This post originally appeared in the Forbes PT site on May 26, 2015.
One of the hot button political issues of the day is income inequality. The stagnation of low-income workers’ wages has focused attention on policies to offset that, such as possibly raising the minimum wage or boosting tax benefits. Last week, Warren Buffet in an Op-Ed piece in the Wall Street Journal chimed in, first situating inequality in today’s economy:
That mismatch is neither the fault of the market system nor the fault of the disadvantaged individuals. It is simply a consequence of an economic engine that constantly requires more high-order talents while reducing the need for commodity-like tasks.
He then offers his views that a better approach to inequality is to increase the EITC rather than boost the minimum wage:
The better answer is a major and carefully crafted expansion of the Earned Income Tax Credit (EITC), which currently goes to millions of low-income workers. Payments to eligible workers diminish as their earnings increase. But there is no disincentive effect: A gain in wages always produces a gain in overall income. The process is simple: You file a tax return, and the government sends you a check.
In essence, the EITC rewards work and provides an incentive for workers to improve their skills. Equally important, it does not distort market forces, thereby maximizing employment.
As this is not a macroeconomics policy blog, I leave it to others to discuss the causes costs and possible solutions to the inequality Mr. Buffet speaks of.
This is, however, a tax procedure and administration blog, and much of what Mr. Buffet says, as well as some of the response it has drawn, sweeps in issues of tax administration. I will discuss some of those issues in this post, including overclaims, identity theft and program participation.read more...
Error, Fraud and Identity Theft
First, in couching support for expanding EITC, Mr. Buffet does note some issues with EITC, most of which relate to the IRS’s administering the program.
He discusses how “[f]raud is a big problem; penalties for it should be stiffened.”
While there is no doubt that EITC suffers from a considerable overclaim rate (I discussed recent data on EITC overclaims in IRS Issues New Report on EITC Overclaims) the statement may lead some to believe that the overclaims are all attributable to fraud; GAO and others looking at the EITC overclaim issue identify multiple sources of noncompliance; only one is fraud. Moreover, as my fellow Forbes contributors Kelly Erb and Janet Novack note there are already in place some of the most draconian penalties on the books for fraudster EITC claimants, including a 10-year ban on fraudulent claims, a penalty I have discussed in the past year in The Ban on Claiming the EITC: A Problematic Penalty. EITC fraud penalties will do little to address the underlying compliance issues.
As a practical matter, it is hard to push for expanding the EITC when IRS has a hard time relative to other transfer programs in stopping erroneous claims. For example, my Forbes colleague Janet Novack states,
Its already substantial size–as much as $6,242 for parents with three or more qualifying children and $5,548 for those with two kids–combined with pressure for the Internal Revenue Service to administer the credit on the cheap, has set off a tsunami of identity theft tax fraud that has swamped both the IRS and some of the very workers the EITC is supposed to help.
Janet (looking to Keith’s Senate testimony from this spring) suggests that Congress should get the IRS tax administration house in order through adequately funding IRS, regulating preparers and accelerating the reporting of information returns to give the IRS a fighting chance to administer the program.
Many articles focus on EITC error costs without considering the program’s reduced direct administrative costs; Janet’s post also sensibly compares the differences across programs, noting that IRS spends only about 1% to administer the EITC. I offer some more on this issue. EITC given lack of upfront eligibility administrative mechanisms is much cheaper to administer than other transfer programs such as TANF and SNAP (food stamps). Congressional testimony this year from the NTA (at page 26) lays this out nicely.
I couId not agree more that if Congress asks IRS to do more in terms of delivering benefits through expanding the EITC it needs to give the agency the tools to do the job right. A major part of the allure of having IRS in the mix is the low administrative costs Yet that figure is misleading, as Janet notes (also referring to Keith), we are just pushing costs on other parties, including the claimants who struggle in the audit process and all of us as IRS is pressured to audit EITC claimants at perhaps a far higher rate than it should given that most of the individual tax gap stems from the underreporting of income among self-employed taxpayers.
How does identity theft fit in with this? As to identity theft, it is a huge problem for the tax system. Yet, identity theft is a problem that is quite different from the EITC compliance problem. Only a small amount of EITC overclaims is due to identity theft; the overwhelming majority of EITC error is due to the misclaiming of qualifying children who do not reside with the claimant.
[Update: Since posting this story yesterday IRS revealed that it was subject to a major breach that allowed data thieves access to tax return information of over 100,000 people. The breach led to IRS sending over $50 million in fraudulent refunds before it detected the problem. The news highlights the challenges that identity theft presents to the tax system (and our economy overall).]
We are going to run posts discussing identity theft in greater detail, but for now I note that the identity theft problem is mainly due to IRS issuing refunds before it has access to third party documentation that would allow it to prevent issuing refunds to the wrong person. From the 2015 GAO report Additional Actions Could Help the IRS Combat the Large Evolving Threat of Refund Fraud:
[Fraudulent Identity Theft] refund fraud takes advantage of IRS’s “look-back” compliance model. Under this model, rather than holding refunds until completing all compliance checks, IRS issues refunds after conducting selected reviews. While there are no simple solutions, one option is earlier matching of employer-reported wage information to taxpayers’ returns before issuing refunds. IRS currently cannot do such matching because employers’ wage data (from Form W-2s) are not available until months after IRS issues most refunds. Consequently, IRS begins matching employer-reported W-2 data to tax returns in July, following the tax season. If IRS had access to W-2 data earlier—through accelerated W-2 deadlines and increased electronic filing of W-2s—it could conduct pre-refund matching and identify discrepancies to prevent the issuance of billions in fraudulent refunds.
EITC errors mainly relate to the misclaiming of qualifying children, and in particular their residence. To claim an EITC with children, claimants need not only the taxpayer’s SS# but also the children’s numbers. That makes most EITC claims more difficult for identity fraudsters. Moreover, IRS filters addressing possible EITC errors add another layer of defenses making it less likely for identity fraudsters to get their illicit refunds.
There are administrative and legislative tools available to combat identity theft, including changing the time which IRS issues refunds or accelerating the filing of third party data. No doubt that the possibility of credit driven refunds attracts identity fraudsters to our tax system, but dummying up tax returns with phony withholding amounts that take advantage of the IRS’s lack of early access to information returns is the main tool of the identity theft fraudster.
Whether Congress expands EITC or not, the identity theft problem will persist and get worse, unless Congress and IRS take actions to reverse its look back compliance model.
Participation and Filing
In Buffet’s piece in the WSJ, he also discusses how “[t]here should be widespread publicity that workers can receive free and convenient filing help.”
The statement brings attention to one challenging aspect of housing a benefits’ program in the tax system. Benefits’ programs in other areas tend to have an application process that revolves on a greater ex ante review process through the form of case workers and government bureaucrats reviewing eligibility before doling out benefits. The tax system essentially has assumed (with safeguards like document matching and the threat of audit) that taxpayers on their own or increasingly through assistance like software or commercial preparers are accurately preparing their eligibility statements in the form of tax returns.
The tax system’s approach has substantial costs, one of which is that claimants often have to pay third parties to get their claims (tax returns) in; the market has stepped in in the form of software and commercial preparers, both of which are major players in the tax administration landscape. The issue of return prep costs warrants a separate post but suffice to say claimants often pay dearly to get access to their refunds. For example, the National Consumer Law Center earlier this year released its annual study on preparation and related costs. It looks at EITC and goes through the various charges in addition to return preparation charges. As to the specific charges for return preparation (separate from ancillary fees, like fees for quicker access to cash from the refund, which in the last filing season to over $424 million) the report notes that mystery shopper testing has documented preparation fees up to $400 or $500 per return. The GAO in an April 2014 study found that the fees charged for tax preparation varied widely, even between offices affiliated with the same chain.
Despite the costs, there is, however, access to free income tax return filing. IRS through its Free File program makes free filing available to taxpayers with incomes below $60,000, but the take up on that has not been stellar and some have criticized its approach of opening up claimants to other fees. Likewise, VITA prep centers are available to help claimants prepare returns for free. All else being equal it would be better if more claimants could access their refunds without having to pay for the privilege of getting their benefits.
Despite many paying prep fees and other costs one of the aspects of the EITC thought of as a positive is its high take up rate. Yet some of the criticism of Mr. Buffet’s plan also focuses on that there is only an about 80% participation rate, As my Forbes colleague Kelly Erb notes, “[t]he IRS estimates that only four of five eligible taxpayers take advantage of the existing credit: nearly 20% eligible taxpayers either don’t know about it or simply don’t take advantage.”
Yet, in looking at other transfer programs, 80% participation is not bad at all and is roughly consistent with SNAP (food stamps) and much higher than TANF, which is well below 50%. But when you look at the EITC numbers more closely, the 80% figures are misleading because the participation rates are very sensitive to the amount potentially on the table for EITC claimants, i.e., the take up rates are much higher when taking into account the dollar amount of EITC eligible. For example, in a study published in the IRS 2009 research conference looking at 2005 tax year data, EITC participation rate was 88% when refunds were over $3,000 and about 90% when refunds approached $4,000 (see page 1982).
In other words, for the people whom Congress intends to benefit the most, the EITC participation rates are higher than just about any other transfer program.
One other point weaves in the themes of identity theft and participation. In Janet Novack’s post she discusses Forbes contributor Laura Shin’s reporting about a low-wage McDonald’s worker who decided against filing a tax return claiming thousands in EITC due to her being an identity theft victim. This suggests that prior victimization will chill people from claiming an EITC. IRS actually has in place procedures to facilitate victims to file current year returns, including getting a secure Identity Protection PIN. I am not aware of research suggesting that identity theft is a major barrier for eligible claimants from participating in claiming EITC, but no doubt that prior victimization may contribute to eligible claimants being wary about spending money and time on return preparation costs.
Some Parting Thoughts
As Mr. Buffet knows, there is no such thing as a free lunch. Using the tax system to deliver benefits is no silver bullet when it comes to addressing inequality. To administer the tax system as we know it today is no easy task. When Congress asks the IRS to do more, there are costs to taxpayers and the system overall. As Congress considers whether to ratchet up EITC, it should do so with the absence of rhetoric. It should also consider the tools it wants to give IRS to combat errors as well as address what costs it wants to impose on claimants and third parties. The current system passes costs on others, many of which are hidden. As with lunch, someone has to pick up the tab.