Yahoo Finance Can the IRS really build a free tax-filing program? Many obstacles remain.
The IRS wants to offer a free tax-filing service, but the road to get there is full of obstacles.
The pilot program the agency wants to unveil next year faces administrative, operational, and technology challenges. While the Internal Revenue Service is still working out many of the details, unanswered questions around cost, incentive, and state integration threaten the feasibility of this ambitious project, dubbed IRS Direct File.
But if successful, the service could be a game-changer for the nearly 75% of taxpayers who are interested in an IRS-run free filing system.
"This is a small pilot for the IRS, but a big step for the government," Ayushi Roy, adjunct lecturer in digital government at the Harvard Kennedy School and deputy director at New America, the think tank selected by theIRS to contribute to the report, said, "I know it's not the moon landing, but this is a huge step."
'A very archaic system'
One big issue is the IRS technology. The agency is still using a 60-year-old software system to process taxpayer data and its antiquated processor has caused paper and refund delays, according to the National Taxpayer Advocate’s report to Congress.
"They really haven't entirely entered the 21st century in a lot of ways," Andrew Wilford, a senior policy analyst at the National Taxpayers Union Foundation, a nonprofit providing tax policy research, told Yahoo Finance. "They are still running their Masterfile on a program from the 60s; they haven't figured out how to secure direct messaging of documents. It's a very archaic system."
But the agency has successfully modernized a portion of its system in the past. It piloted an e-file program in 1986 and implemented the operation nationwide in 1990. Not only did the user count increase from 25,000 in the beginning to 160 million returns each year, but the system changed the process forever.
"The IRS has done this before," Roy said.
State cooperation
Nearly 60% of taxpayers would stay with their commercial software if the IRS direct file does not offer state returns, according to a survey conducted by MITRE Corp on behalf of the IRS. This means that a major factor for success hinges on not only the federal government, but also legislators from 41 states that require state income tax returns and two other states that tax investment income.
"[One of the] top two concerns in this program is state interoperability," Roy said. "The main difficulty we found with the state interoperability was really from a technical angle. How will the federal tax filing not be duplicated for taxpayers in order for them to file their state returns?"
Although 14 states offer some type of direct filing system, it would still take more work to integrate these systems with the IRS free filing service because they were developed independently without the same standard.
"Each of those 14 systems is built out in a variety of different ways. Some are custom instances of private tax preparation software, and some are software they fully built in-house by the state team or a state partnership," Roy said.
Furthermore, there is no guideline on who or what group decides if a state joins the IRS service or not. It could be the state's revenue department, the legislators, or even through popular vote.
"It's up to each state," Wilford said.
It is also unclear if it would be the IRS or state that would carry the burden of overseeing or paying for such a project. One of the purposes of the pilot program is to explore a way to distribute the load in a more "equitable fashion," Roy said.
Taxpayer costs
The IRS Direct File aims to create a widely used and zero-cost filing option for taxpayers. But one analyst questioned the premise of free.
"I think that the fact that it says free is appealing. It's irritating to have to pay money to help the IRS rifle through your pockets." Wilford said. "But I think in the long term, taxpayers might end up paying more to have the IRS do things for them even though there's not an upfront set cost."
This is because tax prep services are incentivized to help taxpayers find all the credits and expense deductions available to taxpayers. Commercial software asks a variety of questions to find applicable scenarios that could help users save money. The IRS, though, might not be as motivated, Wilford said.
"The IRS has had an institutional position for some time that when it gets into disputes with taxpayers, it's because those taxpayers are trying to pull one over on [the IRS]," Wilford said. "The IRS has not left much room for differences of opinion as to what a taxpayer owes."
The ability for a software to identify credits and deductions are crucial for lower-income families that rely on tax benefits such as the earned income tax credit and the child tax credit for a bigger refund. Joanna Ain, associate policy director at Prosperity Now, hopes the pilot program will take that into account during the testing phase.
"Each US household is different and may be eligible for a diverse set of credits and deductions, it is crucial that we make sure low-income filers have access to every tax credit they qualify for," Ain wrote to Yahoo Finance in an email. "If well developed and implemented, I believe that an IRS system can look for credits and deductions just as well as a private system."
But not everyone shares the same faith.
"You kind of have to be a little bit skeptical that the IRS is really going to be looking out for every last cent they can possibly save you," Wilford said.
How much is this program?
Another big question is how much will such a high-caliber program cost, and, secondly where should that money come from?
For at least a decade, IRS funding has been on the chopping block in Washington. Even the agency’s recent win of $80 billion from the Inflation Reduction Act was cut by more than a quarter, or $21.4 billion, in the debt-ceiling deal.
Aside from the initial program development — including creating a secure, multilingual, mobile-friendly tax filing software — the IRS needs a budget for annual maintenance and updates to keep up with technology and tax law changes.
The tax agency estimated the program would cost $250 million a year for 25 million filers, which is about $10 per return. But the filing-cost-per-return can increase to $16 if there were only 5 million taxpayers who use the service, according to the IRS report to Congress published last month.
Thus, the feasibility of the program could depend on the total costs, which in turn, is based on the number of users. But there is no way to know how many Americans would switch to the program.
"Worst case, IRS diverts resources from other significant technology priorities, ends up with a prototype that's expensive, doesn't work very well, and is not widely used, and then discarded," 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 returns for the 2022 tax year, which means the overall cost can grow if the agency decides to broaden its reach.
"If [the IRS ] wanted to expand the scope, not just in terms of the taxpayers being served but also what services it would offer, it will cost taxpayers even more," Wilford said.
"A filing portal is a promise, but we don't know if it's something that [the IRS] would actually be able to keep."
Rebecca Chen is a reporter for Yahoo Finance and previously worked as an investment tax certified public accountant (CPA).
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