IRS Data Web Snares Mostly Low- and Middle-Income Taxpayers

The Internal Revenue Service relies on technology more than ever to sniff out tax cheats using robo-audits and data mining--but so far it has caught lot of minnows, and big fish are still eluding detection.

Even as millions of people's accounts are screened online and matched against their digital files elsewhere, the IRS's data-detection tools come nowhere close to collecting the $400 billion in tax dodges estimated to take place each year. The area in which its robo-audits have had the most impact is on tax returns for low-income taxpayers who try to claim the Earned Income Tax Credit. In total, fraudulent claims totaled $2 billion, just 0.01 percent of the total of individual taxes. The EITC was the biggest single compliance problem cited.

[Read: How IRS High-Tech Tools Track Your Digital Footprints.]

That amount is expected to rise in the tax year ahead as the IRS extends the use of data mining to include the personal data of millions more taxpayers. Its sophisticated data-matching and pattern-recognition technology, largely developed by IBM over the past decade, will reach up the income ladder to include more middle-income and small-business filers who itemize deductions, although it is unlikely to have any impact on the complicated filings of high-net-worth taxpayers in the top 5 percent of income earnings, say tax experts who have studied the IRS plans.

"Real time" audits of electronic tax returns. The IRS's next phase in high-tech tax collection will be to create a "real-time" check of tax returns to "match them to third party information," said U.S. Treasury Inspector General for Tax Administration J. Russell George in testimony before Congress. Starting this year, the IRS tools will be able to track all credit card transactions, for starters. The agency has also instructed agents on using online sources such as social media and e-commerce sites including eBay, as well as the rich data generated by mobile devices. In one controversial disclosure in April, the ACLU showed documents in which the IRS general counsel said the agency could look at emails without warrants, but the IRS has said it will not use this power.

While the agency has declined to give details about what third-party personal data it will use in robo-audits and data mining, it has told government and industry groups that its computers are capable of scanning multiple networks at the same time to collect "matching" comprehensive profiles for every taxpayer in America. Such profiles will likely include shopping records, travel, social interactions and information not available to the public, such as health records and files from other government investigators, according to IRS documents.

The IRS did not respond to written requests for information on its program. But George gave Congress an outline last April of the ambitious aims of its $1 billion "modernization" that gave it access to dozens of databases it has not previously used. "This capability is designed to feed into a single, consolidated taxpayer-account database that will support the deployment of the next generation of taxpayer service and enforcement functions," George said in testimony.

[Read: What Does the IRS Know About You? A Lot.]

But the many problems encountered already with the relatively simple screens used for Earned Income Tax Credit filers suggest there may be greater problems ahead for taxpayers. Already, independent advisers to the IRS have publicly warned that the agency is not prepared to take the next big step. "Little has been accomplished to remove the confusion and uncertainty related to these rules," said a report from an IRS Tax Advisory Committee group that studies emerging issues such as use of third-party networks and data mining. Other IRS advisers have cautioned that the lack of transparency and secretiveness of the IRS could undermine the credibility of the tax-collection system.

Big problems with small robo-audits. History shows that public convenience and even-handed service is not a high priority for the IRS when it launches new technology. The robo-audits targeting the Earned Income Tax Credit have caused problems for millions of low-income working people, the population least prepared to appeal tax cases and one that lacks the lobbying clout of major accounting firms that help draft tax legislation for high-end individuals and corporations. The result is that hundreds of thousands of legitimate filers have had their tax returns frozen since the program began--and the number keeps rising each year, says National Taxpayer Advocate Nina Olson, who leads an organization of some 2,000 advocates who help U.S. taxpayers resolve problems and work with the IRS .

Increased auditing of the EITC recipients has real consequences for low-income Americans. The credit represents 25 percent of income for the average filer who claims it, IRS records show. Delayed refunds have led to a cash crunch for millions of filers, and "rapid return" high-interest lenders raced to fill the void for those expecting EITC cash sooner, routinely charging interest rates of 35 to 100 percent before the government altered its rules to prevent abuses.

Olson says the IRS has not done enough to educate taxpayers about how to claim the credit, which involves calculations based on progressive income levels and a phase-out formula that has confused even professional tax preparers. Because it involves family members, for example, differences arise over who can claim the credit in cases of joint custody for divorced or estranged parents.

The IRS says it targets this credit because it is widely abused. Those who claim the Earned Income Tax Credit are audited twice as often compared to the average for all taxpayers, the National Taxpayer Advocate reports. Olson says the aggressive pursuit of tax cheats has intimidated some from appealing audits or even filing for the credit. The IRS itself says that as much as 25 percent of people eligible do not claim it. And unlike other classes of audits, returns are frozen as soon as questions are raised and refunds are not issued until the case is cleared. Many who appeal do win their cases, but the lack of professional help is a barrier. A study by the Office of the Taxpayer Advocate found that those who manage to bring representatives to an IRS appeal were twice as likely to win.

The IRS launched a huge publicity campaign when it went after identity theft, but has said next to nothing about this much larger program involving "real time" audits using third-party networks including such information as credit card charges. The agency has disclosed so few details that some tax experts who have worked closely with the IRS suggest that its intent seems to be a "gotcha" strategy aimed at trapping tax cheats rather than deterring bad behavior and encouraging compliance. The IRS's own advisory committee, made up of high-level tax professionals and managers, says people are operating in the dark even when it comes to basic issues. For the tax community to understand how to comply, a clear understanding of a "third party payment network must be defined," the committee said in a November report.

"Are they being too secretive? Probably," says Joel Slemrod, a University of Michigan business economics professor who studies the impact of government policy on consumer behavior. "They can't tell the public everything they do, but I don't know why they are being as secretive as they are. "

What's known is that the IRS has gradually moved to a system of electronically "scoring" returns, according to tax experts who worked closely with the agency. Points are assigned for unusual deductions, inappropriate credits, math errors and other suspicious items on tax returns. Most importantly, the screening program assigns a score for how likely the success of an audit will be and how much time it might take an agent to close a case. It even estimates the number of hours a hearing might require. Agency cutbacks mean fewer agents are available to follow up on audits. The result is that "low-hanging fruit" gets picked for audits. When the program was launched in the mid-2000s, the IRS testified that such cases would not be the priority. Budget constraints have shifted that view.

"There is a cost-benefit analysis applied in the scoring," says Eric Toder, an economist who is co-director of the Urban Institute-Brookings Institution Tax Policy Center. He has worked as a consultant to the IRS and its overseers in the past on issues of tax collection.

Hidden income remains invisible. At the opposite end of the income spectrum, it's far more expensive to chase down high-income tax dodges. A low-income family might be flagged by the robo-audit for a math error on a $1,500 student loan credit that can be collected with a simple letter from the IRS. A questionable $5 million investment in a euro debt swap involving unlisted derivatives and having no clear economic purpose beyond tax avoidance, even if it is detected, might require a trip to a Liechtenstein bank to meet with a team of lawyers and accountants. Often, this kind of tax action amounts to a multimillion-dollar bet of the IRS's thin resources with low odds of paying off.

The IRS has become more proactive in targeting banks and financial institutions that aid in illegal tax dodges using offshore accounts. But its technological push is largely focused on domestic filers. Meanwhile, a report by former McKinsey & Co. economist James Henry estimates that 100,000 super-rich individuals worldwide have $9.8 trillion stashed in offshore accounts.

That means a large portion of the $15 trillion of U.S. investment in the global economy generates income that is increasingly out of the reach of U.S. tax authorities, said Inspector General George in his testimony. Private estimates suggest there may be as much as $125 billion in tax evasion, he said. That's on top of the IRS's $400 billion "tax gap," which is estimated largely by auditing and following up on existing tax returns and checking the validity of audits, but not touching "unreported" or hidden income. George told Congress that global tax dodges are not targeted because "identifying hidden income in international activity is very difficult and time-consuming."

The expansion of IRS technology was heralded for its potential to bring more tax cheats to justice. But Toder says, "It's unlikely they can move that number very much." The likeliest group to be caught, Toder says, will be small businesses, filers of Schedule C "side business" expenses and independent contractors whose income is not backed up by a W2 wage report. This group is believed to make up the largest portion of the so-called "tax gap."

Avoiding controversy, IRS stealth strategy. Going forward, many more people will feel the intrusive pinch of IRS robo-audits and personal data mining--although they may not know for sure what personal data is being used. Legal and privacy experts, as well as the IRS National Taxpayer Advocate, have called on the agency to share detail on what documents it examines in audits. By working in collaboration with taxpayers, it will be more likely win cooperation and compliance, they argue. The IRS has told Congress such disclosures might hamstring its efforts. The agency prefers a "stealth" approach of not informing taxpayers about what information is used, which Acting IRS Commissioner Steven T. Miller told Congress is "less intrusive."

The IRS is following the philosophy of former Obama regulatory czar, Cass Sunstein, who advocates using technology tools and behavioral science policies to "nudge" people to do the right thing. In the case of the IRS, that policy so far has fallen most heavily on lower-income taxpayers and has done little to collect substantially more tax revenue.

Ultimately, the agency's legacy could be measured in lost privacy, says Harry Surden, a University of Colorado--Boulder Law School associate professor and former fellow at Stanford's Center for Computers and Law, who has done in-depth studies on the use of technology by government. He has found that data mining and new technology make possible a level of government intrusion into personal lives that few realize is possible. At a hearing this month, Iowa Republican Senator Charles Grassley said IRS Acting Commissioner Miller has not done enough to explain the agency's stance on "abusive intrusion of privacy," adding that "the IRS has to take this issue seriously, and a casual explanation is inadequate." He called to "clarify the true policy in writing" on how and why it uses private electronic communication in tax work.

[Read: Good News, Bad News for Tax Refunds.]

"You could get the tax gap down close to zero, but it would certainly not be a good policy to spend that much," says Michigan policy expert Slemrod. "Nor is it advisable in the same way that it is not good policy to put someone on every corner of every street to eradicate street crime."

Technology and law experts say that for such major expansions of government into people's lives, simply doing what is legal could have unintended effects that could be detrimental to a system that requires cooperation from taxpayers and the legal community.

"When technological change in the ability to analyze and aggregate data allows activities that are different, not just in degree, but in kind, we as a society should have the ability to think about whether or not we should go down that path," says Surden, who worked as a programmer for Cisco Systems before studying law at Stanford University. "As a publicly accountable agency," he says, "the IRS should make the public aware if technology is allowing them to analyze data in ways that were not possible in the past. That should be an open discussion we all participate in."