DRI-312 for week of 5-19-13: Our IRS Relationship: Business/Customer or Ruler/Subject?

An Access Advertising EconBrief:

Our IRS Relationship: Business/Customer or Ruler/Subject?

Last week, it was revealed that, over the course of roughly two years between 2010 and 2012, the Internal Revenue Service (IRS) sorted applications for tax-exempt status by right-wing organizations and designated them for special treatment. Special bad treatment, that is; it delayed processing of these applications by an average of more than twice as long as other applications. The organizations complained about the delay and even voiced their surmise that political sabotage by a Democrat administration might have been responsible for the delay. The complaints got them nowhere until last week, when the truth began seeping out.

The first reports gave little hint of a major scandal. According to the mainstream news media, a few crackpot right-wing outfits with the words “patriot,” “tea party” and “9-12” in their names had to cool their heels until their tax designations came through. It was all the work of a few “rogue IRS operatives” in the Cincinnati office. The New York Times buried the story on page 11. The Washington Post, though, apparently remembered that back in 1973 it ran an obscure item about a President named Nixon using the IRS to investigate his political enemies. It ran the story on page one.

The agency harrumphed and allowed as how mistakes had been made, but no serious damage had been done. President Obama assumed his by-now-familiar pose of innocent bystander loitering in the vicinity of a crime scene, remarking breezily that the IRS was “an independent agency.” This was too much for The Wall Street Journal, which ran an editorial titled “The ‘Independent’ Revenue Service,” pointing out sharply that the IRS is a key agency in the Executive Branch of the federal government, with a chief appointed by the President.

Within the next two days, further revelations emerged. The manner of their revelation was as revealing as the revelations themselves. An internal report by the Treasury Inspector General, soon to be released, confirmed the IRS targeting and the fact that IRS officials had known about it for at least two years. The targeting was not confined to one office; it was nationwide. The basis for the “special attention” devoted by the IRS was not merely the names of the groups – it went much further than that. The issues addressed by the groups were also targeted; they included “government spending,” government debt” and “taxes.” Targeted groups included those that “criticized how the country is being run” and sought to “make America a better place to live.” Questionnaires were sent requesting voluminous information; some of the more intrusive questions demanded to know future political plans of employees and the nature of religious beliefs of groups requesting religious exemptions.

President Obama abruptly reversed his previous indifference to the brewing scandal by declaring that if the “allegations” were true, they were “outrageous.” As the Journal noted, the President was referring in the conditional tense to events that his IRS subordinates had already admitted to be true. Equally significant was the fact that both of these admissions came in the form of response to questions rather than at news conferences called to discuss the specific events, as would ordinarily have been expected. The obvious inference was drawn that, had the questions not been asked, the statements made by the IRS and the President would have gone unsaid. Subsequently, it transpired that the IRS question and response had been a preplanned strategy designed to minimize the impact of the eventual Inspector General report.

In general terms, what is the significance of the scandal? In particular, what does it tell us about the relationship between the IRS and American citizens?

“The Power to Tax:” A History of Abuse

Supreme Court Chief Justice John Marshall coined the phrase: “The power to tax involves the power to destroy.” The IRS was created with the birth of the federal income tax in 1913. A centenary is traditionally a time for recapitulation and stocktaking. A good place to begin is by recalling the IRS’s history of political abuses, which reinforces Marshall’s maxim.

President Franklin Roosevelt inaugurated the practice of using the IRS as an all-purpose tool of revenge and intimidation against his political opponents, particularly his bête noire, Col. Robert McCormick, Republican owner/published of the Chicago Tribune. One of the Kennedy administration’s many well-closeted skeletons was an Ideological Organizations Audit Project, devoted to auditing tax returns of administration opponents. Lyndon Johnson was among the beneficiaries of FDR’s influence with the agency, which derailed an IRS audit that might have ended his political career by exposing an early financial peccadillo. Richard Nixon’s famous “enemies list” was a handy source of potential names for IRS scrutiny. The Clinton administration apparently launched hundreds of IRS audits of individuals and organizations that opposed the administration politically.

Now the Obama administration has taken its place on this historical roster of infamy. Its one distinctive talent seems to be one for extreme actions – spending, debt, regulation, exceeding its authority, et al. Now it has become the first administration whose IRS scandal has matured during its time in office.

Collusion Between the President and the IRS

Much of the furor surrounding the IRS scandal has raged over President Obama’s degree of involvement. Considering the history previously recounted, this is not surprising. It is hard to believe that such consummate politicians as Franklin Delano Roosevelt and Richard Nixon should have left an incriminating paper (or audio tape) trail. To date, the President’s defenders have focused on the absence of any such “smoking gun” directly linking him with the agency’s actions.

But critics such as Kimberly Strassel of The Wall Street Journal have denied the need for any such link. President Obama’s public utterances – speeches in the 2010 and 2012 election campaigns, public addresses and his remarks during press conferences – drew a road map for regulators and officials to follow. Sounding uncannily like Henry II, he lamented the burden placed on him, his administration and the country by the actions of his right-wing opponents. The only thing missing was a frustrated, whining cry a la T.S. Eliot’s Henry: “Will no one rid me of these meddlesome right wingers?”

The notion that President Obama could tell the IRS to harass the right-wing groups, not by making direct statements but purely by hinting, is embodied by the term tacit collusion. This concept is well-known to economists who specialize in the field of Industrial Organization. Ironically, academic economists tried for decades to pin the term on certain private markets – which didn’t deserve it – rather than applying to government and regulatory interactions – where it did apply.

In the 1930s, economists such as Edward Chamberlain, Joan Robinson and Paul Sweezy developed theories of “imperfect competition” – markets whose structural characteristics fell in between those of pure monopoly and ideal or “perfect” competition. One popular conjecture was that markets containing a small number of relatively large firms would feature sluggish price competition. The thinking was that each firm would be conscious of the effects of its own pricing and output decisions on the market outcome, as well as the reactions of rivals to its decisions. Instead of lowering price to compete with each other, firms would recognize their mutual interest in pricing and output restraint. Moreover, this recognition would come intuitively, without explicit cooperation on their part. Thus, they would collude tacitly to attain the same result otherwise obtained by formation of an illegal cartel.

In practice, this seldom if ever happened; it was just too difficult to achieve. The reasons for this were the same ones that made successful cartels so rare. Each party to the cartel agreement has an incentive to violate the agreement by cheating – lowering its price to steal customers while its fellow members keep their prices high. The incentive exists automatically whenever price is elevated substantially above marginal cost – which is what accounts for the profit potential of the cartel in the first place. But when all or most cartel members succumb to this temptation to cheat, the cartel falls apart because the large increase in output drives down the price and kills off the profits. This has been the fate of most cartels throughout history. And it is much harder to sustain a tacit cartel, where the terms are merely understood intuitively rather than agreed verbally or in writing, than an explicit cartel.

But collusion between government or regulatory agencies is much easier to achieve and maintain. It involves general actions rather than the specific, quantitative price and quantity decisions faced by private businesses. Instead of puzzling over “how much should we raise price, and how much should that change when our costs change by a certain magnitude?,” an agency like the IRS knows instinctively that its mandate is simply “hurt those right-wingers.” Bureaucrats and regulators do not have the same clear, strong incentives to cheat on the agreement that are present in a business cartel. When a business-cartel member cheats by lowering its price to steal customers from its fellow cartel members, its reward is increased profits. But government bureaus and regulatory agencies do not earn profits, so there is no profit motive to violate their (tacitly) collusive agreement.

Thus, collusive arrangements like the IRS policy can persist for years until and unless they are discovered. It is publicity and fear of prosecution that gives government employees their one and only motive to squeal, thereby upsetting the applecart. But the beauty of this type of collusion – from a Presidential standpoint – is that its strictly tacit character leaves the President untouched. Here, for example, there is no legal evidence – no signed document, no incriminating tape recording, no e-mail – that he instigated the IRS behavior, even though the world knows that he did.

“Was the White House involved in the IRS’s targeting of conservatives?” the Journal’sKimberly Strassel asked (5/17/2013) rhetorically. “Of course it was.” Mr. Obama’s collusive communication with his executive branch underlings began no later than his 2010 State of the Union address, when he “cast aspersions on the Supreme Court’s Citizens United ruling, claiming that it ‘reversed a century of law to open the floodgates for special interests’ (read conservative groups).” He “derided ‘tea-baggers,'” whom his Vice-President “compared to ‘terrorists.'” Then, “in more than a dozen speeches Mr. Obama raised the specter that these groups represented nefarious interests that were perverting elections. ‘Nobody knows who’s paying for these ads,’ he warned. ‘We don’t know where this money is coming from.’…In case the IRS missed his point, he raised the threat of illegality: ‘All around this country there are groups with harmless-sounding names like Americans for Prosperity, who are running millions of dollars of ads against Democratic candidates…And they don’t have to say who exactly the Americans for Prosperity are. You don’t know if it’s a foreign-controlled corporation.’ Short of directly asking federal agencies to investigate these groups, this is as close as it gets.” Strassel noted that the President’s efforts were reinforced by Democratic representatives who publicly called on the IRS to validate the credentials of right-wing groups.

The President didn’t stop at corporate intimidation. His 2012 campaign website listed eight Mitt Romney donors by name and tarred each one with various slurs, the most outrageous being that they were “on the wrong side of the law.” The most prominent was Frank VanderSloot, an Idaho businessman and longtime donor to right-wing causes. This earned him mention by the Obama campaign as a “wealthy individual” with a “less-than-reputable record.”

In April 2012, shortly after the website mention, Democratic activists sought Mr. VanderSloot’s divorce records. In June, he and his wife were audited for two tax years. In July, the Department of Labor audited records pertaining to the guest workers on his cattle ranch. In September, the IRS audited another of his businesses. That was three audits in four months following the tacit signal sent out by the Obama campaign.

The Motivation for the Crime

Although President Obama and IRS officials initially pretended that the IRS targeting of right-wing groups was merely a wayward impulse that struck a few rogue IRS functionaries, it was really a serious crime. The key distinction separating felonious criminal acts from civil torts is mens rea, or criminal intent. This makes the issue of motivation highly relevant.

When the President speaks, the IRS listens. Not only does the President appoint the head of the IRS, he also submits an annual budget – or is legally supposed to, anyway. In this case, the IRS is the agency ramrodding ObamaCare, which means that the President has made it the most important agency in the federal government. Congress votes on budget appropriations for the IRS, so IRS ears are constantly attuned to the Congressional frequency as well. Leading IRS officials recently received annual bonuses worth over six figures. These had to be approved by the President. Recently it was revealed that the President’s counsel was notified in 2012 of the findings of the Inspector General’s report revealing the targeting of conservative groups by the IRS.

What inferences can reasonably be drawn from the above set of facts? That the President and the IRS tacitly concluded in a campaign to harass, intimidate and suppress right-wing political activist groups; that the President knew of its ongoing nature and its success and rewarded IRS officials for it.

Government officials do not commit crimes randomly or capriciously. Like all criminals, they respond to incentives, both positive and negative. In this case, the specific positive incentives were the bonuses received by top IRS officials and the increase in responsibility, size and budget conferred by the award of ObamaCare responsibility. The annual appropriations process left open the potential for additional future rewards in the form of increased appropriations. Because the IRS is a command-and-control, top-down bureaucracy, top officials could give orders to subordinates to commit and support these criminal acts. The negative incentives were the potential discipline of budget cuts administered by the President and/or Congress for failing to collude.

The latest development in Congressional hearings is the refusal by IRS official Lois Lerner to answer questions and her invocation of the Fifth Amendment against self-incrimination, following an opening statement in which she denied wrongdoing.

“Just Bad Customer Service”

Not surprisingly, the IRS from the outset has employed a typical criminal strategy: minimize the crime or redefine it away altogether. In May 17, 2013 testimony before the House of Representatives’ Ways and Means Committee, outgoing Acting IRS Director Steven Miller called the IRS actions “obnoxious” but “not illegal” – in fact, he did “not believe that partisanship motivated” the agency. What was responsible, then? “Foolish mistakes,” suggested Mr. Miller with a straight face – a case of “horrible customer service.”

Fewer recent public comments by a government official have drawn more hilarity. The Wall Street Journal editorially marveled at his equating of “the coercive power of taxation” to “rude service at a Best Buy.” But the full meaning of Mr. Miller’s comparison seems to have eluded observers.

The difference between the IRS and Best Buy is not a joke. It accounts for the existence and magnitude of the abuse itself. When private citizens approach the IRS, they do so with hat in hand, virtually begging not to be destroyed. Alternatively, they arrive in the company of a lawyer who does all the talking. But when Americans walk into a Best Buy, they are in control. They may complain about prices or service, but they hold the whip hand. They can always take their business elsewhere. And, in the particular case of Best Buy, they have done just that – its stock price has been decimated in the last few years. The company has been the one to go hat in hand to the public and capital markets in order to hang on by its fingernails.

The difference between the two cases is that we are not “customers” of the IRS because the IRS faces no competition. Our relationship to them is not “business/customer” but rather “ruler/subject.” They dictate and we obey – or go to jail. Under those circumstances, any demands we make for better customer service ring hollow indeed.

That is the key to the IRS scandal. To the degree that commentators have offered solutions, they have been the usual thin gruel of reform – politicians should behave better, the press should be more vigilant, the public gets the government it deserves, ad infinitum, ad nauseum. But the only way to get better customer service from the IRS is to provide it with competition. Since that is impossible, the only solution is the removal of the IRS. And that requires the replacement of taxation as a basis for funding the federal government.

End the Power to Destroy

Several of the agencies scrutinized by the IRS are supporters of the Fair Tax, a measure designed to replace the federal income tax with a national sales tax. An ancillary result would be the elimination of the IRS. No wonder the IRS tried to harass and intimidate these groups!

Leaving taxation in place, however, would provide government with an ongoing weapon to hold at the public’s head. In order to make sure that we didn’t end up with the worst of both worlds – a national sales tax and a federal income tax still in place – we would have to amend the Constitution to end income taxation so as to eliminate the IRS. Since we have to go to this much trouble anyway, it would be far preferable to end taxation itself. That would allow us to solve the overriding crisis of our time by ending the welfare state and its mortal threat to our freedom and financial lives.

Taxation is a continual source of inefficiency and a serious hindrance to productivity. The true solution to the threat to freedom and productivity represented by taxation and the IRS is to fund government by user fees. Government would charge a price for each service it provides. Any private business could compete with government in the provision of any service.

This would allow the public to scrutinize government activities at the margin, comparing the price paid for each one with the value received. It would provide an automatic check on overspending. Coming at a moment when the civilized world is drowning in sovereign debt, it would provide an Alexandrian solution to the Gordian knot of big-government welfare-statism – a solution that probably will otherwise elude us.

Vested interests, starting with the executive and regulatory branches of government, would oppose this reform to their last breath. That and its inherent logic are two of the strongest arguments in its favor.

The chief difficulty in moving to a system of user fees lies in funding a big-ticket item like national defense, where the product must be funded and produced in advance of its “consumption” – that is, before citizens have an opportunity to gauge the value of what they are buying. Defenders of the status quo will insist that we cannot live with such a system and must put up with the bureaucratic behemoth of a defense establishment that we have now.

Increasingly, though, it is becoming clear that we cannot live with the system we have, which is now proceeding down F.A. Hayek’s famous “road to serfdom” at a breakneck pace.

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