IRS Data Web Snares Mostly Low- and Middle-Income Taxpayers

Agency expands its robo-audits to get more personal data, but has so far only netted small change.

Izmir, Turkey - March 29, 2011: Close up of Internal Revenue Service (IRS) main page on the web browser. IRS is a United States government agency tasked with collecting yearly state and income tax from working residents and businesses.
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Increased auditing of the EITC recipients has real consequences for low-income Americans. The credit represents 25 percent of income for the average filer who claims it, IRS records show. Delayed refunds have led to a cash crunch for millions of filers, and "rapid return" high-interest lenders raced to fill the void for those expecting EITC cash sooner, routinely charging interest rates of 35 to 100 percent before the government altered its rules to prevent abuses.

Olson says the IRS has not done enough to educate taxpayers about how to claim the credit, which involves calculations based on progressive income levels and a phase-out formula that has confused even professional tax preparers. Because it involves family members, for example, differences arise over who can claim the credit in cases of joint custody for divorced or estranged parents.

The IRS says it targets this credit because it is widely abused. Those who claim the Earned Income Tax Credit are audited twice as often compared to the average for all taxpayers, the National Taxpayer Advocate reports. Olson says the aggressive pursuit of tax cheats has intimidated some from appealing audits or even filing for the credit. The IRS itself says that as much as 25 percent of people eligible do not claim it. And unlike other classes of audits, returns are frozen as soon as questions are raised and refunds are not issued until the case is cleared. Many who appeal do win their cases, but the lack of professional help is a barrier. A study by the Office of the Taxpayer Advocate found that those who manage to bring representatives to an IRS appeal were twice as likely to win.

The IRS launched a huge publicity campaign when it went after identity theft, but has said next to nothing about this much larger program involving "real time" audits using third-party networks including such information as credit card charges. The agency has disclosed so few details that some tax experts who have worked closely with the IRS suggest that its intent seems to be a "gotcha" strategy aimed at trapping tax cheats rather than deterring bad behavior and encouraging compliance. The IRS's own advisory committee, made up of high-level tax professionals and managers, says people are operating in the dark even when it comes to basic issues. For the tax community to understand how to comply, a clear understanding of a "third party payment network must be defined," the committee said in a November report.

"Are they being too secretive? Probably," says Joel Slemrod, a University of Michigan business economics professor who studies the impact of government policy on consumer behavior. "They can't tell the public everything they do, but I don't know why they are being as secretive as they are. "

What's known is that the IRS has gradually moved to a system of electronically "scoring" returns, according to tax experts who worked closely with the agency. Points are assigned for unusual deductions, inappropriate credits, math errors and other suspicious items on tax returns. Most importantly, the screening program assigns a score for how likely the success of an audit will be and how much time it might take an agent to close a case. It even estimates the number of hours a hearing might require. Agency cutbacks mean fewer agents are available to follow up on audits. The result is that "low-hanging fruit" gets picked for audits. When the program was launched in the mid-2000s, the IRS testified that such cases would not be the priority. Budget constraints have shifted that view.

"There is a cost-benefit analysis applied in the scoring," says Eric Toder, an economist who is co-director of the Urban Institute-Brookings Institution Tax Policy Center. He has worked as a consultant to the IRS and its overseers in the past on issues of tax collection.

Hidden income remains invisible. At the opposite end of the income spectrum, it's far more expensive to chase down high-income tax dodges. A low-income family might be flagged by the robo-audit for a math error on a $1,500 student loan credit that can be collected with a simple letter from the IRS. A questionable $5 million investment in a euro debt swap involving unlisted derivatives and having no clear economic purpose beyond tax avoidance, even if it is detected, might require a trip to a Liechtenstein bank to meet with a team of lawyers and accountants. Often, this kind of tax action amounts to a multimillion-dollar bet of the IRS's thin resources with low odds of paying off.