Debt ceiling deal throws a wrench into IRS overhaul

The bipartisan deal to raise the debt ceiling would claw back billions of dollars meant to enable a large-scale refurbishment of the IRS, which has withered over the last decade due to budget cuts, outdated technology and loss of staff.

No less than a quarter of the $80 billion in new funding awarded to the IRS in Democrats’ Inflation Reduction Act (IRA) would be taken back from the agency in a deal struck by the White House and House Republicans over the weekend.

The White House has emphasized that all the new initiatives at the IRS — laid out in an ambitious operating plan released in April — are still full-steam ahead and that the agency will be able to make good on the Treasury Department’s promise to go after rich tax cheats.

Even so, the debt ceiling deal puts extra stress on the regular appropriations bills for the IRS and rattles the foundation of its long-term restructuring.

“Look at the strategic operating plan — so much of it has been laid out in terms of steady investments,” Janet Holtzblatt, a former Senate Budget Committee analyst and former deputy director of the Individual Taxation Division in the US Treasury Office of Tax Analysis, said in an interview with The Hill.

“My worry is that this gives an incentive to spend money more quickly.”

What happens to IRS money now?

The $20 billion excision from the IRA’s $80 billion boost is not an explicit budgetary provision in the text of the House bill itself.

Rather, it is an oral agreement between the White House and House Republicans about money that will be taken away from the IRS and spent elsewhere in appropriations bills in 2024 and 2025.

Of that excision, $10 billion will be “repurposed” throughout the course of the fiscal 2024 appropriations process, along with another $10 billion in 2025 to be allocated toward more resources for nondefense priorities, White House officials said Sunday. That leaves a total effective funding boost of about $60 billion for the IRS.

If appropriations negotiations preserve the $8 billion investment in taxpayer services and systems modernization that Republicans approved of in their own debt ceiling bill passed earlier this month, that total boost could fall as low as $52 billion.

That means that roughly $29 billion could now be spent on additional enforcement and auditing over the next 10 years as opposed to the $45 billion originally allocated. The $25 billion boost to operations could fall as low as $16.25 billion under this scenario.

Funding cut hobbles tax revamp

The White House said the IRS will pull forward some of its IRA funding to keep the agency on track to deliver its updates. But experts in U.S. tax administration say the funding modifications could still pull the rug out from under these initiatives.

The IRS is piloting new enforcement techniques using data and analytics tools that have yet to be assessed. The debt ceiling deal removes funding for years in which some of the pilots — including the test of a free online filing system for regular taxpayers — are already planned.

For fiscal 2025, the IRS is working on “new tailored treatments developed and piloted based on data and analytics” to help fix “issues and omissions” on tax returns, according to the agency’s new operating plan.

Why the ‘tax gap’ could widen

The funding cut could also limit new hires of seasoned accountants and auditors, who are perhaps the most crucial component of the agency’s increased enforcement capacity.

IRS planners pledged in the April operating plan to hire more than 7,200 auditors and 3,800 operations specialists in 2024 at a cost of more than $5.8 billion.

These new hires would be especially important for the auditing of complex partnerships, S-corporations and limited liability companies, where much of the tax revenue that is owed to the government but not collected — an amount known as the “tax gap” — is located.

In the years 2014-16, the last time the tax gap was definitively measured, $130 billion of individual business income tax went unpaid, one of the largest chunks of the tax gap. It’s likely substantially higher than that now.

Noncompliance with the U.S. tax code is much more common among business owners than workers, who report their income with 99 percent accuracy to the IRS.

Individual business income makes up 26 percent of the uncollected tax in the U.S., with nonfarm proprietors making up 16 percent, and partnerships and trusts constituting around 5 percent, according to IRS calculations of the tax gap.

The Congressional Budget Office estimated that the original $80 billion funding boost for the IRS would increase government revenues by around $200 billion over 10 years.

‘There were no guardrails here’

The debt ceiling deal’s funding reduction for the IRS in the short term is not as serious a concern for the agency’s advocates as the political target that the deal places upon the IRA funding in the future.

“It’s certainly a signal that the funding was fragile to begin with. There were no guardrails here – there was always going to be the opportunity for Congress to short the IRS on annual appropriations,” Holtzblatt said.

The omission of the funding reduction from the legislative language of the bill likely adds to its political vulnerability, increasing the amount of wiggle room negotiators have to maneuver around it and potentially establishing a recourse in the event of stalemates.

“There isn’t really a template here for spending reductions,” Daniel Bunn, president of the Tax Foundation, a Washington think tank, told The Hill. “This allows it to be from the budget itself, from future budgets, or in the annual appropriations process.”

While the funding cut could hamper the IRS’s big picture plans, the agency proved surprisingly nimble and responsive to demands from Congress during the pandemic, even as its basic service levels suffered and backlogs of tax returns piled up. 

The IRS sent out $800 billion in stimulus checks through successive rounds of legislation from both the Trump and Biden administrations, effectively becoming a benefits-administering agency akin to Social Security or Medicare.

The so-called “Economic Impact Payments” of the pandemic raised millions of American children out of poverty and revealed the IRS to be a resourceful and quick-acting bureaucracy when it needs to be.