia or who actually love history, I wrote a long boring article about those original tax audit practices here.
So if Congress has required the IRS to do something in a statute and if the IRS started to try something in 2011, what’s the holdup? Nothing has happened since. Why not?
Well, one could once again blame industry lobbyists as this article did in 2013.
But the more likely reason is simply this: Congress is starving the beast. Since 2010, Congress has made increasingly severe budget cuts to the IRS. I wrote about this two years ago. The situation has only gotten worse.
To overcome this first barrier does not require Congress to write a new statute; it requires Congress to fund the agency sufficiently to accomplish the task. Good luck with that.
Technology Is A Barrier
The second barrier to taxpayers being able to logon to their federal tax accounts like they do their bank accounts and then review a pre-prepared tax return is technology. The Service is just a long, long, long, long, long (and long!) way from developing a taxpayer accounting system that could produce reliable and secure pre-populated returns. The Service has been trying to update its computer systems since the late 1970’s! But for a variety of reasons (plenty of fault to go around) it has only been able to created networks of computer systems piggybacked on the backbone of what is called the “Master File System” which is a system designed and implemented in 1964 and physically still housed in the IRS Computing Center in Martinsburg, W.Va. (thanks Senator Byrd!).
The IRS has simply not been able to integrate the various systems into one. It’s trying. The name of the system that is supposed to integrate everything is called CADE (Customer Account Data Engine). Folks, when I was an attorney in the IRS Office of Chief Counsel, I was working on a data element committee for CADE in the mid-1990’s. CADE was a work in progress then and is still a work in progress now. Here’s a good review from last year of that (lack of) progress. As with other efforts, CADE has been only partially successful and it is now looking like it’s going to be just another add-on.
Complexity of Tax Is a Barrier
The third barrier preventing a seamless and screamless tax filing experience for honest taxpayers is the substance of our tax laws. Even if the statutory barriers were removed AND the Service magically obtained Star Trek computers to handle all taxpayer accounts, there is yet a more fundamental barrier to Mr. Reid’s ideal “let the government do it for you” approach: the complexity of our system of taxation compared to other countries. I can, offhand, think of three complexities that hinder a successful pre-populated return system.
First, go back and read that quote I gave from Mr. Reid’s article up at the top. Notice he claims that the IRS “already knows the numbers.” Well, yes and no. He is correct that third party information returns are generally accurate. But there are significant exceptions where the third party information returns are flat-out wrong. Caleb Smith has a great post on faulty information returns over on Procedurally Taxing.
Even if the information returns are accurate, however, that is only in terms of the amount of payments. They are not necessarily accurate on the amount of reportable income. Third parties must report only payments they make to a taxpayer. Whether those payments count as “gross income” that is reportable depends on what potential exclusions apply.
Here’s a quick example: when my grandmother died she left her home to her three grandchildren (me and my two sisters). As executor, I sold the home and split the $32,000 gross proceeds with my sisters (hey, it was a small house in Houston during a read estate downturn). But the title company sent a 1099 reporting that it had paid me $32,000. That was indeed accurate. But only 1/3 of that amount was actually for me, so the 1099 was wrong on the numbers. And none of it was gross income because of the exclusion for gifts in section 102.
Mr. Reid and others might claim that taxpayers could simply fix the incorrect 1099’s in a pre-populated return. Errrrr, well, yes, if the taxpayers know the tax law. And this is really the crux of it. Sure, maybe most taxpayers know that money and property inherited from grandma is tax free. But more taxpayers simply “follow the forms.” If it’s on a form, they think it’s income. If it’s not on a form, they don’t think they have to report it. The tricky part is knowing all the exclusions. That’s where taxpayers need much more help than they can get from a pre-populated form using third party data.
The second complexity of our tax system is the scope and gnarliness of deductions and credits. The Service has no idea what deductions or tax credits each taxpayer is allowed. Moreover, each taxpayer is responsible for proving up all deductions or credits claimed. Now, it is true that about 2/3ds of taxpayers don’t itemize deductions. But one of the most complex deductions is not an itemized one. It’s the dependency deduction. Trying to figure out who is a dependent under the rules in section 152 is incredibly difficult for a large percentage of taxpayers, particularly low income taxpayers who have unstable or fluctuating living arrangements. While the IRS may have “the numbers” as Mr. Reid wants to believe, it certainly does not have the information to guess at what deductions and credits taxpayers may claim. Again, figuring that out is where taxpayers need help.
The third complexity is that our system of taxation discriminates against labor income. We impose as significantly smaller tax on gains from capital: the sale or exchange of property held for more than one year. Go compare Mitt Romney’s Tax returns for 2011 with Hillary Clinton’s. You can find them here. They each reported about $15 million in income. But Romney paid about half the taxes that Clinton paid. Why? Because she worked for her money, but Romney’s money worked for him. His gain was all from capital; hers was from labor.
Distinguishing between capital gain and ordinary gain is hellishly complex and would make it very difficult for the Service to pre-populate returns for taxpayers, even regular middle-class taxpayers like most of you who are reading this blog post. Say you sell your home. What gain must you report? What is the character of that gain? Those are not easy questions and, again, most taxpayers need help in figuring them out.
I see these three complexities on a regular basis in situations where the Service does already prepare a taxpayer’s return. That is, currently, when the Service receives third party information returns on a taxpayer but there is no corresponding Form 1040 from that taxpayer, section 6020 authorizes the Service to create a return for the taxpayer, mail it to the taxpayer’s last known address, and give the taxpayer 90 days to come in a protest the proposed return. This the Service does via one of those add-on computer systems I mentioned, called the Automated Substitute for Return system (ASFR). Those returns, however, assume the worst filing status for the taxpayer (remember there are five to choose from), assume the taxpayer has no deductions other than the standard deduction, and assume that all payments reported are gross income that must be taxed at ordinary rates. It is very, very rare that all of those assumptions are correct.
If the Service were to implement a pre-populated return system, I suspect that taxpayer confusion and consternation would be little different than it is now---the difficulties would just come out at a different point in the processing stream.
The Normative Barrier: Who Should Help Taxpayers?
So far, I’ve described three operational barriers to achieving Mr. Reid’s dream state of taxpayers being able to discharge their tax obligations with a few mouse clicks. Here I would offer another consideration for readers who have gamely made it this far....or who just skipped here: Who ya gonna call?
Even if the IRS could pre-populate returns, someone still has to help taxpayers figure out (1) what income must they report as gross income; (2) what expenditures may they claim as deductions; and (3) what tax credits may they claim. The normative question is: who should help taxpayers figure that stuff out?
In an intriguing 2007 article, Professor Lawrence A. Zelenak argues there is a “civil virtue” in forcing taxpayers to go through the yearly ritual of filing their tax returns. The virtue is that the yearly agony keeps taxpayers aware of the tax system and the filing provides a ritual enabling taxpayers to see their connection with their government.
I don’t go quite so far. Taxpayers could get very similar civil virtues from online tax return preparation and filing. To analogize, the fact that I can now renew my car registration online and no longer have to interact with the Department of Motor Vehicles has actually improved my relationship with my state government! And a 15 minute ceremony is way better than a 15 hour ceremony. So I don’t think a ready return system in the U.S. would undermine taxpayer connection to government.
I do believe, however, that requiring taxpayers to prepare their own returns has a positive effect on tax compliance and taxpayer understanding of the idea of “rule of law.” Taxpayers bear the responsibility to confront their finances and figure out what taxes they owe as a consequence. A tax system where government agents (whether electronic or human) prepare returns or where individuals work directly with government agents (again, either electronic or human) creates an us/them situation where taxpayers (us) must confront IRS agents (them).
I prefer that taxpayers be able to work with other private individuals (other us’s) to help them ensure they are complaint with the law. That’s what, in theory, the tax-return preparation industry should be doing. This is a familiar task for any attorney. Lawyers help clients comply with the law, but not as an adversary. The same should remain true for tax return preparation. No matter how genuinely the individual IRS employee wants to help that taxpayer on the phone, the social roles create an unavoidable tension. If tax return preparers are the main source of taxpayer compliance with the law, however, then it’s a cooperative endeavor where taxpayers work with other private citizens---other “us’s”---to ensure they are compliant. It’s not the police telling them to comply; it’s their fellow citizens.
My bottom line on the question of ready-returns is that taxpayers will still need help to comply with the law and that help may be better coming from the private sector. Operationally, while the IRS tries valiantly, it is not able to help taxpayers answer all those questions. Every year, the National Taxpayer Advocate wrings her hands over the poor customer service that taxpayers receive when they try to call in for help. And normatively, as I’ve just described, I think it preferable that citizens help citizens.
My ideal is far from current reality, however, so long as a significant percentage of tax return preparers remain unregulated and unlicensed. The tax system suffers from both foolish and nefarious tax return preparers. The IRS can and should require that all taxpayers who need help with their taxes should seek help from tax return preparers who are adequately trained and certified, either under a state or federal licensing regime. For those who are interested, I wrote this article about the problem of unregulated tax return preparers and how the IRS can help protect taxpayers by using current statutory law to ensure that return preparers are competent and ethical.