Why the IRS scandal is both not as bad, and also much worse, than it seems.

If an advertising agency gets money from clients to produce television ads touting the clients’ products, the advertising agency has income on which income taxes must be paid. But if the advertising agency is a non-profit organization operated “for the promotion of social welfare”, then it doesn’t have to pay income taxes under Section 501(c)(4) of the Internal Revenue Code.

But what if the non-profit is producing television or internet ads taking political positions in the months preceding an election? Someone has to decide whether an organization like that is more political than for the promotion of social welfare, which would disqualify it for the tax exemption. That difficult task has fallen on the Internal Revenue Service, the least loved agency of our federal government.

The Internal Revenue Service has admitted doing a terrible job in executing that function. In a ham-handed attempt to cope with dramatic increases in applications for 501(c)(4) status following the 2010 Supreme Court decision recognizing political spending as the constitutional equivalent of free speech, the IRS branch in charge of tax-exempt organizations attempted to screen out those applications requiring closer scrutiny by singling out those with “Tea Party” or “Patriot” or other indicators of conservative political intent in their names.

Those singled out organizations received detailed requests for additional information, and experienced prolonged inaction by the IRS to their applications. That the IRS branch in charge was experiencing an increased workload with no increase in resources is irrelevant. The use of political indicators to screen out applications for delay and closer scrutiny was clearly improper, and should have been reversed by IRS managers. And the failure to report the problem as soon as it was discovered up the line of command was a blatant violation of the first rule of the federal bureaucracy, “No surprises.”

Two IRS managers have already lost their jobs, and it seems likely that others will, too, as Congress conducts hearings to determine who’s at fault, and who bears the political responsibility. But the criminal prosecutions that some members of Congress are calling for seem unlikely and farfetched. This scandal is about bureaucratic screw-ups and inefficiency, not political manipulation of the IRS, which the American public has reason to fear.

As a law student in the 1970’s, I studied tax law under Stanley Surrey, a former Assistant Secretary for Tax Policy under President Kennedy. Like most tax law professors at the time, Professor Surrey taught that our tax system had three basic requirements: It had to be fair, however we wanted to define that. It had to be easy to administer. And it had to actually raise the revenue required by the government.

When I began practicing, and then teaching, tax law, I felt that our tax system met those minimum requirements, and I even perceived some nobility in our tax system as representing the price to be paid for living in a free society. But over the years, I’ve become increasingly alienated from our tax system as perceptions of unfairness have increased, along with a dramatic increase in the complexity of the tax laws, and deficits have increased as the tax system fails to produce the revenue to meet government requirements.

The IRS was once an agency with a single mission, collecting the tax revenue owed by taxpayers under the Internal Revenue Code. But the IRS has become burdened with other non-revenue responsibilities, like distinguishing between social welfare and political organizations under Section 501(c)(4). The IRS is expected to develop the expertise to distinguish between different kinds of non-profit organizations, to identify which are political and which are not. The current scandal suggests that perhaps the IRS is not the right agency to do that. Maybe political organizations should be identified by another agency, like the Federal Election Commission?

The IRS has also been assigned by Congress with responsibility for spending programs, in the form of targeted tax credits. Instead of direct government spending on desired programs (spending is bad!), Congress prefers to disguise its spending through targeted tax credits (because tax cuts are good!), even though they amount to the same expenditure of federal revenue.

But the IRS ends up holding the bag for administering spending programs like the Earned Income Tax Credit directed at low-income taxpayers with children. And the IRS gets the blame for unpopular rulings it makes in the course of distributing the credits. It gets the blame if credits are delayed, or if credits are paid out to fraudulent claimants, which we are discovering now is common. Isn’t there another agency which could better administer an anti-poverty program, perhaps the Department of Health and Human Services?

And guess which agency has been designated to enforce the Affordable Care Act, also known as Obamacare? The IRS is expected to assess and collect tax penalties for failures to comply with the myriad requirements of the new statute, and will no doubt be blamed for any sins of omission or commission in trying to execute its new responsibilities. Again, political motives will be attributed to its actions. Couldn’t some other agency than the IRS do this?

So the current scandal over classification of 501(c)(4) organizations is just the tip of the iceberg which is our overburdened Internal Revenue Service, tasked with missions beyond its primary expertise. While I do not expect the immediate scandal over exempt organizations to be a big one, just wait. More and bigger scandals and controversies involving the IRS are just around the corner!