Why Did the IRS Destroy 30 Million Paper Records Before Processing Them?

A new report issued last week by the Treasury Department’s Inspector General for Tax Administration (TIGTA) has taken the IRS to task for failing to prioritize e-filing. While 93 percent of individual returns are now filed electronically, only 63 percent of business returns and 49 percent of employment returns are e-filed.

All told, the IRS received 34 million paper returns in 2020. These paper returns cost the agency $226 million to process when it would have cost about $8 million had the returns been filed electronically. One major reason why e-filed returns are less costly to process is their reduced error rates: according to the report, “paper-filed tax return error rates are significantly higher because of IRS employee keypunch errors.” This is because, instead of scanning in data from special barcodes as many state revenue agencies do, IRS employees manually enter in data from paper returns. The report notes in footnote 10 that the error rate for paper individual returns is an astonishing 43.6 percent, compared to 4.5 percent for electronically filed returns.

There are big costs from the triple combination of (1) the costly and labor-intensive nature of paper tax return processing, (2) the closure of IRS facilities from March 2020 to February 2021 due to the pandemic, and (3) the antiquated nature of IRS computer systems. In March 2021, the IRS destroyed 30 million paper-filed information returns, such as Forms 1099, without first using them for audit or data comparison purposes. The IRS explained that because they were in the next tax filing season, the information could “no longer be processed due to system limitations…the system used to process these information returns is taken offline for programming updates in preparation for the next filing season.” (All while the IRS is demanding intrusive documentation from “listed transaction” filers and seeking expanded data reporting from Americans’ bank accounts.) At least 2,000 open taxpayer cases are right now held up because a paper document has not been processed; based on anecdotal reports, this is likely a significant underestimate. We’ve detailed other costs and our own recommendations to ease tax filing and administration burdens, but the issues uncovered by the TIGTA should serve as a reminder to taxpayers to retain copies of all documents.

The IRS agreed in 2009 to move forward with optical character recognition and barcode scanning technology, but has yet to do so beyond minor pilot projects. In 2014, the Inspector General recommended the IRS allow business taxpayers to file employment taxes on the same portal where they file business taxes; the IRS rejected this in favor of developing their own comprehensive e-filing platform, but then proceeded to discard their multiyear rollout strategy by 2018. In 2019, the federal Office of Management & Budget directed all federal agencies to create, retain, and manage all future records in electronic formats, but as of 2021 the IRS still has 226 tax forms that cannot be e-filed at all. The IRS did, however, move forward with adopting more severe penalties on tax preparers and businesses who do not e-file, but in the end did not assess $2.4 million in penalties on the 93 percent of those who failed to comply.

In response to all this, the IRS claims “other agency priorities and limited funding.” It brings to mind the old saying about government officials who argue that “it takes longer to do things quickly” and that “it’s more expensive to do them cheaply.” As the Inspector General’s report demonstrates, the status quo costs the IRS hundreds of millions of dollars in additional processing costs when compared to allowing easy e-filing by all taxpayers for all forms. Reduced errors, faster case processing, and generally happier taxpayers also fall into the benefit column. The IRS acts as if they must reinvent the wheel, with endless pilot projects and multi-year plans that are discarded in year two. Yet multiple state revenue departments and other federal agencies have moved toward electronic filing and document processing —  not even to mention private industry, which made these changes years ago. If “agency priorities” is really the problem here, that represents more a problem of managerial leadership than funding or technology.