What to do about the IRS.

By the time Charles O. Rossotti, former chairman and cofounder of American Management Systems, was named by President Clinton to head the Internal Revenue Service, it was clear that the agency was plagued with more than mismanagement and outmoded technology. Congressional hearings underscored how many Americans feared and loathed an agency that had become an oppressor, arbitrarily seizing their moneys, and property, refusing to explain, let alone apologize, and unwilling or unable to correct its mistakes. Senate Finance Chairman William Roth (R-DE) has put forward legislative proposals that further open the debate on the fundamental role of the agency itself, and even raise the issue of whether it should be abolished in favor of a different approach. CE asked two business leaders deeply involved in tax issues to comment. Forstmann Little's Ted Forstmann argues the IRS, as bad as it is, is not the problem; it's the tax code that should be abolished. ADP'S Josh Weston, who was the only business leader among the 18 members of the National Commission to Restructure the IRS, thinks the agency can be whipped into shape and offers a blueprint for action.

THE ROAD TO IRS REFORM

In 1996, in response to alarming charges of mismanagement, Congress created the National Commission on Restructuring the Internal Revenue Service. At the time, General Accounting Office (GAO) reports indicated that the IRS was unable to balance its books, had wasted $4 billion on failed computer modernization, answered only 26 percent of calls to its taxpayer assistance lines in 1996, and had a 22 percent error rate on individual tax returns - half caused by the IRS itself. No wonder many Americans view the IRS as malevolent. In fact, in an October 1997 Fox News poll, 81 percent of Americans thought that the IRS has too much power, and 57 percent favored simply abolishing it and building a new tax collection agency from the ground up.

This concern with rebuilding the collection system is often confused with reforming the tax code. But they are not the same thing at all. Our complex code is the 42,000-page hodge-podge result of many Congresses' complex social goals and special reliefs to selected groups. There is recurring talk of eliminating the entire code and/or the whole IRS. Yet, even if sweeping legislative changes, such as a national sales tax or a simple flat tax did occur, some kind of substantial IRS will always be needed in a society where $1.6 trillion needs to be collected from some combination of 10 million businesses and 200 million adult citizens. Without an effective collection and enforcement entity, compliance would likely plummet. With the large volumes of tax revenues, reportings, and verifications this collection requires, it is far more appropriate to apply effort to improving our system than to denigrating it.

As chairman of ADP, I was the only private sector CEO on the 18-person national commission charged with looking into the agency and coming up with recommenclarions for truly changing it. The commission, which released its report on June 23 last year, was the first to examine the IRS in depth since 1952. I agreed with most my fellow commission members that the agency was reformable - if we could move on a number of recommendations.

Since then, important strides have been made, with the launch of several improvements in 1997, including:

* A new IRS commissioner. Charles Rossotti. Rossotti is the first ex-CEO (American Management Systems) and EDP expert in that post. The prior 10 commissioners were capable tax lawyers, but lacked experience in line management, data processing, high-volume client service, operational planning, and organization development - a mismatch of skills and needs at the top that should not be repeated.

The IRS is a huge operating organization with 100,000 employees and large data centers, which annually process 200 million tax returns, 150 million phone calls, and $1.5 trillion in receipts. Yet prior administrations and Congress erroneously believed that the IRS leader needed to be a tax code expert. Past commissioners were also separated from their taxpayer service by eight management layers.

* A five-year commissioner term. During the last 20 years, there were 10 commissioners. Such short tenures undermined any likelihood of accountability and success with major multi-year programs. Future IRS CEOs should be apolitical, with five-year terms that don't coincide with presidential elections.

* Service and IT focus. Rossotti's highest priority is enhancing taxpayer service and accelerating conversion from 59 standalone, legacy computer systems to contemporary architecture with interfaced databases that permit one-stop problem inquiry, and resolution from a single work station. Such IT systems changes are very, complex and take several years to implement.

* External oversight. The House has voted 424 to 4 for a bill to fundamentally change IRS governance that calls for a new external board of experienced operating executives with staggered five-year terms to add continuity, oversight, and expert guidance in operations, service, organization development, budget approval, and long-term planning. The board would not be involved in tax policy, privacy matters, or legal enforcement, which properly remain within the Treasury Department's domain.

Currently, the IRS commissioner reports to Deputy Secretary of the Treasury Larry Summers, a former Harvard economics professor. Historically, the deputy secretary's fiscal and monetary responsibilities have understandably made his IRS role secondary. In addition, no deputy secretary has had the relevant organizational, operating, or IT experience appropriate for IRS oversight. Furthermore, relationships between the deputy secretary and the IRS commissioner have been hampered by a lack of continuity. For example, Peggy Richardson, the previous commissioner, reported to three different deputy secretaries in four years, which obviously undermined accountability.

Now awaiting Senate review, the bill could greatly improve matters - provided the President's appointees are chosen solely for their qualifications. Such a provision might seem obvious, and yet the somewhat analogous independent Postal Commission, which oversees a huge operation, had a doctor named chairman. Senator Roth's version of the House bill aims to assign enforcement to this citizen board, which seems inappropriate to me.

WHERE WE SHOULD BE

The above progress was stimulated by the National Commission on Restructuring the IRS, created by Congress in 1996 for a one-year term. Much of the commission's report was included in the recent House bill. Yet, while great strides have been made, much remains to be done. Even if the bill is adopted by the Senate, further major IRS improvements and problem avoidance to make the IRS more effective and service sensitive will require much better shared perspectives and coordination between Congress and the IRS in the following areas:

* Effective Funding A reluctance by Congress to appropriate funding beyond one year, coupled with much discontinuity between successive budgets, has put multi-year programs and hirings into disruptive start/stop and hesitation modes. No organization can function well without multi-year plans and predictable funding. Furthermore, the single-year appropriations often do not clear Congress until several months into the relevant year, thus delaying timely starts of new programs. To permit proper planning, the Commission recommended that Congress provide stable funding in three-year increments.

The IRS is the government's only large revenue center; all other government agencies are cost centers. Yet, when budgets are proposed, Congress and the OMB treat the IRS as just another cost center. In some years, arbitrary, budget cuts have created declines in audit rates, three-year lags and omissions in document matching (1099 vs. 1040), declines in phone answering to abysmal 50 percent connect rates, and delays and losses in attempted collection of delinquent receivables - all of which yield negative effects, including taxpayer irritation, garnishees, and foreclosures. In fact, budget cuts in past years have cost far more in lost revenues and aggravated taxpayer relations than the value of saved expenditures.

Although the current IRS budget of $7.8 billion is often cited as proof of the agency's inefficiency, the figure actually compares favorably to that of other nations' collection agencies. The U.S.'s IRS budget is less than 0.5 percent of revenues collected, while the highly regarded tax administrations in the U.K. and Australia are funded at more than 1 percent of revenues. The efficacy of any IRS budget level depends greatly on effective leadership, planning, staffing, and accountability-little of which have existed. Therefore, the foremost priority should be to fix the organization, rather than to shave its budget.

* Tax Simplification. Virtually no heed is paid by Congress to the administrative complexity of tax legislation - which is why we now have 42,000 pages of tax regulations, compounded by 821 new tax code changes in the 1997 Taxpayer Relief Act. The total detachment of legislation from administrative practicality is illustrated by the capital-gains form's growth from 17 lines in 1996 to 54 lines in 1997, accompanied by virtually unintelligible new instructions.

There should be a formal process for the IRS to submit complexity indices and administrative comments to relevant Congressional committees before new tax legislation is written. As to the existing tax code, the IRS should be invited to submit simplification suggestions bi-annually that could enhance compliance and administration with little threat to tax revenues or underlying social objectives. The legislature's gross inattention to complexities costs taxpayers an estimated $75 billion annually for compliance, as well as aggravation, uncertainty, and misdirected decisions driven more by tax regulations than common sense.

One simplification should aim to enable more of the 100 million simple filers (people with only wages and interest income) to file scannable 1040EZ and 1040A forms. For example, present rules bar 1040EZ usage by a taxpayer with more than S400 in interest income.

* Encouraging Compliance. The IRS estimates that our nation's self-assessment tax system has an 85 percent voluntary compliance rate, which is higher than rates in other advanced economies. This compliance rate is crucial to the collection of $1.6 trillion of annual IRS revenues. A mere 1 percent degradation would cost S16 billion in lost revenues. Threats to current compliance include the negative behavioral influences of the 15 percent of non-compliers on conformers, as well as flaws such as complexity, poor service, and weak audit practices, in terms of quality, quantity, and timeliness - many of which have been worsened by budget cuts. As a remedial step toward improvement, the new IRS commissioner recently expanded peak season telephone service to six clays per week and 12 hours per day; 90 percent of calls now get through.

* Efficient Problem Resolution. There are many examples of frustrations, time delays, abuses, and staff contradictions in dealing with taxpayer grievances and irregularities. These enervating and costly happenings are caused by unjustifiable IRS reluctance to delegate common-sense authority and trust to the most proximate, knowledgeable, local IRS representative who first encounters the discrepancy or grievance. Fear of an occasional, honest error in judgment obstructs quick, fair, polite resolution of differences.

The smarter way is to give more authority - and integrated data access - to problem resolvers, subject only to post-audit samplings that identify agents who need further guidance or changed behavior, responsibilities, anti authority. Special discretion or sensitivity should be granted to first-time "offenders" or discrepancies, and more rigor should be reserved for repeat offenders.

Furthermore, IRS problem resolution officers (PROs) and taxpayer advocates (TAs) should not report to the same line organization whose problems they correct, because their remedial action may be viewed as criticism of their line boss and/or damaging to their carer - precisely why our nation's judges do not report to the Executive Branch. All PROs and TAs should report directly to a senior and empowered IRS Taxpayer Advocate, who should be accountable only to the IRS commissioner.

One index of ineffective and rigid TA performance is the fact that of 32,000 "Taxpayer Assistance Orders" (TAOs) requested in 1996, only five were granted by the administrative process. The rest were concluded by assessments or taxpayer compromises and concessions - some perhaps out of fear or fatigue.

* Restructuring Congressional Oversight. Seven committees in Congress have chairmen and staffs who claim some jurisdiction over the IRS. These committees often give different (occasionally contradictory) priorities and advice to the IRS Commissioner, who is called to many Capitol Hill hearings because of the numerous committees and staffs. In 1997 there were 20 such appearances and 12,000 other congressional contacts and inquiries. In the past three years, various congressional entities also launched 140 GAO audits of diverse IRS activities, far more than can be competent, useful, and remedial.

There needs to be one Joint House/Senate Taxation Committee that coordinates or supersedes IRS activities of the seven other committees and the GAO. Such a "supra-committee" might include the chair and ranking minority member of each other IRS-related committee. The staff of this joint committee might be the focal point of complexity reduction out-lined above.

* Staffing Flexibility. Civil Service rules, union rules (the IRS is fully unionized), and federal hiring guidelines make it very difficult to attract and keep good managers from the outside and/or to terminate ineffective performers. Improved staffing flexibility is especially critical in IT because of tremendous hiring competition. Currently, the large IRS processing and service organization may not pay its top IT and service executives more than $120,000 per year - hardly a prescription for successful seniorlevel recruiting. Prior to 1997, only one senior external line manager was brought into the IRS, thereby reinforcing inbreeding, complacency, and lack of exposure to best practices.

* Exploring Outsourcing. The IRS processes high volumes of simple 1040EZ and 1040A tax returns. Exaggerated conterns about privacy and job protection have precluded adequate and objective consideration of outsourced processing. In contrast, New York State has outsourced all taxpayer processing to a joint venture with Fleet Street Bank. Visits by knowledgeable operations executives quickly indicate that the system smarts, service sensitivity, productivity, timeliness, automation, and esprit de corps of the seasonal New York work force in the New York joint venture clearly exceeds what exists for 1040A and 1040EZ processing in IRS centers.

With suitable privacy protection, the IRS should be encouraged to consider outsourcing highly repetitive, large volume, seasonal chores to gain operational efficiency through the competitive and motivational techniques and flexible technologies that are more readily available and funded in the private sector.

In conclusion, compared to most of the world, we have a pretty good tax collection system. But it could be much better.

WHAT WOULD YOU DO TO FIX THE IRS?

"Simplification would benefit everybody. A flat tax would be more egalitarian, easier to administer, and create a tremendous competitive edge for the U.S. economy."

- Howard W. Lutnick, CEO, Cantor Fitzgerald

"It's politic these days to bash the IRS, but running the IRS is a fairly impossible job. Congress plays pork-barrel politics. They make a tax law that's longer than an encyclopedia, and then they say, 'go enforce it.' A lot of the supposedly egregious acts of the IRS are due to!the fact that the tax code is so complicated that it creates thousands of gray areas. I think it is the height of hypocrisy for Congress to create the unenforceable tax code that We have, and then bash the very agency that they've created to collect the money.

"I think the IRS can get fixed if Congress can get fixed. The way to fix them would be to create a simple tax law - like the flat tax - that got Congress out of the special-favors business, which is a real motivating force behind the complicated tax code. That would get theiRS out from under the impossible-toexecute tax code. With a flat tax, the IRS could be cut by a factor of five; whether or not somebody was paying their taxes would be very black and white."

- T.J. Rodgers, president and CEO, Cypress Semiconductor

"To curb taxpayer conflicts with the IRS, reform the tax code. When neither side knows what the law means, it leaves room for error or mischief by both sides. Don't pretend that things or businesses pay taxes; only people do. Define people's income correctly - revenues less costs of earning revenues; a flat-rate, savings-deferred cashflowtax on individuals' domestic income would be too simple to fight over.

"To end outright rudeness of a few overzealous agents: training, training, training - and a complaint department with teeth."

- Stephen Entin, executive director and chief economist, Institute for Research on the Economics of Taxation

"My recently introduced bill [for IRS reform] includes three features:

"Make the IRS a one-stop shop that provides better and more specialized service to all taxpayers. Agency staffing and operations should be along customer lines - individuals, small businesseS, and large corporations. The questions a married couple has about the new Roth IRA are a lot different than a corporation's questions about depreciation allowances.

"Guarantee taxpayer rights: Seizure of a family's property, for example, should require prior court approval, with notice and hearing for the taxpayer. IRS penalties should be reformed, bringing an end to the "guilty until proven innocent" scenario where penalties and interest add up while the taxpayers try to prove their case.

"Establish a full-time, independent board of governors to run the agency, with full authority over how the IRS enforces the law."

- Kit Bond, U.S. senator (R-MO)

"One of the problems with the current system is that it can't be understood by the people who have to use it. It's analogous to a computer system - each time they've had new tax legislation, instead of making it better, they've made it more complex.

"The U.S. tax system rewards expenditure, and it does not reward savings - and savings are the basis for the capital that can be put into our economy to build a stronger economy, provide jobs for the people, and enhance America's competitive position in the world. So I think many people feel that the solution to the tax dilemma is to have a consumption tax of some kind that creates a taxable event when somebody spends money, but does not create a taxable event when somebody saves or invests money.

"Tax policy tends to shape people's behavior, and I think that once there's a majority consensus on which system best meets the needs of the citizens of the country, plus the capital requirements of the nation, then we can go to step two and determine how to best implement and monitor this structure. Even under the current system, there are things they could do to simplify things by administrative fiat. But anything they do would just be tinkering around the edges."

- Clark A. Johnson, president and CEO, Pier 1

Josh Weston is chairman of Automatic Data Processing, Inc., a $5 billion computing and information services company, and served on the National Commission on Restructuring the Internal Revenue Service.

ABOLISH THE TAX CODE, NOT THE IRS

While working on the National Commission on Economic Growth and Tax Reform, we both observed firsthand how the internal revenue code and the IRS are crippling our country. The commission was besieged with complaints about the capricious way in which the code is enforced. We heard countless stories of ordinary American citizens suffering nightmarish IRS investigations. One woman enclosed a notice from the IRS assessing her a $150 penalty for a one penny underpayment on her taxes. Another taxpayer expressed a sentiment common to many Americans: "Why must we feel bullied and intimidated by agencies of our own government?"

Why, indeed? To find the answer we need to look beyond the Frankenstein monster of the IRS - and find out who and what made the monster what it is. The real villain here is not the IRS, but Congress. Congress gave this agency a mission impossible: to enforce and administer an unenforceable and byzantine tax code. Many of the abuses of the IRS are a natural consequence of the labyrinth complexity of the code itself.

When the income tax system was born in 1913, The New York Times published all the required forms on one page. At that time, there were 3,000 employees at the IRS. Today the tax code is lengthier than the Encyclopedia Britannica, and, consequently, there are now 115,000 IRS employees to interpret and enforce this monstrosity. (See Table, page 51) Incredibly, the IRS now has more employees than the Environmental Protection Agency, the Occupational Safety and Health Administration, the Federal Bureau of Investigation, the Drug Enforcement Agency, the Food and Drug Administration, and the Bureau of Alcohol, Tobacco, and Firearms - combined.

Over just the past 10 years, Congress has nearly doubled the IRS budget. This year the IRS budget rises by another $600 million - or 11 percent. Despite the revelations at the recent IRS hearings, Congress still seems to be operating under a "don't ask, don't tell" policy regarding the means by which the IRS does its business.

In his wonderful book, For Good and Evil: The Impact of Taxes on the Course of Civilization, historian Charles Adams reminds us that: "From the earliest records of civilization, tax laws have taken away liberty more often than foreign invaders." Anyone who has had to undergo the indignity of a lengthy IRS audit will not find overstatement in those words. Because of the vague and subjective nature of the current tax code, the criminal provisions of the tax code could technically be used to imprison virtually every taxpayer who signs his name to a return.

Today, without a search warrant, the IRS has the right to examine the personal papers and financial documents of American citizens. Without a trial, the IRS has the right to confiscate private property - and these seizures are becoming a more and more routine technique for collecting suspected unpaid taxes. Meanwhile, twice in the last five years the IRS has been reprimanded by the Justice Department because hundreds of IRS auditors and clerks were caught illegally snooping through the returns of friends, neighbors, anti celebrities.

Clearly the IRS is an agency in crisis. IRS error rates have soared in recent years. A study by tax attorney Daniel Pilla found that the IRS telephone taxpayer "assistance" program provided about 8.5 million Americans with the wrong answer to their tax questions. (That the IRS itself often can't decipher the rules, would seem prima facie evidence that it's high time we started all over with our tax laws.) A recent U.S. General Accounting Office report found that in 1990 the IRS issued 16,000 erroneous liens. Audit results, when challenged, overcharge taxpayers an average of $2,000 per return. This is all the more remarkable given that tax court is perhaps the only area of American jurisprudence where the burden of proof is on the accused, not the government. "The IRS fails to meet the standards of financial accountability and diligence that it imposes on the citizenry," concludes a harsh 1994 report on the performance of the IRS.

Congress is now designing an IRS reform bill intended to make the agency more taxpayer friendly. While we applaud the effort, Congress is treating symptoms, not the disease. The cancer is not the IRS; it is the tax system itself.

During the past four decades, Congress has tried to make the tax code more taxpayer friendly 31 times with an astounding 400 additional revisions through public laws. But after almost every "reform," the tax system became more unintelligible. In fact, the standing joke in Washington is that the big winners from the tax bill passed last summer were the tax lawyers and accountants. The joke is more sad than funny - because it rings so true: The 1997 tax bill added some 600 new pages to the Internal Revenue Code.

Emerson once said that "the field cannot well be seen from within the field." Members of Congress need to step outside the cluttered field for a moment and ask themselves: what is the proper function of a tax code in a democratic society?

If the role of the tax code is to regulate human behavior, to encourage some forms of industry over others, to punish bad habits, and to redistribute wealth, then they should just keep tinkering. But if they believe - as we do - that the purpose of the tax code is to simply raise revenue, then it's clearly time to consider whether the ludicrously complex, expensive, and burdensome tax code is the best vehicle to accomplish such a straightforward task.

We propose that the first test of a rational tax code should be: Can ordinary Americans function under the system - even if they are not lawyers or CPAs? Our internal revenue code flunks this test. The Tax Reform Commission found many, many small business owners who told us that they have spent more money each year paying accountants and tax lawyers to figure out how much taxes they owed than they actually paid in taxes. That is the very essence of a mindless and inefficient tax system.

We all want American industry to compete and win in this new global marketplace, but our tax system is a millstone around the necks of our businesses. Mobil Oil Co. told Congress a few years ago that it now spends $10 million a year and has the equivalent of 57 full-time workers to figure out taxes. Mobil's 1994 tax forms weighed 76 pounds and reached a height of more than six feet. After serving on the Tax Reform Commission and hearing endless horror stories of this type, we were not at all surprised to learn that under the recently enacted Americans with Disabilities Act, a number of Americans are now claiming that "fear of filing" income tax returns is a protected disability.

VOLUNTEER WORK

For all of the billions of dollars we spend each year at the IRS chasing down tax cheats, there is one unwavering truth about our tax system: tax collection still depends fundamentally on the voluntary compliance of millions of honest American workers and businesses. Without voluntary compliance, the system breaks down into chaos. The IRS hearings we observed last September suggested we may be approaching that critical juncture.

Income Tax Then And Now

                                          1914           1994

Income Taxes Paid (Billions 1994 $)       $6.7         $683.4
Per Capita Income Taxes (1994 $)           $69         $2,622
Individual Tax Filers                  360,000    113,829,000
Percent of Population Filing Return       0.5%            45%
IRS Budget (Millions 1994 $)              $110         $7,100
IRS Employees                            4,000        110,000
Pages of Federal Tax Law                    14           9,40
Pages of IRS Forms                           4          4,000
Top Tax Rate                                7%            40%
Tax Rate on Median Family                   0%            28%

Sources: Cato Institute and Harper's Magazine, April, 1977 p.22.

The solution is so obvious. Every study on tax enforcement indicates that there are two overriding factors that increase voluntary compliance: First, the taxpaying public must believe the system is fair. Tax fairness does not mean that the rich pay all the taxes, but rather that everyone is playing by the same rules. And second, that the system is simple, so workers and taxpayers can easily compute what they owe. We are thoroughly convinced that a fair and simple tax code will do more to increase tax collections than doubling the size of the IRS.

Congress needs to stop talking and begin enacting some type of fiat tax. The tax could be paid on a postcard return or as a sales tax. But it must have one low tax rate (20 percent or below), and no deductions, loopholes, or credits - or at least as few as politically possible. Income must be taxed once and only once, thus ending the punitive treatment of savings and investment. And we would add one special request to Congress: please stop this reckless behavior of monkeying around with the tax system year after year.

A flat tax or consumption tax is the best way to tame the IRS. The intrusiveness of the tax collectors is directly proportional to the size of the tax code. With deductions and loopholes virtually eliminated, the scope of audits will be narrowed considerably because there is so much less information that needs to be reported and monitored. It speaks volumes about the virtues of a fiat tax system that those who lobby most passionately against it are H&R Block and tax lawyers.

A few years ago, Parade Magazine polled its readers about whether the current income tax system should be entirely scrapped and replaced with a simple fiat rate tax. By a 50-to-1 margin, readers said abolish the tax code. The most intriguing finding reported was that even hundreds of IRS agents responded with a plea to ax the current tax code.

Somehow it's reassuring that the IRS feels as victimized by our incomprehensible internal revenue code as the rest of us do.

Theodore J. Forstmann is founding partner of Forstmann Little & Co, a private investment firm whose best-known acquisitions include Gulf-stream Aerospace, General Instrument, and Ziff-Davis Publishing, and also served as a member of The National Commission on Economic Growth and Tax Reform. Stephen Moore is director of fiscal policy studies at the Cato Institute and served as an economic consultant to the Commission.