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Tax History: The Bank Reporting Plan and Fear of an ‘Inquisitorial’ IRS

Posted on Oct. 25, 2021

It was always going to be a hard sell.

When Democrats proposed a new bank reporting requirement to help shrink the tax gap, industry pushback was inevitable. After all, banks and other financial institutions have been required to provide information about their customers to federal tax authorities for over 100 years. And for pretty much all those years, financial institutions have been complaining about the requirements.

Lawmakers and Treasury officials have sometimes caved to these complaints, as in 1943 when they eliminated the requirement that brokerages report trading details on their biggest clients. Other times, officials have forged ahead with plans for expanded requirements, essentially telling financial institutions to suck it up.

That response can be effective when targeting regulated businesses. It’s unlikely to work when used with taxpayers.

And taxpayers, it turns out, might be displeased with the Democrats’ new reporting proposal. In recent weeks, we’ve all borne witness to a cascade of complaints — about lost privacy, intrusive government, and tax collectors run amok.

These complaints come not from taxpayers but from the politicians and pundits who claim to represent them. Which raises some questions about the authenticity of this outrage: Is it genuine or manufactured? Grassroots or AstroTurf?

Polls might help answer the question. But there are problems with using polls to measure public opinion on specific policy issues. Like all surveys, issue polls can be unreliable (although they probably don’t deserve their reputation for being especially bad). Polls on this particular issue are also rare. And issue polls sponsored by industry groups? Well, they have to be taken with enough salt to worry your cardiologist.

That said, a poll conducted by a reputable firm shouldn’t be dismissed out of hand, and a recent survey by Morning Consult should concern Democrats (even though it was sponsored by the Independent Community Bankers of America). Apparently, 67 percent of Americans oppose the reporting proposal as originally structured with its $600 reporting threshold. (A similar poll by Rasmussen Reports — less reliable in my view, but you make the call — found 69 percent opposed to the original proposal.)

This number is a bad one for Democrats, even when heavily salted. It’s bad because it’s big. But it’s also bad because it resonates with the history of American attitudes toward federal tax authorities. Americans have always been suspicious of the tax agency, inclined to view it as both intrusive and inquisitorial. And when combined with the self-interested opposition of various industry groups, this popular suspicion can make information reporting a hard sell.

Let’s start at the beginning.

In 1861, as Congress was debating the nation’s first income tax law, Rep. Roscoe Conkling of New York attacked the levy for its necessary but invasive bureaucracy. “One of the most obnoxious — perhaps the most obnoxious — of all it[s] features is that which creates an army of officers whose business it is to collect the tax,” he told his colleagues. “It provides machinery cumbrous and unnecessarily expensive. It provides oppressive modes of assessment and collection.” Indeed, Conkling proclaimed in a good 19th-century burst of righteous rhetorical outrage that the law would create “a system more unendurable than the tax itself.” (Prior analysis: Tax Notes, Dec. 24, 2001, p. 1739.)

As Ajay K. Mehrotra, a law and history professor at Northwestern University and executive director of the American Bar Foundation, has pointed out, there’s evidence that this outrage existed outside the walls of the Capitol. “Petitions and protest letters poured into congressional offices,” Mehrotra writes in a 2016 article on the history of withholding and information reporting. Both taxpayers and business groups wrote to complain about the “unlimited power” of federal tax authorities.

The Civil War income tax proved to be a fiscal success but a political failure; after raising large sums to fund the war, it was allowed to disappear when peace returned, thanks to the complaints of disgruntled taxpayers. Its financial burden on taxpayers was obviously paramount, but questions about the “invasive” and “inquisitorial” nature of its collection also helped activate postwar opposition to the levy.

In 1894, when Congress tried to revive the income tax, lawmakers tried to soften some of its more inquisitorial qualities, chiefly by replacing specific direct withholding provisions (used during the Civil War) with new information reporting requirements. Lawmakers hoped that reporting would seem less invasive than withholding.

The Supreme Court ended that speculation by tossing out the whole law.

In 1913, when the income tax returned for good, lawmakers ditched their worries about taxpayer sensitivities and revived a vigorous withholding regime. The new legislation required any person or entity making payments of more than $3,000 annually — whether for salary, interest, or any other sort of regular income — to withhold tax payments on behalf of the taxpayer.

Such a regime seemed almost sure to raise hackles — and it did. The old complaints about inquisitorial officials were suddenly fresh again. “Philadelphia Representative Robert Adams Jr. warned that the process of withholding and self-assessment would ‘corrupt’ the people and bring an unwanted army of ‘spies’ and ‘informants,’” Mehrotra writes. Those spies and informants, meanwhile, now included bankers and brokers who were collecting tax and submitting information returns to the Bureau of Internal Revenue.

Defenders of the new system were unapologetic. Mehrotra quotes Garrard Glenn, a New York commercial lawyer and Columbia University law school lecturer, in his defense of privatized collection responsibilities. “Thus in every case of deduction at the source, the Government ends by not only getting the tax, but by knowing whom it is taxing,” Glenn observed. Lawmakers had given financial institutions new and important responsibilities, having “laid upon this citizen turned tax gatherer the additional duty of collecting from the creditor a statement identifying himself as such.”

Glenn’s bottom line was sobering but largely unapologetic. “We might as well face the fact that the Government cannot go very far with taxation of incomes without being forced to adopt an inquisitorial system for discovering objects of taxation,” he declared with only modest ambivalence.

Yikes.

Glenn and like-minded defenders of the new regime believed that inquisitorial procedures could serve good, useful, and even small “d” democratic ends. In particular, they could ensure that the new income tax operated fairly — that all taxpayers shouldered their legal burdens rather than escaping them through undetected subterfuge.

“The process of collecting taxpayer information not only facilitated greater social control and surveillance by making national taxpayers more visible or legible to state actors,” Mehrotra writes. “It also assured other Americans that the federal government was serious about enforcing a tax aimed primarily at the country’s wealthiest citizens.”

This fairness argument — that better information reporting will ensure that wealthy taxpayers pay their fair share — is the same one being deployed today in defense of the new bank reporting proposal. By closing off avenues of evasion, the new reporting plan would ensure that fewer people manage to skip out on their moral and legal responsibilities to the fisc — and their fellow citizens.

It’s a powerful argument, but not always a successful one. In those early years of the modern income tax, it struggled to prevail against business-led hostility. Withholding gave way almost immediately to business opposition, but so, too, did information reporting. While the reporting regime never disappeared entirely, business interests managed to limit it, especially after Republicans captured the executive branch in the 1920s.

Then, as now, financial institutions and their editorial allies complained about the burden of information returns. The new Form 1099 (then used for almost all information reports) was the target of special animus. As The Wall Street Journal complained in 1917:

This is regarded as the most important blank form in the whole process of collecting income tax. It will involve an almost endless amount of labor on the part of many thousands of employers throughout the country, who will be asked to fill out a blank for every employee who earns $800 or over. Owing to complicated methods of compensation where day wages, commissions, bonuses, time checks and various other arrangements are employed a great deal of bookkeeping will be required in order to comply with the law.

Such complaints kept a lid on information reporting, at least for brokerages, until the 1930s. But then, with Democrats in the ascendancy and Wall Street in disrepute, financial institutions found themselves saddled with new requirements. They were in no position to resist.

I’ve explored some of the later history of information reporting in previous articles. (Prior analysis: Tax Notes, Feb. 13, 2006, p. 787.) But the key issue is this: Financial institutions required to report information never like the idea. It antagonizes their customers and requires extra work. Those arguments can be less than persuasive — especially complaints about administrative burdens, which always seem chronically overwrought.

But the point is simple: Reporting institutions will resist these proposals. As they have this year. As they have every year.

The problem for Democrats, however, is that reporting requirements can also prove unpalatable to actual voters. Americans have a long history with their tax collection agency, and while it has never been a warm one, it’s fair to say that it has gotten worse in recent decades. Americans certainly worried about invasive, overreaching tax collectors in the 19th century, and even well into the 20th century. But concerns about the IRS and its “army of officials” have been very much alive these past 30 years or so.

None of which means that the current proposal to expand bank account reporting is a bad idea — just that it is fraught with political danger for Democrats. It doesn’t take much to activate latent fears of the IRS. They run deep.

And I suspect that these perils are especially real this year — a year when the IRS is getting most of its media attention for operational failures. A year when the agency can’t answer its phones or process returns in a timely manner.

These failings may be the fault of lawmakers even more than the agency, thanks to chronic underfunding. But that’s beside the point: The failings make the agency more frightening to taxpayers (aka voters). Is anything scarier than a powerful agency that is also incompetent?

The campaign against the bank reporting proposal has many of the hallmarks of a well-organized AstroTurf operation. But it would be a mistake to dismiss opposition to the legislation as purely artificial. It draws on a long, and genuine, history of suspicion and worry.

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