A Framework for Optimal Resource Allocation for the IRS

1. A Framework forOptimal Resource Allocationfor the IRS Alan Plumley International Conference on Institutional Taxation Analysis 21 September 2009

2. The Most Crucial Question • What is the “best” allocation of IRS resources? Is there one right answer? • Enforcement vs. Service? • Audit vs. Collection? • In-person vs. Internet Services? • Individuals vs. Businesses? • IRS vs. Private costs? 21 September 2009

3. The Stakes Are Huge • Sub-optimal allocations lead to: • Low voluntary compliance • Numerous inadvertent errors by taxpayers • Unnecessary compliance burden placed on taxpayers • Unnecessarily large budget deficits • A disproportionate share of the overall tax burden borne by compliant taxpayers • Noncompliant businesses taking a competitive advantage over compliant ones 21 September 2009

4. Three Subsidiary Questions • Ultimate Objective: What, specifically, should the IRS be trying to achieve? • Theory: How can we identify the best use of resources to achieve our objective, given our constraints? • Plan: What should we do in the short and long terms to make progress toward optimal use of IRS resources? 21 September 2009

5. 1. Ultimate Objective Maximize: weighted net benefits (i.e., benefits - costs) Subject to: budget and other constraints • Tax revenue paid timely • Enforcement revenue • Other late payments • Revenue protected • Refunded overpayments • Tax payments more closely aligned with true liabilities • IRS budget • Taxpayer costs • Out-of-pocket expenses • Time • Frustration • Third-party costs • Information reporting • Withholding 21 September 2009

6. 1. Ultimate Objective • Weights • Late payments vs.timely payments • Apply a discount rate • Enforcement refundsvs. enforced assessments • Private compliance costs vs.government costs • Constraints • Fixed budget • Tax law in place this year • Geographic distribution of taxpayers & employees • Job markets, hiring rules, training needs 21 September 2009

7. 1. Ultimate Objective • What About Non-Revenue Benefits? • If they can be expressed in dollars, include among the other benefits. • If their cost is mostly overhead, then reflect in the cost of those programs. • Otherwise, allocate resources to these functions separately, much as they are now. 21 September 2009

8. 1. Ultimate Objective • How is Fairness Incorporated? The aggregate value of underpayments of tax is minimized. “Levels the playing field” as much as possible. The aggregate value of over-payments of tax is minimized (by preventing or correcting them). Taxpayers wouldn’t have to pay more than is due. All activities would be funded (and all workload would be selected) on the same objective basis. Taxpayers would not receive stronger or more lenient attention from IRS for other reasons. 21 September 2009

9. 1. Ultimate Objective • Burden Reduction Not Another Objective • Necessary compliance costs (a means to the end) • Produce more net benefits than alternatives • E.g., third-party information reporting • E.g., forms & publications that explain & apply the Tax Code • Unnecessary compliance costs • Little or no benefits generated • E.g., confusing forms, publications, procedures • Customer & Employee Satisfaction • Also means to achieve the objective, not a competing objective • Helpful if it increases benefits and/or reduces costs 21 September 2009

10. 2. Theory:A Constrained Optimization Problem • Solution: Allocate resources such that the next “dollar” spent in each activity would produce the same expected benefit. Equalize the marginal benefit/cost ratio (“bang for the buck”) across all activities that can be expanded • If not equal, then we could increase expected net benefits by shifting resources from activities with low marginal benefit/cost to those with higher marginal benefit/cost. • An “activity” could be a program, a return, or a line item. 21 September 2009

11. 2. Theory:Sub-Optimal Approaches to Allocation We will forgo potential net benefits if we allocate operational resources based on: • The size of the tax gap to be addressed • The noncompliance rate in each activity • Average “yield” in each activity • Average benefit/cost in each activity • Direct enforcement results only • “No-change” rates • Rules of thumb • Vague perceptions of noncompliance 21 September 2009

12. 2. Theory: The Tax Gap Is Not a Guide For Allocation • It is natural to focus our effort on the areas where noncompliance is worst. • However, that’s sub-optimal operationally because… • The largest components of the tax gap are often also the components that are the least cost-effective to combat (at least with current approaches). • That is often why noncompliance is worse among those components. • Expanding current activities in those components would typically result in lessof the tax gap being reduced than with more cost-effective activities. 21 September 2009

13. Is It Fair to Ignore Noncompliance That’s Not Cost-Effective to Pursue? 2. Theory : • Yes. • Remember that the benefits include indirect effects. If pursuing a segment increases voluntary compliance, that will be reflected in its overall cost-effectiveness. • Pursuing work that is less cost-effective means that less of the tax gap will be closed, which is unfair to compliant taxpayers. • The “fairness” to noncompliant taxpayers (potential targets of enforcement) is not as important as the fairness to compliant taxpayers. • No. We must not “ignore” those areas. • We should use the tax gap as a guide in allocating our research resources, developing better (more cost-effective) ways to improve voluntary compliance and enforcement. 21 September 2009

14. 3. Plan: Priorities for the Long Term (10 years) • Estimate marginal benefit/cost for each activity as a function of budget outlay for that activity • Direct effect (enforcement & processing activities) • Indirect effect (service & enforcement activities) • Combine marginal benefit/cost curves for all activities into an overall optimization model • Modify model output only to take into account benefits, costs, and constraints that are not yet quantified appropriately • Move incrementally toward optimal allocation 21 September 2009

15. 3. Plan: What Can Be Done in the Meantime (2 Years)? • Develop consensuson key components of our ultimate objective • Whatbenefitsandcosts (to IRS and to taxpayers) should be included • What relative weights to assign to the various benefits and costs • What discountrate to apply to future amounts • Estimate marginaldirect revenue/cost for each program as a function of budget outlay • Enforcement data on total revenue (won’t include all benefits) • Budget data on expenditure by program • Not as detailed nor as much variation as would be available with our long-term data 21 September 2009

16. 3. Plan: What Can Be Done in the Meantime (2 Years)? • Derive assumed marginal indirect revenue/cost curves for each program based on “consensus judgments” • A 1998 exercise conducted by PriceWaterhouse-Coopers • Senior executives developed consensus on the relative magnitudes of the indirect effects of various enforcement and service activities • Relative magnitudes can be used to derive presumed indirect revenue/cost curves for other programs • Start with a “known” curve estimated statistically for Examination • Derive a presumed curve for each other program as a multiple or fraction of the “known” curve, where the multiples and fractions are based on the consensus relative magnitudes. • Advantages and Disadvantages 21 September 2009

17. Conclusions • IRS can undoubtedly makebetter use of existing and new resources to achieve greater benefit and impose less cost on taxpayers. • To do that, we need to be explicit about our ultimateobjective, and allocate resources at the margin accordingly. • Developing that capability will likely take a concerted, long-term (10-year), cross-functional effort to: • Gather the right data every year; and • Introduce extra variation in our activities, making it easier to estimate their direct and indirect impacts at the margin. • We can take other steps in the short term to make some improvements. • Allocating resources according to the size of the tax gap is not the right approach. 21 September 2009