The Center's work on 'Federal Tax' Issues

The Center analyzes major tax proposals, examining their likely effects on the economy and on the government’s ability to address critical national needs, especially over the long term. We place particular emphasis on the effects of tax proposals on households at different income levels. In addition, we analyze trends in the level of federal revenues, income distribution, and tax burdens.


IRS Funding Cuts Likely Mean More Tax-Credit Errors

December 11, 2014 at 11:00 am

Even as the Treasury Department’s Inspector General noted a significant overpayment rate in the refundable part of the Child Tax Credit (CTC) this week, lawmakers chose — in the pending 2015 government funding agreement — to weaken the IRS’s ability to reduce errors in this credit and other parts of the tax code by once again cutting IRS funding to enforce and ensure compliance with the tax rules.  And, while lawmakers such as Senator Orrin Hatch (R-UT), the Senate Finance Committee’s top Republican, assailed the IRS for failing to address the errors, the Treasury and IRS have recommended a series of measures to Congress to reduce errors in the tax credits and other parts of the tax code — and Congress has failed to act on them (except for one very small measure included in the 2015 funding agreement).

Errors in the CTC and the Earned Income Tax Credit (EITC) — another working-family tax credit — need to be reduced (as do errors related to small businesses and various other groups of tax filers).  But the debate around this issue often is misleading and ignores three significant points:

1. Most overpayments result from unintentional errors, not fraud. IRS studies indicate that the majority of EITC errors stem from the interaction between the credit’s complex rules and complicated family and child-rearing arrangements, not fraud.  The EITC has very strict rules over who can claim a child, for example, which often trip up separated or divorced couples or three-generation families.  The CTC eligibility rules are similar.

Moreover, overclaims in these tax credits account for a small share of the tax compliance gap.  Underreporting of business income alone accounted for $122 billion of the $450 billion tax gap in 2006, the latest year for which such data are available.

2. IRS funding cuts have weakened tax enforcement. The IRS’s budget has taken repeated hits in recent years and will shrink further under the fiscal year 2015 budget agreement, falling to its lowest inflation-adjusted level since 2000.  Funding for IRS enforcement has been hit particularly hard; its 2015 funding level under the agreement is 20 percent below the 2010 level, adjusted for inflation. Yet the number of tax returns filed has grown significantly over the same period, and the IRS received substantial new responsibilities related to the Foreign Account Tax Compliance Act and the Affordable Care Act.

Because of these cuts, the IRS lacks the resources to pursue a substantial share of the questionable EITC and CTC claims that it identifies or to improve enforcement of other parts of the tax code.  For example, the IRS can use data matching and other techniques to identify questionable claims on tax returns related to the tax credits, but it cannot pursue many of those claims further because it lacks the staff resources to do so.  Due to budget cuts, the number of IRS staff devoted to enforcement has dropped by 15 percent since 2010.

3. Congress has failed to act on proposals designed to lower error rates. The year-end funding bill requires people who prepare their own returns to answer due diligence questions when claiming refundable tax credits, a useful but small measure.  But Congress has ignored an array of other, more significant proposals from the Treasury and the IRS (most of which are in the President’s fiscal year 2015 budget) to reduce errors in these credits.  These include:

  • Giving the IRS the statutory authority to require paid tax preparers to demonstrate basic competence in the rules governing these credits and other basic tax matters. The Treasury has found very high EITC error rates among returns filed by certain types of paid preparers (e.g., those who aren’t lawyers, CPAs, enrolled agents, or affiliated with a national tax preparation firm).  These preparers do not need to get any training whatsoever or demonstrate basic competence in the tax rules, a factor that contributes to tax-credit errors.
  • Requiring employers and other third parties to send the IRS information such as W-2’s and 1099’s earlier in the year to help it detect erroneous or fraudulent claims before it pays them.
  • Requiring paid return preparers to follow due diligence requirements in determining eligibility for the CTC, as they already must do for the EITC.

Senator Hatch said this week that “[t]he IRS’s inability to properly administer these refundable tax credits fails American taxpayers.”  In reality, it’s Congress that has failed American taxpayers by not giving the IRS what it needs to enforce the tax code.

New York Times Warns Against “Dynamic Scoring”

December 8, 2014 at 12:06 pm

A New York Times editorial this weekend raised several red flags about so-called “dynamic scoring” — that is, including estimates of the macroeconomic effects of policy changes in official cost estimates for tax and spending legislation.  We strongly agree.  Our recent paper making the case against dynamic scoring, and a short summary we released today, explain that:

  • Current budget estimates aren’t “static.” The Congressional Budget Office (CBO) and the Joint Committee on Taxation (JCT) incorporate in their cost estimates many changes in individuals’ and companies’ behavior in response to proposed changes in tax rates and other policies.
  • Dynamic estimates are highly uncertain. Different models and assumptions produce widely varying estimates of how policy changes would affect the overall economy.  Some models’ results depend on assumptions about how future Congresses will reduce deficits.  And the models all have significant gaps.
  • Dynamic estimates are prone to manipulation. Because of this uncertainty, congressional leaders will likely cherry-pick the model and assumptions that give the most favorable estimates.  That’s exactly what House Ways and Means Chairman Dave Camp did in touting the highest estimates of economic and revenue growth for his tax reform proposal — estimates more than ten times greater than JCT’s lowest ones.  (See figure.)
  • CBO did not use dynamic scoring for the 2013 Senate immigration bill. Some members of Congress claim, incorrectly, that CBO used dynamic scoring to estimate the bill’s budgetary effects.  CBO’s official cost estimate took account of the bill’s direct effect on the U.S. population and labor force.  But it did not include estimates of the bill’s more speculative and uncertain effects on the economy, such as its effects on investment and productivity.

You can follow me on Twitter at @PaulNVandeWater and my co-author Chye-Ching Huang at @dashching.

“Tax Extenders” Package Even Worse Than First Appeared

December 1, 2014 at 3:34 pm

12-1-14taxWe’ve explained that the package that emerged last week to permanently extend several temporary tax breaks (“tax extenders”) and enlarge some of them would raise deficits — thereby putting more pressure on domestic programs for cost-saving cuts — while favoring large corporations and leaving out millions of working families. Following a presidential veto threat, the package now appears dead; but as lawmakers continue to consider options for what to do about the extenders, they should recognize another serious flaw in that package: nearly a quarter of its roughly $400 billion cost would have come from expanding tax cuts for businesses, not just extending them (see chart).

In particular, the package doubled the tax credit for research and experimentation, raising its ten-year cost from $75 billion to $151 billion. Making this and other extenders permanent without paying for them would be fiscally irresponsible; expanding some of them while doing so would be even more egregious.

Our report detailed the package’s main flaws:

  • It would have given back more than half of the revenue raised by the 2012 “fiscal cliff” legislation. If it had become law, more than 85 percent of the deficit reduction achieved since 2010 would have come from budget cuts rather than new revenues.
  • Congressional Republicans insist that future congressional budget plans balance the budget in ten years with no new revenues, cuts in Social Security benefits for current retirees, or defense cuts. Such a plan would already demand deep cuts in important areas; the extenders package would require even deeper cuts. As incoming House Budget Committee Chairman Tom Price (R-GA) said recently, “anything that’s made permanent now makes it more difficult to get to [budget] balance.”
  • While permanently extending and expanding tax benefits mostly for businesses, the package failed to extend temporary tax provisions for low-income working families with children. Those provisions — in the Earned Income Tax Credit and the low-income piece of the Child Tax Credit — lift more than 16 million people out of poverty or closer to the poverty line each year, including nearly 8 million children. Their omission would make it less likely they will continue beyond 2017, when they are slated to expire.
  • If policymakers make a number of extenders permanent now, without paying for them, they won’t have to offset the cost of making them permanent as part of tax reform. That would enable them to produce a tax reform bill that cuts the top tax rate more deeply, curbs fewer special-interest tax breaks, or both — and yet still is labeled “revenue neutral.”

4 Reasons Why the House Has the Wrong Approach to Tax Extenders

November 20, 2014 at 4:09 pm

Congress is expected during the lame-duck session to address “tax extenders,” a set of tax provisions (mostly for corporations) that policymakers routinely extend for a year or two at a time.  While the Senate has pursued temporary extensions, the House has taken a far different approach that’s flawed on both policy and priorities grounds, as our updated paper explains.

The House has: made a number of extenders permanent; permanently expanded one of the biggest extenders, the research and experimentation credit; and permanently extended some temporary tax breaks that aren’t extenders — such as “bonus depreciation,” which lets businesses take larger upfront tax deductions for purchases like machinery.  (A temporary measure to help revive a weak economy, bonus depreciation is largely ineffective.)   But it hasn’t offset any of the considerable costs.

The House approach would:

  1. Undo a sizeable share of the savings from recent deficit-reduction legislation. At a combined ten-year cost of $312 billion, the nine extenders provisions that the House Ways and Means Committee has passed this year would give back two-fifths of the $770 billion in revenue raised by the 2012 “fiscal cliff” legislation.  (The full House has already approved seven of these, costing $235 billion.)  House Republicans also are pushing to make permanent an expanded version of bonus depreciation in an extenders package; adding this to the nine Ways and Means provisions pushes the total ten-year cost to $588 billion, or roughly three-quarters of the revenue raised in the “fiscal cliff” legislation.
  2. Constitute a fiscal double standard. Failure to pay for making the extenders permanent would contrast sharply with congressional demands to pay for other budget initiatives, from easing the sequestration budget cuts to extending emergency unemployment benefits for long-term unemployed workers.  While demanding that spending measures be paid for, the House is pushing for permanent, unfinanced tax cuts that would cost much more.
  3. Bias tax reform against reducing deficits. If policymakers make the extenders permanent before they enact tax reform, a tax reform plan wouldn’t have to offset their cost to be revenue neutral.  This would free up hundreds of billions of dollars in tax-related offsets over the decade that policymakers could then channel toward lowering the top tax rate.  The resulting package would lock in substantially larger deficits than under revenue-neutral tax reform that paid for the extenders or let them expire.
  4. Place corporate tax provisions ahead of other, more important tax provisions scheduled to expire. Most notably, key elements of the Earned Income Tax Credit and Child Tax Credit will die at the end of 2017 unless policymakers act, pushing more than 16 million people in low-income working families, including 8 million children into — or deeper into — poverty.  When policymakers consider which expiring tax provisions to continue, they should give top priority to making those key low-income provisions permanent.

“Dynamic” Estimates Are Highly Uncertain, Subject to Manipulation

November 17, 2014 at 5:10 pm

An American Action Forum event today to promote “dynamic scoring” for tax and spending legislation unintentionally illustrates what Chye-Ching Huang and I explain in a newly updated paper:  estimates of the macroeconomic effects of policy changes — which is what dynamic scoring would include — are highly uncertain and subject to manipulation, so they shouldn’t be part of official cost estimates.

In reasonably balanced remarks, Senator Orrin Hatch (R-UT) said that “we should not expect dynamic scoring to produce outsized miracles from either the supply side or the demand side.”

But Tax Foundation President Scott Hodge, in giving his organization’s estimates of the effects of several tax proposals, promised just such miracles.  According to Hodge, cutting the corporate income tax rate or allowing full expensing of investments (that is, allowing firms to deduct the investments’ full cost from their taxable income up front, rather than depreciating it over the investments’ lifetime) would more than pay for itself by boosting economic growth and, in turn, tax revenues.

That’s highly implausible.  But it shows how advocates can manipulate assumptions or cherry-pick dynamic-scoring estimates to buttress their agenda.  Ways and Means Committee Chairman Dave Camp (R-MI) did the same thing when he cited only the most optimistic of many “dynamic” estimates in touting the benefits of his tax reform proposal, as our paper and the graph below show.