Opinion pieces and speeches by EPI staff and associates.
[ THIS TESTIMONY WAS PRESENTED BEFORE THE U.S. HOUSE OF REPRESENTATIVES' COMMITTEE ON SMALL BUSINESS ON APRIL 5, 2006. ]
The bulls-eye is on efficient government
The IRS, small business, and tax administration
I would like to thank the Committee for the opportunity to present my views. I particularly compliment Chairman Donald Manzullo, who deserves credit for opening this issue up to vigorous debate.
The dramatic shift in the budget outlook since 2001 will compel a search for revenue. About this there should be no doubt. Projections from the Congressional Budget Office document the inevitable growth in deficits, primarily due to the national demand for increasing expenditures on health care.
While there should be no dispute that tax cuts have played an important role in current and near-term deficits, it does not follow that rescinding the cuts solve the long-term problem. Even with a budget that was balanced next year, the budget outlook would be unsustainable in the long run.
The rising demand for health care spans both the public and private sectors. It is said that “we” cannot afford it. But if “we” don’t pay, somebody must, or somebody must forego medical care. Economies can surely be squeezed out of the system, but the fact of growing usage of health care services would remain, along with increasing costs. There are few less-pressing issues in public policy today.
Earmarks and other controversial uses of discretionary spending are often pointed to as culprits in deficits, but the fact is that under current trends, the entire discretionary budget could be zeroed out and the deficit problem would remain. Revenue increases will be inescapable.
Thus far the nation has enjoyed a bountiful tax holiday resulting from the willingness of foreigners to buy U.S. Federal debt. Absent this indulgence, which cannot persist indefinitely, interest rates would rise and real damage to the economy would follow.
Congress would be compelled to act. It will be compelled to act. Few informed observers expect current trends in the trade deficit to endure.
Tax increases will be required, but the logical distaste for tax hikes will encourage a look at the tax gap. By the latest estimates, nearly $350 billion a year in Federal taxes are not paid voluntarily and on time. This is the same order of magnitude as the cost of tax cuts enacted since 2000.
To its credit, the Bush Administration has recognized the potential for improved enforcement by proposing modest measures to reduce the tax gap. They have also defied the misgivings of some economists and scored the returns to their proposals, to the tune of $3.6 billion over ten years. Compared to the proposed increase of $46 million in IRS outlays, this is an impressive return. Estimates of the payoffs from assorted enforcement measures indicate there is much more where that came from.
Unfortunately, the $46 million is not maintain the IRS budget in the face of inflation, so only $46 million more for enforcement means less resources for other IRS functions. A single percentage point of inflation reduces IRS resources by over $100 million.
The Bush proposals and upgraded enforcement since 2001 constitute a modest U-turn from the disastrous legislation of 1997 that reduced the ability of the Internal Revenue Service to enforce the law. This legislation followed hearings in the Senate featuring testimony by witnesses of grave abuses by the IRS.
We should not doubt that the IRS would be the first to admit that abuses have occurred in the past. The respected periodical Tax Notes reported that the specific charges aired at the hearings were later investigated by the General Accounting Office and found to be without foundation. The GAO report was never released to the public. It sits somewhere in a file cabinet, mute testimony to the potential for public hysteria to motivate ill-considered legislation.
The IRS is engaged in careful study of the roots of the tax gap, under the auspices of the National Research Project. This research should be augmented to cover all sectors of the economy, not confined to individual returns. Additional investments will be required, but it will be money well spent. The better the information, the more effective the IRS will be in allocating dollars to improved compliance, and the better they will be in finding the right bulls-eye.
In past research, evasion rates for small business have been found to be particularly high. Worries about unfair emphasis on unincorporated business are natural. I would encourage the following points as a way towards a better perspective on this matter:
• The big fish in tax evasion are high-roller tax shelters, crafted by the same sort of accounting legerdemain that gave us the Enron debacle. They are holders of offshore accounts that hold undeclared income. They are blue-chip corporations, accounting firms, and attorneys able to outgun the IRS in litigation, due solely to their resources and not the merits of their case. They are recipients of unreported capital gains – the income of the truly rich in America. Genuinely small business firms – as opposed to very short people with high profits – are not the top priority in this game. Even a business person with net income of $100,000 had income well over that of 80 percent of Americans in 2001.
• From a benefit-cost perspective, it would behoove the IRS to focus on business firms with high income and many employees because, after all, that’s “where the money is.” Businesses struggling on the margins of profitability with low income and few workers are not likely to owe much in the way of taxes in the first place. From a revenue standpoint, the logical course for the IRS is to pursue opportunities with low cost and high payoff, free of reverse favoritism.
• If the IRS estimates of evasion are correct, it is likely that some taxpayers are enjoying unfair advantage over others with whom they compete. On top of unfairness, this is bad for the productivity of the sector, entrepreneurship, and the economy as a whole.
• One such advantage is the use of “off-the-books” workers, including those who have entered the country illegally. For such workers, the greatest tax would be on payroll. Increasing the IRS capacity to enforce the payroll tax would augment enforcement of immigration laws, reduce the adverse affect of immigration on low-wage labor market, and not incidentally improve the outlook for Social Security.
• Regarding the IRS interest in classifying so-called “independent contractors” as small business, we might consider that every worker is a small business, and as such they deserve the full benefits of fair labor standards.
• With additional resources, the IRS could do more to assist taxpayers of all types. In this context, Bush Administration proposals to reduce funding for taxpayer assistance and technology modernization are ill-advised. In the same vein, closing walk-in centers and neglecting the potential of the voluntary tax assistance community are the wrong direction to go.
• Tax enforcement entails much more than sensational raids by IRS agents and high-stakes criminal prosecutions. There is also increased information reporting, withholding of taxes on non-labor income (as on labor income), and e
xpanded collection of tax debts that are already known to the IRS.
• Simpler taxes would be easier to comply with, and easier to enforce. Tax changes since 1997 have gone in the wrong direction on this count. In general, broader tax base – fewer deductions, exclusions, and credits – enable lower tax rates. Lower rates reduce the incentive to spend time and money exploring legal tax avoidance, as well as the incentive to cheat.
• If there is one danger to small business, it would be the possibility of enactment of the national sales tax as a replacement for the current system. This tax would put the entire responsibility for tax payment on retail merchants. As such, it would focus the entirety of tax enforcement on these same people. In effect we would see an IRS person behind every cash register.
For all of our problems, the U.S. tax system relies substantially on voluntary compliance. The absence of a need for onerous enforcement measures is an asset to the U.S. economy, including our competitiveness in world markets. This invaluable asset deserves the highest safeguards, not least because of the problem noted above – America’s unsustainable economic imbalances in the Federal budget and international trade.
A favorite cartoon of mine shows a suburban homeowner standing in his doorway. In the wake of a nuclear war, nothing is left of the houses on his block but the facades. With singed hair and tattered clothes, he is scanning his mail, complaining “Bills bills bills!”
I hope we all gain the best perspective on where we are in the matter of tax enforcement. Thank you again for the opportunity to address this committee.
Max B. Sawicky is an economist at the Economic Policy Institute in Washington, D.C.
[ POSTED TO VIEWPOINTS ON APRIL 6, 2006. ]