A Dysfunctional IRS Is Bad for Red and Blue State Taxpayers Alike

Americans love to hate taxes and tax collectors. So it’s not surprising that the Trump administration’s drive to hobble the IRS is drawing a muted response instead of outrage in state capitals. Yet both red and blue state leaders should beware: Pushing the IRS into dysfunction will impose a world of bipartisan hurt on state finances and state taxpayers.

At the beginning of this year, the IRS had roughly 100,000 employees. But the administration aims to massively reduce the IRS workforce—and fast.

It’s possible that a carefully planned and brilliantly executed 30% to 40% reduction in staff might be manageable if the IRS had the proper technology tools to maintain critical functions such as answering taxpayers’ questions, processing returns and payments, issuing refunds, and maintaining credible audit and collection functions that generate revenue and support voluntary compliance.

Unfortunately for America’s taxpayers, recent developments suggest that new technologies, such as artificial intelligence, won’t be riding to the rescue anytime soon. The Republican Congress has zeroed out the IRS’s baseline budget for modernization.

On March 14, the IRS announced a “strategic pause” of its multi-year technology modernization plan, already years behind schedule. A few days later, the Department of Government Efficiency claimed to have canceled $1.5 billion in contracts from the IRS’s $3.7 billion modernization budget. On March 29, the IRS placed some 50 of its top technology executives on administrative leave. On April 14, the day before Tax Day, the IRS’s chief information officer and two acting deputy CIOs announced their departure.

Politely stated, it’s obvious that the agency’s technology operations and modernization program are under considerable stress.

Meanwhile, the Trump administration is challenging the post-Nixon era statutory and normative framework that protects the confidentiality of tax return information and guards against the politicization of tax administration. This risks undermining our relatively high rate of voluntary compliance with tax laws at every level of government, resulting in less voluntary revenue and greater relative reliance on unpopular and disruptive enforced collections.

But it’s not just the IRS and federal taxpayers who are at risk. The IRS is the linchpin of an integrated federal fiscal architecture that includes all 50 states and Washington, D.C.

Processing federal data provides a significant share of state compliance revenue. The IRS and state agencies have long shared data such as audit results, federal individual and business return information, and employment tax information under federal-state tax information agreements.

Due to strong statutory links between federal and state calculations of taxable income, changes in federal tax liability often have a direct impact on state tax liabilities. Filing an amended federal return—whether to correct a math error, rectify a reporting omission, or close out a federal audit—generally triggers notices to state tax administrations and requirements to file an amended state return and satisfy any additional state liabilities.

Federal-state exchange agreements also extend to data such as foreign source income and the allocation of income, deductions, credits, or allowances among commonly controlled corporate affiliates. Access to this data is critical to the states’ ability to administer taxes for larger national- or international-scale taxpayers.

Faltering federal returns processing and compliance programs thus translate into less state revenue. To make up for the loss, states can cut spending, raise taxes, or build out their own separate capacity to audit “above the line”—that is, examining the components of federally reported income, which inevitably places a greater compliance burden on state taxpayers.

For example, some of the 31 states that provide an earned income tax credit based on the federal EITC credit states have developed an independent capacity to screen applications for fraud and errors that otherwise might have been detected at the federal level.

Beyond formal exchange agreements, most states use federal tax information in some capacity to administer their own tax laws. For example, both Texas and Wyoming, which have no personal or corporate income taxes, require businesses to use their IRS-issued federal employer identification number when registering to pay sales and use tax.

Similarly, state laws regulating charitable organizations routinely reference federal tax exemption under Section 501(c)(3). Many states require filing a copy of an organization’s federal Form 990 (Return of Organization Exempt From Income Tax) or the information therein.

President Donald Trump and Congress should be careful what they wish for. It’s easy for politicians to demonize the IRS as remote, overbearing, and unresponsive—and it’s also easy to frame hobbling federal tax administration as tantamount to securing a tax cut.

But the IRS and the states are in the tax administration business together. A dysfunctional IRS that lacks the financial, human, and technical resources to do its job fairly and efficiently will create fiscal havoc, leading to very angry taxpayers. Who will cover the political bill?

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Andrew Sidamon-Eristoff is a former commissioner of the New York State Department of Taxation and Finance under Governor George E. Pataki.

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