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September 2, 2002
Historical Perspective -- The Price of Reorganization: Fewer Audits and Tax Forgiveness
Joseph J. Thorndike

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Acting Assistant Treasury Secretary for Tax Policy Pamela F. Olson relates lower audit rates to IRS reorganization.

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In a recent interview, Acting Assistant Treasury Secretary for Tax Policy Pamela F. Olson tried to explain declining audit rates with a curious historical analogy:

    One way of looking at the audit rate decline is to compare the restructuring of the IRS that precipitated the audit decline to an example from history. In particular, to when we instituted wage withholding back in the Second World War. In exchange for putting current wage withholding on the books, we forgave an entire year of tax liability. I see the restructuring of the IRS as somewhat akin to that.

An intriguing thought: Today's declining audit rates somehow resemble the tax forgiveness enacted in 1943. But how? Olson goes on to explain:

    We let a year or two go by while the IRS reorganized and we changed procedures. Part of the drop off in the audit rate and in collection was inevitable. Particularly on the collection side, it wasn't possible to change all the procedures without it resulting in a drop off in the number of seizures, liens, levies, and so forth.

In other words, lower audit rates are the price we pay for IRS reorganization. By analogy, the World War II generation must have paid for the withholding innovation by sacrificing a year's worth of tax liability (actually, forgiveness topped out around 75 percent of the annual tax bill, but let's not quibble).

It's an interesting comparison, but essentially wrong. Olson misconstrues the history of the 1943 tax forgiveness, suggesting parallels where none exist. If we accept Olson's assertion that today's lower audit rates are a function of reorganization, then we should look for similar administrative difficulties to explain the wartime tax forgiveness. As it happens, though, tax forgiveness had nothing to do with administrative problems. Rather, it was a political phenomena, designed to alleviate perceived inequities in the transition to withholding.

Wartime Tax Innovations

World War II brought two major changes to the federal tax system. First, it dramatically expanded the individual income tax, boosting the number of taxpayers sevenfold in just six years. Second, it introduced wage withholding to help new taxpayers meet their obligations.

The switch to current collection and wage withholding was not easy. Indeed, the Bureau of Internal Revenue (as the IRS was then called) warned repeatedly that withholding would be expensive and difficult to implement. Lawmakers ignored those complaints, and the agency eventually implemented the new system with surprising effectiveness. First, however, lawmakers had to confront a serious problem: How to implement current collection without bankrupting taxpayers.

Before 1943, taxpayers were expected to save enough money over the course of the year to pay their tax liability when it came due early in the next calendar year. Had pay-as-you-go withholding been simply superimposed on that system, then taxpayers would have been making payments on their current liability while simultaneously paying the tax bill for the previous year. For many taxpayers, that was impossible, especially given the steep annual increase in tax rates during the war.

The Roosevelt administration, which had been asking for withholding since 1941, understood the transition problem. Treasury officials offered several plans for postponement or even partial forgiveness of tax liability. The tax forgiveness that Congress enacted in 1943, however, did not emerge from those proposals. Rather, its principal champion came from the private sector.

Beardsley Ruml was the chairman of the Federal Reserve Bank of New York and treasurer of R.H. Macy, Inc. Prominent in political and business circles, he had developed a tax forgiveness plan that soon proved popular in Washington. Ruml argued that many taxpayers were struggling to meet their obligations. Recent retirees, for instance, were faced with big tax bills based on their employed income; paying it with their more modest pensions was difficult. Similarly, many well-paid executives had left the private sector for wartime service in the government. They, too, had to pay steep tax bills with shrunken incomes.

Ruml's solution was to forgive the last year's taxes and move to a system of current collection. The flow of money into the Treasury would remain largely unchanged. "As far as the Treasury and income were concerned, things would move along just the same as time moves on under daylight saving," he said. Of course, the government would be sacrificing a year's worth of uncollected tax revenues, but Ruml insisted that the asset loss would only show up when examining the books on "Judgement Day."

The White House rejected Ruml's argument, insisting that tax forgiveness would be a windfall for rich Americans. Franklin Roosevelt and his Treasury Department persuaded Democrats on the House Ways and Means Committee to approve a shift to current collection without including Ruml's forgiveness plan.

Republicans, however, were more sympathetic to the idea, and after long debate, Congress enacted current collection, wage withholding, and a scaled-down version of the Ruml forgiveness plan. Essentially, conservative Democrats in the Senate joined with Republicans in both houses to force the issue. If Treasury officials wanted pay-as-you-go taxation, they would have to accept tax forgiveness as a corollary.

Olson's Analogy

Wartime tax forgiveness, then, was a political phenomena. It had nothing to do with administrative difficulties. By contrast, today's decline in the audit rate is all about administrative problems, according to Olson. Which makes these two historical episodes more distinct than similar.

But perhaps Olson's point is simpler; maybe she's just saying that reforms to our collection system don't come cheap. In 1943, lawmakers paid for reform by sacrificing uncollected revenue. In 2002, they paid, indirectly, by throwing the IRS into administrative turmoil. In both cases, change cost real money.

If that's her point, then perhaps she's right. Lawmakers are often eager to give money back to taxpayers. In 1943, they did it directly. In 1997, they took a more roundabout route, decreeing that Americans deserved a kinder, gentler tax collector -- one that doesn't try too hard to actually collect revenue.