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Tax History: Historical Perspective on IRS Funding: 1914-1923

Posted on Apr. 24, 2023

As the national taxpayer advocate has pointed out, the IRS functions as the “de facto Accounts Receivable Department of the federal government.” It collects trillions of dollars annually, but spends just billions to get the job done. By almost any measure, “the IRS is an extraordinary investment.”

Consider fiscal 2022, as described in the recently released IRS Data Book. The agency collected about $4.9 trillion while spending $14.3 billion. That translates into a return on investment of about 344 to 1 for the agency’s overall operations.

The specific ROI varies somewhat from year to year, depending on a range of factors, including several outside the agency’s control. And the ROI can actually improve when Congress starves the IRS of funds, since revenues don’t necessarily fall precipitously in response to budget cuts.

It’s also important to note that ROI discussions don’t always focus on overall IRS funding. In fact, they more typically concern the agency’s enforcement activities, for which the IRS calculates its own numbers. But as Janet Holtzblatt and Jamie McGuire have pointed out, even cuts to enforcement can result in higher ROIs as the IRS narrows its focus to the most lucrative cases.

Generally speaking, however, IRS defenders enjoy citing any sort of ROI figure because they all tend to reflect well on the agency. “It is economically irrational to underfund the IRS,” declared the national taxpayer advocate in the 2022 purple book. “If a company’s accounts receivable department could generate an ROI of 345:1 and the chief executive officer (CEO) failed to provide enough funding for it to do so, the CEO would be fired.”

This fondness for ROI figures is evident across history; IRS officials have frequently cited the agency’s ROI to bolster arguments for additional funding. As they do today, they have usually focused on the likely return to additional enforcement funding. As described in a recent Tax Notes article, for instance, Commissioner Mortimer Caplin told Congress in 1961 that new money for enforcement and technological modernization would deliver an 11-1 ROI. (Prior analysis: Tax Notes Federal, Apr. 3, 2023, p. 28.) There have been many similar episodes.

Forms of Expression

The IRS sometimes chooses to frame its collection and cost numbers in different forms, depending on political context. The “x number of dollars in additional collections for every dollar of new funding” formulation is popular when asking Congress for more money. By contrast, the “cost of collection” is a defensive presentation of the same data. Sometimes expressed as a percentage of total collections and other times as the number of cents needed to collect $100, it underscores the agency’s efficiency by emphasizing its small budget relative to its collections. In both cases, however, agency officials are making the same basic point with the same raw data: The IRS provides American taxpayers with a great deal, raising huge amounts of revenue at a distinctly modest cost.

Earlier this month, the IRS offered the most recent version of this statement. “For FY 2022, the gross collections of the agency totaled more than $4.9 trillion, or about 96 percent of all government funding,” it wrote. “When compared against the cost to fund the IRS, the ratio of agency costs to revenue was 29 cents per hundred dollars collected for 2022, the lowest cost to taxpayers in the history of the agency.”

When the IRS says its current costs are the lowest in agency history, it knows what it’s talking about — it has been tracking this metric for more than a century. The annual report for fiscal 1865, for instance, estimated that “the costs of assessing and collecting the internal revenue,” when adjusted for refunds and expressed as a percentage of total receipts, would “not exceed two and seventy-five one hundredths.” Costs would increase in 1866, the commissioner predicted, but not above 3.5 percent.

This article explores a slightly more recent episode in the history of this particular budget metric, when the “cost of collection” figured prominently in debates over funding the Bureau of Internal Revenue (BIR), as the federal tax agency was known until 1953. This period, which stretched from 1914 to 1923, included both the advent of the modern income tax and the fiscal revolution of World War I, bringing enormous change to the BIR — and to the nation’s tax system. These interrelated phenomena helped reveal the limited utility of “cost of collection” figures when trying to measure BIR efficiency — especially when Congress insisted on saddling the tax agency with administrative responsibilities that had little bearing on revenue collection.

A New Income Tax

The story begins in 1914, the first full year of income tax collection after the ratification of the 16th Amendment. The BIR had been forced to move quickly after passage of the new individual and corporate levies in late 1913, since Congress allowed scarcely any lead time for either the agency or taxpayers.

In her fascinating article, “Oleo, Whiskey, and Cigars: How William Henry Osborn Implemented the 1913 Federal Income Tax,” Mary M. Stolberg of Appalachian State University tells the story of the BIR commissioner charged with implementing the new tax. Osborne was not a lawyer or an accountant, but the owner of an addiction treatment center. He was also, however, a two-term mayor of Greensboro, North Carolina, who knew how to pick a winner: The BIR commissioner’s job was a reward for his early support of Woodrow Wilson in the 1912 race for the Democratic presidential nomination.

Osborne was sworn in as commissioner on April 28, 1913. The BIR was a respectably sized agency, in those days when the federal government was still modest in scope; it had a budget of $5.4 million and a staff of 4,860 full-time employees. It also employed “more than 5,000 part-time informants, guides, and posse members who helped track bootleggers,” Stolberg notes. But only 283 BIR employees actually worked in the agency’s Washington headquarters.

After Congress passed the Revenue Act of 1913, Osborne assigned 100 employees to work on its new income tax. Drafting regulations, designing forms, and answering public inquiries, they had their hands full; the last task alone occupied 30 full-time clerks. And then, on January 4, 1914, Osborne himself became the first person to file an income tax return under the new fiscal regime. “Reporters and the Bureau’s top officials watched as Osborne provided his information to S. H. Boyd, chief of the individual tax division,” Stolberg writes. And then things went rather badly.

Stolberg relays the account of a reporter for the Raleigh News and Observer. The process of filing Osborne’s return took six hours. By the time it wrapped up, all the notaries had left for the day. After some “scurrying to produce one,” Osborne signed the document just before 6 p.m. and mailed it to his home collection district in North Carolina. Osborne joked that he felt sorry for the rest of the nation if it took other taxpayers as long to fill out the forms as it had taken him.

Not the sort of joke you want to hear from the commissioner of internal revenue on the eve of a fraught, unprecedented filing season.

Still, when the books closed on fiscal 1914, the year had proven to be a good one — at least for the BIR. The agency had collected $380,008,893.96 and spent just $5,779,329.72. “The cost of collecting the internal revenue for the fiscal year was $15.25 per $1,000, or 1.52 percent,” the commissioner noted in his annual report. “The cost of collection the previous year, in which the largest sum was collected prior to fiscal year 1914, was $15.94 per $1,000, or 1.59 percent.”

Things were headed in the right direction, apparently. And they were certainly looking better than they had in the bad, old, inefficient days of the 19th century, when the BIR had struggled to collect almost all the nation’s non-tariff revenue in the form of excise taxes. As the commissioner had observed in the 1865 report described above, the cost of collection at the end of the Civil War was running somewhere in the neighborhood of 3 percent, and the agency had been tracking that number ever since. “The average cost of collection since the establishment of the bureau is approximately $25.14 per $1,000, or 2.51 per cent,” Osborne pointed out in 1914.

If 1914 was a good year, then so were the next few. Total revenue continued to rise at a good clip: to $415.7 million in 1915, and to $512.7 million in 1916. Expenses were up, too: to $6.8 million in 1915, and to $7.2 million in 1916. The average cost of collection rose to 1.64 percent in 1915 and then fell to 1.40 percent in 1916 — still good in historical terms.

By fiscal 1917, taxes levied to fund U.S. military preparedness, and then the war itself, had started to inflate total revenues at a very brisk clip. Total receipts jumped to $809.4 million. BIR funding, however, did not immediately keep pace. As a result, the cost of collection fell to 0.95 percent of total revenue, the lowest in the bureau’s history to that point.

That record was not destined to stand for long.

A New Regime

Fiscal 1918 was a transformative year, both for the BIR and for the nation’s tax system. A new commissioner, Daniel C. Roper, took charge of the agency. Among other things, he abandoned the dry-as-dust annual reports of his predecessor and replaced them with a narrative epic about the transformation of the nation’s tax agency and its fiscal regime.

Roper began with a statement that spoke volumes about the nation’s wartime fiscal revolution: “In a brief period the Bureau of Internal Revenue has been transformed from an agency for collecting tax from a relatively small number of firms and individuals engaged in certain specified occupations to an arm of the government reaching out to every citizen and establishing a direct fiscal relationship with every business enterprise in the United States.”

In case anyone missed the significance of that generality, Roper spelled it out: “The revenue collected and the number of transactions with individual taxpayers within the last year exceed by 10 times the corresponding yield and number of transactions in any year prior to the ratification on February 25, 1913, of the sixteenth amendment to the Constitution, under which the income-tax law of October 3, 1913, was enacted.”

In other words, the modern income tax had changed the tax system rapidly and dramatically. But the war had ramped up the pace and scale of change even more. “Collections by the Bureau have increased from $809,393,640.44 to $3,694,619,638.72.” That was a single-year increase, not a “since ratification” increase. Revenues had more than quadrupled between fiscal 1917 and fiscal 1918.

The BIR’s growing workload was the result of wartime tax legislation that expanded the individual and corporate income taxes while also creating a new excess profits tax. The agency strained to cope with its new responsibilities: “This large increase in the magnitude of the Bureau’s operations has necessitated the formulation of new policies, the adoption of new methods, the expansion of personnel, quarters, and equipment, and a general reorganization,” Roper said.

The commissioner, however, wasn’t complaining. Indeed, he was almost celebrating the BIR’s new role in American society. He offered a remark that spoke volumes — perhaps even more than he knew — about how the bureau and the country had changed. It vividly illustrated how Americans had transformed their relationship with their own government.

“As this bureau has now been brought into relationship with all citizens,” Roper began. And he might well have stopped right there, for that introductory clause was worth a moment’s reflection.

The BIR was already more than 50 years old by the time America entered World War I. But for most Americans, it was little more than an abstraction. To the extent that people paid federal taxes, they came in the form of tariff duties and excise levies, neither of which brought consumers into regular contact with federal revenue officials. Even after the return of the income tax in 1913, the new levy remained quite narrow in scope — someone else’s problem, in other words.

World War I began to change all that. To be sure, Roper was exaggerating the shift; the BIR was not in a direct relationship with “all” U.S. citizens by 1918, since direct taxes were still being paid by only a relatively narrow slice of the population. But it was a much bigger group than it used to be.

And the war had given new cultural salience to the federal tax system. Suddenly, income taxes were everywhere, evident even to people who weren’t required to pay them. The BIR organized a comprehensive “campaign of education” across a range of mass media outlets, including cartoons and motion pictures. It sponsored speeches by volunteer “Four Minute Men” who gave talks around the nation about taxpaying responsibilities. It even persuaded some preachers to offer tax-related sermons from the pulpit. “Especial effort was made to popularize the war taxes by emphasizing the needs of the country and appealing to national pride and patriotism,” Roper explained.

By the time the war was over, the BIR had introduced itself to millions of new people. It was on its way to being one of the most visible elements of the national state in an era when the federal government had a modest presence in the day-to-day lives of regular people. Increasingly, the bureau was becoming the face of the federal government — a shift that would change not just taxation but government and politics in America more broadly.

Roper’s 1918 annual report hailed the BIR’s great work, but he praised taxpayers, too. The bureau had approached taxpayers in a cooperative spirit, and taxpayers responded in kind. “A liberal and open-minded policy in all relations with the citizens called upon by the law to make tax returns has been vindicated by experience,” Roper wrote. “The people have become, by generous response to the bureau’s attitude of cooperation and reasonableness, full partners in the successful performance of raising for the support of our government, in millions of direct contributions, and aggregate sum greater than any tax levy in history.”

Issues and Concerns

Still, there were issues in the world of federal tax collection. Roper noted that wartime legislation had “created a tax-gathering task of greater magnitude than had ever before been undertaken by any nation.” The revenue collected had actually exceeded expectations, but its collection had been a complex and difficult task. Among the issues Roper pointed out were:

  • “Complexities in language gave rise to serious question as to whether the most important provisions of the law were administrable.”

  • “Concern was aroused as to the ability of the business community to respond to the requirements of the law.”

  • “Anxiety over the tax burden was accentuated by apprehension of difficulties in financing the huge tax payments.”

  • “It was asserted that the financial organization of the country could not withstand the strain of withdrawal from circulation and payment to the government of the gigantic sums that would be due in income and excess-profits taxes during the month of June, 1918.”

Somehow, the BIR had managed to overcome these problems. And as Roper laid out the results, he had reason to be proud. As noted above, the BIR had collected $3.7 billion in revenue at a cost of just $12 million. That translated into a cost of collection of just 0.33 percent of total collections, down from 0.95 percent the previous year. Revenues were expanding faster than the agency was building out its administrative capacity. That lag would create problems in short order, as the BIR developed a huge backlog of unprocessed returns. But for the time being, it made for some impressive efficiencies, at least on paper.

Roper, however, disliked this statistic, despite its tendency to make the BIR look efficient. It was misleading, he contended. “To refer to the ratio of expenditures to collections, or to the expenditures per $1,000 of revenue collected, as ‘the cost of collecting’ internal revenue is incorrect, for the reason that the Bureau performs many functions in which no collection of revenue is involved,” he complained.

The “cost of collection” number was even worse when policymakers got more granular with it. Sometimes, Congress tried to evaluate the appropriations assigned for the enforcement of a particular tax (say, the excess profits tax), comparing it to the revenue collected from that tax. But since personnel and other costs were often shared across functional divisions of the BIR, the accounting quickly got muddy and misleading. As a result, Roper said, it was “impossible to determine the exact cost of collecting particular items of revenue.”

Roper’s report for fiscal 1919 restated many of these complaints. And this time, he made his case against a less flattering number for the BIR. The “cost of collection” rose to 0.53 percent in 1919. Roper offered three explanations for the increase, none of them related to any sort of inefficiency at the agency.

First, he said, “the program of investigating and auditing tax cases has been greatly advanced during the year.” These audits were much more expensive than routine processing of returns but would not produce much in the way of additional revenue over the short term. Second, the bureau had spent considerable sums preparing for changes included in the Revenue Act of 1918. Much of the revenue derived from that measure would not show up until fiscal 1919 or fiscal 1920. Third, some tax measures were expensive to administer but yielded little in the way of revenue — usually because they were principally regulatory in nature. The Child Labor Tax Law was a case in point.

These explanations underscored Roper’s central point, which he hammered home to lawmakers for the second year in a row: “The ratio which the cost of administration bears to the collections of the Bureau is not valuable as an index year by year to the efficiency of operation because of the many nonrevenue functions which the Bureau is called upon to perform,” he wrote. “Furthermore, as long as the cost of collection remains at such negligible proportions it is probable that increases in the ratio, if accompanied by absolute increases in the amount of taxes collected or volume of nonrevenue work performed, may rather be indicative of increased efficiency than would any reduction in the ratio.”

Here was the very essence of the BIR position regarding its efficiency as a revenue agency. Translated into more contemporary language, it can be rendered more bluntly: When the cost ratio rose, the fault lay with Congress, not the BIR, since lawmakers insisted on loading up the agency with expensive, extraneous responsibilities. Plus,even when the ratio rose, it was still low — and look how much money the BIR was collecting! So don’t talk to me about efficiency; you’re getting a bargain.

Roper had a point. But the ratio continued to appear in the commissioner’s annual report.

Prohibition Costs

Expenditures relative to collections started to rise significantly after the war, partly for the reasons Roper had cited. Indeed, Prohibition enforcement became a major cost center for the BIR, costing the agency millions but producing very little revenue. (For this and other reasons, both BIR and Treasury officials had resisted taking on Prohibition enforcement, but Congress had other ideas.)

In fiscal 1921 the cost of collection ratio reached 0.87 percent, up from 0.55 percent the year before. And even after backing out Prohibition enforcement costs, the ratio was still 0.72 percent. The principal explanation for the rising cost of collection was decreased total receipts, thanks to postwar tax cuts. But ramped-up audits and return processing costs were also to blame, as the BIR struggled to clear a huge backlog of unprocessed returns. And the agency had already cleared many of the returns with the greatest revenue potential. Auditors were now looking at smaller returns, which demanded almost the same resources but held far less revenue potential.

The news only got worse the following year. The cost of collection ratio reached 1.30 percent in fiscal 1922, and 1.07 percent with Prohibition costs backed out. As the BIR closed out its first full decade of income tax collections, Commissioner David H. Blair (in office since 1921) took stock of the situation. The agency was simply unable to shrink many of its costs, he said, despite tax cuts and declining tax revenues. “In the face of decreased revenue receipts the Bureau is forced to maintain its large organization to audit the returns filed for prior years, which audit results in the refund of taxes as well as in the assessment of additional taxes,” he wrote. “The result of the decreased revenue yield and the maintenance of the large administrative body results, necessarily, in an increase in the cost per dollar of collection.”

Stepping back even further than Blair, it is possible to see the broader limits of the cost of collection metric. At various points in the decade between 1914 and 1923, the ratio rose and fell dramatically. But the changes reflected mostly exogenous factors, like American entry into World War I, the postwar recession, and Congress’s tendency to assign the BIR administrative tasks loosely connected to revenue collection.

Roper had understood these issues with the cost of collection metric — and especially any attempt to use it as a gauge of BIR efficiency. But history was a powerful influence, and the BIR had been tracking this metric for more than half a century. The agency couldn’t abandon the measure simply because modern commissioners didn’t like it. The agency did start breaking out Prohibition costs when calculating the cost of collection, but the number itself remained a staple of agency budgeting.

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