The Internal Revenue Service and the American Middle Class

Transcription

1 Tulane Economics Working Paper Series The Internal Revenue Service and the American Middle Class Bibek Adhikari Department of Economics James Alm Department of Economics Working Paper 1523 November 2015 JEL codes: A1, A2

2 The Internal Revenue Service and the American Middle Class Bibek Adhikari and James Alm The United States Internal Revenue Service (IRS) is a federal government agency within the Department of the Treasury. It is responsible for administering all federal tax laws, including collecting taxes (issuing tax refunds), enforcing tax laws, and assisting taxpayers in meeting their tax obligations. The IRS was established in July 1862 with the passage of the Revenue Act of 1862, which established the nation s first income tax to help finance the Civil War. The income tax was repealed 10 years later, and in 1884 Congress revived the income tax. However, within a year this tax was declared unconstitutional by the U.S. Supreme Court. In 1913, Congress amended the U.S. Constitution to allow for the imposition of an income tax with the passage of the 16 th Amendment ( The Congress shall have the power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or emuneration ). The name of the agency was changed from its original name (Bureau of Internal Revenue) to its current name in During the Civil War and until World War II, the income tax was levied only on high income individuals. The initial marginal tax rate in the Civil War was only 3 percent, and even in 1913 the top rate was only 7 percent. Indeed, some individuals considered paying income taxes as proof of their financial success, and they proudly reported that they had paid their income taxes. By the time of World War II, the top rate was close to 90 percent. It was during World War II that the IRS greatly enlarged its scope to affect the vast bulk of the American middle class. This was due largely to the expansion of the individual income tax base to include most income earners and to the application of employer source withholding, both done in order to finance the war effort. During this period, the revenues of the IRS increased from $3.4 billion (4 percent of GDP) in 1936 to $40.7 billion (18 percent of GDP) in Also, the number of income tax returns increased from less than 4 million in 1933 to nearly 44 million in 1943, and the number of IRS employees nearly quadrupled during World War II. At present, the IRS collects roughly $3 trillion (18 percent of GDP) from 145 million tax returns using a total staff of over 100,000 and a budget of $11.6 billion. Marginal tax rates have varied enormously over time, reaching a top marginal tax rate of 92 percent in the 1950s before declining in the last several decades to 35 percent. See Tables 1 and 2. Table 1: The Size of the Internal Revenue Service and Gross Revenue Collections Year Number of IRS Employees Number of IRS Employees per 1000 Population Gross Revenue Collections (in millions of dollars) Gross Revenue Collections (as percent of GDP) , $ % , , , ,

3 1906 3, , , , , , , , , , , , , , , , , ,486, , ,518, , ,855, Sources: L. Shelley Davis, IRS Historical Fact Book: A Chronology , IRS Historical Studies, Washington, D.C. (1992); and IRS Data Book, Washington, D.C. (2013). Table 2: Number of Individual Income Tax Returns and the Top Marginal Tax Rate Number of: Top Marginal Tax Rate Year Income Tax Returns Taxable Returns Nontaxable Returns (in percent) , % ,698,321 4,270,121 3,428, ,723,558 1,747,740 1,975, ,602,456 40,318,602 3,283, ,838,184 45,223,151 12,615, ,943,236 51,323,221 12,620, ,693,000 64,267,000 16,425, ,321,310 78,016,323 18,304, ,601,819 86,435,367 28,166, ,423, ,392,812 29,030, ,928, ,995,860 35,932, Source: IRS Statistics of Income, Washington, D.C., various issues. The individual income tax is the largest single component of the $2.9 trillion in revenue that IRS collected in Included here is the administration of the Earned Income Tax Credit (EITC), which is a wage supplement that supports low- and moderate-income workers with children. At present, it is nation s largest federal anti-poverty program, and in 2013 more than 18 percent of income tax filers received the EITC with a $2407 credit. Apart from the individual income tax, the IRS also administers the collection of income taxes from businesses, employment taxes (Medicare, Medicaid, and Social Security taxes), the estate tax, the gift tax, and all federal excise taxes (e.g., alcohol, tobacco, fuels). Table 3 provides the number of returns and the gross amount of revenue collected in 2013 from each of the major tax types.

4 Table 3: Number and Amount of Tax Collections and Refunds, by Type of Tax, 2013 Tax Returns (in thousands) Collections (in thousands of dollars) Refunds (in thousands of dollars) Individual Income Tax 145,996 $1,539,658,421 $312,775,138 Business Income Taxes 39, ,993,954 41,569,223 Employment Taxes 29, ,847,151 6,375,725 Estate Tax 32 14,051, ,243 Gift Tax 313 5,778,377 84,086 Excise Taxes ,033,674 1,137,764 Source: IRS Statistics of Income, Washington, D.C. (2013). Another way in which the IRS affects American middle class is through its role as the largest spending agency in the federal government. After World War II and especially in the 1980s, many tax expenditures were introduced or expanded to include the middle class, where a tax expenditure represents a revenue loss due to exemptions, deductions, credits, and other special provisions. The IRS therefore spends via foregone tax revenues on housing, on health programs, on promoting saving and investment, on education, on child support, and so on. Some of the tax expenditures are larger than the budgets of the departments that spend money for the same purposes. For example, the tax expenditures for homeownership exceed total spending by the Department of Housing and Urban Development. In 2015, IRS-administered tax expenditures are estimated to equal more than $1.2 trillion, or roughly 7 percent of GDP. Some of the tax expenditures that are most relevant to the middle class Americans are the exclusion of employer contributions for medical care and pensions, the mortgage interest deduction, the exclusion of net imputed rental income, the exclusion of capital gains, the various deductions for state and local taxes, the deduction for charitable contributions deduction, and the child tax credit. See Table 4. Many of these benefit disproportionately higher income individuals, given that the tax benefit of any deduction is larger for individuals in higher marginal tax brackets. Table 4: Estimated Tax Expenditures, 2015 Estimated Amount Tax Expenditure Type (in millions of dollars) Exclusion of employer contributions for medical care $207,200 Deductibility of mortgage interest on owner-occupied homes 73,910 Exclusion of net imputed rental income 79,810 Capital gains (except agriculture, timber, iron ore, and coal) 68,850 Defined contribution employer plans 61,050 Deferral of income from controlled foreign corporations 75,540 Capital gains exclusion on home sales 56,510 Deductibility of nonbusiness state and local taxes, other than on owner-occupied homes 49,290 Deductibility of charitable contributions, other than education and health 46,630 Defined benefit employer plans 42,340

5 Exclusion of interest on public purpose State and local bonds 35,010 Deductibility of State and local property tax on owner-occupied homes 33,880 Step-up basis of capital gains at death 32,370 Social Security benefits for retired workers 29,840 Self-employed plans 25,530 Treatment of qualified dividends 26,650 Exclusion of interest on life insurance savings 23,040 Child tax credit 23,500 Total Tax Expenditures, All Categories 1,241,615 Source: Office of Management and Budget, Analytical Perspectives, Washington, D.C. (2014). The IRS has on many occasions been the source of controversy. In the 1990s, the IRS was accused of abusive and aggressive behavior. Senate hearings were held, leading to the passage of the Taxpayer Bill of Rights, which ensured taxpayers of greater protection in any disputes with the IRS and which also established the Office of the Taxpayer Advocate. More recently, the IRS was accused of targeting for special scrutiny conservative organizations (e.g., Tea Party groups) that were applying to the IRS for nonprofit and tax-exempt classification, again leading to Congressional hearings in 2013 and An important part of IRS activities is enforcement of the tax laws. The IRS attempts to improve taxpayer compliance by several main strategies: providing better services to taxpayers, simplifying the tax code, and auditing taxpayers. The number of tax audits has generally fallen over time, to less than 0.8 percent of all returns in Even so, the IRS has achieved some success in maintaining taxpayer compliance. The so-called tax gap, or the taxes that should be paid but are not, is estimated to equal $450 billion in 2006, the most recent year for which detailed estimates are available. This estimate implies that the voluntary compliance rate is 83.1 percent, or that nearly 5/6 of all legally due taxes are paid. Voluntary compliance is significantly higher for income subject to employer withholding, approaching nearly 100 percent for the largely middle class individuals who receive only wage income.