The IRS could be on the verge of changing the way Americans file their taxes

Editor’s note: This story has been updated to clarify that the IRS removed a noncompete clause in its agreement with commercial providers.

The IRS could be on the cusp of revolutionizing the way that Americans file their taxes.  

The Inflation Reduction Act signed into law by President Biden on Tuesday provided $80 billion in funding for the agency, including $15 million to deliver a report on a free, government-run tax e-filing system that tax simplification advocates have long argued for.  

But the agency is on a tight deadline to deliver.  

While most of the $80 billion for the IRS in the new legislative package goes out over the next decade, the agency has only about a year to turn in its e-filing report.  

Specifically, the agency has to figure out how much an online filing system would cost, the design of the system and how taxpayers would feel about using one. 

Tax experts say the system could take two basic forms: one more conservative in scope and one more far-reaching. 

The more conservative option would be a standardized government version of popular commercial software from companies like Intuit, H&R Block and TaxACT that prompts users to fill out a digital tax return. 

There has already been an IRS program in place that allows low-income Americans to use these and other commercial products for free, but the program has performed poorly. 

An April report from the U.S. Government Accountability Office found that while 70 percent of taxpayers are eligible for the Free File Alliance program, only 3 percent use it. 

In its agreement with commercial providers, the IRS signed a noncompete clause promising not to make its own free software tool. The clause was removed in subsequent versions of the agreement.

Former Treasury Inspector General for Tax Administration (TIGTA) J. Russell George testified to the Ways and Means Committee back in 2006 that, “According to representatives of Alliance member companies that TIGTA interviewed, their primary goal is to keep the Federal Government from entering the tax preparation business.”  

It’s not clear how a new free e-filing system would line up with the IRS’s agreement with private tax preparers, but it may simply be allowed to expire if the agency decides to move ahead with its own large-scale public filing system. 

The Free File Alliance came to be because Congress originally mandated the IRS to do away with tax returns altogether in a law called the Internal Revenue Service Restructuring and Reform Act of 1998.

After a major lobbying push by the tax preparation industry, the Free File Alliance was introduced as a way to let low-income Americans file their taxes for free without getting rid of tax returns.

The Alliance drew institutional momentum away from the change to return-free filing, which likely would have rendered large segments of the tax prep industry totally useless.

In 1998, Congress told the Treasury to “develop procedures for the implementation of a return-free tax system under which appropriate individuals would be permitted to comply with the Internal Revenue Code of 1986 without making the return required.”

Return-free filing is the second, more dramatic option for a free, IRS-run e-filing system that experts say could once again be under consideration as part of the Inflation Reduction Act.

Return-free filing is used by many countries with advanced economies in the Organization for Economic Cooperation and Development. It essentially means that the government would do your taxes for you, withholding what’s owed and then doing its own accounting without requiring forms to be sent in by taxpayers. 

The main type of return-free filing — used by the United Kingdom, Japan and Germany, among dozens other countries — is referred to as an exact withholding system. With this system, the IRS would try to withhold fewer taxes from people’s paychecks and skip the refunding process made necessary by a self-reported tax return. 

“In most of these countries, taxpayers meet their tax obligations entirely through tax withholding payments made throughout the year,” the Treasury Department found in a 2003 report on return-free tax systems. 

But experts say that all the tax credits in the U.S. tax code make self-reporting helpful — if not necessary — from an administrative point of view. 

“With withholding, the IRS already has that information. So it’s kind of annoying that you have to go through and enter it in yourself. But in the U.S. we have, for instance, joint filing. So if your employer knows what your income is, they don’t necessarily know what your spouse’s is. Employer withholding isn’t reflective of various credits and tax programs,” Alex Muresianu, tax analyst at the Tax Foundation, a Washington think tank, said in an interview. 

The other kind of return-free filing is called agency reconciliation. This is where “tax authorities prepare tax returns for individuals based on information returns from employers and others, and send taxpayers a completed tax form for their review,” according to the Treasury report. 

Some studies have shown that the government would lose revenue with this kind of system since the IRS is doing all the clerical work without relying on reporting from taxpayers. 

“If you as a taxpayer know things the IRS doesn’t know that are to your advantage, then you might not want to share that with them,” Robert Weinberger, a nonresident fellow at the Urban-Brookings Tax Policy Center, said in an interview. “But there are arguments that that would be worth it, since the whole system would be simplified and people will be happier. So maybe that’s a trade-off we’d be willing to make.” 

The government found in 2003 that a simplification of U.S. tax law, which is full of credits and exceptions to credits, should be a prerequisite for implementing any return-free filing system.

“Moving to a return-free tax system without first simplifying the income tax would require substantive changes in tax administration,” the Treasury report found. “These changes could shift burdens from taxpayers to other parties, including employers, financial institutions, state governments, and the IRS.”

But that prerequisite may no longer make sense in an age when everything from doctor visits to school records can be accessed instantaneously online.

Tax simplification advocates say a slimmed down tax code, which now stands at nearly 10 million words between statutes and regulations, would be well worth the effort. 

“It’s critical to make filing taxes as easy as possible,” Frank Clemente, director of the left-leaning advocacy organization Americans for Tax Fairness, said in an interview. “We’ve got to move away from this adversarial feeling. A simpler tax system will reduce cost, increase compliance and make people just feel better about the IRS.” 

Clemente added that the $15 million in the Inflation Reduction Act for the report on e-filing “indicates a seriousness to move beyond where we currently are on this problem.” 

“Whatever the proposals look like, it means there’s got to be a plan behind that,” he added. 

Advocates are keeping an eye on a provision in the act’s requirement for the e-filing task force that says it needs to look at “options for differential coverage based on taxpayer adjusted gross income and return complexity.” 

They say this focus on “differential coverage” could suggest that Americans with more complicated tax returns, who are typically wealthier, could interact differently with a new e-filing system than the average wage earner. These differences could raise questions about the fairness of such a system. 

In a Wednesday memo to IRS Commissioner Charles Rettig, Treasury Secretary Janet Yellen expressed concern about unfairness built into the tax system, which she described as “two-tiered.” 

“Most Americans pay what they owe, but those at the top of the distribution often do not,” Yellen wrote.

Updated at 3:44 p.m.