You Get What You Pay For: Lessons From the IRS Scandal

Henry J. Aaron

Everyone is outraged by the IRS scandal—Republicans and Democrats, members of Congress and the president, alike. Outrage is a good clean emotion to have when one encounters outrageous behavior. But after a good fist-clenching growl, serious people need to decide what to do to prevent a repetition of such misbehavior.

Here are three suggestions. First, implement the specific reform suggestions put forward by the Inspector General whose report documents the misdeeds. Next, tighten the law under which organizations are granted tax exempt status. The third suggestion—and this may surprise you—raise the budget of the Internal Revenue Service—a lot!

Before explaining the suggestions, let’s start with the facts. As far as tax exemption is concerned, organizations claiming tax exempt status don’t have to apply to the IRS, but most do to avoid challenge later on. Tax exempt status under section 501(c)(4) of the Internal Revenue Code is supposed to be granted to an applicant only if it is a ‘social welfare’ organization. That means that no income of such organizations is taxable and that the names of contributors may be kept secret. Under current administrative interpretation such groups may spend up to half of their income directly on political campaigns and limited amounts on lobbying, but they may spend without limit on ‘general advocacy,’ provided that such spending is related to their ‘social welfare’ purpose. In 2012 some such organizations—conservative and progressive, alike—spent virtually all of their income on ads advancing the cause of one political candidate or another, presumably on the theory that a particular candidate’s victory will advance social welfare.

Spread too thin

Of course, the IRS spends most of its time on other matters. It collects taxes—well over $2 trillion. It must also provide a lot of data for the soon-to-be-implemented health reform law and impose penalties to enforce it. For these tasks, it is dreadfully underfunded. The IRS budget is virtually unchanged since 2008 as is its staffing levels, despite the increase in its responsibilities related to health reform.

The IRS lacks sufficient resources to do all of these jobs adequately. If you doubt me on this point, consider the following facts. The IRS audits only 1 percent of all returns. An estimated $450 billion that is legally due goes uncollected, in significant measure because so few individual returns are audited. If you cheat or make an innocent mistake, there is little chance that the over-worked and under-staffed IRS will find out. The Government Accountability Office estimates that each additional dollar spent on auditing would yield more than $8.

The toll from short-changing the IRS is not just lost revenue. When resources are so meager and the return to enforcement is so high, administrators are loath to divert budget and staff from chasing evaders to staff training and oversight. It would be absurd to say that the administrative abuses now so much in the news are caused by meager budgets—after all, real live people who should have known better did what was done and real live supervisors failed to stop them from doing it. But a major reason why training and oversight were missing is that short-sighted, penny-pinching members of Congress deprived the IRS of enough money and staff to do what Congress asked them to do. Members fearful that the IRS will run amok, should recognize that the way to avoid that risk is more supervision not less.

The law needs to be changed

Even with adequate staffing, however, the law governing tax exempt status for so-called ‘social welfare’ organizations is so vague that anything other than rubber stamping all applications would likely evoke complaints of politicization. What is a tax administrator to do when an organization says it is engaging in “social welfare” and then defines those activities as paying for TV ads and staff devoted entirely to explaining to voters why a particular candidate has taken the right or the wrong position on political issues or why a particular bill should be approved or rejected? What are voters to do when such organizations shield the names of donors who are financing the attack ads that pass as ‘public education’? The result of such a loosely drafted law is an avalanche of anonymous funding for political campaigns. The result is that members of Congress are driven to spend most of their time—and not just in election years—raising money from hard-headed pragmatists many of whom buy influence with their ‘donations.’

Only Congress can remedy this flawed law. It can do so by requiring that names of all donors to tax exempt organizations, not just those the IRS singles out for selective scrutiny, be divulged and by denying tax exempt status to any organization that engages in more than de minimis lobbying or campaign spending. The Supreme Court ruled that past limits on campaign spending were unconstitutional. It did not rule that organizations doing the spending should be exempt from taxes. Only Congress can assure that the Internal Revenue Service has sufficient resources to do the jobs they are charged with doing. But only the IRS management can implement the common-sense reforms that the Inspector General who documented these abuses prescribed to prevent them from recurring.

But for these reforms to occur, the American public must get beyond their well-justified anger with administrators who abused their authority and recognize why shoddy legislation and budgetary penny-pinching created an environment that fostered those abuses.