Can the IRS Really Develop a Free Tax Return Program? Many obstacles remain

The IRS wants to offer a free tax filing service, but getting there is fraught with obstacles.

The pilot program, which the agency plans to unveil next year, faces administrative, operational and technological challenges. While the Internal Revenue Service is still working out many details, unanswered questions about costs, incentives, and government integration threaten the feasibility of this ambitious project, called the IRS Direct File.

But if the service is successful, it could be a game changer for the nearly 75% of taxpayers interested in a free tax system operated by the IRS.

“This is a small pilot for the IRS, but a big step for government,” says Ayushi Roy, associate professor of digital government at Harvard Kennedy School and associate director at New America, the think tank selected by the IRS to contributing to the report said, “I know it’s not the moon landing, but that’s a big step.”

“A very archaic system”

A big problem is the IRS technology. According to the National Taxpayer Advocate’s report to Congress, the agency still uses a 60-year-old software system to process taxpayer data, and its outdated processor has caused delays in paperwork and refunds.

“They’re not quite in the 21st century in a lot of ways,” Andrew Wilford, senior policy analyst at the National Taxpayers Union Foundation, a nonprofit organization that conducts tax policy research, told Yahoo Finance. “You’re still running your master file on a program from the 1960s; they haven’t figured out how to secure the direct messaging of documents. It’s a very outdated system.”

However, the authority has successfully modernized part of its system in the past. In 1986, the company piloted an e-file program and rolled it out nationwide in 1990. Not only did the number of users grow from the initial 25,000 to 160 million returns per year, but the system changed the process forever.

“The IRS has done this before,” Roy said.

OGDEN, UTAH - MARCH 31: An IRS employee goes through tax documents at the staging warehouse of an Internal Revenue Service facility on March 31, 2022 in Ogden, Utah.  (Photo by Alex Goodlett for The Washington Post via Getty Images)

An IRS employee goes through tax documents at the staging warehouse of an Internal Revenue Service facility March 31, 2022 in Ogden, Utah. (Photo by Alex Goodlett for The Washington Post via Getty Images)

State cooperation

According to a survey conducted by MITER Corp on behalf of the IRS, nearly 60% of taxpayers would stick with their commercial software if the IRS Direct File didn’t offer state tax returns. This means that a key success factor depends not only on the federal government, but also on the legislatures of 41 states that require state income tax returns and two other states that tax capital gains.

“[One of the] “The two biggest concerns of this program are state interoperability,” Roy said. “The main difficulty we found with state interoperability was actually from a technical standpoint. How do you prevent the federal tax return from being duplicated for taxpayers to file their state tax returns?”

Although 14 states offer some form of direct filing system, it would require more work to integrate these systems into the IRS’s free filing service because they were developed independently and without the same standard.

“Each of these 14 systems is built in a different way. Some are custom instances of private tax preparation software, while others are software developed entirely in-house by the country team or a country partnership,” Roy said.

Fourteen states currently offer some form of direct filing system.

Currently, 14 states offer some form of direct filing system.

Additionally, there is no policy as to who or which group decides whether or not a state will join the IRS service. This can be the state Treasury Department, legislatures, or even a popular vote.

“It’s up to each state,” Wilford said.

It’s also unclear whether it would be the IRS or the state that would bear the burden of overseeing or paying for such a project. One of the purposes of the pilot program is to find a way to share the burden “more equitably,” Roy said.

costs for the taxpayer

The goal of the IRS Direct File is to create a widely available and free filing option for taxpayers. But one analyst questioned the premise of freedom.

“I find the fact that it says free enticing. It’s irritating to have to pay money to help the IRS rummage through your pockets,” Wilford said. “But I think in the long run, taxpayers could pay more to have the IRS do things for them, even if there’s no predetermined cost.”

This is because tax preparation services provide an incentive to help taxpayers find all the credits and expense deductions available to them. Commercial software asks a variety of questions to find applicable scenarios that could help users save money. However, the IRS may not be as motivated, Wilford said.

“The IRS has had the institutional position for some time that when it gets into disputes with taxpayers, it’s because those taxpayers are trying to outsmart you.” [the IRS]” Wilford said. “The IRS has not allowed much room for disagreement over what a taxpayer owes.”

A software’s ability to identify credits and deductions is critical for low-income families who rely on tax benefits like the Earned Income Tax Credit and the Child Tax Credit for a higher refund. Joanna Ain, associate policy director at Prosperity Now, hopes the pilot program will take this into account during the testing phase.

WASHINGTON, DC - FEBRUARY 8: US Secretary of the Treasury Janet Yellen speaks during an event marking the Child Tax Credit/Earned Income Tax Credit Day of Action in the South Court Auditorium in the Eisenhower Executive Office Building on February 8, 2022 in Washington, DC.  Vice President Harris encouraged all Americans to take advantage of the child tax credit, which is part of the American Rescue Plan.  (Photo by Alex Wong/Getty Images)

US Treasury Secretary Janet Yellen speaks during a Child Tax Credit/Earned Income Tax Credit Day of Action event in the South Court Auditorium in the Eisenhower Executive Office Building on February 8, 2022 in Washington, DC. (Photo by Alex Wong/Getty Images)

“Each US household is different and may be entitled to different tax credits and deductions. It’s critical that we ensure low-income applicants have access to any tax credit they qualify for,” Ain wrote in an email to Yahoo Finance. “If an IRS system is well designed and implemented, I believe it can look up credits and deductions just as well as a private system.”

But not everyone shares the same beliefs.

“You have to be a little skeptical that the IRS is really going to look at every penny they can save you,” Wilford said.

How much does this program cost?

Another big question is how much such a high-profile program will cost, and secondly, where will that money come from?

For at least a decade, IRS funding in Washington has been on the brink. Even the agency’s recent $80 billion gain from the Inflation Reduction Act was cut by more than a quarter, or $21.4 billion, by the debt ceiling agreement.

Aside from initial program development—including building secure, multilingual, and mobile-friendly tax filing software—the IRS needs a budget for annual maintenance and updates to keep up with technological and tax changes.

The IRS estimated that for 25 million applicants, the program would cost $250 million per year, which equates to about $10 per tax return. However, according to the IRS report to Congress released last month, the cost of filing per tax return can rise to $16 if just 5 million taxpayers use the service.

FILE - The exterior of the Internal Revenue Service (IRS) building in Washington March 22, 2013. To stop personal threats against IRS employees, the agency is announcing it will begin capping the number of workers.  personal data to communicate with taxpayers.  (AP Photo/Susan Walsh, file)

The exterior of the Internal Revenue Service (IRS) building in Washington, March 22, 2013. (AP Photo/Susan Walsh, file)

Thus, the feasibility of the program could depend on the total cost, which in turn depends on the number of users. But there’s no way of knowing how many Americans would switch to the program.

“At worst, IRS diverts resources from other key technology priorities and ends up with a prototype that’s expensive, doesn’t work very well, isn’t widely adopted, and then gets discarded,” said David Kautter, editor-in-chief of Tax Notes Today International, said in a recent podcast episode.

Statistics show that the agency processed nearly 169 million tax returns in tax year 2022, meaning total costs may rise if the agency decides to expand its reach.

“If [the IRS ] “I wanted to broaden the scope, not just in terms of the taxpayers to serve, but also in terms of the services offered, it’s going to cost taxpayers even more,” Wilford said.

“A registration portal is a promise, but we don’t know if it is [the IRS] would actually be able to keep.”

Rebecca Chen is a reporter for Yahoo Finance and previously worked as an investment tax advisor Chartered Accountant (CPA).

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