AN OVERTAXED IRS

By RICHARD STENGEL/WASHINGTON

The small bronze letters on the outside of the seven-story neoclassical building on Constitution Avenue spell out the following:

ERNAL REVEN E SE VICE

Despite the missing characters, the second two words are teased out easily enough: REVENUE SERVICE. But the first word is puzzling. ETERNAL REVENUE SERVICE? PATERNAL REVENUE SERVICE? INFERNAL REVENUE SERVICE? Perhaps all of the above?

Inside, purposeful people stride down endless hallways, past frosted-glass doors with signs denoting COLLECTION, AUDITING, INFORMATION--and one that reads OFFICE OF ACCURACY AND PERFECTION, ROOM 7513. But within the empire of the largest and most successful tax and enforcement agency in history, there is nothing resembling perfection. Like the old Soviet Union, grand and powerful on the outside but an antiquated shambles within, the IRS has profound problems with outdated technology and outmoded thinking that have undermined its self-described mission: "To collect the proper amount of tax revenue at the least cost."

The agency better known for turning the thumbscrews on tax miscreants is collecting something like $150 billion a year less than the proper amount, and misspending billions doing it. The IRS's mammoth nationwide collection and processing machine is a great, clanking Rube Goldberg contraption, a computer system that has long been disastrously and inexplicably inept--so much so that the agency allowed some 5 million suspect returns to go unexamined in 1995.

Despite being tethered to hardware that was state-of-the-art when color television was a novelty, the agency harvested about $1.5 trillion from more than 200 million individual and corporate taxpayers in 1996. Over the past decade it has spent nearly $4 billion in an attempt to bring its computers up to date. But Arthur Gross, the assistant IRS commissioner who is the agency's first world-class information-systems officer, concedes that the IRS's computers "do not work in the real world."

THE CREAKY SYSTEM INVITES SCAMS

Gross describes the IRS's information network as a "stovepipe" system--vertically aligned computers that do not communicate with one another. Tracking down the records of a single taxpayer means getting access to as many as nine different computer systems. The once vaunted IRS computer system has trouble accomplishing what would seem to be the most basic of functions: reconciling Social Security numbers, W-2 forms and even the number of children in a household. Notes Gross: "Resolving taxpayer account issues often requires considerable research on multiple systems and a series of complex, time-consuming tasks to update the various databases." In English: You can't get there from here. "Dysfunctional as some of these systems may be today," Gross says, "the IRS is wholly dependent on them."

Like it or not, the IRS is the indispensable agency. With its 106,000 employees, $7 billion annual budget and 10 regional service centers, each the size of a small city, the IRS is the second largest federal agency, after the Pentagon. It handles in excess of 200 million returns a year and sorts 1.2 billion pieces of information from 1,200 financial institutions. It reviews 60,000 employee-compensation plans and checks 90,000 tax-exempt organizations.

Americans, perhaps because they have a guilty conscience, think of the IRS as being omniscient. In fact, the IRS is often not paying attention at all. Your chances of being prosecuted for a tax crime are about the same as for being murdered on the street, 17 in a million. Fewer than 4 of every 10,000 nonfilers ever get caught. Not filing is known as noncompliance, small beer to the IRS. "We eat $200 billion a year in unpaid taxes," says Representative Bill Archer, chairman of the House Ways and Means Committee, which oversees the IRS. "All of that is fraud." The IRS's computer problems, he says, "open the door to more and more fraud."

Open the floodgates, he should say. While you've been fussing over itemization, less solid citizens have been pillaging the IRS, having discovered that the agency can't catch them. The foundation of fraud detection is what professionals call "information matching"--reconciling all the information supplied by the taxpayer (including Social Security numbers) with the information on W-2s and 1099 (miscellaneous income) forms, not to mention investment income and bank transactions. The antiquated IRS computer system is apparently unable to do this in a timely way, or sometimes to do it at all. Fraud happens between those stovepipes. "The IRS does not have a modern customer-service capability," says Jeff Trinca, staff director of the National Commission on Restructuring the IRS, "the sort of thing Visa and American Express do every day."

Frazier Todd Jr., a flimflam man from Atlanta, sussed out the IRS's inability to detect fraud. Todd obtained Social Security numbers from dozens of Atlanta women who lived in public housing projects. He then secured employer IDs from the IRS (making him look as if he were hiring them) and transcribed both numbers onto W-2 forms that he used to prepare electronic returns. Todd filled in an income for these women and a figure for taxes withheld that was high enough to kick back a generous refund. Todd then took the returns to banks to obtain "refund anticipation" loans, which came through within 48 hours. Todd's take was an estimated $511,000 over two years (tax free, of course) before an informant tipped off the IRS. He was sentenced to 30 months in jail.

Richard M. Hersch of Florida and Pennsylvania owned a tax-preparation company called Quik Tax Dollars that he turned into Quik cash. In 1991 he filed 145 false returns, using W-2 forms, fictitious names and phony Social Security numbers to get refunds for the phantom taxpayers. He too received refund anticipation loans. When the IRS began to improve its control on Social Security numbers, Hersch started using real numbers to perpetrate the same scam. All told, he filed 431 false electronic returns claiming refunds of $1,131,241. He was nabbed after the IRS raided his office in 1993, and is serving five years in a federal prison. No one knows how many folks pulled off this ruse, but it is safe to say that most were never caught.

Another sublimely uncomplicated scam involved the earned-income tax credit (EITC), which gives a tax credit to low-income families for each of their children. No complex accounting rigmarole here. Thousands simply gave birth to paper children on their tax forms and immediately got their "credit" in checks from the IRS. The cost: "a couple of billion," according to former IRS Commissioner Larry Gibbs. But that is almost certainly a lowball figure. According to the restructuring commission, at least a quarter of the more than $25 billion in refunds went to people who were simply ineligible, and an additional 35% to 40% went to folks who were entitled to less credit, if any. That amounts to more than $5 billion annually, and as they say in Washington, pretty soon you're talking about real money.

The IRS has hustled to catch up with these scams. It ended its arrangement with banks in the refund-loan program in early 1995. At the same time, it made an emergency installation of computer filters to screen electronic returns. "It amounted to the sort of front-end screen the credit-card industry does at the point of sale," says assistant IRS commissioner Ted Brown. With new filters, the IRS discovered 4.1 million "problems" with Social Security numbers--an increase of more than 3 million from the year before. In 1995, 1.8 million dependents suddenly disappeared from the system, and there were 2 million fewer EITC claims than the year before. According to the Government Accounting Office, even the IRS's cursory effort to validate Social Security numbers on paper returns resulted in more than $800 million in reduced refunds or additional taxes.

NEAR MELTDOWNS

That same year, the IRS held up 6 million returns that seemed fishy. "The problem for the IRS," says a staff member on the restructuring commission, "was that they did not have the ability to go after 6 million people, so the agency arbitrarily took 800,000 to a million cases and tried to deal with them." According to the GAO, the IRS released 2 million questionable refund checks that year, even though its computers had detected irregularities.

IRS managers went to Congress to beg, plead and cajole for money to rectify the problem. But their entreaties fell on deaf ears. Congress just isn't very sympathetic to the IRS's real and imagined plaints. But both sides saw eye to eye on one thing: the extent and nature of the swindles had to be secret. No one wanted to give Americans a primer on how to cheat on their taxes.

This year the IRS asserts that it has a more comprehensive fraud-detection system up and running for electronic filing. The agency will not say exactly what the new system does, though it is thought to be able to provide sophisticated "matching" across various computer networks.

Alas, the fraud detection works only with electronic returns, a mere 13% of those filed. There is evidence that some unscrupulous filers have shifted back to old-fashioned paper, which bypasses the sophisticated screening. The IRS recently reviewed some rejected electronic returns only to discover that the same taxpayers subsequently refiled on paper, using the same phony Social Security numbers, and duly got their refunds.

Back in the 1960s, at the same time that the Beatles were wailing about the Taxman ("If you drive a car, I'll tax the street/If you try to sit, I'll tax your seat"), the men at the IRS, in their IBM white shirts and skinny ties, were at the cutting edge of computer technology. The IRS had automated its processing system, eventually gathering everything into 10 service centers, with a computer nucleus in West Virginia. For the first time, taxpayers were required to write their Social Security number on their return. Computers, it seemed, could keep track of everything.

But by the early 1970s, in the mutating world of computerization, the IRS had fallen behind. Instead of making incremental changes, the IRS spent six years formulating an overarching plan called the Tax Administration System that would cost $649 million and be in operation by the early '80s. The IRS presented the plan to Congress shortly after the final agonies of Watergate (which featured a paranoid President who used the IRS to harass his enemies). Congress was spooked by the idea of a more centralized, all-knowing, all-seeing IRS, and said no thanks. The IRS was told simply to replace worn-out machines: nothing new and nothing fancy.

The IRS burrowed away on a new plan, known innocuously enough as the Service Center Replacement System, whose deadline for start-up was 1985. Instead 1985 was the year the great meltdown almost occurred. Because of computer bugs, a backlog of unprocessed returns (in Philadelphia more than 100 unopened envelopes containing returns were found in garbage cans) almost brought the entire system to a halt. "We came as close as you can to going out of business," says Gibbs, who took over as IRS Commissioner in 1986.

Members of Congress got nervous. The lifeblood of democracy--and of their fancy offices--had almost been cut off. So Congress promptly funded IRS computer modernization. Before, the IRS had had a plan and no money; now it had money and no plan. No matter. It initiated a flood of programs (a state-of-the-art computer was necessary just to keep track of all the acronyms--ACI, AES, ALSS, AUR, FAISR, ICS, IMS). But each system was designed independently to meet specific needs within the empire. All systems would be go by the year 2001, the agency blandly assured Congress. With all the requests and funding, the final price tag for what ultimately became known as the Tax Systems Modernization plan was around $8 billion.

Modernization turned out to be a digital Tower of Babel. Treasury Deputy Secretary Lawrence Summers, charged with looking after the IRS, says, "I think modernization has gone way off track. They tried to build the Taj Mahal." Senator Bob Kerrey, co-chairman of the restructuring commission, describes tax modernization as a failure. Says Kerrey: "While the world has moved into the wireless age with home banking, atms on every corner and stock investing over the Internet, IRS technology has remained stagnant."

This year when your conventional returns go to a regional service center, tens of thousands of people, many seasonal hires at $7 an hour, will process them in much the same way as when the first Star Wars movie came out. The workers will handle the 200 million taxpayer envelopes, opening and sorting the returns into categories, coding and editing them and then laboriously tapping much of the data into an out-of-date keypunch system.

TECHNO DREAMS

The alphabet-soup modernization programs make up a scrap heap of failed technology. Herewith the IRS's roll of glitches:

--SCRIPS. The Service Center Recognition/Image Processing System was meant to enable the IRS to "read" tax forms. The original cost was pegged at $133 million, later rising to $288 million. The IRS initially predicted it would save $17 billion in labor costs, but by last year the agency said scrips would in fact eat more money than it saved. Cost to taxpayers to date: $209 million.

--DPS. Like SCRIPS, the Document Processing System was meant to create "optical images" from paper returns, converting them to a readable format for the agency's computers. A number of states have such a system, yet the GAO's Rona Stillman declared DPS "a complete fiasco." The $1.3 billion project was scrapped. Cost to taxpayers: $284 million.

--CAPS. The Corporate Accounts Processing System was meant to create a single integrated database of taxpayer account information. The idea was to resolve corporate issues immediately via access to the CAPS database. The system was axed. Cost to taxpayers: $179 million.

--ICP. The Integrated Case Processing system was supposed to permit customer-service representatives to access in one step all the data needed to answer taxpayer questions or resolve problems. It failed. Cost to taxpayers: $44.8 million.

--Cyberfile. This program was meant to allow taxpayers to file returns through their home computers. It fizzled. Cost to taxpayers: $17 million.

In all, according to Gross, 12 major IRS modernization programs have been either canceled or put on hold. Not all the money was wasted. A billion dollars went to upgrade aging systems and improve customer service. But the gao is not sure about the rest. The problem, it says, is that the IRS keeps such lousy books the agency can't actually account for it. "They can't come anywhere near demonstrating how they spent this money," says Stillman. The gao claims that if the IRS were a business, its accountants would not be able to sign off on its financial statements.

The IRS has a monster future problem to deal with: the double goose-egg, better known as the millennium dilemma. IRS computers, like those of most businesses, use only two digits to denote the year, so when the clock strikes midnight on Dec. 31, 1999, the computers will assume it's 1900. Without a fix, thousands of Americans could get bills dunning them for decades of delinquency--or undeserved refunds of considerable proportions. Because of the threat of a great crash at the turn of the century, says IRS Commissioner Margaret Richardson, the agency is deferring "all but critical and legislatively mandated legacy systems changes during fiscal year 1997." More delay.

The situation on Constitution Avenue is not altogether bleak. That the IRS is publicly acknowledging problems is a sign that it is on the road to remedying them. The agency is not entirely in the digital Dark Ages. It has a nifty Website www.irs.ustreas.gov) which is taking a million queries daily. Although it is still hit-and-miss to get through to a real live person on the phone, taxpayers who do speak to an IRS employee now have a 94% chance of getting the right answer, compared with 63% in 1989, according to the GAO. Last year the agency's Teletax recorded information line took 45 million toll-free calls.

The 1997 filing season, according to the IRS and independent observers, is going swimmingly. The agency says it has "seen significant increases...in electronic filing and telephone accessibility." By March 21 this year, 15.9 million electronic returns had been filed, 3 million more than at the same time last year. Testifying in late March at a Ways and Means Committee hearing, Beanna Whitlock, representing the National Association of Enrolled Agents, said, "This is not the old IRS. In many respects, it's now doing a good job."

So is it necessary to destroy the IRS in order to save it? Not quite. Remember, the IRS already collects what it estimates is 86% of the tax pie; to get to 90% should not be impossible and would mean an extra $65 billion or so. Gross's game plan--making incremental reforms and remedying the stovepipe problem while improving customer service and electronic filing--is a sensible start. The IRS should also consider the following:

--Get Thee a Manager. The agency has had four commissioners in the past four years, all of them green-eyeshade tax specialists. The job requires continuity and independence. The IRS ought to have an uber-manager with the stature of the head of the Federal Reserve.

--Oh, for Multiyear Funding. The IRS needs at least a two-year budgeting cycle. "Congress is mischievous when it appropriates funds and then cuts them," says Mitchell Adams, Massachusetts revenue commissioner. "You can't budget and plan that way."

--Outsource What You Can. Although the IRS has long resisted this on privacy grounds, there are tasks (like hassling people for money) that are not confidential and might be done better by commercial agencies. The IRS has realized this as well. According to Treasury's Summers, the agency is already contracting out 64% of modernization work in 1997, compared with 40% in 1995.

--Be at the Table. Congress proposes, the IRS disposes. Tax legislation is drafted without reference to the consequences for the IRS. Let the exigencies of tax collection guide the framing of tax legislation.

--Weed Out the Bureaucracy. Top managers have overseen the failure of modernization. They've had their chance. The quality of agents is declining. Morale is low. Broaden the merit pay system: the fact that managers have it but not those in the field creates an unhealthy rivalry.

This is a nation founded on a tax revolt. No one wants a meddlesome Big Brother tax system that can find your odd sock for you, but it ought to be as capable as American Express or Citicorp. Chiseled above the entrance of the IRS building in Washington is an Oliver Wendell Holmes axiom: "Taxes are what we pay for civilized society." Americans also pay for the agency that collects those taxes, and they have a right to expect not perfection but efficiency.

--Reported by Bruce van Voorst/Washington, Sam Allis/Boston and S.C. Gwynne/Austin

With reporting by BRUCE VAN VOORST/WASHINGTON, SAM ALLIS/ BOSTON AND S.C. GWYNNE/AUSTIN