How the tax preparation industry killed free e-filing

The private capture and monetization of a public service

Tax Day is upon is. Even if you agree with Oliver Wendall Holmes Jr. that taxes are the price we pay for a civilized society, its ok feel frustrated with the hassles involved in paying those taxes. It’s more expensive and onerous than it should be. And that is partly by design.

This is the story of the creation and decline of Free File, a promise to make the process easier by making free e-filing of taxes widely available. Instead, Free File became emblematic of private capture of a public-private partnership, leaving the public paying for a service monetized by the tax preparation industry. Only about 3.6% of the roughly 110 million Americans eligible for Free File actually use it.

The first site you reach if you google “free file” is Intuit’s TurboTax, which is no longer part of the Free File program. It is one of many techniques used to divert the public away from the actual free option. The FTC is now suing Intuit to stop such deceptive practices.

How burdensome is paying your taxes? According to the Office of Information and Regulatory Affairs, Americans spent 6 billion hours on tax compliance in 2020, the equivalent of about $220 billion worth of our time. The IRS itself estimates that, on average, it would take individual taxpayers 9 hours and cost $160 to file their taxes.

Since paying taxes is something the government imposes on the public it has, surely, some obligation to reduce the pain of paying. And every tax season we hear numerous such proposals about how it might do so, which never seem to go anywhere.

Free File is one such missed opportunity. In 2001 the Bush administration was ready to push free electronic tax filing for all. Over the next two decades, this innovation to make paying taxes a little easier was strangled by the private tax preparation industry under the guise of a public-private partnership.

A longer version of this article, written to serve as a classroom case study can be found on the Better Government Lab website at the McCourt School of Public Policy. The case study is free to download and use, and includes sourcing for this article.

A Missed Moment: Killing the Public Option

After a wave of critical reports about overzealous IRS agents, President Clinton signed into law the Restructuring and Reform Act (RRA) of 1998. This legislation expanded taxpayer protections but also set a target of making 80% of all tax returns electronic by 2007. Further, the law required the IRS to “cooperate with and encourage” the private sector in promoting electronic filing, a provision included at the behest of Intuit. At around the same time, Intuit began offering free tax preparation for those who made under $20,000, reportedly as a way to stave off potential government encroachment into its tax filing service.

President Bush would also promote digital government. His 2001 The President’s Management Agenda promoted “Expanded Electronic Government” to “champion citizen-centered electronic government that will result in a major improvement in the federal government’s value to the citizen.” In response, the Office of Management and Budget (OMB) created a task force, known as “Quicksilver,” with the goal of choosing a set of e-government initiatives to fund in line with President Bush’s goal. One of the programs chosen was the EZ Tax Filing Initiative, which proposed that the IRS create its own free, automated tax filing software and promote e-filing in line with RRA’s goal. According to Mark Forman, who at the time was leading the Quicksilver task force as the OMB Associate Director for IT and E-Government, this proposal “was seen as a low-cost, high-payoff initiative.”

In 2001 the federal government seemed poised to encourage e-filing by having the IRS directly deliver this program to the public. However, problems soon emerged. In December, a group of eight Republican House Representatives wrote a letter to the head of OMB arguing the EZ Tax Filing Initiative violated OMB’s Circular A-76. A-76 is decades-old directive that encourages agencies to rely on the private sector for commercial services. The Bush administration itself enthusiastically used A-76 to encourage contracting out of public services.

What is a public service?

Was tax filing a commercial operation? The Republican House members stated that “income tax preparation software and interactive online preparation is well-established non-governmental commercial activity” and that they found “no compelling reason for the federal government to compete in this field.” The group was led by Representative Randy “Duke” Cunningham (R-CA), whose district was home to Intuit’s headquarters. (Cunningham would resign from the House in 2005 and end up in jail for accepting millions in bribes and tax evasion. He was pardoned by President Trump).

On the other hand, the collection of taxes is an inherently public function, one which private tax preparation services depend on. OMB documents outlined the value to the public of free e-filing software: “Citizens will no longer have to pay for basic, automated tax preparation. Refund checks will be delivered sooner, online security will be increased and customer service will be improved.”

Facing political pressure, the IRS backed off. IRS leadership doubted that Congress would provided the resources needed resources required to pull off free e-filing. Such worries were not unfounded. Even as the US population grew, and even as the IRS would be asked to undertake new tasks, the number of IRS employees declined sharply.

A Public-Private Partnership

In January 2002, Treasury Secretary Paul O’Neill formally asked Charles Rossotti to establish a partnership between the IRS and private tax preparation companies to develop a system for helping low-income taxpayers file for free. In response, Intuit, H&R Block, and a set of much smaller tax preparation companies formed a coalition called the Free File Alliance and began to negotiate with the IRS.

After months of negotiations, the IRS and the Free File Alliance signed a “memorandum of understanding” (MOU) on October 30, 2002, establishing the Free File program. The MOU held that, in exchange for the Free File Alliance offering free federal tax services that would cover at least 60% of American taxpayers, the IRS would “not compete with the Consortium in providing free, on-line tax return preparation and filing services to taxpayers.” While Free File would never come close to the 60% target, the IRS kept its pledge not to develop their own product.

In 2005 multiple members of the Free File Alliance allowed all taxpayers to use Free File, following the lead of one member, TaxACT. The CEO of TaxACT saw a marketing value in simplicity: “Why not just make the offer that’s simpler to understand, free for everyone?” Over 5 million people used Free File that year, a high point for the program. By 2017, it had just 2.5 million users.

The “free for all” model was not the preferred route of Intuit, who complained to Congress that Free File had “become a ‘universal-free’ program, operating off a national marketing and sales platform hosted by the IRS.” While this sort of access was very much the original vision of free e-filing, Intuit saw this as an outcome to be fought at all costs.

So the IRS responded wrote a new MOU that made access to Free File means-tested, available only to the lowest 70% of earners. Crucially, this closed off the possibility of a simple “free for everyone” outreach campaign. As a result, members of the Free File Alliance could now impose restrictions that made using Free File more onerous.

Monetizing a Public Brand: From Free File to “Free-to-Fee”

What the early success that Free File showed was that “free” was a powerful marketing tool. People liked free. It could draw users to a specific provider who might ultimately charge for their service. The MOU with the IRS did nothing to stop vendors from marketing their own “free” services but with greater control of user experience. In effect, while Intuit focused on IRS “encroachment,” it and other members of the Free File Alliance had cannibalized the idea of free electronic tax returns.

Users who googled “IRS free file taxes” would find ads offering free services from Free File Alliance members. But the top hits would offer the vendor’s own “free” version, rather than the one offered via the IRS web page. This was no accident, but instead was the result of hundreds of millions of dollars in advertising, which overwhelmed any attempts by the IRS to promote Free File on its website. Intuit and H&R Block’s Free File pages also included code that made them harder to find in web searches. The result was to exploit people’s interest in free filing, while making it hard for them to actually find Free File.

Why would users put up with this? Many were confused. Intuit also created an array of products with highly similar names in order to confuse customers into inadvertently picking paid options. Finding the actual free product that private vendors had agreed to provide became akin to finding a needle in a haystack.

Sunk costs also played a role. Intuit designed its free-to-fee options such that paywalls would not appear until the return was mostly completed, leading many to simply pay the fee rather than find another product.

Underinvestment and Decline

As members of the Free File program were investing in making their free-to-fee products more accessible, the relative quality of the actual Free File offering looked worse.

Internal IRS data showed many users giving up when trying to find and use the product. Most of the software options had age restrictions, meaning older users had limited options. There were not Free File options for English as a second language. Users frequently experienced errors. Saving the form was complex.

But such concerns were not discussed publicly, and the decline in users was not seen as a source of concern among IRS leadership. The IRS stopped spending money on outreach for Free File after 2014 in order to “be more efficient.” It also halted producing customer surveys, despite only half of users returning from previous years, again citing budget constraints. Thus, as members of the Free File Alliance innovated and aggressively marketed their “free” offerings, the actual Free File products remained stagnant.

The Collapse of Free File

Intuit and other members of Free File Alliance had poured millions into lobbying to make Free File permanent, but efforts fell short in 2008, 2013, and 2017. In 2019, the Taxpayer First Act seemed set to deliver their long-pursued goal. Couched within a broader tax bill was language from the Free File Permanence Act of 2017 that would have mandated the IRS’s continued participation in the Free File program. The bill enjoyed bipartisan support and was expected to easily pass the House and Senate.

On April 9th, the day the Taxpayer First bill was scheduled to be voted on in the House, the investigative news outlet ProPublica published a story titled “Congress Is About to Ban the Government from Offering Free Online Tax Filing. Thank TurboTax.” The story highlighted not just the effect of tying the hands of the IRS from providing its own tax filing software, it also centered on the lobbying efforts by members of the Free File Alliance.

This is a rare Capraesque moment where muckraking journalism had a real effect. As ProPublica published a stream of more stories, support for making the Free File permanent eroded. Lawmakers started to look more closely at the relationship between IRS and the tax return industry.

At a moment when IRS was portrayed as being asleep at the wheel in maintaining control over the relationship with the tax preparation industry, they did little to dispel this image. They outsourced their review of the process to a long-time contractor, MITRE, which confirmed many of the specific problems identified by ProPublica reporting, but seemed remarkably anguine about it. Such failings were treated as a natural outcome of a public-private partnership: “(T)he Free File program operates as a public-private partnership and, as such, program oversight is a mutual, collaborative effort with the industry, represented by the Free File Alliance. While there is room for improvement, based on assessment findings, MITRE considers the IRS’s current compliance processes adequate and effective to support the integrity of the program.”

Later reports would be more critical of Free File, and the IRS. A February 2020 report from the Treasury Inspector General for Tax Administration estimated that more than 14 million taxpayers eligible for Free File may have paid a fee to e-file in 2019. It was also blunter in its criticism of the IRS: “The IRS does not provide adequate oversight to ensure that the Free File Program is operating as intended and in alignment with the MOU.” A bipartisan June 2020 Senate Investigation came to similar conclusion: “Until recently, the IRS conducted little oversight of the Free File program.”

The IRS had once feared pushing too aggressively against the lobbying power of the tax preparation industry. It was now blamed for being too lax in its oversight.

In response to these criticisms, a revised MOU was unveiled in December 2019. Free File members were forbidden from engaging in techniques to hide their Free File offerings and were required to standardize how such products were presented to minimize confusion. The new MOU also dropped the provision that prevents the IRS from competing with private services.

Both H&R Block and Intuit have since exited the partnership.

Goal Alignment Matters

If the purpose of Free File was to push electronic filing, it might be judged a success. More than 90% of taxpayers filed electronically in the 2020 tax season. If the goal was to provide free access to e-filing, the program’s record looks less positive. While about 110 million people, or 70% of taxpayers are eligible for free filing, only about four million taxpayers used Free File in 2020. Intuit and H&R Block remain the primary beneficiaries, dominating the tax preparation services market.

The logic of public-private partnerships is that governments can’t do everything, and should take advantage of private sector expertise in certain domains. This sounds appealing, especially in cases where government has limited resources, and the private actor can offer a solution for free. (See also: the criminal justice system). But ultimately, it’s not free. The cost of the Free File Partnership was paid for by the public, who handed over billions for a service that they could have gotten for free if the original vision of Free File was implemented.

Instead, Free File became a classic example of rent-seeking. Only the first part of the stated goals of Free File — to expand e-filing and free filing — were of interest to the private actors. With such goal misalignment, the partnership was destined to fail unless the public partner held the private partner to high standards. Instead, the private tail wagged the public dog. The private partners took control over a public process, and used their expertise and lobbying power to prevent the public sector both from providing a public option, or enforcing terribly high expectations of the partnership.

Never Too Late to Invest in Public Sector Competence

It is unclear what will happen next for Free File and the promise of free electronic tax filing. Ironically, use of the Free File program began rising after the 2017 tax season. The scrutiny of the program may have helped users to understand how to access Free File, and show that there is a market even for a poorly-designed and under-advertised public tax filing service. Imagine the potential for a well-designed free option that was aggressively promoted by the federal government, and was seen as reliable enough that non-profit tax prep services could rely on.

To be a competent agency, the IRS needs resources. President Biden has proposed large increases in spending. Republicans oppose this. For example, Senator Rick Scott’s “Rescue America” plan calls for cutting IRS budget and number of employees in half.

As Matt Yglesias points out, defunding the tax police means massive tax evasion, concentrated among the very wealthy, while the IRS fruitlessly directs its limited audit capacity to low-income earners on food stamps. Properly funding the IRS would not just raise more money than it would cost, it would reduce criminality and inequality of treatment. And it would make the IRS functional again, able to provide good service to the regular taxpayer, and invest in new innovations that would reduce the burdens it places upon the public.

Expect Intuit and others to oppose upgrades in the quality of the IRS. It is a “a conflict of interest with added burden at tax time on taxpayers” for IRS to get involved in helping people to file tax returns according to an Intuit spokesperson. Given how Intuit extracted rents from a very large conflict of interest in their public-private partnership by burdening taxpayers, this is an extraordinarily hypocritical stance. As I discuss in my book with Pam Herd on administrative burden, Intuit has an aggressive track record in blocking tax agencies from improving their services, by, for example, pre-filling tax forms. It’s a classic example of a rent seeker using resources they made from a public function to make that public function worse.

In other words, we have the knowledge to make paying taxes easier, but we don’t exploit this capability because the middlemen we pay use some of that money to bribe the political system to undermine the public service.

A Missed Opportunity

What haunts me about this case is that it offers a glimpse of an alternative history of digital governance and public administration. The US government saw the potential of e-filing at the same time as the private sector. It could have committed to a high-quality digital product. It didn’t. This was a deliberate choice, one driven by ideological mindset that ran across government. For example, Newt Gingrich killed the Congressional Office of Technology Assessment in 1995 because he believed technology was a private function the government should stay out of. This is not a policy judgement that, to put it kindly, looks terribly wise in retrospect. Just this year, the House finally set up its own Digital Services team.

Early investments in digital expertise would have paid dividends in other parts of government. We had to wait until the disastrous rollout of the Obamacare website for the US federal government to seriously invest in such capacity with the creation of the US Digital Service in 2014. Thats a lost couple of decades of innovation for the US federal government. Time to catch up.

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